Adjusting in this way for the selection bias of firms that go bankrupt, the mean return on VC investments is 57 percent per year, still very large but less dramatic that the 700 percent mean before correcting for selection bias.
Venture capital (VC) investments carry more risk than most investments in the broad public market and their returns are much more modest than commonly thought, according to a new paper by NBER Research Associate John Cochrane. He concludes that VC investments are not dramatically different from publicly listed small growth stocks.
Estimates of the returns to VC investments can be highly misleading because they typically reflect only those firms that have initial public offerings or are acquired by another company. Private companies are more likely to go public when they have achieved a good return. Those that do not achieve a good return are more likely to stay private or go bankrupt. Therefore, ignoring those companies that stay private only counts the winners; it induces an upward bias in the measure of expected returns for potential investors.
In The Risk and Return of Venture Capital (NBER Working Paper No. 8066), Cochrane includes those companies that stay private -- the losers as well as the winners-- so as to more accurately estimate the returns on VC investments. His analysis is based on 17,000 financing rounds in 8,000 companies, representing $114 billion of VC dollars, between 1987 and 2000.
Before controlling for the selection problem, Cochrane finds very large average returns among companies that go public or are acquired. The average return is almost 700 percent. Returns in this sample are also very volatile, with a standard deviation of 3,300 percent. Underlying these averages, however, there are a few companies with astounding returns, and a much larger fraction with modest returns. About 15 percent of companies that go public/are acquired achieve returns greater than 1,000 percent; yet 35 percent of the companies achieve returns below 35 percent; and 15 percent of the companies deliver negative returns. The most probable return is only about 25 percent.
Cochrane then estimates how the probability of going public or being acquired increases as the value of the firm increases and the point at which companies go bankrupt, in order to estimate the overall underlying average return, volatility, and sensitivity to movements in the stock market (beta) of VC investments.
Adjusting in this way for the selection bias of firms that go bankrupt, the mean return on VC investments is 57 percent per year, still very large but less dramatic that the 700 percent mean before correcting for selection bias. VC investments are still extremely volatile, with an annual standard deviation of about 100 percent. This is much greater than the roughly 10 percent standard deviation for the S&P-500 in the same period, but similar to the volatility of small publicly traded NASDAQ stocks. The "beta" is close to one, indicating that VC investment returns move up and down one-for-one with the stock market as a whole.
The high volatility is necessary to explain the occasional spectacular successes. Only very volatile investments can occasionally attain 1,000 percent returns. The high average return is explained by the high volatility. If an investment has an even chance of doubling or halving in value, it has a 25 percent mean return. For each dollar invested, you could make a dollar, or lose 50 cents. The larger the volatility, the greater this effect. More directly, VC investments derive their large average returns from a very small chance of a huge payoff. Therefore, enjoying this average return without enormous risk requires a very diversified portfolio. The market also went up substantially in this period, so a 57 percent return would not be that surprising with a beta of 2 to 3; the estimated beta of one implies that investors received an extra reward for holding the poorly diversifiable risks of venture capital in this period.
Cochrane finds that although typical health/biotech investments did better than typical information technology (IT) investments, the higher volatility for IT gives it a larger chance for occasional spectacular successes and thus a larger arithmetic mean return.
Cochrane also finds that second, third, and fourth rounds of VC financing are successively less risky than the first, as one might have guessed. They have progressively lower volatility and therefore lower mean returns. The betas of successive rounds also decline dramatically, from near one for the first round to near zero for fourth rounds, reflecting lower risk in the form of lower sensitivity to market conditions.
In closing, Cochrane cautions that his data sample ends in June of 2000, and most of the positive returns come from the late 1990s. As our sample extends to the NASDAQ decline and the wave of failed venture capital projects, the mean return estimates may decline, and the beta estimates may rise.
-- Andrew Balls
FAQs
The outperformance of venture capital funds is also evident using an IRR (Internal Rate of Return) metric. The average annual IRR return of VC funds between 2005 and 2018 was 22%, compared to 16.6% for all other PE funds. No other type of PE fund averaged more than 18% IRR over the period.
