First, it’s important for investors to keep in mind that venture capital has certain specific characteristics that affect how the asset class’ performance is assessed.
Three realities of venture capital and startup investing
Reality 1: High risk, high reward
Venture capital is a high-risk, high-reward game; this means it has the power to deliver outstanding returns, but that investors shouldn’t bet the entirety of their nest egg on it.
In fact, venture capital is sometimes used by investors to produce excess returns relative to more traditional asset classes and market indexes – such as the S&P 500 and Nasdaq.
Reality 2: The 10+ year-long roller coaster ride
Venture capital is an investment business with a long gestation period. It can take many years of ups and downs for an investor to reach results for his or her investment in a startup. Promising startups that have raised follow-on rounds at sky-high valuations can occasionally later see their value take a dive—just look at Zenefits, Theranos or Beyond the Rack. At the same time, it sometimes can take much more time and capital than planned for a startup to become a success.
Timing and lack-of-liquidity MUST be considered before investing in early-stage companies. Moreover, because the time factor plays such an important role, venture capital returns should be benchmarked with other investment alternatives on an annualized basis.
Reality 3: Batting averages, strikes and home runs
A lot of VC lingo is derived from Baseball (perhaps a consequence of the VC “Boys Club”). Historical venture capital performance shows that 5-10% of investments generate 60% of VC returns. Investments that return 10x the capital or more, called “home runs,” are more important than an investor’s “batting average” (the number of investments that at least returned the initial invested capital).
It never feels good to lose money, but investors should remember that in venture capital, strikes are part of the underlying investment strategy. Investors need to focus on portfolio performance instead of individual specific investments.
Calculating VC returns
Now that we’re all on the same page about the realities of VC investing, let’s have a look at how its performance is calculated:
Internal rate of return (IRR)
Most investors agree that when measured correctly, the IRR is the best way to evaluate venture returns.
The IRR is the annualized effective return rate which can be earned on the invested capital in a portfolio. The calculation takes the element of elapsed time into account, which is integral in venture capital because cash flows aren’t distributed in a periodic, predictive way unlike interest payments from a treasury bond, or dividends from a well-established stock. The main consideration when using IRR as a performance metric is to remember that it rewards fast exits.
When looking at IRR, investors should ask themselves: Is the IRR net or gross?
Distribution to paid-in (DPI) multiple
This metric represents the ratio of cumulative distributions (cash and stocks) to investors, divided by the amount of capital contributed by investors.
DPI is highly valued because in venture performance only real, actual cash and stock distributions matter. However, DPI isn’t the best indicator of an early portfolios’ health since it takes many years for investments to turn into distributions.
Total value to paid-in capital (TVPI) multiple
TVPI is the sum of cumulative distributions (cash and stocks) to investors and the net asset value of their unrealized investment, divided by the capital contributed by the investors.
This metric can give investors a good overview of a portfolio, even in its early life, but it is highly controversial because calculating the value of unrealized returns can be subjective.
When looking at TVPI, investors should ask themselves: How are the value of unrealized returns calculated?
Investors: Don’t fall into these traps!
Gross vs. Net
The metrics above can be presented as gross or net. Gross returns represent the performance of the investments, the portfolio or the fund. Net returns are actual returns to the investors after the fees and carried interest paid to the investment manager is accounted for.
Many angel investors and fund managers will show-off their returns without mentioning if they are gross or net.
The differences between gross returns and net returns are significant because managers sometimes take up to 2.5% of management fees per year and 20% of carried interest on the upside. It’s important to understand the difference and be clear about what numbers are used when you discuss returns.
Estimating the unrealized
Venture capitalists report the value of their portfolio companies on a quarterly basis. This is unlike mutual funds, which can mark their current assets based on the actual, marketable value of public securities. On the other hand, in venture capital, estimating portfolio companies’ valuation can be quite tricky and variable.
Believe it or not, there are over six valuation methods for early-stage companies and, to make it a bit more complex, they can all produce very different numbers. For the same startup, there are likely at least two investors valuing their portfolio differently. One tends to be more conservative and the other optimistic.
Keep in mind that any VC performance metric that includes the unrealized asset value is an estimation and is no guarantee of actual returns. It simply represents an unrealized gain at a single point in time.
Over time, venture capital returns follow a J-curve. A portfolio will deliver almost no returns in its first few years and its performance will explode once it hits one or multiple home runs.
Just like a fine wine, a well-managed VC portfolio gets better with age. So when you compare the performance of investment managers, make sure to benchmark portfolios against ones of a similar vintage.
Curious to see Brightspark performance metrics? Stay tuned for our upcoming report!