Monday, December 29, 2014

The Venture Capital Lottery

Venture capital investing has never been for the faint of heart. It seems to be getting even less so with a new type of deal risk entering the market. The current VC environment is characterized as follows:

1)     Profitable exits 2012-2014 and LP distributions have increased the demand for VC investments.
2)     VC industry has responded to LP’s forgetting that past success does not guarantee future success by raising new VC funds to satisfy LP demand.
3)     VC funds are having trouble investing the funds raised in high quality investments and are engaging in higher risk transactions.
4)     The number of hyper risk lottery ticket investments is increasing i.e. investments in pioneer-idea only type firms (no sales) at high valuations.

Usually in such investments founders remain fully invested until later financing rounds i.e. they have skin-in-the-game and are committed. Now, VC are allowing founders to withdraw liquidity in the first financing round. This should send a negative signal to investors. If founders, usually an optimistic lot, are willing to share their upside, it suggests they are unsure about that upside. If founders have questions, then so should investors. Founder liquidity should depend on the firm’s success not the VC fund raising cycle. Remember, these firms must at least pass the revenue test, and hopefully the cash flow positive test before the end of the current up cycle in VC fund raising; otherwise they will fail.

This newest development is being rationalized as removing financial distractions from founders. May be I am cruel, but I want the founders to be paranoid committed to their firm’s success. If they want me to take the plunge, then I want them jumping alongside me for the entire journey. This development is another froth indicator in the VC industry along with nose bled valuations.
VC is moving into the lottery phase. In lotteries, the size of the prize, regardless of its likelihood increases the demand to participate. Everyone becomes fixated on the multibillion payouts of firms like Whatsapp. They are focusing on the greatest maximum return or variance, while ignoring the negative expected return. This is not investing-it is gambling.

I hope everyone had a Great Holiday Season.  I wish all a Happy New Year!


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