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"The Venture Capital Math Problem" Open Letter

Posted by Anonymous on 2009-04-30


According to one of the most visible venture capitalists, Fred Wilson, the math of venture capital does not add up, and limited partners are starting to take notice:

"Yesterday Albert and I visited one of the investors in our fund. The good news is they are happy with the job we are doing. The bad news is they are frustrated with the venture capital asset class."

Fred writes about the "math problem" in his blog. While the post is interesting, the comments by dozens of other venture capitalists are more insightful. It looks like Fred has publicly announced that the reckoning is underway, and everyone agrees that the numbers don't add up anymore.

If only these people read TheFunded, they may have figured this out months ago. And... if the "math" doesn't add up for VCs, it certainly doesn't add up for most entrepreneurs, either.

Posted by fnazeeri on 2009-04-30 17:06:36

The fundamental problem is that "VC doesn't scale." The reason it doesn't scale is because there aren't enough good companies to invest in. That means there is more capital than quality entrepreneurs.

You could argue that this is an indictment of entrepreneurs (for not providing sufficient quality companies) more so than VCs. Maybe it's time we stop pointing the (middle) finger and take a look in the mirror?

Posted by Anonymous on 2009-04-30 19:41:32

@1. You must be joking. There is no dearth of talent. Nor talented opportunity. What I've witnessed firsthand is that talent does not always get funded, and what does get funding often leaves me shaking my head.

Posted by Anonymous on 2009-04-30 19:52:17

I 100% agree with #2. VCs are "clubby" investors, many times picking random newbies from top schools that they themselves attended or old friends to back.

Posted by Anonymous on 2009-04-30 20:34:58

I think fnazeeri is wrong here. The problem with the VC model and even the stock market for that matter is that the laws of supply and demand are not efficiently applied. Basically, the information that separates good companies from bad companies and good ideas from bad ones is not clear. This means that we expect both VCs and stock market investors to make decisions based on some clear criteria to choose good companies but what they do is pick firms that are represented by people with good networks, good connections or just lucky. As you all know, one of the laws of sales is "It's not who you know, it's who knows you". You can say that the stock market model is broken just as the VC model is broken. The pattern is the same: a crowd of "smart" investors chase few chosen or well known companies until everyone crashes and burns. A lesson here can be for a lot of us to play this market the way it is and profit from its inefficiencies. The VC model will not disappear just as the stock market and real estate speculation will not disappear. They always come back.

Posted by fnazeeri on 2009-04-30 21:03:17

Ok, now this is getting good. Fred's "math problem" posts argue that, based on exits (which has nothing to do w/ VCs) there is only the capacity for $10-12 billion per year in VC investments (which is about half the $25 billion historical number). The "exit" numbers are determined by the IPO and M&A market. That market in turn defines the size of the VC market. In order to double the VC market, you have to double the exits. @2-4, how does that happen?

Posted by #4 on 2009-04-30 22:06:03

Good question fnazeeri. I think Fred's problem is that he is being too rational. You can't. A 5B deal today, could be a 25B deal next year on the same company. The same way a house in the Inland Empire was worth 1MM 2 years ago and it is 300K now. The same way Facebook was worth 15B a couple of years ago. The VC model does not work right now because the exits are too cheap but they sure worked in the late nineties and mid 00. A lot will go out of business but they will come back. There will always be people or institutions with too much money to invest in professional money managers. VCs are just that, money managers. Basically, we as entrepreneurs think that the VC model is broken because they are just not good at picking companies. I say to that, the VC model is not more broken than the stock market is. Is the problem with the stock market that there are few good companies or is it that a lot of money moved to the side? I say it is the later. VCs are just not as smart as we think they are. They are just as stupid as the hedge fund guys turned out to be.

Bottom line. The VC model and the market model in general is not very efficient. It will keep being that way and I think we have to learn to profit from it.

Posted by fnazeeri on 2009-04-30 22:39:58

@ #4/#6: I didn't follow the argument. Are you postulating that VCs are bad stock pickers and that if they picked better the exit market would double?

