The growth imperative (but beware)

First off, a note of apology. It’s been months since I’ve posed here. Not for lack of desire – more about some combination of crazy busyness and lack of proper prioritization. I miss it and am going to try to step it up.

This is a post about the importance of growth, about the current market environment and a note of caution if the growth imperative changes rapidly to the profitability imperative.

A few months ago we held a “SaaS Summit” for about 130 people from across the Foundry Group portfolio. It was a great chance to compare notes, meet far flung colleagues (“cousins” as we sometimes refer to employees at different portfolio companies) and discuss a variety of topics effecting companies selling with a recurring revenue model. As the organizer of the event I pulled together the morning briefing to kick things off – basically a bunch of data from a variety of different sources talking about the state of the SaaS markets. There was some juicy stuff in there, but one set of facts clearly stood above the rest. At the moment, growth is THE single most important factor when considering the value of a SaaS company. Let’s start with some data and then we’ll parse through what it means.

The data below are a mix of things I came up with as well as a some key data points borrowed from my friends at FirstMark, who undertook an extensive analysis of the SaaS market. The full methodology here isn’t worth stepping through in detail, but essentially what the study did was try to separate companies into “leading”, “lagging” and “middle” SaaS companies. This was a reflection of their trading behavior, not an assessment of their underlying business (i.e., we relied on the market for the determination of leading vs. lagging). It’s important to note that there weren’t material differences in revenue size, geography, target market, etc. between these companies.

First the cold hard trading facts. “Leading” companies trade at significantly higher multiples than their peers.

trading stats






No huge surprise there – that’s pretty much the definition (in this study) for a “leading” company. But helpful to show the stark difference.

So what causes this massive difference? We looked at a bunch of different factors, but as I give away above, the single most important factor for valuation of a SaaS business is growth.

growth rate






The “growth effect” was highly statistically significant. In fact, a 10% (meaning 30% to 40%) increase in growth rate translated into a 3x (3x!!) increase in revenue multiple. That’s highly significant. And interestingly if you look at factors such as Gross Margin and EBITDA Margin they weren’t predictive at all. Nor was recurring revenue (meaning the % of revenue that was recurring vs. services). Below is another graph looking at the core correlation between growth and multiple (simply another way of showing the results I discuss above).

rev growth






If I’d been on the ball a few months ago and posted these data back then, this would have been the end of the story. Markets value growth and growth above everything else (at least at the time). But, of course, the markets have changed since then and it’s important to note a few things because of this.

I have another post I’m working on describing why I don’t think we’re in a “bubble”. But even if that’s true, it doesn’t mean that the markets won’t go down, and more importantly for many of the people reading this, that the private markets won’t start shifting their focus from growth to other factors (i.e., profitability). We’re already seeing this in some markets such as security. And we’ve certainly seen in the past that when the markets shift their focus from growth to profitability they do so pretty quickly (briefly in 2011, before that in 2008 and dramatically in 2000/2001). Unlike some, I don’t actually have a view on how drastic a correction we’re headed into (as I said at the start of this paragraph, I don’t think we’re in a bubble to begin with, but we’re clearly experiencing turbulence, nonetheless; however the sky isn’t falling and I tend to agree with what my partner Brad Feld said in the article linked at the beginning of this sentence: “I think everyone will have an opinion and no one will have any real idea,”).

Much more on this in my bubble post upcoming, but I didn’t want anyone walking away from this note saying “Seth says grow at all costs!” I’m saying the markets are valuing growth to a degree that surprised me when I looked at the numbers, BUT that one should take that with a grain of salt given the current market conditions and the tendency for markets to quickly shift their focus. Smart growth is the right strategy (I said this months ago at our Summit as well). The best businesses are sustainable and grow at a pace and in a manner that sets their burn rate at an appropriate level relative to their funding and matching things like CAC to LTV in sustainable ways.

More soon…

Why Companies Fail

I’ve touched on aspects of this topic before, but thought it was worthy of a full post. Companies in the venture business fail all the time. As I wrote last year, the majority of venture rounds fail to return capital. With all the hype one reads in the startup press these days, that fact can be easily lost.

So we know that startups fail all the time, but why do they fail? Here are some common pitfalls based on our experiences (and here I’m referring not just to Foundry portfolio companies, although all of these lessons apply there as well, but also our observations of the broader markets).

