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Demystifying Venture Capital Economics - Wealthfront Knowledge Center

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Demystifying Venture
Capital Economics, Part 1




June 19, 2014

Andy Rachleff


he other day my co-founder, Dan Carroll, asked me
a number of questions about Venture Capital returns because he was stunned by the
valuations of some recently announced deals. After I answered the question, Dan and

Let Wealthfront
for you.
a few colleagues
who were within
me to share
my perspective on
the subject because it is so poorly INVEST
Much has been written about the financial performance of the companies backed by



Demystifying Venture Capital Economics - Wealthfront Knowledge Center

venture capitalists, but very little has been written about the economics of the venture
capital industry itself. With this post we open the kimono on who funds VCs, what
returns they expect and how the best VCs consistently succeed in outperforming those

Who Funds VCs?

The primary providers of funding to the venture capital industry are managers of large
pools of capital. These entities include pension funds, university endowments,
charitable foundations, and, to a much lesser extent, insurance companies, wealthy
families and corporations. Venture capital funds are raised in the form of a limited
partnership that typically has a mandated 10-year lifespan. VCs typically do not invest
in new companies beyond the third year of a partnerships life to insure their latest
investments have a chance to reach liquidation before the partnership legally ends.
That means they must raise new partnerships every three years if they dont want to
stop investing in new companies. Taking a hiatus from investing in new companies is
usually interpreted by the entrepreneurial community as no longer being in business,
which makes it hard to restart ones deal flow later. As a result there is a huge
incentive not to let that happen.

Why Do Institutions Fund VCs?

As we explained in our investment methodology white paper and many of our blog
posts about diversification, almost every sophisticated large asset pool manager uses
modern portfolio theory (the same methodology employed by Wealthfront) to
determine its base asset allocation. Because of their size, pensions, endowments and
charitable foundations have access to a broader set of asset classes, including hedge
funds, private equity (of which VC is a component) and private investments in energy
and real estate, than most individuals. Most large asset pool managers would like a 5
10% allocation to venture capital because of its past returns and anti-correlation with
other asset classes. Unfortunately they can seldom reach their desired allocation
because there arent enough VC firms that generate returns that justify the risk. Thats
because the top 20 firms (out of approximately 1,000 total VC firms) generate
approximately 95% of the industrys returns.



Demystifying Venture Capital Economics - Wealthfront Knowledge Center

These 20 firms dont change much over time and are so oversubscribed that they are
very hard for new limited partners to access. The premier endowments are considered
the most desirable limited partners by venture capitalists because they are the most
committed to the asset class. Even these endowments, though, have a hard time
getting into funds if they werent there in the beginning. Occasionally new firms like
Benchmark and Andreessen Horowitz emerge and break into the top tier, but they are
the exception rather than the rule.

What Returns Are Expected of VCs?

As we have also explained, with greater risk comes an expectation of greater return.
Venture capital has the greatest risk of all the asset classes in which institutions invest,
so it must have the highest expected return. I have heard institutions express their
required return from venture capital necessary to compensate them for taking the
additional risk (i.e. the risk premium) in two ways:
The S&P 500 return plus 500 basis points (5%) or
The S&P 500 return times 1.5
These expectations were created when the S&P 500 was expected to return on the
order of 12% annually. These days the expectations baked into market options would
lead you to believe the investment public expects the S&P 500 to return on the order



Demystifying Venture Capital Economics - Wealthfront Knowledge Center

of 6 7% annually. Im not sure what that means for the current appropriate return
expectation, but its still probably at least in the mid teens.

How Does a VC Generate These Returns?

According to research by William Sahlman at Harvard Business School, 80% of a
typical venture capital funds returns are generated by 20% of its investments. The
20% needs to have some very big wins if its going to more than cover the large
percentage of investments that either go out of business or are sold for a small
amount. The only way to have a chance at those big wins is to have a very high hurdle
for each prospective investment. Traditionally, the industry rule of thumb has been to
look for deals that have the chance to return 10x your money in five years. That works
out to an IRR of 58%. Please see the table below to see how returns are affected by
time and multiple.

IRR Analysis: Years Invested vs. Return Multiple

Source: J. Skyler Fernandes,

If 20% of a fund is invested in deals that return 10x in five years and everything else
results in no value then the fund would have an annual return of approximately 15%.
Few firms are able to generate those returns.

Buyer Beware
Over the past 10 years, venture capital in general has been a lousy place to invest.
According to Cambridge Associates the average annual venture capital return over the
past 10 years has only been 8.1% as compared to 5.7% for the S&P 500. That clearly
does not compensate the limited partner for taking the increased risk associated with



Demystifying Venture Capital Economics - Wealthfront Knowledge Center

venture capital. However the top quartile (25%) generated an annual rate of return of
22.9%. The top 20 firms have done even better.

You Need To Be Non-Consensus

The only way to generate superior returns in venture capital is to take risk. This
reminds me of a framework popularized by my investment idol, Howard Marks of
Oaktree Capital. He says the investment business can be described with a two-by-two
matrix. On one dimension you can either be right or wrong. On the other you can be
consensus or non-consensus. Obviously you dont make money if you are wrong, but
most people dont realize you dont make money if you are right and consensus
because the opportunity is too obvious and all the returns get arbitraged away. The
only way to generate outstanding returns is to be right and non-consensus. Thats
hard to do because you only know youre non-consensus when you make the
investment. You dont know if youre right.