What is a good return for a VC? ›
Top VCs are typically looking to return 3-5X+ on their entire fund to their LP investors over ~10 years. For this, they need multiple 'fund mover' outcomes in each fund, since many early-stage investments will eventually fail or return only a small % of the fund.
What is the average rate of return for venture capital? ›
They expect a return of between 25% and 35% per year over the lifetime of the investment. Because these investments represent such a tiny part of the institutional investors' portfolios, venture capitalists have a lot of latitude.
What is a good IRR for a VC? ›
According to research by Industry Ventures on historical venture returns, GPs should target an IRR of at least 30% when investing at the seed stage. Industry Ventures suggests targeting an IRR of 20% for later stages, given that those investments are generally less risky.
What is a good moic for VC? ›
In venture capital, a MOIC of 3x or higher is often considered good, as it demonstrates that the investment has tripled the original amount invested, reflecting strong value creation and investment performance.
What is the top quartile return for VC? ›
Based on detailed research from Cambridge Associates, the top quartile of VC funds have an average annual return ranging from 15% to 27% over the past 10 years, compared to an average of 9.9% S&P 500 return per year for each of those ten years (See the table on Page 13 of the report).
What does 10X ROI mean? ›
The part of the equation that eludes most marketers is how to actualize 10X ROI (return on investment) in PPC (pay per click) campaigns. The difference between a 10% and a 10X increase boils down to adopting an exponential way of thinking, instead of an incremental mindset.
What percentage of VC investments fail? ›
There will always be money to be raised. And yet, despite all that cash flowing into VC-backed companies, twenty-five to thirty percent of them will fail. One in five fail by the end of their first year; only thirty percent will survive more than ten years.
What is a reasonable return on capital? ›
What Is a Good Percentage for Return on Capital Employed? The general rule about ROCE is the higher the ratio, the better. That's because it is a measure of profitability. A ROCE of at least 20% is usually a good sign that the company is in a good financial position.
Does venture capital outperform the S&P 500? ›
Several articles and research papers have been published on the PME and the comparison of VC versus public stock performance. These studies often show that top-tier Venture Capital funds outperform public markets, while the median or average VC fund may underperform.
General ROI: A positive ROI is generally considered good, with a normal ROI of 5-7% often seen as a reasonable expectation. However, a strong general ROI is something greater than 10%. Return on Stocks: On average, a ROI of 7% after inflation is often considered good, based on the historical returns of the market.
What is the target return in venture capital? ›
Target return is calculated as the money invested in a venture, plus the profit that the investor wants to see in return, adjusted for the time value of money (TVM). As a return-on-investment (ROI) method, target return pricing requires an investor to work backward to reach a current price.
What is a good VC return? ›
The TLDR; seed investors shoot for a 100x return; Series A investors need an investment to return 10x to 15x and later stage investors aim for 3x to 5x multiple of money.
Is 7% a good IRR? ›
There isn't a one-size-fits-all answer, but generally, an IRR of around 5% to 10% might be considered good for very low-risk investments, an IRR in the range of 10% to 15% is common for moderate-risk investments, and in investments with higher risk, such as early-stage startups, investors might look for an IRR higher ...
What are the return expectations for a VC fund? ›
In venture capital, LPs typically expect a fund's net IRR to reach at least 20% by the time a fund has exited all of its investments. Other asset classes, such as public equities, private equity, and real estate have differing IRR expectations.
What is the average success rate of VC? ›
Successful startup founders have the highest success rates on their VC investments, nearly 30 percent. They are followed by professional VCs at just over 23 percent, and unsuccessful founder-VCs at just over 19 percent.
What percent of VC funds fail? ›
There will always be money to be raised. And yet, despite all that cash flowing into VC-backed companies, twenty-five to thirty percent of them will fail. One in five fail by the end of their first year; only thirty percent will survive more than ten years.
What do venture capitalists get in return? ›
Although the venture capitalist may receive some return through dividends, their primary return on investment comes from capital gain when they eventually sell their shares in the company, typically three to seven years after the investment.
