The Venture Capital Math Problem

twitter as a math crutch didn't work out very well.

So in order to finish this post and get to a discussion, I'll assume that the biggest deal, $5bn, represents 5% of the total value of all 1000 exits and that the total value of all exits is $100bn per year. If others come up with different numbers I will update this post with them here.

So here's the venture capital math problem. We need $150bn per year in exits and we are getting about $100bn. That $100bn produces roughly $50bn in proceeds for venture firms per year. After fees and carry, that $50bn is around $40bn. Which is only 1.6x on the investor's capital if $25bn per year is going into venture funds. If you assume the investors capital is tied up for an average of 5 years (venture funds call capital over a five year period and distribute it back over a five year period, on average), then the annual return is around 10%.

Here are the most recent NVCA numbers which I got from Anthony Ha's Venturebeat piece a few days ago:

I tend to look at 5 year and 10 year numbers since 20 year numbers include a period when there was a lot less money in the venture business. Those numbers suggest that the 10% per year returns are about right, or are at least in the ballpark.

So here's my conclusions from all of this math (some good, some not so good). The venture capital asset class does not scale. You cannot invest $25bn per year and generate the kinds of returns investors seek from the asset class. If $100bn per year in exits is a steady state number, then we need to work back from that and determine how much the asset class can manage.

If you use my 3x gross and on average 50% ownership by VCs, then the number that the asset class can take on each year is around $15bn to $17bn. It's interesting to note that the industry raised $4.3bn in the first quarter of 2009. That's a good thing. If we can keep it to that level, or less for a while, then we may be able to downsize and get returns back on track.

I'm optimistic that it will happen. In an open and free market, capital will flow to the places where it can earn an appropriate return. I suspect we'll see some of the large public pension funds who have been drawn to venture capital over the past decade decide to leave the asset class because it does not scale to the levels they need to efficiently invest capital. That will leave the asset class to family offices, endowments, and other smaller institutions who made up the largest part of the asset class in the 1980s and early 1990s.

I think "back to the future" is the answer to most of the venture capital asset class problems. Less capital in the asset class, smaller fund sizes, smaller partnerships, smaller deals, and smaller exits. The math works as long as you don't put too many zeros on the end of the numbers you are working with.