Premature scaling. The number one reason companies fail in my experience is premature scaling. Companies that fall prey to this typically 1) believe they’re in a winner take all market; 2) are impatient to get to “scale” (for all sorts of reasons); and 3) extrapolate early data incorrectly (or just ignore it). Every time this happens to me I vow it won’t again. And inevitably it does. The most dangerous pitfall above is #3 (#s 1 and 2 are exacerbating factors that multiply the effect). A company gets some early data on sales performance and either completely misinterprets it or believes that early sales scales linearly (or even worse, on a log basis). Then rather than increment up and test your sales performance hypothesis you hire like crazy (see #’s 1 and 2 again) and all of a sudden your burn rate is out of control. Reading it here in black and white this is something I’d never do. Ever. But that’s not how it works and unfortunately it happens with way too much frequency. Typically in retrospect these kinds of mistakes are obvious, but when you’re in the middle of it everything seems nice and logical. An adjunct to this is believing that whatever problem you’re having in your sales and marketing funnel will somehow be fixed by scale/time (classic example is deciding that fixing your CAC payback period is a matter of spending more on marketing, vs spending some time honing in on what specifically is failing and what is working).

Not recognizing that your sales problem is actually a product problem. This could be a blog post of its own, it’s so common and such an interesting topic. The typical response to lack of sales is to reexamine your sales and marketing organization. Perhaps you replace your VP of Sales ((hint: if you’re on your 3rd head of sales, you probably don’t have a sales problem) or perhaps you change marketing strategies over and over. Less frequently do companies look at their product and realize that their lack of sales isn’t at all related to their sales organization.

Not taking money when it’s available. Perhaps with the markets changing more entrepreneurs will learn that raising capital is actually hard, but in the last cycle we commonly saw companies over optimize for founder dilution and under fund their businesses – presumably with the assumption that more cash would be easy to raise if needed. Sometimes that worked. But often it didn’t (because often the circumstances that make you need more cash are the same ones that make raising that cash difficult). Countless times I’ve watched companies make the mistake of trading a small amount of dilution today for the hope of more money tomorrow. The risk of taking a bit more capital now is a little less ownership. The risk of running out of capital is your company shutting down. You do the math.

Lack of conviction. This is a dangerous one and often sneaks up on you – akin to watching a car crash in slow motion. As Gretzky once famously said, he skates to where the puck will be, not where it is now. To do that you have to have some idea of where the puck is headed. Some entrepreneurs get paralyzed by a fear of getting the market wrong that they sit back and wait for a sign of where they should go. This kind of passivity rarely works. I often tell CEOs that I’d rather us be wrong with convocation. Startups have limited resources and while getting feedback on what customers want or where a market is headed makes sense, at some point as a company you need to make a decision about where you’re headed and run hard there.

Time doesn’t heal everything. This is related to lack of conviction, but occasionally I see companies who feel that their job is to maximize the runway they have left. And while making sure you have time to execute against a vision is important, doing so by treading water never works. This is most prevalent in companies that are shifting their focus or vision from an initial idea to something new. As part of that process they cut burn and somehow get attached to the 34 months of cash runway they have left at their low point, struggling to hire back up for fear of seeing that number jump down. But no company succeeds by treading water and ultimately these companies die a slow, but predictable, death.

Careful introspection is important here. Typically it’s hard to admit when you’re in the thick of things that somehow you’re not a special case where the rules don’t apply (or put another way, it’s easy to squint at the data and suggest that you’re situation is different; it likely isn’t). And, of course, many times companies fail because they were just wrong about the market and the product they were trying to build. But understanding where companies typically fall short is a great way for you to lower your chances of falling prey to these common mistakes, and increase your chances of succeeding, even if your initial idea takes some iteration.

My final thought is an obvious one, but companies fail because they run out of cash and aren’t able to raise more (or sell the business). Many of the ideas above relate to spending cash either too quickly or on the wrong things (or not raising enough capital when you can). There’s a saying in the advertising business that 50% of ad spend is wasted, you just don’t know which 50%. The same can often be said of startups. In every startup that I’ve been involved in that’s failed, I can look back and see dozens of places where we wasted money (always thinking to myself: “if I could only have that money back to spend knowing what I know now.”). Ultimately your job as a CEO (and my job as an investor and board member) is to help you make smart investment decisions so that you waste as little money as possible on your way to building a successful business.

