Value Minus Perception: A Practical Framework for VC Returns
Originally a thread on X/Twitter:
People are curious how the “pandemic vintage” of startups is going to perform.
Are returns going to collapse because entry points are 3-5X what they were years ago?
Will the public markets correction crush returns?
A thread about how “Opportunity = Value – Perception”
Observation #1:
VC returns are driven by investing in companies that aren’t fully de-risked that ultimately succeed because the risks never materialize.
A lot of things can skink a startup, but the best dodge bullets, avoid landmines and ultimately create enterprise value.
Investor interest varies because each investor evaluates the risk/return profile using its own methods.
Consensus startups attract capital at higher prices than non-consensus startups because the investor community believes these startups will succeed with high probability.
This leads to a critical VC truism that’s often overlooked:
Opportunity = Value – Perception
If every investor saw every investment opportunity the same way then returns would collapse to the risk adjusted cost of capital. There wouldn’t be “top quartile” managers anymore.
Observation #2:
Even with the correction in the public markets, the best VC backed companies have produced amazing outcomes for early stage Investors. Any early stage Investor who found at least one “right hand tail company” returned their fund many times over.
This isn’t a new phenomenon. The “power law” can be trusted as a fundamental force of the universe with the same level of certainty that every morning the sun will rise in the East and every evening it will set in the West.
Observation #3:
The power law is used to justify lofty valuations. “You can’t pay too much for the best companies” is mostly true.
It’s also true that building a portfolio made exclusively of “best companies” is a fantasy because they’re difficult to spot before they break out.
Observation #4:
Buying a winning lottery ticket isn’t the same as being a great investor. Both produce fantastic economic returns but only one is repeatable.
Repeatability requires skill and discipline. Repeatability requires feedback and learning. Repeatability requires work.
If you want to be a top decile investor, it’s important to do the work to understand the potential return of any investment. And potential returns aren’t only a function of the “exit valuation in a success scenario”.
Only looking at a theoretical exit valuation is the equivalent to buying a lottery ticket without understanding the odds of winning.
Many factors influence returns including a variety of exogenous factors. “Returns math” isn’t based on set-it-and-forget-it formulas.
Buying one lottery ticket with your own money can be fun but assembling an investment portfolio with other people’s money is different.
It kind-of-sort-of feels like you should know what the risk/return profile is of your investments. Your LPs probably care about this.
So when answering the question: “How will a vintage of investments perform”, a good place to start is to examine the key drivers of return and how they’re moving.
10-year VC returns have been fantastic so another 10-year period of similar performance would be welcomed!
Individual investments will follow their own paths but a “vintage” will succumb to the forces of the mega-trends.
And because “Opportunity = Value – Perception”, top quartile managers will always outperform the “vintage” definitionally.
The next step is to lay out the main drivers of returns and how they’re changing.
A simple framework that I like to use collapses the drivers into four major categories: Entry valuation, Capital Efficiency, Exit Valuation and Probability of Success
An oversimplified value formula: Return = (Exit Valuation/Entry Valuation – Dilution From New Shares Issued For Employees and Investors Between the Entry and Exit Period) * (Probability of Success)
So what do we know about how the key drivers are changing?
PROBABILITY OF SUCCESS
Startups aren’t uniform beasts. Unseating an incumbent or creating a market the world hasn’t seen before isn’t easy, but the reality is that some spaces are easier to disrupt than others. Startups chances of success span the entire risk spectrum.
What is true is that launching a startup is easier and less expensive than it’s been in the past.
What is true is that capital availability has given startups more time to crack the code on their businesses than they’ve had in the past.
What is true is that shipping code on time and budget is easier than it’s been in the past.
What is true is that there are established “go to market” strategies that can help scale startups faster and with more certainty than in the past.
Impact to early investors: Positive
EXIT VALUATION
VC backed companies are staying private longer than they did in the past which means that more enterprise value is accruing in the private markets. The best are staying private long enough to “price” at multi, deca and even centi-billion dollar valuations.
Public investors have internalized how good well-run tech companies can be relative to the incumbents they’re attacking. Even with the recent correction in the public markets, exit valuations are very healthy from a historical standpoint.
Impact to early investors: Positive
CAPITAL EFFICIENCY
There are many forces at play that impact how capital efficient a startup is. Generic trends can be examined, but dilution is more a function of “business model specific forces” than the other drivers.
With this said, a few macro forces at work include:
Startup tools
It’s easier than ever to leverage existing infrastructure players to launch functionality. The impact is profound because most tech heavy startups live and die by how quickly they can ship code.
Impact to early investors: Positive
Talent war
The available talent pool hasn’t kept pace with the Cambrian explosion of well-funded startups. Hiring and retaining talent dilutes investor returns because it consumes cash and equity.
Impact to early investors: Negative
Late-stage multiples
Early investors benefit from cheap downstream capital. Multiples have been high (cheap capital) but there are signs that this is changing as we speak given public market comps.
Impact to early investors: Positive relative to historical norms but changing
ENTRY VALUATIONS
Since the magnitude of right-hand tail outcomes have increased dramatically, it’s logical that entry prices have also increased. But not all startups have the same potential which is where investor skill and insight come into play.
Great investors know when to pay up for opportunities that are near-certain winners or opportunities that have outsized “if everything goes right” outcomes. Mediocre investors aren’t as discerning. Poor investors pay up for everything because it’s how they win deals.
Getting this right is important because paying up for the wrong type of startup can crush returns.
Entry valuations for “consensus” oriented investments have mooned in the past few years. And entry valuations for “serial Founders” reflect the belief that “winners win”.
But if Opportunity = Value – Perception, then the way to produce outsized returns is to find non-consensus opportunities where the odds of success are greater than what the broad investor community believes.
But non-consensus companies are risky because raising downstream capital can be tricky until they de-risk the business.
And first time Founders are risky because they don’t have the same access to resources, capital and talent that will follow them to the ends of the Earth.
Impact to early investors: Disciplined investors are paying up for businesses that have reduced odds of failure and truly massive potential outcomes.
And investors who are willing to do the work to find fantastic non-consensus opportunities should outperform the market handily.
With this framework in mind, the question about whether the “pandemic vintage” will underperform can be diagnosed.
We need to ask and answer the question:
Is the “Opportunity = Value – Perception” equation stable, improving or declining?
For the “pandemic vintage” as a whole, returns are likely to come in worse than the vintages generated in the 2010s. Entry valuations are up as are the probabilities of success. Capital efficiency is good but getting worse. Exit valuations are good but getting worse.
But Top Tier VC firms that chased consensus investments during the pandemic should do well. The “opportunity” wasn’t generated by pricing deals carefully. It was generated by winning as much “right hand tail alpha” as possible.
And great VC firms that looked for non-consensus alpha during the pandemic should also do well. Their “opportunity” was to find investments where their view of value was greater than the consensus perception of value.
The losing strategy during the pandemic was to be a VC firm paying-up for consensus deals because they were losing to Top Tier VCs but felt the need to deploy capital. I wouldn’t want to be an LP in one of these funds because the results will probably make you cry.