This blog post was a collaborative effort by my team. In particular, I want to thank my partners Alan Patricof and Dana Settle for their help.
We founded Greycroft on the basis of three observations:
1.) Successful VC firms increase assets under management over time, as each new fund is bigger than the prior fund. This is a reality in every area of the money management business.
2.) Firms adjust investment strategies to accommodate larger funds. The most obvious change is to increase investment size, but large funds also syndicate fewer deals and develop higher ownership thresholds.
3.) Over the last decade the venture industry migrated from an IPO-based exit environment to an M&A-based exit environment. The distribution of M&A exits is much more modest than IPOs, with an average exit just over $100MM.
Some investors assumed that the venture industry was broken, or that it only worked during an IPO frenzy like we saw in the late 1990’s; however, we had a theory that returns could be generated with a new approach to allocating capital. In many ways our approach borrowed from an earlier era in which venture funds managed smaller amounts of capital, although we tweaked it to reflect improvements in capital efficiency today versus 20 years ago.
VC Math – Sample Fund Model
Before explaining Greycroft’s approach, let’s start with an example of another early stage fund. This fund manages $300MM with the following strategy: 30 investments, 20% ownership of each company, 20% carry, and a target return of 3x for investors (VC funds aim for a 3x multiple to compensate investors for risk and illiquidity). This fund allocates $5MM to $10MM for each company initially, and up to double that amount over time.
If you break this down, the fund must generate proceeds of $900MM for the 3x, plus another $120MM for the carry, plus $50MM for fees (assuming that fees decline towards the end of the fund), for a total of $1.07BN. If the firm owns 20% of each company, the total value of all the exits combined needs to be $5.3BN to generate the advertised return. Assuming that some of the investments will be write-offs, say a third, then the remaining 20 companies must exit for an average price of $265MM.
This may sound realistic, but I pulled some data below from the NVCA Yearbook, which tracks the venture industry in the US. These two charts show all the venture-backed exits over the last decade.
This data is troubling for many VC firms.
Over the past 10 years, almost 90% of the exit events have been M&A (3,465 M&A events versus 476 IPOs). Of the M&A events, 2,007 of them did not report a valuation, which means they are either private-to-private transactions or small public transactions. For the remaining transactions, the weighted-average exit value was $109MM.
IPO exits have had higher valuations, but even IPO exits have fallen below the $265MM mark for 7 of the last 10 years. And if a single fund was lucky enough to have 20 IPOs, which would be roughly a 5% share of all IPOs over the last decade, the median holding period is approaching 10 years. This means that early stage investors must accept a lower IRR and a decade of illiquidity.
In spite of the exit data, there are a few firms that have been successful with this strategy. The common theme is that they have all found at least one outlier that sells for over $3BN. Unfortunately, the odds of having a $3BN exit are pretty low. Venture firms have funded roughly 20,000 new companies since 2001 and only a handful of companies have reached this valuation milestone. Correspondingly, only a few firms (and a subset of their funds) that pursued this strategy have hit their return targets.
The Greycroft Venture Model
If you look back in time you will see that the IPO dynamics of the early 1990s are similar to the M&A dynamics today – approximately 200 exits per year with an average valuation of just over $100MM. It is not a coincidence that a lot of what we do mirrors this earlier generation of venture.
The first tenet of the Greycroft model is to manage a small fund. This is heresy in the money management business, but we didn’t set out to raise as much money as we could. Our first fund was only $75MM and our second fund is $130MM. We have committed to our investors that our third fund, whenever that comes, will be $150MM.
The second tenet is to weight the portfolio towards smaller Series A financings. The rationale was that this afforded shareholders an opportunity to make money if the company was sold at industry average levels, while preserving the option of doing a larger B round (as well as a C round) if we had conviction that the company would be an outlier exit.
The third tenet is to be sector focused. We specifically focus on a few verticals within digital media (ex. Adtech, Marketing SAAS, Gaming, Publishing, Mobile Apps, and eCommerce) where we have particular expertise. We have a small partnership and this allows us to scale business development and recruiting across a number of companies simultaneously.