Once bitten but nothing learned …. betting on the Superbowl again


Apparently I didn’t learn from my experience last year. As you may recall, I bet Dan Levitan from Maveron $5,000 that the Broncos would beat the Seahawks in last year’s Superbowl (one of several ultimately losing bets). They failed to do so. In spectacular fashion. (truthfully I didn’t watch past the first play of the 2nd half) And that was just the most public bet I lost (that money went to Seattle Children’s Hospital, so at least I was supporting a good cause). There were others – less expensive but more humiliating. </sigh>

Fast forward a year and we’re doing it again. Dan gets to bet on his beloved Seahawks. And while the Broncos didn’t make it back for a rematch (and let’s be honest with ourselves – they weren’t going to beat the Seahawks even with their somewhat revamped defense this year), the Patriots did. Turns out I’m from Boston and that makes me a big Pats fan.

So…when the Pats win, Dan is going to donate $5,000 to Boston Children’s Hospital. On the off chance that I lose, Seattle Children’s gets another $5,000 from me. Like last year, I’d encourage some side bets – we actually raised several thousand more for Seattle Children’s by people taking on a similar challenge.

Go Pats!

Introducing Pledge 1% – Let’s make a difference together

pledgeThere’s a great scene in Office Space where the movie’s heroes check their ATM balance after one of them has written a program to scrape tenths of pennies off of Paymetech (the movie’s fictional company) transactions. The guys figure this action will both go unnoticed and also generate a relatively modest sum for them. Instead when they check their balance it turns out that the sum of their tiny rounding transactions actually equated to over $400k to them over a weekend!

It’s a funny scene (and a funny movie) but the moral here is actually important: The sum of a large number of small actions can be huge.

Today we’re announcing the launch of Pledge 1%. A joint effort between The Entrepreneurs Foundation of Colorado, The Salesforce Foundation and The Atlassian Foundation, Pledge 1% encourages entrepreneurs and companies to give back to their local communities through a gift of equity, profits and/or product. With Pledge 1% we’re aiming to aggregate a large number of smaller transactions to create meaningful impact.

For years we’ve seen the benefit of companies giving back to their communities through the Entrepreneurs’ Foundation network. Since it’s founding 7 years ago, EF Colorado alone has generated over $3M in direct philanthropy back to local non-profits. And we’ve seen participating companies benefit from the incorporation of clear values from their very founding.

But we can and should do so much more. 

Pledge 1% aims to encourage all companies to incorporate a small pledge of philanthropy into their corporate culture through the pledge or gift to a non-profit of their choosing. This gift can be in the form of stock from the company, a pledge of stock from founders or other employees, gifts of time, gifts of profit or gifts of product. We’re encouraging the entrepreneurial community to put a stake in the ground around the importance of giving back. Pledge 1% acts as a clearing house for these gifts and pledges with simple tools to encourage and facilitate giving. In addition to myself, the Pledge 1% founders include Mark Benioff of Salesforce, Ryan Maretns of Rally, Scott Farquhar of Atlassian, Jeremy Stoppleman of Yelp and Dan Siroker of Optimizely.

Check out what we’re doing at And join me in making the pledge.

IPO or M&A? Here’s exactly how large companies exit

I wrote a post a few months ago based on some data from Correlation Ventures about the distribution of returns on venture deals (which revealed that outsized winners are, in fact, much more rare than most people think).

Today I’m focusing on companies in those top return categories with some new data from Correlation that show the percentage of large exits (>$500M) that are generated through M&A vs. IPO (quick side note: I seriously love how much information Correlation collects and how free they are in letting me post about it – as a reminder, Correlation is a firm that co-invests based on an algorithm that predicts the success of the a company; we’re in a few deals together and I can tell you the process is quick and painless; end of advertisement, but seriously – these data are from their work and the fact that they’re so interesting shows why the model works for them).

The graph below shows the trend of exits – IPO vs. M&A over the past handful of years (side note here that Foundry, like many firms, considers an IPO a financing event, not an exit in and of itself; although obviously it can be a path to an exit shortly thereafter).


