Venture Capital Math and the Challenges of Small Markets

I’ve talked before about the dynamics surrounding venture capital funds. You can read that post here, but I’ll run through a high-level refresher.

  • Private investors commit money to venture capital funds hoping to get a large return on their investment
  • Venture capitalists take the money in the fund and go out looking for promising startups to invest in
  • When a startup is successful, the value of its equity rises
  • After a number of years—usually between five and ten—the venture capitalists and private investors exit the investment (i.e. somehow sell their equity stake in the company) and realize a return
  • Most startups fail

That last point is obviously what makes the job difficult. A recent Startup Genome Report—co-authored by Stanford and Berkeley researchers—found that 92% of the 3,200 high-growth web & mobile startups analyzed failed within three years of inception. It’s an intimidating statistic, but it’s also what makes the math behind venture capital funds so interesting.

Costs of doing business

Imagine that you are a venture capitalist; take a moment to consider the costs of investing in a single startup. Networking, website maintenance, newsletters, blogs, emails, flights, wining and dining, lawyers, due diligence, and negotiations finally result in a $100,000 investment in a promising young company. You’ve spent a lot of money, but you’re feeling confident. You’re certain that the company will be very valuable five years from now.

Two weeks later, one of the founders forgets that he is lactose intolerant and eats an entire three-pound wheel of uncured goat cheese in one sitting. He is hospitalized indefinitely, and the startup is forced to search for a replacement. That hastily hired replacement doesn’t mesh with the rest of the team, and the company begins to spiral out of control. Negative customer reviews, product malfunctions, and reports of employee discontent pile up faster than you believed possible. After a few months, the flaming wreckage of the company is pronounced dead and the startup officially closes its doors.

Your equity stake in the company is now worth a whopping zero dollars. You don’t have anything to show for all of the expenses that you incurred during the investment process. And this is just one investment—remember, the vast majority of startups fail.

How the heck are you supposed to make any money?

Venture capitalists don’t have any type of regular cash flow. A portion of the funds that they raise from private investors is allocated to cover costs like travel and legal fees, but that necessarily means less money for investing in startups. The more money that is allocated to expenses the harder it is to recoup the original investment, return a profit to private investors, and still have money left over for the venture firm.

In other words, in order to make any money as a venture capitalist you have to achieve incredibly high returns on your investments. This seems like a tall order given that most of the things you’ll wind up investing in are bottomless, money-devouring pits.

Home runs

The truly significant returns of the best venture capitalists are generated by only a few, wildly successful startups. The rest of the companies in their venture portfolio—even the ones that don’t fail—are essentially meaningless. Even if a startup is moderately successful, it may not achieve returns sufficient to cover costs and provide some level of economic profit.

Let’s consider an extreme example in order to illustrate this point. Y Combinator is a famous startup accelerator headquartered in Mountain View, California. It takes batches of founders and helps them grow their companies, investing $120,000 in each startup in exchange for a 7% equity stake. Some of these companies fail (far less than the average due to the help they receive at Y Combinator), some of them are moderately successful, a few manage to generate meaningful returns for the accelerator, and a very small portion of these companies are home runs. One of Y Combinator’s home runs is Airbnb.

Airbnb is a peer-to-peer online marketplace enabling people to rent their residential properties, with the property owner setting the cost on a nightly basis. After making its way through numerous successful rounds of fundraising, Airbnb has grown from its initial Y Combinator valuation of $1.7 million to a valuation of  roughly $30 billion. Even accounting for dilution during later rounds, this investment has yielded returns upwards of 10,000x for Y Combinator.

This is certainly an outlier, but that’s exactly the point: though most startups fail, there are a few that produce almost unimaginable returns for investors. This means that startup investing is about finding those home runs, and accepting that the majority of investments are just part of the cost of doing business.

What does this mean for small market venture capitalists?

This phenomenon—that a small percentage of your investments make up the majority of your returns—has major implications for small market venture capitalists. By “small market venture capitalist” I mean a VC that is operating outside of a large startup hub such as San Francisco, New York, or Boston. Obviously this is a sliding scale, not a clear delineation. However, there are certainly cities that we can point to and confidently say that they are “small market”. As you move down the scale away from large hubs, the challenges facing venture capitalists grow more pronounced.

These challenges arise because startup founders are incentivized to leave small markets and move to larger startup hubs. Hubs provide access to deeper talent pools, more funding, and (unfair though it may be) more credibility. All things considered, confident and ambitious founders will almost always choose to start their company in a startup hub or relocate to one soon after inception.

Hearing this isn’t surprising; most of us already associate startups with a short list of cities. But the extent of this phenomenon can still catch us off guard. Crunchbase—a website that provides market research on startups—developed a ranking system for companies in their database using factors like commercial success and amount of money raised. Eight of the top ten and twenty-one of the top twenty-five companies have a listed location in California. The four that aren’t in California are listed in China, Sweden, New York, and India.

Now, venture capitalists aren’t solely limited to investments inside their market; they can invest in startups from other areas. However, by choosing a location they are setting a focus, implying that they expect the majority of their investments to come from their chosen location. Investing in distant companies can be very expensive and ineffective.

We can see the significant challenge that small market venture capitalists face when we consider all of the points that we’ve made up until now:

  • Most startups fail, and venture capitalists can treat the majority of their investments as a cost of doing business
  • A few “home run” companies usually generate the majority of a venture fund’s returns
  • Startup founders—especially the most deliberate and driven—are pulled away from small markets and towards startup hubs

This implies that small market venture capitalists will have very limited exposure to home run startups, and will have a harder time tapping into the huge success that large market venture capitalists have enjoyed.

Jumper cables

This doesn’t mean that small market venture capitalists can’t survive. It means that the odds aren’t in their favor, and that they often have to work harder and be more adept than their large market counterparts.

This reinforces the importance of the points that I made in A Venture Capitalist’s Most Valuable Asset: great venture capitalists can help jumpstart startup ecosystems by aligning their interests with founders’ and providing real value-add services. This means working closely with founders without being overbearing, crafting terms that incentivize success rather than focusing too heavily on downside protection, and helping to attract talent and attention to the area. Momentum builds, and the work that venture capitalists and founders do to promote industry in an area will compound.

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