Investor Education Series: How do Venture Capitalists Return Money to Investors?
Introduction
In the month of February, we shared a series of educational posts for non-institutional investors. We get a lot of questions about private markets for those new to the asset class, so the goal was to make it easier to understand and more accessible to the average investor.
In last week’s post we wrote about “How venture capital compares to other asset classes.”
In this week’s final post, we discuss “How do venture capitalists return money to investors.”
Overview
Individual (accredited) investors have the freedom to invest in public and private markets and have the independence to make their own investment decisions. According to Dr. Thomas Stanley, author of The Millionaire Next Door and The Millionaire Mind, most high net worth individuals earn their wealth through hard work, creativity, and an independent mindset. Sure, they all had advisors and people who advised them along the way, but for the most part these individuals earned their lot independently. This is helpful to understand because these same individuals, who are brilliant at what they do, sometimes avoid venture capital because of the lack of control they have over how the assets are managed. And in my experience, many aren’t sure how they will get their money out of it.
Understanding Valuation Risk
As I discussed in my previous posts in this series, venture capital is a ‘risk-on’ asset class. Fund managers (VCs) raise capital from investors and invest it in a portfolio of private companies. Depending on the fund manager’s strategy, capital may be invested in companies in a specific sector, region, or at a specific stage (early or late-stage). Most VCs invest in technology companies who create/develop intangible assets (e.g., software, etc.) as these companies tend to scale faster and are usually less cost-intensive than companies who build physical products (e.g., hardware, etc).
Valuing private companies is more an art than a science.
Valuing private companies is more an art than a science. While there are mathematical ways to assess the value of later-stage companies (i.e., companies with a few years of financial performance metrics), most early-stage company valuations are subjective. To determine the value of an early-stage private company, most VCs compare that company to similar companies at the same stage to determine its value. Other factors are considered such as founder experience, strength of the product/service/technology, level of competition in the market, and the company’s revenue or customer growth traction.
According to ASC 820 Fair Value Measurement, private companies valued in this manner are considered Level III assets because not everyone has access to the same information and it’s up to the fund manager to determine a suitable method of determining that company’s value. As an FYI, Level I assets are valued based on “unadjusted quoted prices in active (i.e., public) markets, and Level II assets are valued based on “quoted prices that are observable and available for all to see” (like real estate prices). There is no one method for determining the value of a private company. However, every fund manager must develop their own company valuation methodology and consistently apply it to justify the value of their portfolio to their stakeholders (i.e., their limited partners) and their auditor.
One of the risks inherent in the Level III valuation process is that one VC might significantly over or undervalue a company compared to another VC. There are several reasons why this happens. As such, my suggestion to investors is to ask about it. This will enable them to understand a VC’s process and could provide insights into whether a VC is over or undervaluing their portfolio.
Understanding Company Mark-ups
Now that you know how companies held within venture capital funds are valued, it’s also worthwhile to understand what it means when a VC says a company has been ‘marked-up.’ A ‘mark-up’ is VC lingo for when a company increases in value. A private company is marked up when that company A) raises additional capital at a higher valuation than its previous financing round or B) is performing exceptionally well in comparison to its peers in the same or similar industry. It is difficult to obtain adequate information about similar private companies and it may look suspicious to investors for VC firms to independently mark up portfolio companies unless there is a follow-on funding round. But at the end of the day, mark-ups are important because they indicate positive progression in a company’s growth trajectory, and they also add balance to VC portfolios where, characteristically, many companies are marked down.
Generating Liquidity for Investors
Finally, there’s no guarantee that a company that has been marked up will provide liquidity for a fund. However, a portfolio of companies that have been marked up has a higher probability of returning capital back to investors than a portfolio of companies that have been marked down. Startups that excel attract attention from larger, established enterprises who may want to partner with or acquire said company to expand or improve their business. Or, in some cases the larger company may purchase a smaller company just to shut it down because the smaller company robs them of market share. Whatever the case may be, this creates a liquidity event in a VC’s portfolio. Contrary to popular opinion, most VC-backed companies are acquired and not by ‘going public.’ There is also a large and growing class of secondary fund managers who purchase interests in a venture capital fund’s underlying portfolio companies (usually at a discount), which also provides liquidity to VC’s.
Myth of Public Markets
Public market exits are great, but it’s far more common in today’s environment for private, high-growth technology companies to stay independent and raise money from larger, institutional investors like private equity funds, corporations, and/or sovereign wealth funds. In fact, there has been a decreasing trend in the number of publicly traded companies as can be seen in the chart below.
Distribution Mechanics
After a company sells, the profits are distributed to each investor on the company’s capitalization table. The capitalization table (cap table) is basically a list that shows who each investor is in a company. It also shows the financing round (or rounds) each investor participated in. Contrary to what one might think, investors who participated in a company’s first (official) financing round usually get paid second to last. It’s weird, I know. But that’s how it works. Investors who invest in later stages often invest greater sums and therefore structure their investment terms such that they not only get paid back first, but at a predetermined minimum multiple (usually equal to or greater than one). And herein lies the rub. If a startup company performs well enough to achieve an exit, the exit/liquidity event needs to be large enough so that there’s sufficient profit to distribute to each of the stakeholders on the cap table, including the founder herself/himself who is usually paid last.
For companies to reach this point, it can take a while. It often takes successful VC-backed companies seven to eight years (or longer) to sell or go public. Since most VCs deploy capital over a two-to-three-year period, it’s possible their best companies won’t come to fruition until very late in the fund’s life. Most funds have a fund life of 10 years, so the most promising companies might not exit until the very end or even past the stated termination date of the fund. As such, it’s critical for individual investors to gain comfort with venture capital’s liquidity profile before investing. In addition, they need to understand how to measure a VC’s progress while waiting for potential returns. Simple things to consider are the number of mark-ups in a VC’s portfolio, how quickly a VC’s underlying portfolio companies are growing, how does the VC underwrite opportunities to estimate the long-term potential of companies they invest in, and most importantly, how the VC adds value to its portfolio companies to position them for long-term success.
Conclusion
Venture capital is one of the most exciting and influential asset classes. Many of the world’s largest companies such as Microsoft, Apple, Facebook, Netflix, and Google all raised venture capital to get started and grow to become large, global enterprises. Venture capital is a risky asset class. However, I believe it persists around the world because humankind thrives by taking risks and continually innovating to build a better future for all. Venture capital enables that.
If you’re curious about the venture capital asset class and want to learn more, please reach out.
Cheers — KM