A few key take-aways here:

– Acquisitions represent about half of all large exits in recent years, showing that both are – at the moment – reasonable paths to exit.
– There’s quite a bit of variability year to year (and cyclicality – not surprisingly), but the overall trend has been to more larger acquisitions (at least relative to IPOs). This reached it peak in 2008, although that may in large part be due to the lack of a public market option at that time.
– Generally speaking this trend holds true regardless of the absolute number of large exits in a given year (this is from the underlying data – not the graph, obviously).

I find data like these fascinating. Humans are horrible at proper attribution (a subject for another post) and I think this is particularly true in a hype driven industry such as venture/entrepreneurship. We all latch on to the big stories and the outlier returns – likely why so many people wrote me after my post on the distribution of venture exits and why there was so much interest on Twitter about it – the data didn’t match the heuristic people had in their heads. For me at least the same is true here – I would have expected the percentage of large exits from M&A to be significantly higher than exits through IPOs.

And that, of course, is why it’s important to actually look at the numbers rather than guess.

Ello World

elloAt the front end of every new investment we hope we’ve found the next break-out company. But it’s rare when you have the feeling that you’re investing in a business that may both be that and has the potential to touch millions of lives. We feel we’ve found that in Ello – a social networking business that’s part Twitter, Tumblr, and Facebook, but at the same time all its own. Ello is a beautiful and easy to use product that allows people to express themselves as they see fit but without relying on selling its users to make money. We’ve just led the Series A financing for the business along with Bullet Time Ventures and FreshTracks Capital. As part of the financing, I’ll be joining the Ello board. You can find the Foundry post about this investment here, and a post from Mark Solon of Bullet Time Ventures here.

Before I go any further in talking about my thoughts on this investment it’s important for me to state unequivocally my support (and Foundry’s support) for Ello’s manifesto to build a company that doesn’t rely on advertising or the selling of user data. We’ll either figure out a sustainable business model that doesn’t rely on compromising these values or we won’t have a business. Below is the mission statement that I’ve signed – along the Ello founders and all other investors – making our intentions around this completely clear (you can click on the image below to see a larger version).

ello-pbcAlong with the financing we’ve also reincorporated Ello as a PBC (public benefit corporation). PBC is a relatively new concept and this is Foundry’s first PBC investment. The idea is reasonably simple – being a PBC allows us to write into our Charter (the founding document of our business from a legal perspective) that we exist to serve not just our shareholders, but also to uphold specific values. In this case we’ve included in our charter a prohibition for selling advertising and user data. While the charter is an agreement among and between the shareholders of Ello, we took the unusual step of essentially restating our mission in our charter because we wanted to emphasize our commitment to building a business on these terms.

I suppose it’s easy to be skeptical about these claims – or for that matter, the fact that Ello has investors in the first place. And perhaps nothing I say here will allay the concerns of those who are looking to take shots at something that is gaining momentum and excitement in popular culture (and it might even be a mistake to try to defend Ello and our involvement with it from those that would prefer the company fail). I know plenty about selling advertising on the internet – we have many portfolio companies that help publishers do this (or that are publishers themselves and who make money selling ads). I’m on the board of several of them (you can see the full Foundry portfolio here). And I’m sure those that want to view this financing negatively will point to these companies as evidence that Ello has somehow sold out or they’re bound to change their business model and lose their way in the pursuit of cash.

Simply put: this isn’t the case.

To be clear, Ello is a for profit business. They plan to make money to support the costs of developing and growing the business. They raised this round to support those efforts. I’m confident the team will develop a profitable business model that supports our investment. This wasn’t a charitable investment by Foundry; our mandate is to make money for our investors and we believe that our investment in Ello will help us do that.

One of the things I’m most excited about Ello is Paul Budnitz, Ello’s co-founder and CEO (and the founder of Budnitz Bicycles and before that Kidrobot). I’ve known Paul for 7 years, and over on the Foundry blog talk a little about how we first met Paul, and the singular position he holds in the history of Foundry. I love Paul’s passion and his creative instincts as well as his singular pursuit of his ideas. Creative Genius is a term that’s thrown around much too loosely in our industry, but Paul truly is. He has a visceral passion for Ello and is unstoppable in his quest to create a place for people to interact with their friends that puts users first. It would be easy to dismiss Ello – a new and of late extremely popular social network – as either a flash in the pan or as too idealistic in their mission to stay true to it. But from our perspective Ello is on the cusp of something huge and potentially game changing. And our belief is that they’ll be successful because of their mission, not in spite of it.

