Winning by Losing in Early-Stage Investing
One of our limited partners recently asked, “What are the normal failure rates for early-stage venture capital investments?” After digging through our data, we estimate that early-stage fund losses range between approximately 35% and 70%.
How did we determine this? We reviewed 20 funds that made early stage investments between 2006 and 2011. Among this group, which invested in more than 500 companies, 45% of their investments failed to return 100% of capital, while 34% returned less than half. The median loss rate was 39%, the median multiple on invested capital (MOIC) was 1.9x, and the internal rate of return (IRR) was 13%.
Admittedly, there was an element of dispersion in our results (see correlation chart below). In the case of two top performers, for example, “Fund A,” a 2007 vintage, had a 4.4x MOIC and a 66% loss rate, while “Fund B,” a 2008 vintage, had a 5.8x MOIC and a 38% loss rate.
Taken together, these results suggest that funds with loss rates near the lower or upper bands of the 35%-70% range tend to underperform because they take too little or too much risk, respectively.
To see if our hypothesis was on target, we compared our results to those reported by others, including Adams Street Partners. They concluded that 55% of invested capital was allocated to losing deals, with a capital-weighted loss rate of 45%.
Cambridge Associates conducted its own research and published results that were somewhat similar, as illustrated by the chart below.
We compared the various findings above to those from a 2013 analysis of Union Square Ventures funds by Fred Wilson (who has also written about the losses and returns at his AVC blog). He reported that USV’s top-performing 2004 fund had a loss rate of 40%, near the lower end of our range. Perhaps not surprisingly, that loss rate was consistent with that of Fund B, detailed earlier.
Finally, we note the work of our friend Trevor Kienzle’s firm, Correlation Ventures, which analyzed 21,000 financings for the period 2004-2013. They found that 64% of all VC investments lose money.
Simply put, venture funds should be taking risk to generate acceptable returns. Based on past experience, a loss ratio between 35% and 70% would seem to signal a healthy balance between risk and reward. No one likes to see losses, of course, but it is important that LPs not be fixated on investments that don’t work out. Great managers, like great athletes, should be able to deliver good results by remaining consistent, focused and disciplined, regardless of the (expected) hiccups along the way.
Needless to say, that doesn’t mean risk management is unimportant. There are various tactics that managers can employ to optimize returns when bad outcomes are inevitable. These include recycling proceeds from earlier realized losses and maintaining sufficient dry powder to take on a more concentrated exposure in high-performing investments.
(Note: for more insights on the loss-return relationship, please read Venture Outcomes Are Even More Skewed Than You Think at Seth Levine’s VC Adventure, and Venture Capital Disrupts Itself: Breaking the Concentration Curse by Cambridge Associates.)