Walking Around In Your VC’s Shoes

Much has been written recently about the venture capital "ecosystem"—whether there is enough capital flowing into the industry for it to thrive, or even stay afloat. As the 2011 numbers rolled in, many observers were aghast to see that VCs invested twice as much as they raised. Many tend to see this as a necessary correction following a long period of over-capitalization relative to the opportunity set—this is small consolation, though, to the entrepreneur fretting that there will be less capital from fewer sources when it’s time to raise the next round.  

Many entrepreneurs have asked me how to avoid being shut out from a shrinking pool of capital. It’s a good question, and one that all entrepreneurs should be asking themselves as they look toward raising their next round. 

The reality for most entrepreneurs is that raising capital is rarely easy, and it’s never without strings. As venture capitalists, we don’t like talking about those strings. It’s anathema to our whole approach to the VC-entrepreneur relationship. We are founder-friendly, we are patient capital, and we are long-term partners for company building. Yet we are also accountable to our own investors (queue the strings). 

Our investors, who are Limited Partners in our funds, expect an internal rate of return (IRR) that is at least 500 basis points above the S&P 500—reasonable, given that venture capital is such a high-risk asset class. As most markets grow an average of 8-10 percent each year, investors in our asset class are looking for an IRR in the mid-to-high teens. 

For a fund to return that kind of IRR to its limited partners, the IRR for general partners must be several points higher than that. Given that not all investments will return money and successes must compensate for failures, you need to ratchet that up to about a 25 or 30 percent IRR. An entrepreneur needs to have this figure on the radar—that’s what a segment of our very complex ecosystem will consider a "successful" investment. 

It’s the cost of capital for the entrepreneur. And at the end of the day, it’s not just about a cash-on-cash return; it’s also about the time value of money. A 2x in 3 years is a 26% IRR, but a 2x in 10 years is only 7% IRR. As VCs, our investors measure our performance based on IRR—when they talk about top quartile or top decile funds, it’s net IRR to LPs that drives those rankings. 

Interestingly, when NEA coined the phrase "venture growth equity" investing more than a decade ago, it was a strategy that played well to these dynamics. By opportunistically making some investments in later stage companies with venture-like risks but a shorter time horizon to return the capital, we saw an opportunity to increase IRR on a subset of investments, thus creating some portfolio performance wiggle room for the core early-stage companies that would need our support for longer periods to reach maturity. 

As a CEO, you have to ask yourself whether you are creating enterprise value. To gauge this from the perspective of a VC, it is necessary to think about the return on invested capital compared to the cost of that capital. If your return on invested capital is lower than your cost of capital, then you are decreasing enterprise value. Not all investments are accretive to enterprise value. Here is a simple equation to keep in mind when contemplating any kind of investment, whether related to operations or capital expenditures:

Enterprise Value Added = (Return on Invested Capital – Weighted Average Cost of Capital)∙Capital Employed

In an industry where there will likely be less dry powder to spread around, entrepreneurs who think like an investor will be in high demand. There are a lot of high-quality CEOs out there focused on all the core tenets of the business—vision, mission, strategy, execution, and culture—but they are forgetting that they are also a steward of investor capital. 

VCs can’t forget that. And for the ecosystem to work, entrepreneurs can’t either. 

—Author Krishna "Kittu" Kolluri is a general partner at New Enterprise Associates, where he focuses on information technology and energy technology investments. 

[Image: Flickr user dcosand]

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