Posted by #4 on 2009-04-30 23:50:26

No. VCs are just market followers. Think of real estate speculators. 7-8 years ago everyone started borrowing money and "investing" in real estate. Some of the houses they bought were good and some were awful. So, builders started building a lot of crappy houses which the "investors" bought because everybody else was doing it. Then the crash happened and a lot went out of business. The same is happening with the VCs. A lot are going out of business but they will not go away altogether. All the talk about "no scale" etc is just over analyzing. Skype was valued at a lot more a few years back but is lower now. Facebook was valued at a lot more a few years back as well. Would we have said in 2005 that VCs business model can scale?

Fred is a VC. He is scared and I don't blame him. He can't raise money and the value of exits is lower.

Bottom line, it is not true that there is more money than talent. Most of the time there is more money than good judgment. When VCs were flush maybe they did not think hard enough where to put their money. After all, why would they be any different than all the people who made up reasons why house prices would go up forever? Are they smarter?

I am not going to cry that some MBAs playing with other people's money are going to go out of business now. Maybe their friends will find them another cushy job where they can pretend to know what they are doing.

Posted by dontsueme on 2009-05-01 00:41:42

Sorry Furqan, normally love your insight but I think you're wrong here. As VC's have gotten more "mature" in the way they pick companies, they have gotten worse at picking good companies.

I agree there is a lot of crap companies and entrepreneurs out there. But there are still more "good" people/startups than the # that are getting funded right now.

Posted by dontsueme on 2009-05-01 00:50:37

Follow on thought:

Those with the gold make the rules. Something that's happening more and more is entrepreneurs flexing to meet what a VC wants in order to put food on their table. The poor results of the last few years doesn't mean there are few good entrepreneurs - it means that what VCs looked for was wrong.

The problem isn't a VC's ability to recognize/"pick" a good company, the problem is that most VC's think they can dictate what will and won't be a good company. They need to get out of the way and let entrepreneurs do their jobs.

Posted by fnazeeri on 2009-05-01 05:21:09

It definitely wouldn't be the first time I was wrong! But I'd like to get to the bottom on this... This is a huge point for entrepreneurs, VCs and the whole eco-system. The argument seems to be that VCs are bad stock pickers and that is the cause of the market "not scaling." I'm open to being convinced...can someone provide non-anecdotal evidence to support this argument?

Posted by gorilla44 on 2009-05-01 09:35:54

I don't believe it is correct to look at the problem backwards and say that because the average exits were $X Billion per year, that is all the system can handle.

The current lack of exits is definitely recessionary. Many profitable companies can't go public now and M&A valuations are down. But that will come back in 2010, 2011 at the latest. Good companies will be able to go public or be acquired at healthy, fair valuations.

Looking at the pharmaceutical and medical device industries, there is a huge appetite for new and more effective drugs and devices - by both the end users (physicians and patients) and by big companies that need to fill their pipelines. I believe that big companies (the Pfizers, Boston Scientifics, and Strykers of the world) would acquire more products/companies every year if they were out there. There are so many unmet medical needs, I don't see how you can argue with that.

On the IT side, I'm not sure. But I do know that consumers and businesses are always looking for products that will save them money or will provide more entertainment or will (fill in the blank). There are no lack of critical needs in any industry.

Posted by Anonymous on 2009-05-01 09:43:46

An observations is that the VC community seems to be overloaded with VCs who don't have the experience to know what it means to be an entrepreneur, and there are too many 'fast-food' entrepreneurs who think that creating an iPhone app is all it takes. These two issues feed off of each other, IMHO.

@fnazeeri: I don't have the data to support the conclusion that VCs are bad stock pickers, but I believe it's easily derived if you buy into one basic assertion: good companies with solid value propositions don't have a problem finding exits. If you believe that, as I do, then the declining performance of VCs over the past few years can be plotted using the ratio of investments to exits.

Posted by BeenThere on 2009-05-01 12:07:40

As almost always, Furquan is right on the money (and so is Wilson.) The system IS broken, and what's needed here is innovative thinking about what innovation financing looks like in the 'new' world.

