Lots of venture capitalists claim to add value to the companies in which they invest. But how do they do it? And does it really produce better returns for their investors?
We just published in the Journal of Private Equity the first-ever research study on best practices of venture capitalists in creating portfolio company value through operational support, exploring exactly these questions. Our research originated as an MBA research study sponsored and supported by Professor Morten Sorensen, Columbia Business School Associate Professor of Finance and Economics, which three of our coauthors completed over the course of their second year at Columbia Business School.
We’ve summarized here our findings. We found that certain VCs are aggressively building out a focused portfolio operations skill set and recruiting more people with operational backgrounds. Based on a range of sources, we believe that most funds with well-developed “Portfolio Operator” models have top-quartile returns (typically above 20% IRR in the relevant time periods). Given the mediocre median returns of the VC industry and the high failure rate of the typical entrepreneur, techniques to improve the odds of success are highly needed.
(A slide deck of our findings may be viewed here.)
Our thesis that greater investor participation correlates with higher returns is consistent with two other formal studies. Both studies found that higher levels of angel participation in investments, as measured by number of hours per week interacting with a portfolio company, correlates with higher returns.
Our findings are based on interviews with more than 50 venture capitalists, entrepreneurs, incubators and service providers; research of a proprietary database of VCs’ value-creation practices; a wide scan of academic publications; and the authors’ personal experiences working in venture capital, private equity, early stage companies and strategy consulting. (More detail may be found in “Research Notes” at the end of this article.)
VCs can add more value to their portfolios through the seven elements of the TOPSCAN framework:
- Team Building: Design and recruit for a startup’s most important asset, its human capital. • Operations: Enhance administrative, accounting, legal and technological capabilities.
- Perspective: Create a strategy that defines how a startup’s product fits into its target market and gives the startup a competitive position.
- Skill Building: Build the right skills, especially for senior management. • Customer Development: Identify and reach the right customers.
- Analysis: Ensure entrepreneurs measure, understand and report the performance of their early stage companies.
- Network: Offer access to your network, particularly to potential investors and acquirers; it is the cheapest and sometimes most value-added service an investor can provide.
A company’s need for these services is greatest in early life. However, even among private equity funds that invest in late-stage, established companies, we see many such funds building portfolio operations groups. Venture capitalists have five main resources to increase portfolio company value through the TOPSCAN framework:
- Cash: Given the low average returns of the VC industry, and the modest assets under management of VCs relative to the typical private equity fund, many VCs simply cannot afford to invest meaningful dollars in a portfolio-acceleration infrastructure.
- Brand: The fact that a company has been funded by a respected fund/partner alone can increase a company’s odds of success, because that brand makes it easier for the company to attract employees and investors.
- Industry network: One entrepreneur said of one of the most prominent VCs in America, “[X]’s default response to all problems is to email-introduce you to 3-10 people in his network who can help.”
- Funding network: Later-stage VCs pay careful attention to who the earlier funders in a company are, using the reputations of the funders as a proxy for their own diligence.
- In-house expertise: VCs can provide consulting, accounting or operational resources, both directly from their own staff and from preferred service providers.
All of the resources above are synergistic, i.e., more success creates more cash, which strengthens the brand, which increases the industry and VC network, which strengthens the in-house expertise. This is one of the key reasons that venture capital is one of the few asset classes in which past performance is predictive of future results.
We have identified three common categories of VCs in terms of attitude and practices towards investing and portfolio company support: Financiers, Mentors and Portfolio Operators, ranked in order of increasing level of operational involvement.
In Part 2 of our report, we will explore the three main categories and give some examples of each.
About the authors:
This guest post was written by David Teten, Adham AbdelFattah, Koen Bremer, and Gyorgy Buslig. Teten is a partner at ff Venture Capital and founder and chair of Harvard Business School Alumni Angels of Greater New York in New York, NY. His email is firstname.lastname@example.org. AbdelFattah is the founder and CEO of CircleVibe, a mobile startup in the crowdsourcing space and a consultant on leave from McKinsey & Company in New York. His email is email@example.com. Bremer is a consultant with the Boston Consulting Group in Amsterdam. His email is firstname.lastname@example.org. Buslig is a consultant with McKinsey & Co. in Budapest. His email is email@example.com.
- We interviewed more than 50 venture capitalists, entrepreneurs, incubators and service providers. Interviewees were told they would be given a copy of the full published study results. Each interview was typically 20-40 minutes long; we had a list of 18 questions for VCs and 10 in-depth questions for entrepreneurs.
- We scanned academic publications, e.g., Professor Noam Wasserman’s “Upside-Down Venture Capitalists and the Transition Towards Pyramidal Firms: Inevitable Progression or Failed Experiment?”; “Returns of Angel Investors in Groups” (2007) by Robert Wiltbank and Warren Boeker; “Prediction and Control Under Uncertainty: Outcomes in Angel Investing” (2009) by Robert Wiltban, Stuart Read, Nicholas Dew and Saras D. Sarasvathy.
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