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Venture Capital Structure's Effect on IRR in Early Stage Venture Investing

I. Introduction

Over the last 30 years traditional venture investors have moved up the risk curve with respect to desiring more certainty in their investments and ability to deploy their growing pools of investable capital. (PwC/CB Insights, Money Tree Report, Q4 2018) Furthermore, the accelerating growth in technology as well as growth in the public cloud has created a boom in technology start-ups. These early stage start-ups have created an increased need for investment into this expanding market. The focus of this paper is to analyze the different investment structures employed by investors participating in early stage start-ups and how these structures can affect the investor’s IRR. We will also examine what resources or unique structures groups participating in funding early stage companies provide, beyond cash and board representation, to increase the likelihood of company success and IRR for their investors.


In this paper, we have two goals. First, we describe the differences and similarities among the various types of venture groups investing in early stage companies. These groups differ in several ways including the business and financial models, the organizational structure, the legal status and the skillsets required for a successful operation of a corresponding group.


Second, we compare investors risk-return trade-off across the different groups. This is a challenging task given the spectrum of successes and failures within each group varies greatly. In this paper, we will not judge investors’ ability to make sound decisions but to compare the effect of different venture groups structures in benefiting investor return. In our analysis, we assume that all investors are equally talented and perform to the fullest extent of their capabilities. In other words, we don’t compare who performs better, we only compare what business model is by design the most beneficial for an investor.


The paper is organized in the following manner. Section two defines the various venture groups, section three analyzes the investor returns for each group, and section four provides a brief conclusion.


II. Defining Venture Groups

For this paper we have taken a broad approach to identifying and defining the groups that invest in early stage ventures. Our approach was to classify the venture groups based on the skillsets that lie at the core of the venture group investment model.


A. Angel Groups

Angel groups are networks of wealthy individuals who provide capital for early stage businesses as well as provide advice to their portfolio companies. Angels invest their capital individually rather than in a pool managed by professional investors. They tend to invest in the seed round and take large percentages of equity to compensate for risk. They are, however, subject to dilution during the company’s later stage capital raises.


Angels are typically successful entrepreneurs (oftentimes in the area of their investment). They will make their wealth of experience available to the company they invest in and use their wide networks to make introductions that might provide a valuable access to highly-skilled human capital. In summary the Angel Group’s skills and provisions include:

  • Narrowly focused due diligence skills based on the Angel’s expertise

  • Contacts

  • Business experience that may apply to the target company

  • Added legitimacy from working with well-known or reputable Angel investors

B. Incubators & Accelerators

These groups primary focus is to help startups grow. Incubators and accelerators work with the youngest and smallest companies who are still at their ideation stage. Even before the capital raising stage, young start-up companies are looking for mentorship and expertise to refine their ideas, to double proof whether their business model makes sense, and to uncover unidentified potential risks and impediments. For example, they might simply need a cheap office space in which to work. They may also need assistance getting prepared for potential investor meetings whether that be through learning how to present their ideas, calculate Total Addressable Market and other key metrics, or anticipating questions that may arise from investors.


Incubators and Accelerators focus on sourcing and identifying the most promising of the earliest stage start-ups. They then proceed with their most important function, which is providing mentorship and education (for accelerators it may include providing office space and operational support). When appropriate, they go further by exposing their “graduates” to an auditorium of angels and VCs who listen to the companies’ demo and select the ones in which to invest. Thus, accelerators serve as a “preoperational” stage before entering the life of a VC-backed company and are also a gateway to get in front of investors. A startup must give a share of its company for access to accelerator’s resources. The accelerator eventually uses the money it gains from successful startups in order to cover its operational expenses for the entire pool of successful and unsuccessful companies. In summary the incubator’s and accelerator’s skills and provisions include:

  • Diligence process which serves as a vetting mechanism and grants varying levels of legitimacy dependent on reputation of the group