The problem (and one that unfortunately I see around here all too often) is that we hyperactive entrepreneurs have a 'kill the messenger' mindset, with completely unrealistic prescriptions based on completely unrealistic understandings of how the early stage funding market works. It would be much more productive if we could stop the VC-bashing (and angel-bashing, government bashing, indeed, everyone-bashing) and think through solutions that take into account the essential underlying fact:


That's why banks don't lend money to startups, and that's why you don't invest your grandmother's last nickel in funding your latest brainstorm. It's also why VCs (who are not horned, evil beings out to rape entrepreneurs) do the best job they can at trying (and usually failing) to invest the funds available to them in the long-shot-but-high-potential future rock stars.

If you have a better way to do it...then do it! But (a) don't assume bad faith on the part of investors who are trying to bet on supporting early stage entrepreneurs, and (b) when you come up with your better way, it had better take into account the fact that that ANY investment ANYONE makes in startups is more likely than not to evaporate. This means that your miracle solution has to work for us as entrepreneurs AND them as investors. Get both of those figured out, and you'll have a sustainable model that works for society and the economy as well.

Posted by NWbiotech on 2009-05-01 13:09:25

The data doesn't actually show that there are too few good companies, only that too few good companies are funded and allowed to succeed. Two types of bias of ascertainment muddy the interpretation of the number of successful companies. First, there is the assumption that the funded companies are more likely to have made money than the companies that did not get funded. There would be more successful companies if the VCs were better at choosing companies. One simple example that demonstrates this problem is the fashion issue- every VC wants to finance the business model of the year and ends up over-funding that type of company and under-investing in other business models.

The second problem is poor management of their investments in well-chosen companies. Most long-term entrepreneurs or employees of venture-backed companies have a pretty clear idea of what I mean here. VCs destroy or limit the value of great companies in at least two significant ways: a) by demanding unrealistic growth plans and b) by putting in compliant/incompetent managers.

Many (but not all) VCs will only finance companies with unrealistic growth plans. They then demand specific milestones and drive the company's management to meet them. Sounds reasonable in principle, but for almost any interesting, tech- or science-driven company, plans in business are like those in battle- great to have but don't expect them to survive the first engagement with the enemy. It is easy to see if a company has met milestones, but it takes a true understanding of the technology and market to know if the company is actually progressing towards profitability. VCs who invest in a business they don't understand are in a real bind- they can't tell if it is succeeding so they fall back on milestones. Management often ends up pursuing milestones that sounded good six months ago when we didn't understand the problem but are at a best a distraction now and at worst end up sucking most of the company's resources. I have watched good companies devote a significant fraction of their technology development resources to meeting irrelevant goals simply because management was not willing or able to get the VCs to understand the actual progress.

A related problem is the VC tendency to pick their buddies to run their companies- the classic replace the founder when you get financing scenario. This is sometimes the right choice but often results in a company that is set up for problem 1), pandering to the limitations of the board. If the VC group doesn't understand the company/market/technology then they are unlikely to be able to tell if the CEO they choose understands it. Trying to build a technology company with a CEO that does not understand the technology is not a good way to optimize returns from an investment. You end up with an investment that looks OK or even good that is under-performing its potential returns by many-fold.

Summary: better VCs yield better returns and better companies to work for. As mentioned above, we need VCs that really understand what they invest in. It is the acme of arrogance to think that you can pick winners in a field where you don't understand and an extension of that arrogance to think that you can then choose and oversee the management of a company that you do not understand.

Posted by #4 on 2009-05-01 14:58:22

Furqan, I also have to admit that your posts are always insightful. You are wrong on this one though. So is BeenThere.

The VC model is not broken. It is just going through a difficult time. BeenThere, starting companies is hard and the risk of failure is high. That is true. What is also true is that VCs follow the crowd and there is data for this. How many social networks companies were funded? How many "internet" companies were funded? Time and time again VCs have shown themselves to lack imagination and fund dull ideas.

