Venture Capital and Mutation Theory

Many entrepreneurs that I talk to struggle with understanding how and why venture capitalists make the decisions they make, either in not funding their business or funding a different business.  It helps to understand the top-down dynamics that go on in the VC world, as illustrated by the following anecdote.  I heard this second-hand, so if anyone with first-hand knowledge (I know I have some readers from Adams Street) wants to chime in, I'm all ears.

Adams Street Partners is the oldest and arguably the best fund-of-funds in the private equity sector.  They invest in private equity partnerships in total, of which venture capital is a subset, but they are best known as a venture capital fund-of-funds firm.  They invest over $1 billion per year in new private equity partnerships, and have been doing it for over 20 years.  They have generated an annualized 20% return on capital (IRR) back to their investors over that 20-year period.  They invest in a lot of VC firms, who in turn invest in a lot of underlying portfolio companies.  Multiple thousands of underlying portfolio companies.  Over that period of time and that amount of capital, one would think the 20% return was generated by a very diverse mix of successful underlying portfolio company exits.  Not so fast.  The story told by Bon French (CEO of Adams Street) is that a full 5-points of the 20-points of return over that 20-year period is attributable to a single company exit within a single VC firm portfolio (Benchmark Capital's investment in eBay).

Why is this story important for entrepreneurs seeking to raise VC money?  Because VCs know they have to fund the monster hits in order to generate the type of return necessary for the VC asset class to continue to be attractive to the limited partner investors.  They need to find and fund the "mutant" companies: those with the DNA that creates the potential for them to grow beyond any rational expectation.  Hence, venture capitalists have to believe in "mutation theory" as the reason that the asset class is attractive to limited partner investors, like Adams Street.

I have no data to support this claim, so you've been forewarned about its potential accuracy, but my belief is that if one were to remove the top performing 1% of portfolio company exits out of the VC asset class return calculations, VC would under-perform the S&P 500.  It's that top 1% of exits that drive the whole reason for existence of venture capital as an institutional-grade investment asset class.

Entrepreneurs need to understand this so they can understand how and why VC's make the decisions they do.

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