  • Mentorship, education, operational support at a “pre-VC” stage

  • Access to a large audience of VCs for investment opportunity

C. Venture Capital Firms

Venture capital is the most common type of venture group. VC firms, or General Partners (“GPs”), raise money from Limited Partners (“LPs”) and use it to invest, through a specific fund, in start-ups. If the investment is successful, investors generally expect outsized returns oftentimes around 10x invested capital. VC firms take part of the LP’s capital contribution to support its operations as well as a carry fee from a successful startup’s exit. Unlike angel investors who invest as individuals, investors contribute capital to a fund as LPs and the VC fund itself invests into companies. Venture partners are often either experienced entrepreneurs or have extensive experience in the finance world with their own powerful networks. As stated earlier, there are less and less VC Funds investing in early stage companies since they have moved along the risk-return curve to more developed companies where they believe there is a greater surety of an acceptable return. When examining investments by deal size, deals under $25 million as a percentage of all US VC capital invested have decreased precipitously each year from a peak of 62.7% in 2009 to 25.1% in 2018 (Pitchbook Venture Monitor Q1 2019).

This model has the consequence of requiring a very significant outcome to generate their advertised return for their investors which has been difficult to achieve over the last 20 years. (Kauffman Foundation Report May 2012)


VC’s offer limited skills needed to participate in start-up operations and tend to influence their portfolio companies at the Board level. Hellman and Puri (2002) confirm that on average “[...] venture capitalists play a role at the top of the organization, in terms of replacing the original founders with an outside CEO. Moreover they seem to influence developments further down the organization, in terms of playing a role for the introduction of stock option plans, the hiring of the VP of sales and marketing, and the formulation of human resource policies”.(1) Further, dependent on the portfolio composition targeted by a firm, there may be opportunities for collaboration across portfolio companies and VC funds may assist in exit conversations and other meaningful liquidity events. In summary, VCs investing in early stage companies skills and provisions include:

  • Extensive sourcing, i.e. ability to find as many potentially interesting start-ups as possible

  • Quick and high-quality due diligence - the longer time spent on due diligence the greater the average expected return. A partner at a VC fund quantified the time commitment by stating less than 20 hours of due diligence equates to an average expected return of 1x whereas 20 hours or more equates to a return greater than 5x. As funds often invest in about one out of 100 opportunities, using this 20-hour metric it would take 25 weeks to screen 100 companies and would result in two investments per year. Due to time constraints, in practice VC funds rarely have time for lengthy due diligence processes. (Forbes Article: Here's How Long A Top Global VC Firm Spends Doing Its Due Diligence)

  • Potential collaboration across portfolio companies within a fund

  • Introductions and expertise dealing with exit opportunities and other liquidity events

D. Corporate Ventures

The central mission of this group is very different from that of all other venture types. While angels and VCs typically target the highest IRR, this is not necessarily the case for corporate ventures. Corporate venture groups are established within a corporation and serve that corporation’s mission which does not have to be achieving the highest IRR. The Corporate venture’s mission may be to create a product that will be more disruptive than one of the corporation’s legacy products, to invest in small start-ups to remain competitive with future potential competitors, or to hone start-up skills to retain a nimble and innovative mindset throughout the corporate entity.


Startups within corporate ventures might get as little or as much support as it aligns with the corporate objective. As such, it is of utmost importance for the group to adhere to the corporation’s mission. All other things - from funding to human capital – are provided by internal resources.


In this paper we will not analyze corporate ventures any further. It is important to mention their existence but the very goal of this group is different from to aforementioned groups since they don’t strive to exclusively achieve superior returns. Therefore, we will omit corporate ventures from our analysis.


E. Venture Studios

This is a relatively new type of venture group that combines some aspects of an accelerator with those of the VC in order to reorganize them in its own manner. There is no definitive classification for venture groups. Our research revealed three types of studio models.

  • Production / factory venture studios (PVS) work with small start-ups with revenue traction and provide operational services to develop and grow a company.

  • Full-stack venture studios (FVS) partner with entrepreneurs to drive business ideas and develop a product / service without necessarily providing direct cash capital.

  • Venture builder studios (VBS) are similar to production venture studios in the sense that they have direct impact on a start-up’s operational activity, but do not select start-ups from an outside pool. Instead, a VBS uses its own resources to ideate, launch, and then to operate and grow startups. A VBS produces the entire cycle of creating and developing a company from inside. Its only similarity to a traditional VC is that it has external funding that is used for operational purposes. Since this model combines entrepreneurial skills with development and managerial skills, it is difficult to implement and has few examples in the venture community. The negative aspect of the VBS is they are not exposed to the breadth of companies of the other venture models.