Being willing to intelligently take this leap of faith is one of the main differences
between the venture firms who consistently generate high returns and everyone
else. Unfortunately human nature is not comfortable taking risk; so most venture
capital firms want high returns without risk, which doesnt exist. As a result they often
sit on the sideline while other people make the big money from things that most
people initially think are crazy. The vast majority of my colleagues in the venture



Demystifying Venture Capital Economics - Wealthfront Knowledge Center

capital business thought we were crazy at Benchmark to have backed eBay. Beenie
babiesreally? How can that be a business? The same was said about Google. Who
needs another search engine. The last six failed. The leader in a technology market is
usually worth more than all the other players in its space combined, so it is not worth
backing anyone other than the leader if you want to generate outsized returns.

Needle In a Haystack?
According to some research I did back in the late 90s, there are only approximately
15, plus or minus 3, technology companies started nationwide each year that reach at
least $100 million in revenue at some point in their independent corporate life. These
companies tend to grow to be much larger than $100 million in revenue and usually
generate return multiples in excess of 40x. Almost every single one of them would
have sounded stupid to you when they started. They dont today. Investing in just one
of these companies each year would lead to a fund with an annual rate of return in
excess of 100%.
Speaking of outsized returns, these days the breadth of the Internet has made it
possible to generate returns that were never before imagined. Companies like Airbnb,
Dropbox, eBay, Google, Facebook, Twitter and Uber return more than 1,000 times the
VCs investment. That leads to amazing fund returns.

Never Join a Club That Would Have You As a Member

Investors who have access to the best firms love venture capital. Those that dont,
hate it, but for some stupid reason continue to set aside an allocation because they
think it looks more diversified.
When it comes to investing in venture capital I would follow the old Groucho Marx
dictum about never joining a club that would have you as a member. Beware private
wealth managers who offer you access to venture capital fund of funds. I can assure
you, as a past partner of a premier venture capital fund that no firm in the top 20
would allow a brokerage firm fund of funds to invest in their fund.

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Tags: Andy Rachleff, returns, Silicon Valley, VC, venture capital, venture capital

About Andy Rachleff

Andy is Wealthfront's co-founder and its first CEO. He is now serving as Chairman of Wealthfront's
board and company Ambassador. A co-founder and former General Partner of venture capital firm
Benchmark Capital, Andy is on the faculty of the Stanford Graduate School of Business, where he
teaches a variety of courses on technology entrepreneurship. He also serves on the Board of
Trustees of the University of Pennsylvania and is the Vice Chairman of their endowment
investment committee. Andy earned his BS from the University of Pennsylvania and his M.B.A.
from Stanford Graduate School of Business.
View all posts by Andy Rachleff

7 Responses to Demystifying Venture Capital Economics, Part 1

1. Rohit Divate June 20, 2014 at 11:51 am #
Great read Andy! Thanks for breaking down VC returns so clearly.



Demystifying Venture Capital Economics - Wealthfront Knowledge Center


2. Laurel Weiner June 29, 2014 at 4:49 am #

Dear Andy,
What a truly fine piece you have published. I will be sending this out to everyone I know who
were not sure about the expected returns or were previously confused about the gains
across the table. I look forward to any and all future publications your clarity and
conciseness are refreshing!

3. Ryan June 30, 2014 at 8:44 am #

Curious- could you share the details of the 2% of VC firms that generated 95% of the returns?
Would be interested to see who those firms are, and a further breakdown of the distribution
of returns. Also, given that most of the other 98% lose money, do they die and are
reincarnated in other forms/names/configurations to attract fresh capital after posting a
dismal track record?

Andy Rachleff June 30, 2014 at 9:05 am #

I would rather not list names as the partners of the firms I dont list will get mad at me
for leaving them out. I think you can do a pretty good job of figuring out who they are.
Unfortunately the remaining 98% seldom die. Even with the bursting of the bubble,
fewer than 50% of the remaining firms were not able to raise new funds. My
understanding is that institutions hire consultants who tell them that they need a
minimal allocation to venture capital and they fill it despite the knowledge that the
only firms to which they can get access are likely to significantly underperform. You
have to keep in mind that for other asset classes manager selection is not that
important so the same philosophy is inappropriately applied to venture capital where
manager selection is paramount. I know that sounds crazy, but it has been going on
for almost 30 years.

4. Richard Dulude July 2, 2014 at 6:18 am #

Excellent article. Sharp and without a word of excess to deliver the all the right tidbits.
Thanks for posting.

5. Shishir Vadhavkar August 22, 2014 at 1:14 pm #

Great read Andy. And I completely agree on your view about FoF. It continues to amaze me
as to why that investment still exists and more so why do investors continue to put money



Demystifying Venture Capital Economics - Wealthfront Knowledge Center

into it. On the other hand, while I agree that it is only a few VCs that end up making the
oversized returns that makes this asset class so attractive, I thought it was a little simplistic
to state that it is the same 20 odd VCs that continue to make the right calls every year.
Given the uncertainty surrounding many of the ideas that the VCs back, it must be really
difficult to consistently back the right blue-sky ideas year after year. I am sure there is some
amount of churn in who the top performing firms are every year.

Andy Rachleff August 22, 2014 at 4:10 pm #

Actually the data clearly shows that there is incredible persistence among the top 20 if
you look at five year cohorts.

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