You can find me on Ello at @sether.

Ryan Martens on Councilperson Macon Cowles’ Ignorance of the Boulder Startup Community

Like many here in Boulder, I felt that Boulder City Councilperson Macon Cowles’ recent remarks about our startup community were both ignorant and offensive. A group of entrepreneurs posted an OpEd this weekend responding to those remarks in the Daily Camera (it’s worth nothing the diversity of those entrepreneurs vs. Councilperson Cowles’ flatly incorrect characterization of Boulder entrepreneurs). Ryan Martens – a long time Boulder entrepreneur and community activist – felt the same way and asked to borrow this spot to post some of his own thoughts on the diversity of the Boulder entrepreneurial ecosystem as well as the many ways that entrepreneurs in Boulder are giving back to our community. His post follows.

I was very discouraged to see councilperson Macon Cowles’ comments from Boulder’s city council meeting the 2nd week of August. “Boulder’s startup economy brought a lot of very highly paid white men to the city, and they were pricing out families and others.”  He then followed up with the statement “I don’t think that’s what people want.”  His over simplified view that Boulder’s entrepreneurial community is the direct source of an affordable housing shortage is grossly incorrect.

Why attack the startup community? It is even more disappointing given the significant impact a collaboration between the City of Boulder and local startups could have in addressing complex social issues that face our whole community.

I’d counter his comment with facts:  The startup community is very present in positive ways in many aspects of Boulder.

During last year’sflood, startups pulled together to fund relief and contributed more than $200,000 and hundreds of volunteer hours during normal work hours.  Most participating startups weren’t even making a profit at the time.

The Entrepreneurs Foundation at the Boulder Community Foundation has contributed more than $2 Million for local non-profits during the past two years through donations of stock options at the time of initial offerings (a circumstance unique to startups).

I want to see our community working and collaborating at a level where we are increasing the economy while addressing issues around environmental sustainability and social equity. It is actually the social mission of my company, (a business I started in Boulder 11 years ago and now employees 250+ in Colorado) – to create Citizen Engineers who use their skills to do just that.  The lack of affordable housing issue has been brewing here just like it has in many strong economic cities in America.  It is complex issue tied to the income gap, a booming economy and smart growth strategies that started in Boulder the 1950’s with the blue line and the greenbelt. (Don’t get me wrong, I am a huge supporter of these land management solutions and benefitted greatly by learning from the architects of these models while I attended CU in the 1980’s – Thank you Al Bartlett!).

Thanks to the growing activism of the Boulder Chamber of Commerce, programs such as Better Boulder are forming to help address the housing problem with a systemic approach.  I would encourage the City to reach out, to collaborate and be open to talented people who care about this community working towards creative solutions.

New programs such as Code for America Fellowship program is one such opportunity to reach out towards a creative solution.  This program places two or three full-time technologists on staff with a city government for a year specifically to engage the local citizenry to build a Brigade.   The Brigade goes on to develop solutions for municipal efforts.  Denver has benefitted from Code for America fellows and the City has applied again for fellows for 2015. Boulder’s startup community and my company support these efforts to wrestle with systemic issues such as affordable housing, while increasing citizen engagement in government through civic hacking.

I know the startup community well through work with the Entrepreneurs Foundation, Startup Colorado and other regional efforts, I have helped actively build community capacity along the Front Range and created a venue for corporate giving to Boulder’s Community Foundation.

Starting a contentious dialog by blaming a single component of our community isn’t constructive and doesn’t inspire solutions.   Let’s not take steps backward as a community in our level of engagement.  I know the startup community is here to work hard to make it better for all.

Please remember that community is not something we create, but something we need to recognize we are already in, that takes nurturing.


Ryan Martens

CU Grad, 1988 & 1991

Founder, Rally Software

CEO, Entrepreneurs Foundation of Colorado

Board Member, Startup Colorado

Prior-Board member Colorado Conservation Trust, Friends School and Knight Foundation

Accelerating Accelerators

Screen Shot 2014-08-26 at 11.23.04 AMI spent the day on Thursday last week in a small classroom on the Georgetown campus reviewing finalists in the SBA’s Accelerator Competition. Announced a few months ago, the Accelerator Competition is a program of the Small Business Administration through which they are awarding $50k to each of 50 accelerators across the country to promote entrepreneurship (that’s $2.5M in total for those of you w/o a calculator handy). For a government program it has surprisingly few strings attached – it’s really an experiment by the SBA to see if they can facilitate entrepreneurship across the country through providing assistance to the various programs that support entrepreneurs around the country. Of several hundred applicants the group last week reviewed the top 99 to come up with the final 50 who will be awarded the prize.

