I keep puzzling over the fact that only 2% of venture capital flows into early stage companies when it is also reported as a fact that early stage investment funds provide the highest average returns. Maybe VCs like to swing for the fence and only invest in companies that have huge potential–admittedly, most seed stage companies don’t. Many small businesses want to grow a bit, but aren’t necessarily aiming to dominate a multi-billion dollar industry someday and therefore disqualify themselves from getting venture capital.
At an angel investing seminar recently I heard one angel who has done more than 30 deals say that the first thing he does when looking at a business plan is check the five year forecast. If it’s not over some number (I think he said $50 million) he throws the plan out. Even though he knows full well that all revenue forecasts are just dreams, he still has decided that if the dream isn’t big enough he isn’t going to look any further.
So everyone seems to be swinging for the fences.
So what if a venture fund decided to go for all singles? Here’s an interesting scenario:
What if a $10 million venture fund decided to invest $100,000 in 100 different early stage companies who had modest plans but a very low risk of failure? There are a lot of factors that can reduce the risk of failure: low startup costs, established partnerships, proven sales model, experienced management team, growth industry, use of technology, internet marketing skills, etc.
In fact, what if the venture fund focused energy on training key employees in each startup (group seminars, executive curriculum, required readings, etc.) so they could develop the skills they needed to be successful?
What if 50 of these companies fail, and the other 50 end up growing to $1 million in annual revenue over a 5-year period, and were either breakeven or slightly profitable?
What if the venture fund had the right to liquidate each company that didn’t achieve more than $2 million in annual revenues in a 5-year period, and it’s equity stake in companies under $2 million in revenue were automatically pushed to 50%? In other words, if the management team doesn’t hit the milestones of $2 million in revenue, not only does the venture fund have the right to sell the company, but the management team doesn’t get all the equity they originally hoped for.
So back to the scenario. If 50 companies doing $1 million in annual revenue were each sold for 1x revenues and the fund owned 50% of each company, then the fund would return $25 million to its investors.
The little calculator at youcalc.com says this would be a 20.1124% annual return over the 5 year life of the fund–higher than the average return for venture capital funds over the last 20 years.
Does anyone know of any venture capital firm that systematically goes for singles, and tries to help every company it invests in to eliminate the possibility of failure? I think that VCs often increase the chance of failure by investing too much money and asking management to spend it quickly so they can get big fast. The VCs still win if only 2 out of 10 portfolio companies hit a home run and the others all fail. But what about the entrepreneurs? 80% of them end up with nothing if 8 out of 10 companies fail.
Has anyone ever thought of something like this, or tried it? I’m curious to know if there is any academic literature on this or if anyone can point me to any articles that explore this concept.