Bart Balocki on Practices of Venture Capitalists

Or, how “big bets” are made on “incomplete data”. Bart Balocki, an alumnus of Stanford University, researched the practices of Silicon Valley (US) venture capitalists. These are rough highlights from his talk to the Edinburgh Entrepreneurship Club/Edinburgh-Stanford Link gathering on 17 October 2007. Bart covered the history of US venture capital, outlined how venture capitalists operate, and developed a model of how perceptions of value change over time.

Brief History of US Venture Capital

A simplified time-line:

Although venture capital activity continually cycles through boom and bust, the overall trend over time is increasing real terms investment through venture capital.

Venture Capitalist Practices

Venture capital firms are typically small - about 20 people, primarily consisting of partners (who make deals and control the money), associates (who make deals), analysts and support staff. Firms may also have an “entrepreneur in residence” (a budding entrepreneur within the firm - termed “micro co-location”), and venture partners (sector specialists).

Firms run several funds concurrently. Funds typically run for a 10 year period. They raise money from investors (such as pension funds), and invest the equity in many different entrepreneurs’ ventures. Most ventures will fail, but a few will succeed. The successes should offset the failures within the fund. Successful ventures are sold - either as a merger/acquisition or (rarely) as an IPO. The performance of funds is commonly referred to by year “vintage”, indicating the value of returns from funds started in that year.

Venture capitalists typically take 2% of the fund as a setup fee, and 20% of the value of the final sale - colloquially a “2 and 20″ structure. Within the firm, partners take most of the 20% as a bonus to their salary.

Finding deals tends to be quite labour intensive: “doing lunch”, maintaining networks of local contacts, hosting events. Evaluating deals involves a combination of pattern recognition, due diligence, hiring in expertise, or even just following the crowd. Historically firms would invest in any sector of the economy, however there is now growing specialism, making venture capitalists “faster and smarter”. Typically each associate or partner will complete just 2 deals per year.

Venture capital firms can be characterised as passive or active in their involvement with the ventures they have backed. Active investments might involve a partner or associate as board members. Passive investments might simply stage the financing (not provide all the money up front).

Perceived Value over Time

A particularly interesting aspect of Bart’s research was the graph below (a simplified version, redrawn from my notes). It shows how “perceived values” (y-axis) change over time (x-axis).

Perceived value graph.

Each line indicates the threshold which must be reached for a deal to be considered valuable by each stakeholder.

Line D (green) shows how a new associate venture capitalist (the “deal champion”) perceives value: At first they are still learning, so the line rises in the first few years.

Line P (dotted red) shows how the value of the deal champion’s work is perceived by partners: At first they are not trusted, so it will be almost impossible for the deal champion to convince her partners to commit to a deal.

Line H (dashed blue) shows the first deal the deal champion is able to convince the partners to invest in - the first to exceed line B. The “home run”, this venture becomes the focus of the deal champion. It is highly successful, and eventually its value exceeds the public market perceived value (pink line M): The venture is sold as an IPO at point 1.

Now the deal champion appears to be able to “do no wrong” - she just earnt back the entire value of the fund in one deal! The partners’ perceived value drops below that of the deal champion (at point 2) - the partners are prepared to back ventures with far lower perceived value in the belief that the deal champion knows more than they probably do. Simultaneously, the pre-dot com bubble encourages the deal champion to invest with far less care than before (line D has a far lower perceived value threshold).

Unfortunately, endlessly repeating success in such a high-risk environment is difficult. The deal champion makes many rash investments, none of which repeat the success of their first “home run”. By 2000 both deal champion, partners, and public markets have lost much of their confidence, and lines D, P and M rise again.

Tim Howgego, 18th October 2007. Related topics: Edinburgh, Venture Capital.

Comments welcome