I’ve written before about what I’ve been calling the Democratization of Entrepreneurship and why I think it’s so important to think broadly about entrepreneurship.  What really struck me about the applicants we reviewed was exactly this. Entrepreneurship is alive and well in the US and it’s thriving in places well outside of what those of us in the tech world think of as the traditional pockets of entrepreneurship. The finalists for this program included accelerators from towns as small as 1,000, many run by (and sometimes focused on serving) women or minorities, from ares of the country looking to reinvent themselves and join the new economy, to accelerators that were leveraging historical manufacturing capabilities into the new economy. It was an impressive collection of people and stories, all with a common passion for helping entrepreneurs.

I left the day feeling as optimistic as ever about the role entrepreneurship plays in our economy and excited about how strong the entrepreneurial ecosystem is across our country. I was also impressed by the passion that the team from the SBA has for supporting small business (not to mention the pretty amazing group of people they put together to review the applications). I get that it’s their charter, but this goes beyond that. This program isn’t universally loved within the government and I applaud the team I worked with at the SBA for making it happen.

Update: Here’s the link to the SBA announcement of the winners of the competition. 

Some more data on Venture outcomes

Quick update here. The data I site below is from Foundry LP StepStone. Since my original post I’ve confirmed with them that they’re ok with my identifying them as the source of the data. And they’ve offered to help me play with the raw data of a future report – I’ll work on some interesting updates here soon!

Yesterday’s post on venture outcomes – Venture Outcomes are Even More Skewed Than You Think – generated lot of traffic. Clearly, it’s interesting to put real data against a heuristic and see how reality maps to our expectations. As I pointed out in my post, the data set from Correlation Ventures I was working with had some limitations. For starters, I didn’t have the raw data to run my own cuts of the analysis. And more importantly the data were financing level, not company level. A bunch of people asked me about this and I’m working with Correlation to see if the next time they do this analysis we can get a few different views of the data.

In the meantime I went poking around for some additional information and remembered an analysis that one of our investors sent me on roughly the same subject. I thought given the interest in my last post I’d put it up for further discussion. Still not exactly how I’d parse this if I had access to the full data set, but interesting nonetheless. This analysis is on a company basis, not a financing basis (the chart is labeled “Deal” but in this case that means company, not round). I should also note that its skewed a bit towards better performing funds. This was an internal analysis by an LP so I’m not able to release the full report but the data set represented over 3,000 companies and more than $20Bn in invested capital and spanning years 1971 through 2012. The data only represent companies that have exited (and not, for the more recent fund vintages, companies current carrying value). It’s also worth noting that this data set likely shows a slight upward bias, reflecting this LPs selection over the years of better performing funds vs the VC average (from the internal report: “In our view, the data set is skewed toward higher quality funds; the average returns of these deals across vintage years outperform the VC average.”).

The first chart below shows the distribution of venture outcomes by fund size. Interestingly, the loss ratio of smaller funds (where outcomes are <1x) is smaller as a percentage of the portfolio than for larger funds. 49% of deals for funds smaller than $100M fail to return capital, while 73% of deals from larger funds failed to do so. The top end showed the same trend between small and large funds – smaller funds were significantly more likely to produce exits of 5x or greater vs large funds. These data largely track to investment size with larger checks producing not only fewer outsized winners (as you might expect given the nature of larger rounds) but also producing far more companies that failed to return capital (which you might not expect given the nature of the types of deals that raise larger amounts – stage, risk profile and investment structure).