In summary, the three studio model’s skills and provisions include:

  • Talent for developing ideas in-house and ability to see promising concepts - VBS

  • Ability to use internal resources and professional teams to create new startups - VBS

  • Ability to quickly bring experienced tested resources to accelerate company growth – VBS, PVS, FVS

  • On average investors retain greater equity participation – VBS

  • Ability to maintain operational consistency and control over all portfolio assets – VBS

  • Legal structure as an operating company rather than an investment company equals less stringent regulatory oversight – VBS


III. Increasing Investors’ Returns

As previously mentioned, we start with a premise that investors in all venture groups are equally professional and talented. We also assume that none of the groups experience lack of capital and that they all are subject to similar systematic risk. With these assumptions, we analyzed the impact of different venture groups design on their ability to deliver superior investor returns.


IRR = [(EP1 * S1 - C1) + (EP2 * S2 - C2) + … - F] / I

where

EP1, EP2, … - exit prices of every successful startup

S1, S2, … - ownership shares in each corresponding startup

C1, C2, … - venture group’s carry from each corresponding exit

F - venture group fees

I - invested money


Assuming equal weighting in each project, averaging the equation we get: IRR = (EP av. * S av.- C av. - F) / I


So, given I is fixed, there are four ways to increase IRR:

  1. Increase the average EP, in other words, increase the success rate

  2. Increase the average S, i.e. increase ownership

  3. Decrease the average C i.e. decrease carry

  4. Decrease F i.e. decrease fees


The following section will discuss which venture groups are most successful in each of these criterion.


A. Increase the Success Rate (EP)

What defines whether a particular start-up will succeed or fail? Obviously, there is no one correct answer.Start-ups fail for different reasons and different combination of factors. However, the shocking fact that about 70% of upstart tech start-ups fail (usually around 20 months after first raising financing)(2), provides sufficient data to analyze the most common reasons for the failures. CB Insights analyzed 101 unsuccessful startups and identified top 20 reasons why startups fail.(3)


For the goal of this paper, we decided to focus on three major reasons and see how the different venture groups address them.


#3 reason: Not the right team (23% of failed startups cited as a major failure reason) A diverse team with different skillsets was often cited as being critical to the success of a company.


Standout Jobs wrote in their post-mortem, “…The founding team couldn’t build an MVP on its own. That was a mistake. If the founding team can’t put out product on its own (or with a small amount of external help from freelancers) they shouldn’t be founding a startup. We could have brought on additional co-founders, who would have been compensated primarily with equity versus cash, but we didn’t.”


What different types of venture groups do about it

  • Accelerators, Incubators, Angels and Angel Groups – these groups do not have influence on a startup team. Even though startups always include information about the team in their pitches, these venture groups can only assess how diverse and professional the teams are but don’t have the power to formally replace members.

  • Venture capital firms – similar to the previous group, unless severe adverse events take place, VC firms do not have the authority to replace members of the management team. Oftentimes, VCs sit at the Board of Directors and add their expertise in terms of management, business development and growth but they, for example, do not add an industry expert to a team of entrepreneurs or a technology expert to a team of ex-consultants. “Investors do not necessarily provide their portfolio firms with more slack resources, but [...] these investors do help entrepreneurs to make the most out of the resources at hand”. (4)

  • Production and full-stack venture studios serve as “co-founders” for entrepreneurs. These structures facilitate the addition of necessary skillsets and professionalism to an existing team and structurally have a greater chance to avoid this failure.

  • Venture Builder Studios are the founders and developers of their portfolio companies. They are solving the “not the right team” problem by sharing experienced internal professional diverse teams among their startups. They try to ensure that from day one every company that they start has all the relevant workforce resources and scales the team with growth across all aspects of the business including managerial, technological, marketing, financial and operational teams.

#2 reason: Ran out of cash (29% of failed startups cited as a major reason for failure)


Money and time are finite and need to be allocated judiciously. The question of how should you spend your money was a frequent conundrum and reason for failure cited by start-ups. As the team at Flud exemplified, running out of cash was often tied to other reasons for start-up failure including failure to find product-market fit and failed pivots. Additionally, there may be poor stewardship of investor capital as is highlighted by Techcrunch’s exposé on a failed startup,


Beepi:

“But Beepi, a source tells us, was run with the wrong priorities. One ex-employee said Beepi was burning through around $7 million a month when it had its peak of 300 employees […] But, as one claimed, there were also many expenses that pointed to a company that was not economizing, spending money on things like a $10,000 sofa for the executives’ private conference room, and covering phone and car expenses for the founders’ significant others. “There was a definite abuse of funds,” an ex-employee said”(5)


What different types of venture groups do about it?

