Vanity Metrics in Venture Capital
Venture Capital is a craft. Despite of the scientific, academic, and economic models that form the fundamental grounds of the venture capital industry, there are everchanging variables that make it hard to define the exact business model of a successful VC. After all, you can model the past performance of a portfolio and understand it, but you can’t even predict the future of a single investment with precision. In other words, investors can’t prove in advance how they’ll leverage high-growth companies to multiply other people’s money… hence, past numbers are all VCs have on their defense.
Speaking about numbers, a lot has been said about the vanity metrics used by entrepreneurs to impress investors: facebook followers, registered user base, number of Fortune500 clients, you name it. VCs repeatedly remind those founders that it’s not about how much you have, but how much you deliver. So they discuss user engagement, churn, lifetime value, and montlhy recurring revenue growth to make things clearer, paving the way for a potential investment negotiation.
Fine. But have you ever thought about VCs and their own vanity metrics? What numbers do VCs use to impress founders and their own limited partners, in a way they feel confident and seem attractive to people, companies, and organizations that hold a considerable amount of money to be multiplied? Let’s look into three of those.
Capital under management
First thing most big funds use is capital under management. Fair enough: billions of dollars are a pedigree certificate, and it usually takes a long time to build an asset that big. But that’s just deployable money, right? And not performance guarantee. Yes, the fund has a track-record and has been able to harvest that amount of bling – but the taller you are, the harder your potential fall by bleeding money on a bad investment. They compensate that risk by following other funds on big rounds in already established companies, or aiming for thinner air and creating a private equity operation.
Return on managed capital is a much better metric than capital under management. When considering a fund, potential limited partners usually know the gain of each managed fund…So wouldn’t it be great for founders to have access to the same metric, and what’s the story behind it? So when analyzing funds, aim for leveraging and returns, not how much money they hold.
Number of big portfolio companies
Imagine the thrill a founder feels when clicking “Portfolio” in a fund’s website and seeing companies like Dropbox, AirBnB and Uber on that list… This is how big funds hook entrepreneurs. Even so, there is a considerable chance that fund followed another fund on that investment. In other words, it didn’t find that startup by itself. But isn’t this how a fund differentiates in the VC market? By finding all the great companies long before they’re discovered by others?
Instead, find the big companies where the fund has been an early investor. Since big funds will often concentrate their bets on billion-dollar companies, the foreseeing powers of a fund will often translate on the companies it found way before everyone else. It’s even better when they’re a big fund, but bent their rules to invest small bucks on a promising startup.
You’ve probably heard this somewhere: “Our most recent exit was a 10x return” – meaning the return was 10 times the capital initially invested. Consider an investor holds 30% of the startup’s equity:
- If the fund invested $2M, the startup exited in a valuation of ~$60M
- If it invested $10M, the startup exited in a valuation of ~$300M
Thus, the multiple helps if you know the amount of capital originally invested and when did the fund invest. If you don’t know round details, the return multiple is just a vanity metric. A tenfold increase in valuation takes considerable time for most startups: was 10x a great investment? Maybe, if it didn’t take 10 years or longer.
A 50x on the best investment made by a fund compensates for all the losses on all other portfolio startups. So if you’re really evaluating how the fund performs, the wins and losses could be on the table for a better analysis; the list of returns on single investments is a better metric than single return multiples, because it’s like a drill-down in the first metric: it brings all the 10x and 20x down to 0x sometimes, because a fund is not all about hits.
You’re so vain
You probably think this post is about you – well, not necessarily. But if a VC is looking into better investments and less waste, metrics should be a heavy duty.
The average founder is not always in a picky position to choose a fund – they mostly need the money, wherever it comes from. Smart founders, on the other hand, envision their subsequent rounds and think: what are US$ 5 billion worth if all we need is a US$ 5 million round? Then the questions become:
- will they bring other funds to the table, diversifying networking and reaching other markets?
- how did the other invested founders leverage the fund in their own benefit?
- how does the fund relate to its invested founders over time?
- how hands-on are these guys?
And many others related to quality, not quantity.
The vast majority of returns, even for big funds, lies in the basis of the pyramid: early-stage startups. When investing early in (still) small but promising startups, funds can dramatically improve their performance in a course of 5-7 years. If they look deep into themselves and consider the numbers that really matter (instead of self-deceiving themselves with vanity metrics), there is an incredible opportunity for improvement.