From Jan Andriessen – HenQ (@janandrssn)
I have a strong recollection of the first time I came in touch with the world of venture capital. It was as the student founder of my own corporate finance boutique called Scord, which helps startup companies raise seed funding. Having landed my first customer, I did not have the slightest idea of what constituted the right type of investor for my client.
After an incredibly inefficient process of approaching over a 100 funds across the Netherlands, London, Berlin and Scandinavia we did manage to find our way, but could have done things much more efficiently. Nearly four years later I have a clearer answer to my question during the first days of Scord: how to decide which VC’s are the right ones?
Against that backdrop, this blog is for those who are not yet fully familiar with VC and wish to avoid some of the inefficiencies we suffered at Scord. Those who are, for example, landing a VC as an investor in their company or joining a VC as an investment team member.
How to define VC Quality
In my view, the two main reasons for choosing a venture capital firm as your long-term funding partner or employer are:
- Personal fit with the VC you go into business with (i.e. do we share the same values and way of working?);
- VC firm quality (i.e. how good are they at the type of investment that is relevant for me?).
These two are the crucial, interdependent pillars of a successful collaboration. I think you should always aim to work with an investor that fits your values and way of working, because success will be pointless if you achieve it without staying true to your personal values and beliefs. On the other hand, staying true to your values and beliefs is rather marginal, or at least not as impactful, if you do not become successful.
A good VC enables you to be successful. It’s one one of the oldest rules in the book and a bit like a force of nature: the best learn it from and surround themselves with the best. Alexander the Great learned it from Aristotle and the great Philip II of Macedon, Henry Ford from Thomas Edison, and Tom Perkins from Bill Hewlett and Dave Packard.
Against that backdrop, surrounding yourself by the very best possible VC firm means getting a business partner on board that has seen successes and failures before and can teach some of the tricks of the trade. Or, in other words: the VC you work with can be your own (slightly less cool and brilliant) Thomas Edison.
Below I will provide you with a quick and dirty, yet relatively adequate way of assessing how good a venture capital fund actually is at what it does and, as such, how much of a Thomas Edison it can really be for you.
Assessing VC Quality
You could argue for different ways of defining the quality of a VC, from either a financial or more societal perspective. However, it is my interpretation that these are largely equivalent in practice.
I see across henQ’s as well as colleagues’ portfolios that financial gains tend to go hand in hand with optimal societal impact. That makes sense. High growth companies with an attractive business model tend to have the strongest ability to attract capital, and by extension of this access to capital, the greatest ability to generate impact.
Even though this might be a rough assumption, I think it holds quite well. Hence, when looking for a well performing, winning VC fund, I will assume for now it does not really matter whether you take on a societal or purely financial perspective.
In light of that assumption, I think the easiest way to judge the quality of a VC fund is by its ability to invest in enough high growth companies such that the fund returns sufficient money to its shareholders, making the latter group happy enough to invest in the VC firm if they would have the opportunity again.
To keep things simple, I will assume that more money returned means happier shareholders, which again is a rough assumption that roughly but sufficiently reflects reality.
In practice, most of the very best VC firms:
- Have spotted one or more major winners (“fund returners”) every 3-5 years. (If a firm does not produce winners, it probably is not the most successful VC, even if all the partners of the firm went to Harvard and previously worked at the most impressive growth companies.)
- Invested in such winners in the right phase and within the industries they focus at (e.g. if you are looking for seed funding for a market place from a fund that invests in market place seed a lot but has its major winners coming from €15mln+ medical equipment investments, it might not be the best fit).
- Invested in their winners in the right geography (e.g. if you are applying for a job at the Danish office of a successful VC that meets the above criteria, but invested in most of its winners from San Francisco, you might still not get exposed to the Thomas Edison Effect).
Below I provide some shortcuts of how to assess each of these indicators. The value of each indicator (e.g. portfolio companies, fund size, exit value, number of investment rounds) should generally be publicly available on sources such as Crunchbase and by simply Googling.
