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The Case For Small Venture Funds

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A healthy IPO market and the prevalence of large growth rounds for private, venture-backed companies at lofty valuations have signaled a renewed interest in venture capital within the LP community. (In fact, venture fundraising in 2014 is on pace for its best year since 2008.) While the prevailing belief is that the most successful venture firms are those with sufficiently large funds to lead these mega rounds, the data does not support that perception.

Reality Check: the $1 Billion Exit

Despite recent hype around a handful of venture-backed companies raising money at multi-billion dollar valuations, achieving a more than $1b exit for a startup is highly unlikely. A recent blog post by Seth Levine illustrates just how tenuous the “picking winners” strategy is for venture firms.

While according to Thomson Reuters there have been on average 1,582 technology companies founded annually during the period between 2003 through 2013 (17,412 cumulatively over the period), an average of only 54 venture-backed companies went public during this period (596 in total) — and the median valuation for all such IPOs was $354mm. Not only are IPOs for venture-backed companies extremely rare, but they also do not guarantee a $1 billion valuation.

M&A as an Exit Path

M&A is a much more likely path to exit for a venture investor. On average over the last 10 years, there were 445 M&A events of venture-backed private companies per year. The average disclosed value of these acquisitions was $136mm. During 2013, an M&A exit was over four times more likely to occur than an IPO. Over the last decade, over 90% of all successful venture exits have been via M&A. We expect this trend to continue as large technology companies accumulate significant pools of cash that they can use to satisfy their appetite for growth and innovation through M&A activity. The implications for the entrepreneur and venture capitalist are clear: both companies and venture funds should be capitalized such that an M&A event generates a successful outcome.

Size Matters: Smaller is Better

Historically, early-stage venture returns for small funds — defined as those with less than $250 million of committed capital — have outpaced those of their larger peers. According to Cambridge Associates, pooled 15-year returns for venture funds smaller than $250 million produced an IRR of 71.1%, while venture funds larger than $250 million produced only 6.6%.

While it is true that a $1 billion exit would generally return the entire fund for sub-$250 million funds, a $100 million M&A event still provides a significant return for these funds. We believe that $250mm is the upper breaking point for funds to deliver attractive returns from more modest M&A exits. We have seen that funds larger than this have no choice but to focus on later-stage companies — and rely on rare IPO exits.

This article was originally published by Venture Capital Journal on October 14th, 2014. (Subscription Required)

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