Exits come in all shapes and sizes in the venture capital business. There’s lots of focus these days on the quick flip which isn’t usually the preferred route for the venture capitalist, but you can’t complain too much when you make three, five, seven, or even ten times your money in a year or two. And of course there's the YouTube quick flip which anyone would be ecstatic to have in their portfolio.
But one thing I’ve learned about the venture capital business is that if you are patient and stick with your best companies for the long haul (and it can be a very long haul), you are often rewarded with some great exits.
I am on the board of four companies that were started in the mid to late 90s and I have a significant investment in one other. All of them are Flatiron Partners portfolio companies. We have had our capital invested in these businesses for seven or eight years now. And we’ve had our time invested in most of these investments as well. The time and money are significant and finance theory teaches you that time works against you when you are in the rate of return business.
But I am always a bit mystified by the focus on rate of return as the measure of performance in the venture capital business. It’s not like you can turn around and invest your money at that rate of return so easily. So if your capital is tied up in a company that is building significant value for its shareholders, it’s often best to let it stay there.
I am much more fond of the return multiple and also total gain numbers as a measure of performance. Time doesn’t work against these numbers. In my experience, times works for you when you are in the return multiple business.
The key thing about patience is that you have to see that value is being created to be patient. It’s not always a quantitative exercise either. It often takes a company five years or more to start producing positive cash flow and it certainly takes time to produce the large high growth operating margins that produce the big valuations upon exit. So in the meantime, you have to have other proxies for value creation.
The most common proxies we use in the venture business are customer adoption, revenue ramp, the development of a strong team, the emergence of a strong brand, the creation of a robust and scalable technology platform, and strategic partnerships with other important companies in the target market.
But even if you achieve all of these, there are other things that will impact how patient the management team and investor group will be. Does the company have a strong supportive and constructive board? If it does, it's often easier to be patient. Does the management team have the desire to slog it out for close to ten years? That's not common and getting less so.
I attended two ten year anniversary parties in the past six months. Both were for companies that I was a lead investor in from Flatiron Partners. It's something special to see a company last that long as an independent entity. Both of these companies are thriving and I suspect the next ten years will be even better for them than the first ten years.
We have a company in the Flatiron portfolio that is looking at a financial transaction in which stock would be sold at 15x the price we paid in 1999. That's a 40% annual rate of return, which is good, but not fantastic by VC standards. But 15x is a great number on a deal no matter how long (within reason) it takes to get there. I'd happily wait 10 years to get 15x.
It's hard to be patient. You can't pay a mortgage or the kid's college tuition with your private company stock. It's even harder on the founders and management. At least VCs have a portfolio which makes it easier to be patient. But I have found that patience is often rewarded handsomely in the venture business. This is and always will be an asset class that requires a long term horizon. The quick flips we get in markets like the one we are in don't change that fact at all.