Screen Shot 2014-08-13 at 3.30.13 PM Screen Shot 2014-08-13 at 3.30.38 PM













One obvious conclusion from these data (and something I’ve seen supported by other data sets as well, although I haven’t written about directly before) is that smaller funds outperform larger funds. There’s more to that argument than is contained in the charts above (with well in excess of 50% of all deals failing to return capital, there’s plenty of devil in the details to make that conclusion) however the report I pulled these from – the writers of that report had the full data, of course – clearly articulated that as one of their conclusions. More on that in a separate post at some point. These numbers generally support the conclusions I drew yesterday about the challenge of finding unicorn investments. But the data also suggest that while they don’t truly follow the 1/3, 1/3, 1/3 heuristic, smaller funds come closer to that hypothetical portfolio distribution than do larger funds (at least above average funds do). In this data set, funds smaller than $250M invest in companies generating greater than 3x return 23% of the time and fail to return capital on a little over 50% of their investments. This compares to less than 10% of investments by funds greater than $500M generating a 3x return and almost 72% failing to return capital.

All of the data aside, it’s clear that venture returns are generated by a minority of funds that find themselves in the outlier deals (and that being a successful venture capitalist is quite difficult).

Venture Outcomes are Even More Skewed Than You Think

The typical “successful” venture portfolio is often described as having the following outcome:

  • 1/3 of companies fail
  • 1/3 of companies return capital (or make a small amount of money)
  • 1/3 of companies do well

Fred Wilson, for example, described this a few years ago:

I’ve said many times on this blog that our target batting average is “1/3, 1/3, 1/3” which means that we expect to lose our entire investment on 1/3 of our investments, we expect to get our money back (or maybe make a small return) on 1/3 of our investments, and we expect to generate the bulk of our returns on 1/3 of our investments.

It’s a generalization but one that’s pretty well accepted in venture circles and it’s how many VCs describe target fund distribution, myself included. But does this heuristic match reality?

Actually no.

Correlation Ventures just released a study that shows the distribution of outcomes across over 21,000 financings and spanning the years 20014-2013. For those of you that don’t know Correlation, they take a data driven approach to co-investing – essentially creating an algorithm that predicts the success of a company based on a number of factors that include both business trajectory as well as financing trajectory (we’re co-investors with Correlation in Distil, for example). The result is that they process a lot of data. Which leads to some pretty interested insights.

venture returns

Based on their data, a full 65% of financings fail to return 1x capital. And perhaps more interestingly, only 4% produce a return of 10x or more and only 10% produce a return of 5x or more. These data suggest that the heuristic I site above potentially presents a rosier picture of the venture industry than reality suggests is the case (there are some missing data here in that the vast majority of companies are in the 0-1x category but the data within that category weren’t released – but my suspicion is that within that category the distribution of outcomes follows a similar power curve).

This really underscores the challenge of creating a venture portfolio that produces reasonable returns.  If you were to actually construct a portfolio based on these averages, a $100M venture fund investing in 20 companies would produce a gross return of approximately $206M (that’s before fees and expenses). The resulting fund would have an IRR in the range of 10% (the exact IRR would depend on the timing of the cash flows, but I constructed a few models to approximate this and 10% was the average return).  That’s hardly something to write home about and underscores the challenge of being “average” in this industry.

Hidden in this exercise – and perhaps more important – is the challenge of finding companies at the right side of the distribution chart. In my hypothetical $100M fund with 20 investments, the total number of financings producing a return above 5x was 0.8 – producing almost $100M of proceeds. My theoretical fund actually didn’t find their purple unicorn, they found 4/5ths of that company. If they had missed it, they would have failed to return capital after fees.  Even if we doubled the number of portfolio companies in the hypothetical portfolio, a full quarter of the fund’s return comes from the roughly ½ of a company they invested in that generated 10x or above. Had they missed it, they would have produced a return that roughly approximated investing in bonds – not the kind of risk adjusted return they or their investors were looking for.

It’s important to note here that I’m extrapolating a bit – the Correlation data are based on financings, not companies (I asked – they didn’t have a sort at an entity level in this exercise). I thought about ways to normalize this but came to the conclusion that the best normalization was to use the raw data and caveat that it was financing level, not company level. I’m going to work with Correlation to get entity level detail the next time the do this exercise.

All of this math simply underscores how important winners are to venture returns and how difficult it is to find them.

Note: An obvious, but important, thank you to Correlation for allowing me to share these data as they were originally prepared as a private exercise for Correlation and their venture partners. As I mention above, we’re coinvestors with Correlation in Distil Networks. They have a bit of a unique model for co-investing which allows them to see a lot of data on a lot of companies to support their data driven investment thesis (which also allows them to reach fast investment decisions).