  • Accelerators, Incubators – these groups are not supposed to infuse money into startups. They help companies raise their initial round at the Demo Day, but the start-ups’ problem is not that they did not secure their first investment. The problem is that if they don’t grow big enough or don’t make enough sales or don’t use resources efficiently, they will run through their funding and will have difficulty raising capital in the future. By that time, they are already too big for accelerators and incubators to ask for additional help.

  • Angels, Angel Groups and Venture Capital firms – the main reason these groups exist is to invest money in start-ups. However, if they don’t see potential in a start-up, they are smart enough to not escalate their commitment and consider previous investments as sunk costs. If the founders are not able to use their first money rounds wisely, they will have a hard time raising additional funds.

  • Production and full-stack venture studios – the focus of these groups is to be operationally involved – not monetarily. This might be indeed helpful but only if one assumes assisting in operational endeavors will translate to cash flow positive operations or a liquidity event.

  • Venture Builder studios employ their own management teams avoiding situations such as the one highlighted in the case of Beepi. Being active participants in their investments, VBSs target first growth thresholds with minimal investments and decrease early stage losses due to the added insight they have into the prospects of a venture.

#1 reason: No market need (42% of failed startups cited as a major reason for failure)


Tackling problems that are interesting to solve rather than those that serve a market need was cited as the No. 1 reason for failure.


Treehouse Logic applied the concept more broadly in their post-mortem, writing, “Startups fail when they are not solving a market problem. We were not solving a large enough problem that we could universally serve with a scalable solution. We had great technology, great data on shopping behavior, great reputation as a thought leader, great expertise, great advisors, etc., but what we didn’t have was technology or business model that solved a pain point in a scalable way.”


What different types of venture groups do about it?

  • Accelerators, Incubators – these groups have a major impact on this problem. During their mentorship programs, they can help founders understand the way to explore the market and find customers’ unmet needs. However, many founders fall short of the confirmation bias and see only those signals that confirm their idea. It is difficult to be objective and accept that a market does need your breakthrough product.

  • Angels, Angel Groups and Venture Capital firms – these groups do not have the power to change the product or the world. They might offer some improvements but if the gap between the product and customers is really wide, the whole concept needs to be changed. This is where founders are the only or at least major decision makers.

  • Production and full-stack venture studios – as “co-founders” venture studios can also shape the product-market fit. But again, as long as the studio agreed with founder’s start-up idea, room for changes is pretty narrow. These groups may bring an objectivity to the process since they don’t have ownership bias.

  • Venture Builder Studios develop ideas internally. Therefore, they have ownership and control over the ideas and can easily change the direction of the product if the market so dictates. Like any entrepreneur, however, they may suffer from ownership bias. In addition, they are by design exposed to a fewer number of ideas and a less diverse range of ideas.

B. Increase Ownership (S)

VC firm’s average ownership in a startup ranges from 30-37%. Angel investors on average range from 20-25%. Incubators and accelerators range on average 6-7% ownership. Professional and full-stack venture studios are usually in the 10% range. Venture builder studios, because they create their own companies rather than buying fractional interests in companies, can range between 65% - 85% ownership in their companies. Median investor stakes acquired at angel & seed deals has shifted over the past two years, with founders now giving up a median ownership stake of 25%.(6)


And not only do these numbers speak for themselves in terms of the role they play in the IRR equation, but also research confirms that increased ownership stake increases investor’s mentorship incentives: “Providing extensive value-adding services and monitoring entrepreneurial actions, however, are costly activities to investors. Hence, without the proper incentives investors may not be sufficiently motivated to be actively involved in their portfolio companies and thus to influence entrepreneurial discretion. An important determinant of investors’ incentive to expend effort on portfolio firms is their ownership stake. A high ownership stake should make investors more motivated and committed to provide information and advice to entrepreneurs and to monitor their actions”.(7)


Investor participation, in its turn, has a positive impact on startup success: “After an angel makes an investment, his or her participation in the venture - through mentoring, coaching, financial monitoring, and making connections - is significantly related to that venture’s outcomes”.(8)


“[...] a positive relationship exists between investor activism and exit performance, and [...] this relationship is both statistically and economically significant”.(9)


These statistics show increasing the S part of the equation may provide investors with a dual effect: from the increased S itself and also from the increased success rate because higher ownership leads to higher mentorship which in turns leads to higher success.