The VC model is not broken because, really, there is no better way to do this. There will always be more ideas than money and the money has to choose where to throw itself. Also, there is no clear rational way to evaluate if an idea and its execution will make money or not. This loosely resembles the stock market. No one yet has come with a sure way to make money in stocks and lots of people follow cheerleaders to their financial ruin. Basically, things will remain the same and we have to learn how to profit from the situation.

Posted by Anonymous on 2009-05-01 19:02:01

There's a lot of math in these posts (especially at Fred Wilson's link) and I think the issue is actually a lot simpler for two reasons. Unfortunately, it takes a bit of math - though easier math - to illustrate the point.

First, to address the issue of too much money chasing too few deals, I think the market is perfectly capable of working through that. If VC firms aren't investing or investing in crappy deals, their limiteds will become disenchanted, won't sign up for future funds and the funds will die natural deaths.

Second, I view the math in specific deal-focused terms, not global terms. You should note that I'm in the medical device space so our exits are scaled a bit differently but you can easily run this exercise for your own venture or space. Rich Ferrari at DeNovo ventures wrote an excellent paper about this subject late last year (link:

Rich essentially tries to "back in" the math to see how a deal will work out. Ventures are taking longer and exits are smaller than they used to be. If the $20 million Series D investors want to get 2 to 3x and the liquidity event is projected to be $200 million (perhaps an optimistic number these days), that implies a Series D pre-money of $50 to $80 million. Assuming there was an expected 50% mark up over the prior round, that implies a Series C post of $35 to $55 million. If the Series C raise was $15 million, then the pre was $20 to $40 million. Etc., etc., etc.

Run the numbers and you may end up with negative values for the Series A or even the Series B. This is not good for founders or any early investors who can look forward to the downstream squeeze from late investors.

So you don't have to look at it globally and use Gaussian curves, just look at your venture and your comparable liquidity events and back in the return expectations and amount of financing required for each round. This is the calculation I'm seeing VC firms doing. So if you can make a reasonable argument that the Series A can get 10x, the Series B 6x, etc., you have a story. If not, you don't.

In the absence of a major success (ie, $1 billion or more) - and those valuations are rare in our space - how are we to get funding at reasonable values? The venture expectations may just be unrealistic and that doesn't serve anyone well.

Posted by fnazeeri on 2009-05-01 20:23:52

Great discussion, I'm still not convinced (call me hard headed). I'm a visual person, so here is my crack at trying to be specific with the "math problem."

VCs don't control the "exit" market (M&A and IPOs) nor do entrepreneurs for that matter. In order to double the size of the VC (and thus startup) market, there needs to be a doubling of the "exit" market. Using numbers (and not words) can someone explain to me how that works if VCs are "better stock pickers?"

Posted by alain94040 on 2009-05-02 01:29:08

I don't see the problem.

1) Even if the VC model doesn't scale for the average VC, it doesn't matter because all you need is to beat the other guys to win (you don't need to swim faster than the shark, you need to swim faster than the other diver - Scott Adams). So be a good VC and everything will be fine.

2) I actually think the exits can scale significantly (say 2X current situation). There is no much innovation possible out there. Think of it this way: could we pull two years' worth of exits into one year? Why not? Is there an inherent reason that the rythmn of innovation is capped? There are some tactical improvements that can be made (not investing in 15 different social networks, etc.). That may not give you 2X on exits, but in theory at least, I can't find a reason for a cap.

So everything is fine.

Posted by Anonymous on 2009-05-02 21:57:36

I agree.

Posted by baracuda on 2009-05-03 13:16:50

The core argument that fnazeeri is making is (based on what I see and understand) is that too much money is chasing not enough deals that can go to M&A or IPO (would go IPO or M&A).

I think we all can agree to that assumption based on what has been going on for the past few years.

At the same time, I think we all agree that generally the VC community has not been able to be good "stock picker" for the past few years either. I think that is the result of lack of knowledge, vision, and operational experience and maybe too much money on hand that often creates a sloppy behavior (which all of them advise others not to do). Being ignorant and arrogant is totally different problem.

