There were some great responses to my post last week as to the poor returns experienced by venture capital fund investors.
Some suggested that the blame for this lied more with the very difficult market and deal conditions of the past decade than with the VC investment model itself.
Typical was this comment submitted by a San Diego VC: "I agree that the VC fund industry is guilty as charged when it comes to being opaque as to real returns data, but I challenge you to revisit your analysis in 24 to 36 months, when we all will have had time to benefit from today’s strong M&A and IPO markets."
One reader reference Gust Founder David Rose’s new book - “Angel Investing: The Gust Guide to Making Money and Having Fun Investing in Startups” and to Rose’s main contention that to access the 25% IRR potential of the asset class one must hold positions in not less than 20 companies.
He asked, “Is this practical advice? I mean - who really has the time to find, diligence, and invest in dozens of companies? And for those that don’t, are there really any “Warren Buffet-types” to back in this asset class?”
This is the billion dollar question, is it not?
And while of course anyone will be very hard-pressed to even approach Warren Buffett’s other-worldly track record, there are some powerful forces right now driving the timeliness of venture investing via the “Berkshire Model.”
These forces fall into three main categories – Improved Liquidity, Investment Flexibility, and what let’s call “Labor Arbitrage.”
Improved Liquidity. Illiquidity is a huge elephant in the room when it comes to startup and emerging company investing. Most startups and early stage companies that seek outside investors are years away from investor liquidity – either via sale to a strategic or financial acquirer, or far more rarely via a Public Offering of the Company’s stock.
Now Berkshire Model companies, as entities with fundamentally investment vs. operating mindsets more naturally position, language, and network their businesses in finance contexts.
While doing so by no means assures successful outcomes, it does create the far more likely possibility of secondary market liquidity alternatives for investors that “want out” in the interim before the final exit.
Investment Flexibility. Investment companies in the Berkshire mold have great flexibility to structure investments of various types: traditional straight cash-for-equity, warrants, contingent warrants, revenue certificates, convertibles, in exchange for professional services, on project-by project bases, and more.
This flexibility is a game changer, as when done right it can provide managed, diversified exposure to a portfolio of deals and opportunities inaccessible via more “traditional” means.
Labor Arbitrage. A wise man once said that all businesses fundamentally do is “bridge the gap” between markets for labor and those for products and services.
Relatedly, one of the best advantages of the Berkshire model is the ability it affords to "Mark Up" the labor involved in effecting deals and transactions.
Let’s explain this by example.
Say a finance or advisory services professional is paid a salary of $80,000 per year, plus bonuses and incentives based on deals, transaction closings, and successful exits (not atypical terms).
Let’s then utilize a 20% load factor and assume that this worker’s fully loaded cost is $100,000 per year. Let’s then assume a 2,000 hour work year (we hope they work harder than this, as this is such an opportunity filled industry!).
Then, on a hourly basis, this professional’s fixed cost is approximately $50 per hour.
Now it is neither unusual nor unreasonable for even midlevel management consultants and investment bankers to bill out at $250 an hour and more on a cash basis, and much more than this on a cash equivalent basis when services are performed in exchange for contingent and / or equity compensation pay structures.
The critical point here is that when services are performed in exchange for equity compensation , even with average deal “picking” there is a natural Deal Arbitrage Effect that can easily create positive expected value on each and every deal.
A massive advantage.
Like everything associated with startup and emerging company investing, a lot of hard and smart work is needed to do it right.
But when done so, the payoffs can be enormous.
Just ask any Early Berkshire investor for confirmation.
To Your Success,
P.S. Like to learn how to apply these principles to your portfolio? Then attend my webinar this Thursday, “What the Super Angels Know about Investing and What You Should Too.”
Click Here to learn more.