Assessing the major winners of the fund
Generally speaking, a major winner is a company in which the VC firm has sold or will likely sell its stake for approximately the value of its entire fund. This is what VC’s call a “Dragon” or “Fund Returner” and, even though a company can also be very successful without achieving these exceptional valuations, it is these extreme returns that most VC firms have built their investment model around.
For a VC fund of €100 million, assuming that most VC’s hold at maximum 20-30% in their winners at exit, a Dragon is a company of which the equity has been sold or is likely to be sold for roughly €300-500 million. For a €500 million fund, this means a fund returner is more likely to have been exited in the range of €1,67-2,5 billion. In other words: to be a successful VC, you need to back a very rare success several times per decade.
There are a couple of further rules of thumb to improve the accuracy of your estimate of the number of winning investments. They are still simplifications, but form a good brain exercise:
- If a VC fund is the single investor in a particular round, its stake in the company is probably roughly between 20-30% (though this may vary in practice, this is a reasonable assumption), so use an average of 25% to calculate the Dragon Factor (DF) of a VC’s investments:
- DF = equity value at exit * 25% / fund size (For a major winner, this factor should be bigger than 1.).
- If the investor co-invested in its initial investment, then divide the above 25% by the number of co-investors (for the sake of simplicity ignoring who was the “lead investor” in that round), so the calculation of the stake at exit becomes [25% / N], N being the total number of investors that participated in the round in which the particular fund made its first investment:
- DF = [ 25% / N * equity value at exit ] / fund size.
- For every follow-on round in which the investor did not invest, multiply the initial stake held by the VC by [1 – 25%], F being the number of follow-on rounds in which the VC’s did not partake:
- DF = [ 25% / N * {1-0,25}F * equity value at exit ] / fund size.
- If a VC does do a follow-up co-investment, generally its equity percentage remains equal to the percentage held after the previous round. This would have no effect on the Dragon Factor calculation for the particular investment. If the VC is the sole investor in a follow-on round, it likely adds another 10-20%, which in turn should be added to the percentage held in the previous round. The easiest way to calculate the latter, is to cheat a bit and manually modify the Dragon Factor as follows:
- DF = [ { (25% / N) + 15% } * {1-0,25}F * equity value at exit ] / fund size.
The above should be accurate enough to get a feeling for whether a particular VC is actually good at what it does.
Some qualitative insights: the more a fund co-invests the more winners it should have. (I.e. Co-investment driven funds are not per se better because they have more winners.) On the same note, a VC should have more winners the more investment rounds in which the fund does not participate after its initial investment. (I.e. Early stage investors need to have an answer to dilution to be successful.)
Assessing the phase this VC is a rockstar at
This is a simple one. All else equal, the initial investment in the majority of a fund’s large winners should have taken place in this phase. For example: a fund is not truly a great Seed investor if it invests in seed mostly, but all of its successes come from initial tickets in Series B investment rounds.
Assessing the geography this VC dominates
All else equal, the initial investment in the majority of a fund’s large winners should have taken place within a certain country or region (e.g. Germany, or Europe). Don’t be fooled by companies that were founded in one geography, then moved and after they move received an investment from the particular fund in the geography they had just moved to. A company might for example be founded in Denmark and a VC might have a branch in Denmark, but if the initial investment took place at the moment the company was already based in San Francisco, then the Danish winner was a US investment from this particular firm.
Conclusion
People like Henry Ford learned it from people like Thomas Edison, who had seen it all before. When you run a starting company or want to work for a VC fund, the people who work at such a fund become the (less brilliant and slightly different) equivalent of your Thomas Edison. Hence, make sure you are on board with one of the winners in the investment stage and geography relevant to you. Do not just believe, as it is not that difficult to do the actual math. The above simplified rules of thumb hopefully prove a tiny bit helpful in making the right decision, whether you are chasing after financial returns or impact.