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Everything You’ve Ever Wanted

To Know About VC Returns (But
Were Afraid to Ask)
September 14, 2016 - By Jason D. Rowley

tl;dr: Talking about venture capital returns doesn’t have to be

complicated. Today, we’re working to understand the one number
that really matters, and why other measures of venture performance
are so hard to pin down.

Earlier this month, the Wall Street Journal published an article

(http://www.wsj.com/articles/andreessen-horowitzs-returns-trail-venture-
it l lit 1472722381)
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capital-elite-1472722381) suggesting that venture capital firm Andreessen
Horowitz’s returns lag behind the top funds in its industry, “[showing] that
Andreessen Horowitz hasn’t yet earned its reputation as an elite firm.” 

If there’s such a thing as fighting words in the VC business, that’s it. Hackles
raised by the report, VC Twitter was thick with the din of complaints (and a
bit of self-conscious defensiveness) in its wake. Here’s why.

The Challenge
Measuring the performance of just one fund can be surprisingly difficult
because venture capital is unique among asset classes.

It has the long periods of illiquidity of real estate without the predictable
financial model. It’s easy to understand how rent prices and occupancy rates
affect the financial performance of real estate assets. On the other side,
venture capital also possesses the volatility of a penny stock portfolio
without the luxury of real-time pricing and transparency of publicly traded
securities. As we’ll see, it’s difficult to determine the value of a venture capital
portfolio when its assets aren’t priced on an open market and there isn’t
even a real consensus on how to value the assets.

It’s no wonder, then, that journalists, entrepreneurs, academic researchers,

and even the investors themselves often make unforced errors when
discussing venture returns and venture performance.

Because valuations are always in a state of flux, it’s best to “unpack”

return on investment figures into their constituent parts, and ideally
report them separately. There are two buckets of venture returns that
are usually discussed:

Realized returns on invested capital, after management and carried

interest fees are taken out by the fund, ought to be the main focus of
any reporting because that’s what investors in VC funds actually care
about.
Unrealized returns, the theoretical value of the startup equity that
hasn’t been liquidated or distributed, are fun to report on because they
can be very big numbers. But as we’ll show, those valuations are, at best,

subject to a lot of variance and are, at worst, just a bunch of hot air.
(See: Theranos and Zenefits.)
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If you’re a little confused about what this means, don’t worry! We’ll dive into
the relevant terminology, discuss the challenge of calculating valuations (and
thus comparing venture fund performance), explain what exactly IRR is and
why it might be a bad performance indicator, and explore where and why
most reporting errors happen. 

Understanding The Terminology

Financial terminology can get confusing. But when broken down, most of it is
straightforward.

“Return on Investment” (ROI) and “Internal Rate of Return” (IRR) are the two
most common numbers you’ll come across in reports about venture capital
performance.

Return on Investment (ROI)

Sometimes, like in the case of the Wall Street Journal piece, ROI is reported
as a single number In reality, ROI has two distinct parts:

1. Realized Returns. Sometimes called “cash on cash returns,” this

number is basically the ratio of invested capital that has been paid back
to investors in the fund.
2. Unrealized Returns. The current value of the fund’s positions in
companies that haven’t yet been acquired or gone public.
Let’s explain these numbers by way of example.

Let’s imagine a fund that’s doing pretty well. The manager initially raised
$100 million in capital and has so far returned $65 million to her investors,
after fees, and has $335 million in unrealized gains. Although it’s tempting to
say that her fund has a 4x ROI (arrived at by summing the unrealized and
realized gains and dividing it by the initial fund commitment), it’s important
to distinguish between the two and account for fees.

Investors have received only 65% of their initial capital back, and even if she
realizes all $335 million in outstanding value, after the traditional 20% carried
interest fee (which can be higher or lower depending on the fund), she’ll be

returning roughly $270 million more. Once all is said and done, she’ll have
returned 3.35x ($270 million in newly realized gains + $65 million in extant
di t ib ti / $100 illi i i iti l
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distributions / $100 million in initial capital).

Fees might feel like a nitpicky distinction to make, but there is a big
difference between a 3.35x return and a 4x return when tens or hundreds of
millions of dollars are at stake.

Internal Rate of Return (IRR)

Let’s start by saying that IRR is kind of complicated and difficult to explain in
a simple way. A textbook definition is “the annualized effective compounded
return rate that can be earned on the invested capital; the investment’s yield”
(Lerner, Leamon, and Hardymon 2012). This probably doesn’t help much. (In
case you want a more substantive walkthrough of IRR, there’s a short and
mercifully math-free explanatory video (https://www.youtube.com/watch?
v=7w-UWuDi0fY) on Youtube that’s worth checking out. If you’re looking to
dive into more of the math behind the calculation by way of example, this
video (https://www.youtube.com/watch?v=OSDDrZZaV8E) might be more
your style.)

Basically, calculating the IRR is a kind of “hack” to help measure the rate at
which a given investment breaks even if its payouts come in relatively
unpredictable “clumps” over the course of its lifecycle.

This is important for venture capital because returns aren’t realized and
distributed in a tidy, periodic way like interest payments from a bank account
or treasury bond. They come in fits and starts because acquisitions and IPOs
can happen at any time. And as we’ll explain shortly, it’s difficult to predict
the size of these payouts. Furthermore, it’s highly unlikely that payouts will
be the same size.