C. Decrease Carry (C) and Fees (F)

Angels obviously do not charge carries and fees for themselves. Accelerators and incubators charge 6-7% of equity for their services and thus do not decrease investors’ returns. Venture capital firms, however, use money from the LPs’ investments to sustain their business model and cover their operational needs. Although payment waterfalls may differ, based on agreements with LPs, GPs also charge a carry on exits (industry norm of 20%). This way, VCs minimize their downside and maximize the upside - all using investor dollars. In this regard, decreasing C and F is almost impossible when dealing with VCs because this is how the model is structured. Venture builder studios are not structured as investment funds. They are more closely related to a traditional operating company than an investment vehicle. They do not charge fees or carry and share any liquidation returns equally with their investors.


IV. Summary

In this paper, we analyzed several types of venture groups: angel and angel groups, incubators and accelerators, venture capital firms, corporate ventures and venture studios. Our goal was to compare these groups in terms of their structure, and the main functions they provide to the startups they invest in. Some of them (like accelerators) are more focused on a pre-investment stage, that is helping entrepreneurs create a sound business model and teaching how to pitch investors. Others are more hands off and do not intervene beyond capital infusion. We then introduced a simplified formula for investors’ returns and described its major components and how each component can be favorably changed. We attempted to identify which of these groups provide a structure and skillset that might assist in generating a greater IRR for its investors.


One point that stands out in our analysis is there are primarily two main groups, those that invest in entrepreneurs and those that include the entrepreneurs as well as the mechanism by which ideas are created for development. Each group then provides specific skills, structures, and assistance to increase the potential for growth and return. Some of these provisions appear to be directly correlated to increasing IRR, while others may have indirect effects on return. With the success rates of early stage companies being extremely low, it appears that there is no holy grail to solve this problem.


The model that stands out from our analysis is the studio model. In addition to providing capital, studios also bring experienced talent to the enterprises in order to avoid costly errors that less experienced entrepreneurs might inflict on their companies. In today’s venture environment, providing proficient talent will probably have a greater positive effect on IRR than just providing more capital. The venture builder studio goes one step further than just adding operational talent by adding the entrepreneurial talent for the “creation of ideas” to its basic structure. With so few venture builder studios in the market we will have to wait and see if this model proves to be the best one for increasing both the percentage of successful start-ups and the IRR of its investors.


Sources:

  1. 1. Hellmann, T., Puri, M. (2002) ‘Venture Capital and the Professionalization of Start-Up Firms: Empirical Evidence’. The Journal of Finance, LVII, 1, 181.

  2. 2. CB Insights. “How to Lose It All: 8 Startups That Went From Investor Darling To Cautionary Tale”. March 6, 2019.

  3. 3. CB Insights. “The Top 20 Reasons Startups Fail”. February 2, 2018.

  4. 4. Vanacker, T., Collewaert, V., Paeleman, I. (2002) ‘The Relationship between Slack Resources and the Performance of Entrepreneurial Firms: The Role of Venture Capital and Angel Investors’. Journal of Management Studies, 50, 1092.

  5. 5. https://techcrunch.com/2017/02/16/car-startup-beepi-sold-for-parts-after-potential-exits-to-fair-andthen-dgdg-broke-down/

  6. 6. Pitchbook: “3Q 2018 VC Valuations Report”

  7. 7 Vanacker, T., Collewaert, V., Paeleman, I. (2002) ‘The Relationship between Slack Resources and the Performance of Entrepreneurial Firms: The Role of Venture Capital and Angel Investors’. Journal of Management Studies, 50, 1077.

  8. 8. Wiltbank, R., Boeker, W. (2007) ‘Returns to Angel Investors in Groups’. 7.

  9. 9. Bottazzi, L., Da Rin, M., Hellmann, T. (2007) ‘Who Are the Active Investors? Evidence from Venture Capital’. 3.

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