I don’t envy venture capitalists these days. The economics of startup investing are changing. And as of today, crowdfunders like you and me hold a significant edge over VCs.
I know that may seem like a bold claim. Right now, VC investors get all the respect and glory. They have the best stories. They distribute the lion’s share of investment capital. They’ve become celebrated millionaires — a handful have even become billionaires, thanks to investments in breakout successes like Facebook.
And — unlike crowdfunders — they actually have a history of success they can point to. I get it. But those success stories hide some ugly numbers. For every 33 startups in a VC fund, on average only one will yield a return between 10X-to-20X (this is gross realized returns and doesn’t include fund costs and fees).
That’s the average. There are some funds that invest in several startups that return big gains. But those cases are very rare. Most funds don’t have any of these big gainers.
Many investors in the VC community quietly acknowledge this less-than-ideal state of affairs. Seth Levine is one. He’s the managing director at Foundry Group, co-founded by the estimable Brad Feld. Brad is one of the brightest people in the VC world.
Here is what Seth says about this subject in a post he published this week…
In order to have a successful fund, it’s almost a requirement that you have an outlier return for at least one of your investments. And that is why the average venture fund isn’t actually a particularly good investment and also why so many venture funds fail to return capital.
I’ve heard similar things before. I used to read stuff like this and agonize over the crowdfunding space. I don’t do that anymore though. Because crowdfunding isn’t VC investing.
“The average venture fund” invests the vast majority of its money into the later funding rounds. The later the rounds, the higher the valuations are. Broadly speaking, valuations range from $200 million to $1 billion at that point. To get a 20X return on a company with a $200 million valuation, it needs to grow into a $4 billion startup. Right now, there are 23 startups worth $4 billion or more according to the Wall Street Journal… The odds of one of the 2,200 active venture funds having a $4 billion startup in their fund is extremely small.
But crowdfunding changes the math for startup investors.
Crowdfunding should be considered its own unique and distinct asset class. Think of it this way. A $500 million exit doesn’t have a big impact on the average venture fund. For most funds, a $500 million exit is written off as a loss.
It’s a different story for crowdfunders, though. A $500 million exit for crowdfunders is a huge win. My last 10 Reg. CF additions to our First Stage Investor portfolio averaged a $9 million valuation. A $500 million exit translates into a 55X-to-70X gain.
Let’s do a little more math. If you invested $1,000 into each of your startups, that’s a $55,000-to-$70,000 return on a single investment. Let’s say you have a portfolio with 20 companies. If just one company exits at $500 million, your net portfolio return is at minimum anywhere from $36,000-to-$51,000.
But you can likely make much MUCH more.
That’s because the math so far assumes all your other investments will make nothing. But crowdfunders like you have an edge that VCs don’t.
Because the companies that crowdfunders invest in have such small valuations, even a relatively modest exit of $100 million or $200 million can generate returns of 10X-to-20X. Remember, a 10X-to-20X gain is a rare occurrence in VC portfolios. But it’s more than realistic for crowdfunders.
Our FSI portfolio has more than 60 holdings. If it were a VC portfolio, I could reasonably expect this portfolio to yield two 10X-to-20X winners. Thank goodness it’s a crowdfunded portfolio instead!
I expect about half of our FSI portfolio holdings to develop into companies with at least a $100 million valuation. Which means at least 30 companies making a 10X-to-20X exit — as opposed to the two I’d expect as a VC investor.
Levine says that “Venture is a hits business.” And he’s absolutely right. Crowdfunding is an adjacent investing space. But it operates on a completely different reward calculation. An exit that is a big loss for a VC investor is a nice gain for a crowdfunder. What could be more different than that?
I look for exits between $100 million and $400 million (and hope for a couple that far exceed the upper range). That’s a far cry from the $4 billion exits VC fund managers need just to sniff a profit-making portfolio.
If one $500 million exit earns you a net portfolio return of $36,000 to $51,000 on a $20,000 stake, just think what 10 exits ranging between $100 million and $500 million can give you?
It’s possible I’m being overly optimistic. We’ll have to see. But I see a reasonable pathway to an extremely successful startup portfolio that’s impossible for VC investors to see.
I don’t feel too sorry for VCs. They’re probably making nice money for themselves just off the fees they charge. But they’re doing their investors (or limited partners) no favors. They’d be much better off crowdfunding.