VC’s Profits and Lack Thereof by Szymon Janiak

The post was originally published in Polish on Szymon’s LinkedIn profile. Szymon kindly agreed to republish what we think is of great value to our readers.

The vast majority of venture capital funds are unprofitable for investors. But – nobody in these circles wants to talk about it, because it would be cutting the branch on which everyone is sitting. The whole industry is more about stories about unicorns than real numbers, which is a paradox in finance.

Many newcomer managers fail to be effective at choosing startups with the greatest potential. As a result, they sell them for little money and cannot return the capital to their investors.

However, this is not the fundamental problem. The big problem is that even VCs that return capital are quite unprofitable compared to other types of investments.

For years, although this is currently changing, it has been assumed that a good fund should multiply investors’ capital threefold. According to the averaging data from various sources, only 10-20% of teams succeed. If the fund returns the capital twice, i.e. e.g. by receiving PLN 50 million, it will earn a total of PLN 100 million, it seems to be a great success. In practice, it takes at least 10 years, which means that the annual return rate is a staggering 7%.

(A TechCrunch author shared comprehensive math some time ago – ITKM)

A similar value can be obtained by investing even in real estate, and in good times even bonds, but the risk of failure is incomparably lower. What’s more, you can always sell property, and shares in VCs are an extremely difficult to sell asset. Therefore, if we take these factors into account, in most cases these investments make no economic sense.

Does this mean that putting capital into VC is a bad choice? Absolutely not. It only means that it only makes sense to invest in the best funds that have access to top startups, thanks to which you can earn a lot of money.

It’s a brutal game where you either find a unique strategy and are at the forefront in terms of returns or fall out of the game. Investors charmed by stories about Silicon Valley should first take out a calculator and see if it really pays off. There is a reason for a popular saying in this market: the first fund gathers for stories, the second also, and the third is no longer raised because of the financial results of the first one.

The comment section had quite a few valuable insights to add:

But when a real estate developer can tell their family at the dinner table that they’re currently investing in deep tech, it sounds a lot sexier than bonds. So a certain category of investors will stay.

– Kamil Niemira, Sales and Marketing Director at zenbox.pl

I agree on the main thesis, but the argumentation itself has several errors sewn in:

1. 3x money on the fund (net of fees) is not a rational expectation of the investor (such returns are rather generated by the top 5% of funds) – a lot depends on vintage, size and geography. As a rule, Europe has earned worse than Asia or the US in recent years. 3x net is 3.6x gross plus Management fee constituting nearly 20% of the fund’s capitalization, so in a nutshell, investments must earn an average of 4x+. With a normal distribution of the investment and disintegration period, this gives an IRR in the range of 20-30% (remember about its folding nature). This is much and much more than we expect from other asset classes.
2. The 7% per year you are talking about is a completely virtual entity – money is committed to the fund, not put in. Distributions also don’t occur at the end of its life, but during. Sometimes a good investment can be sold after a year and earn 3x on it. Hence, the appropriate measure is the IRR, not the rate of return on the committed capital related to the duration of the fund (incidentally, on average it is 13-14 years in Europe, not 10).
3. PE funds outperform other asset classes (attached picture), what we will see for VC.
4. PE/VC is not for individuals.

– Andrzej Różycki, Managing Partner at Tar Heel Capital

It is also worth noting that technology is often evaluated without going into its details, and its in-depth validation could significantly reduce the investment risk. In this matter, our domestic market significantly lags behind the number of inquiries that I receive, for example, from UAE.

– Izabela Anna Zawisza, Founder at ProConChem

7% at this risk really looks like a joke 🙂 Maybe that’s why so many funds now have a problem with collecting rounds?

We  are looking for co-investors in our real estate investments with a return of 15-25% y/y, and it is difficult despite the much lower risk. So I get the impression that either we are looking poorly or in general there is now a big aversion to any risk. Or what attracts investors to VC and does not convince in real estate is this vision of the unicorn, the theoretical possibility of making large returns. It’s safer in real estate, but also less exciting.

– Krzysztof Seweryn, Co-Owner at Velocity Development

To be honest, this is not particularly surprising.

From what I know, most Polish VCs are public money, not private funds of actual people – so they usually play not ‘to win’ but rather ‘not to lose.’ That’s the first thing. 

Secondly, in Poland, VCs do not trade with meaningful capital, which is a consequence of WW2 and the years of communism. There is a common opinion that raising PLN 100K in Poland is often a greater challenge than under ‘more mature capitalism’ several million USD/EUR/GBP. 

The result is that the really innovative projects relatively rarely hit Polish VCs, and even when they do, they usually lose to businesses with a ‘proven’ and ‘verifiable’ business model.

In addition, such companies, having acquired relatively small capital burdened with unrealistic requirements, are fighting for survival instead of scaling and focusing on large-scale global expansion.

Perhaps I look at it pessimistically and see parts of the real picture, but this is how it looks from my perspective. 

I am pleased, however, that the decision-maker in the fund sees the tip of this iceberg.

– Tomasz Żygadło, Founder at SoftWizard

I would extend this thesis to include broad Investment Banking and Consulting. A large part of advisory/M&A/capital raising projects does not bring any value and is not intended to be profitable for stakeholders. It is a huge ecosystem employing a large number of people and in which significant sums of money are traded. It exists for its own sake, read so that those at the top of this ecosystem can make a deal and earn commissions. Rank-and-file consultants and analysts are also well paid, which is a certain value for the economy.

– Filip Nowociński, Managing Director at Top G Worldwide

So long as the criterion of each action is the cash, this is what we get in the best-case scenario – the cash. This is the basic problem of our current civilization. It’s similar to how a politician redefines their goal as simply staying in power.

– Zbigniew Nawrat, President at the International Society for Medical Robotics