From Pieter Welten – Prime Ventures (@WeltenPie)
A couple of days ago I discussed the ‘hits-driven’ nature of gaming companies with several other investors. There is, from a venture capital point of view, a lot of skepticism towards the industry since it is very difficult for a company to achieve ‘sustainable hit creation’. And that’s what makes us VCs excited right, a clear sustainable competitve advantage? Clearly, there are success stories such as Rovio, the developer of Angry Birds, and Supercell, the creator of Clash of Clans, that delivered great financial returns to the investors. However, these companies are considered outliers. I personally share skepticism towards the industry as well as I find it very difficult to predict the (potential) success of a game! I’d have never expected that ‘Flappy Bird’ for instance would become such a massive hit back in 2014! The design was horrible and the concept is far from original!
Anyhow, during our conversation I started arguing that VCs also rely on a few hits or ‘fund-makers’ and that we shouldn’t overestimate ourselves. Talking raised eyebrows, the point I was trying to make is that without 1-2 big ‘hits’ in your portfolio it will become challenging to deliver a great return to your investors. An example might clarify:
Lets assume a $100 million VC fund that would like to return a 4x money multiple (or $400 million) and intends to invest in 12 companies. 
As you can see in the picture depicted above, in order to deliver such return, the VC is required to achieve a total (or combined) exit value of $2 billion assuming it has on average a 20% equity stake per company at the time of exit (i.e. M&A or IPO). 20% of $2 billion equals $400 million. You can achieve this by exiting all your portfolio companies at $167 million. But since only 19% of tech exits in Europe are +$100 million (according to CB Insights) this might be a challenge.
Hence, one could argue that it might be difficult to achieve a high multiple on your invested capital without one or two ‘unicorns’ (+1 billion dollar) or ‘dragons’ (sub-billion dollar) in your portfolio. This especially applies to typical ‘growth investors’. In our case, one exit of $1 billion would already return 50% of our target return. Great! The remaining 11 companies now have to return the other 50%. Or put differently, one unicorn lowered the average exit value per company from $167 million to $90 million.
Therefore, you see that many strong performing portfolios of VCs have on 1 or 2 (potential) fund returners, but the vast majority of portfolio companies achieve ‘mediocre’ exits (2-5x return on investment which is still a very attractive money multiple) and some might even collapse. This is not a big surprise considering the principle ‘power law’, however it begs the question whether we venture capitalists also operate in a ‘hits-driven’ industry or not? I think we are. Maybe my VC friends don’t like to play games, but I believe we all play (or have to play?) this game called Unicorn Hunting. Without those legendary animals in our portfolio we simply might struggle to deliver an attractive return to investors.
Like entrepreneurs, venture capitalists dream big and want to seize opportunities. We have to realize that we need a couple of home runs to win the game. However, we need to be careful in our pursuit to find the next ever-elusive unicorn and definitely don’t give in to this infectious thing called FOMO (‘Fear Of Missing Out’). Warren Buffet once said: ‘Risk comes from not knowing what you are doing’. Luckily we have our due diligence processes in place! We shouldn’t skip that ‘level’.