The fourth tenet is to syndicate every investment. We also prefer observer seats to board seats, which I have blogged about before. The combination of syndicated deals and observer rights has two benefits. First, it provides us with operating leverage and, second, it allows us to invest without a minimum ownership percentage. This makes us friendly to entrepreneurs and our colleagues in the venture business.
The last component is that we have a network of part-time employees, venture partners, EIRs, and consultants (in addition to our full time staff of partners, principals, and associates). Everyone contributes to deal management and due diligence, which allows us to scale our operations within the constraints of a small fund.
With that background, here is what we have learned from our experience with Fund I over the last six years:
1.) Greycroft I has the following composition: $75MM under management, 34 companies, average ownership of 12.5%.
2.) We have shut down and/or written-off nine companies to date. We invested an average of $2MM in these nine investments, compared to $3.2MM in our nine best investments. I wish this gap were wider, but I feel it as an accomplishment nonetheless. It is very hard to avoid putting good money after bad in the venture business.
3.) We have had eight early exits that generated total proceeds to all shareholders of over $600MM. The exits are shown below.
4.) These exits had an average holding period of only 25 months, which is shorter than we expected. This has benefitted our IRR as well as our ratio of distributions to paid-in capital.
5.) We still have 17 active companies in Fund I, including many familiar names like Buddy Media, Collective, Joyent, Extreme Reach, Wide Orbit, Vizu, and uSamp. I realize these names may not be household names, but they are well known in the digital media space.
One characteristic of our approach is that you could remove any company from the portfolio and still generate a top quartile return. We believe that this is a good indication that our outcome can be repeated.
When I talk to other VCs, the most common critique of our strategy is that “we don’t think big enough” because we aren’t singularly focused on billion dollar outcomes. We want large exits as much as anyone, but we invest upfront with a realistic view of exit potential. I expect that this criticism will diminish when our best performing companies exit at high prices.
The most important factor in this equation is that it works for our entrepreneurs. My experience with the $300MM “Sample Fund” above is that many companies remain illiquid, and ultimately the entrepreneurs suffer. We play by a different set of rules and our entrepreneurs have made a lot of money over the last six years.
I hope this sheds some light on what we are doing at Greycroft. Over the last few years I have learned of other investment strategies that are equally good, and perhaps even better, although many of them are based on late stage investing. Our approach is focused solely on early stage venture with small, minority investments. It is an area of the market we like even though it creates some constraints on fund size. As for the future, we have been busy investing Greycroft II since April 2010, and have already made 27 investments from that vehicle. There are great opportunities in the digital media space right now if you know where to look.
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Great post and thanks for sharing. As an EIR and someone bootstrapping a company, I believe this model creates great opportunities for entrepreneurs and investors. In the long run, it also forges great relationships between the two as post exit as most successful entrepreneurs become "serial entrepreneurs" with great partnerships with investors.
This is a great post. M&A is the much more likely exit for a successful venture backed company and the average valuation of these events over the past 10 years is around $100mm. Small funds that focus on early stage, capital efficient businesses have a better chance of outperforming than larger ones.
I applaud your transparency and willingness to share the numbers. Of course, it helps that Greycroft 1's performance has been outstanding!
Very interesting to see that level of transparency in fund performance. It seems VCs should back into a target figure for the size of their next fund by doing the math you did with the $300mm example and looking at industry averages. Yet your #2 observation holds true and firms consistently raise larger and larger funds. What is the rationale for adjusting an investment strategy instead of repeating the same one that is based in historical averages and has already worked?
Ian, thanks for sharing this and being so open about your performance to date. Very interesting. We are definitely aligned with your view and approach at Real Ventures. As a fund that invests mainly in Canada, we have to build our strategy around even lower median M & A prices. I'm all for a more systematic approach to returns. If that means smaller individual exits, so be it. Some fund franchises have been built on the back on one outlier with subsequent funds being underperformers. That's not what LPs want these days.