IRR can be a tricky number to report on because the metric rewards quick
exits. An investor optimizing for IRR may seek exit opportunities for her
investments very soon after investing, potentially leaving a lot of money on
the table if the company took the time to grow. It’s entirely possible that a
fund can rank in the top tier by IRR and lag far behind its industry peers
when ranked by realized gains. Academics like Ludovic Phalippou
(http://www.sbs.ox.ac.uk/community/people/ludovic-phalippou) at Oxford

suggest (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1111796) that

there are other negative aspects to focusing on IRR and propose using net
t l (NPV l i db l )
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present value (NPV, explained below) as an alternative.

The Tricky Business of Calculating & Reporting On

Unrealized Returns
As if the alphabet soup of ROI, IRR, and other financial accounting initialisms
didn’t present enough of a challenge, there’s also the issue of valuing the
fund’s current portfolio.

There are two difficulties at hand here:

1. There are a lot of different ways to calculate the valuation of a given

portfolio company and the overall portfolio.
2. The way big venture performance data sets are constructed creates
ample opportunity for inconsistency.
In his rebuttal to the WSJ piece (https://a16z.com/2016/09/01/marks-
offmark/), a16z managing partner Scott Kupor cites three different methods
for marking valuations to market conditions:

Last Round Valuation/Waterfall. Valuation is derived by taking the

most recent private market valuation of a portfolio company and
multiplying it by the investor’s stake in the company at the end of the
round, after dilution. Example: an investor’s 20% stake in a company that
raised money at a $100 million valuation would be marked up to $20
million.
Comparable Company Analysis. Valuation is derived by comparing the
earnings of a private company to the price/earnings ratio of comparable
public companies or private companies—if there are sufficient data.
Option Pricing Model. Valuation is derived by treating startup equity
like a set of traditional call options. Price is determined using the Black-
Scholes model
(https://www.wikiwand.com/en/Black%E2%80%93Scholes_model). (This
is the method a16z uses, which Kupor explains in his rebuttal.)
But wait, there are even more ways to calculate valuations!

Venture Capital Method. The investor estimates the price at which the

company will be acquired or go public and then derives the price of

company equity as a function of risk and time it will take to reach that
exit event.
S d M th d Wh i
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Scorecard Method. Wherein a company’s valuation is derived by
comparing the target company to recently funded companies in the
same region. Its valuation is based on the median valuation of its peers
and will be higher or lower depending on how well (or poorly) the
target company compares across several different parameters. Example:
If the median pre-money valuation for mobile app companies in a certain
region is $10 million, and the target company is determined to be 15%
better than its industry peers, the investor says the target company is
worth $11.5 million. (Learn more… (http://blog.gust.com/valuations-101-
scorecard-valuation-methodology/))
Net Present Value Method. Valuation is derived by determining the
discounted value of a company’s future earnings minus the capital
outflows from the company. NPV is a close cousin of the Discounted
Cash Flow model. (Learn more… (http://www.investopedia.com/exam-
guide/cfa-level-1/alternative-investments/venture-capital-investment-
characteristics-npv-net-present-value.asp))
It’s easy to see from these six different examples how the valuation of VC
funds can get quite complicated very quickly. Each of these different
methods has its own strengths and weaknesses, which is why investors
sometimes use multiple valuation methods and then come up with a final
figure based on an average of each method’s result. There isn’t really a gold
standard for marking valuations to market conditions. Even the Institutional
Limited Partners Association (ILPA) (https://ilpa.org/), an organization
representing family offices, endowments, pension funds and other investors
in VC, doesn’t list a preferred methodology in its quarterly and annual
reporting best practices guide (https://ilpa.org/wp-
content/uploads/2016/09/ILPA-Best-Practices-Quarterly-Reporting-
Standards_Version-1.1.pdf).

This all presents a challenge to those compiling venture performance

information into a database and those who base their arguments and
analysis on this aggregated data. Most of these venture performance data
are gathered through surveys, including the dataset compiled by Cambridge
Associates that the Wall Street Journal reported on. Put simply, there’s going
to be some variance and uncertainty since every fund portfolio can be valued

differently. Hypothetically, two funds with the exact same portfolio can
report very different valuations of unrealized returns, which is why our focus
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should remain on cash and stock distributions net of fees.

Conclusion: Schrödinger’s Valuation Problem

Most readers will be familiar with Schrödinger’s cat
(https://www.wikiwand.com/en/Schr%C3%B6dinger's_cat), a famous thought
experiment devised by physicist Erwin Schrödinger in the 1930s. What does
this have to do with venture capital? With apologies to the quantum
physicists in the audience, because I’m about to mangle the metaphor here,
a private company’s valuation is a lot like the cat in a box.

As we’ve discussed, there are a lot of ways to determine the valuation of a

company, and, by proxy, a venture fund’s portfolio. But there is a really
important distinction to be made between valuation and worth. A company
is worth only what someone (like an acquiring company or the general public
in the event of an IPO) is ultimately willing to pay for its shares. There can be
many theoretically, technically, and legally correct valuations for a
company. But they all collapse down into one final price at an exit event,
when the cat is let out of the bag, er, box.

All of those valuations may be methodologically sound and GAAP compliant

in theory, but in practice, they’re subject to the mercuriality of market forces
and fundamental information asymmetry between startups, VCs, and limited
partners. This is why it’s so important to take unrealized returns with a grain
of salt. As we’ve just seen with the recent shakeup at Rothenberg Ventures
(https://backchannel.com/mike-rothenbergs-vc-firm-was-young-splashy-
and-loaded-with-cash-now-it-s-all-come-crashing-down-e76fa076c7c5), VCs
can’t pay rent or salaries with paper gains.

In VC, like all business, cash (-on-cash return) is king.

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