Posted by gorilla44 on 2009-05-03 13:58:21

alain94040 - I disagree strongly with your point #1 in the 19th post. VCs don't just need to beat other VCs. VCs are competing with many different kinds of investment classes for LPs attention - from later stage private equity to timber deals to who knows what. LPs don't have to invest in venture capital. And some are reducing their allocation or dropping out of that class of investments entirely. LPs need to get a specific minimum return and if they don't get it, they will put their money someplace else.

Posted by hymanroth on 2009-05-03 13:59:35

I would argue something quite different:

Fred's numbers don't imply the VC market is broken, they imply the internet business model is broken.

As soon as the potential purchasers realized that just buying eyeballs was a risky bsuiness, the IPO and M&A markets began to dry up.

There is too much free stuff on the net. Users now expect everything to be free. Ad funded business models play straight into GOOG's hands.

When entrepreneurs figure out how to generate proper cash flows from the net then purchasers will return to the market and buy those cash flows.

Posted by Anonymous on 2009-05-03 17:39:49

Ah... now this is good. So, if the M&A and IPO deals are only for social networking companies and net based business, then the argument changes.

We all know that there are not that much money available for non-net based companies, according to experts those companies take too long to build and take too much $$.

So, how many net companies can or need to go public anyway!?

Posted by dude on 2009-05-04 04:43:32

There are still unfunded quality deals that VC's are not sophisticated enough in those relevant technologies or that vertical marketplace to understand, then too much money chases only the more obvious and trendy opportunities. This is NOT a slam against VC's as a group, but against the limitations of any outsider (relative to the entrepreneur) of knowledge, understanding, and crystal ball vision of the outcome in taking all sorts of risks (on technology, market acceptance, team, etc.)

The question is whether this means the VC model is broken? Perhaps it is semantics to say it is or isn't. Can you say it is the model that is broken when the limitations are a function of the fundamental limitations and knowledge of those who own and run the process, and perhaps not a fundamental flaw of the basic structure of the process itself? That is not to say that the process does not have room for improvement, however the VC model may just unfortunately be (in its basic form) the best humans can do. The VC model does not scale beyond those opportunities that are easily understood by industry/technology outsiders (investors), or opportunities caught in a popular trend.

So the model may not be broken, but just inherently limited by its human inputs, and "broken" is just an argument of semantics.

On a separate front, if the math is right, then the model is out of equilibrium and investment will shrink or IPO/M&A prospects will need to get a lot brighter in order to re-balance. And while as an entrepreneur it pains me to suggest that, my hope is for the pickup in M&A. But out of balance is not the same as broken.


Posted by susiebizwiz on 2009-05-04 12:55:48

This blog post may be of interest.

Posted by commike on 2009-05-04 12:57:00

The discussion is vectoring a little to the lemming problem being part of the cause as to why the math looks so bad. The majority of companies that are being funded seem to be in the internet space, leaving all those companies and ideas outside of that space not available to build value and exit. How many social networks do we really need that have weak business plans with respect to revenue growth. A $250M valuation of twitter with zero revenue is just not A Good Thing.

Posted by fnazeeri on 2009-05-04 13:09:46

@26: Great article. Summarizes a lot of the recent discussions here and elsewhere from the perspective of an LP on the VC eco-system as a whole.

Posted by fnazeeri on 2009-05-04 13:14:20

@27: I don't think the "majority of VC" investments (or even close) are going into internet businesses. According to this announcement from the NVCA, internet specific investments accounted for 1/6 of total VC invested in Q1 2009. I haven't seen the data over the last several years, but I don't think that the internet deals are crowding out other good investments in the way they were in 1999/2000. I could be wrong tho...

Posted by Anonymous on 2009-05-04 14:04:52

twitter may have zero revenues, but many companies would line up to buy it for $250M.

Posted by commike on 2009-05-04 14:07:55

Here's the MoneyTree report presented in a tabular form. It's good to see there is a spread between sectors, that's not what I've been hearing.

life science_$133.00___133_____4%_______24%
clean tech__$154.00___33______5%_______6%
financials__ $108.00 ___17______4%_______3%
other______$1,435.00 _105_____48%______19%