Fred Wilson has a post up titled ‘Hit Rate‘ which describes the key to Venture Capital Returns.
A fund’s hit rate determines their returns.
One or two companies will determine the returns in a given fund.
I have been on both sides of the hit rate phenomenon. I have invested in a seed fund that had THREE big hits (Uber, Sendgrid, Twilio) and Social Leverage has invested in a few hits ourselves.
Here is a chart from Correlation Ventures that shows how the the hit rates and returns in the venture capital industry have not returned to pre-2000 levels.
As Fred Says:
I think that is all about the amount of capital in the business now. More capital means more businesses get funded. So even if you have more winners, you don’t see the hit rates move up. The numerator and the denominator have both grown in the hit rate calculations.
Before 2000, the venture capital business was a bit of a cottage industry.
In the last 15 years, VC has become an institutional asset class with the permanence and stature that brings seemingly endless amounts of capital to it.
And so the returns have stabilized in or around the 2-2.5x over ten years number, which produces high teens/low 20s IRRs, which is enough to sustain the sector.
The only thing that I think would take us back to mean multiples of 4x or better would be some sort of massive reduction in the amount of capital coming into the venture capital business. And I don’t see that happening any time soon.
But one thing about the VC business has not changed in all of the years in that chart, which is roughly how long I have been a partner in a venture firm, and that is that your big winners will determine your returns.
Same as it always was.
Since, as Fred Says, he does not see capital drying up, when thinking about allocating your money to this sector going forward it is becoming more important to identify managers that can find the big winners.