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Structural Opportunity

Founder Equity takes advantage of durable structural opportunities in the venture markets to target outsized returns and reduced risks.

Explosion in number and size of venture funds in 90’s

The Dotcom era was an extraordinary period of value creation driven by 1,227 IPOS between 1996 and 2000. Perhaps more importantly, IPO returns were extraordinary—averaging 88% in 1999 and 2000. Limited partners (LPs) began pouring money into the venture asset class. More LPs dollars means more management fees (essentially salary) for GPs. The result was an explosion in the number and average size of venture funds.

Evolution towards ever larger funds

LPs continue to funnel money into venture capital (roughly $30 billion in 2015). Dollars under management per venture capitalist have grown 4x since the 90’s. That’s great for VC management fees. But it leads to structural stresses that are hurting returns.

More capital per partner creates intense pressure to put money to work, but the number of deals an investor can do remains fairly consistent. That means more money per deal, forcing investments later in the risk curve, intense competition, and inflated valuations.

Later stage deals and bursting cap tables

Then, VCs tend to pour dollars in the deals that seem to be working. All of this means that cap tables for portfolio companies tend to grow so heavy with venture dollars that they need to hit fantastic scale (often $1 billion+) before they provide a good return for VCs.

Venture capitalists have little to lose (and much to gain) from making hugely risky bets. They make significant income regardless of performance (from management fees). As those fees grow so does the pressure to “swing for the fences.” All of this explains the venture industry’s push towards extremely rare and risky unicorn exits.

Excessive risk and poor returns

It is no surprise that venture returns have been poor for the past 15 years—less than the S&P 500 on average. So why are asset allocators putting so much money into venture? As market efficiencies reduce returns in the public markets, asset allocators seeking better returns have turned to the private markets—where tremendous value is being created. The problem is that it is not being efficiently captured or shared.

Forces powering the unicorn economy

Meanwhile, venture capitalists have found it increasingly difficult to show positive results as the IPO market settled back to reality. They found the answer in so-called “unicorns”; illiquid assets marked at valuations in excess of $1 billion (and often in the tens of billions). These valuations provide—often illusory—support for value creation by VCs.

As unicorn financings became increasingly viable for both entrepreneurs and investors, they became ever more popular. This in turn exacerbated the transition of value creation away from public markets to the private markets. Some of the unicorns are likely to succeed. But many will fail. The result could be catastrophic for the traditional venture industry and the allocators who have heavily invested in them.

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