Puttin’ on the Hits (Part 1): Has Venture Capital Become a Hit Factory?

A few years ago, even before the wheels had come off the tech recovery of 2004 to 2007, I was struck by some observations made by Jack Myers, Peabody award winner, Academy-award nominee and media analyst. Basically, Myers described what he saw as the growing resemblance of contemporary venture capital activity to the failed “hits system” that had long dominated the entertainment industry:

Hundreds of venture capital companies in Silicon Valley, New York, Boston and scattered other cities are losing site [sic] of their purpose for existence. Not all, of course, but many. Rather than working with entrepreneurial growth companies to assist and support their expansion, too many VCs have turned themselves into hit factories, not unlike record labels and movie studios that underwrite hundreds of “productions” in order to find one or two hits.

At the time that I first read this, I hadn’t heard VCs or, frankly, any venture industry commentators talk about venture activity precisely in terms of the entertainment industry’s hits system. So Myers’ views represented, at least for me, a subtly different but immediately intriguing cast on present day venture investing, coming from someone well acquainted with the model that he was describing. Myers went on to write:

Throughout their history, music producers, movie and television studios, and book publishers have followed a financial policy of putting hundreds of bands, scripts and transcripts into development, knowing that only a few would ever see the light of day, and that only a microscopic handful would ever actually return a profit. Those handful of “hits,” however, have such huge profit potential that they support complete industries. In the television, film and publishing business, investments are all about underwriting deficits and failure while waiting for lightening to strike.

Network and studio heads admit they have little clue what will actually work and not work, justifying their speculative investment in hundreds – even thousands – of properties. The “hit-centric” business model collapses as file sharing becomes ubiquitous and new media distribution technologies make access to consumers available to everyone. Fewer and fewer hits achieve the status of blockbuster, and market fragmentation shifts the power from massive traditional moneymakers to branded niche players that can build strong emotional connections with audiences and up-sell premium products.

Too many venture capital companies, however, seem to be embracing the hit model, willing to take pot-luck that one of their investments will be the next YouTube, MySpace or Second Life. There will be hits, but even the ability to monetize them in the new media world will not be a no-brainer. Many venture capital investors are following an ignorance-based approach to the online economy, focusing their investments on companies they perceive as having the best potential to become “grand slam” hits, while acknowledging most of their investments are more likely to turn into outs.

These VCs are least likely to support solidly performing small and mid-sized companies that consistently hit singles and doubles but have little chance of hitting the ball out of the park. It’s becoming more and more challenging for these mid-market slow growth companies that are the solid foundation of the new media economy to sustain themselves without access to investor support.

So has venture investing become co-opted by the type of “hit factory” mentality that Myers describes?  Certainly, VCs use gambling jargon all the time when casually chatting about their work, in much the same way as equity traders do. Still, I think most VCs would reject the notion that they are really, at heart, little more than professional gamblers, let alone the wild speculators suggested in Myers’ article. 

Baseball Economics

Instead, when pressed, VCs often fall back upon a financial rationale that some have called “baseball economics” as the basis for their investment activity. Traditionally, this financial rationale meant that VCs invested capital with the expectation that they needed to “hit above .300;” this meant that approximately one third of a given fund’s invested capital needed to provide substantial “hits” to propel profits, while the remaining two thirds of the fund, made up of less successful investments, needed just to “cover the nut” by returning, at least in the aggregate, their originally invested capital. 

Obviously, there is an expectation of asymmetric payoffs built into this model.  For traditional baseball economics to work, there is a dependence on outsized performance by a fund’s best performers to drive larger positive fund returns. But the model need not represent anything like high-stakes, all-or-nothing gambling. If VCs are disciplined about investing in solid growth companies with upside “optionality,” a majority of their investments can be reasonably expected to have some real exit potential and residual asset value, regardless of whether or not they ever become stratospheric high-flyers. So while a responsibly managed venture fund may not achieve all of its upside aspirations, traditional baseball economics still made complete fund flameouts uncommon. 

Interestingly, Georges Doriot, CEO of the first American venture firm, AR&D, and Bill Elfers, a Doriot disciple who later co-founded Greylock in the mid-1960s, both eschewed investment strategies based on the hunt for “homeruns.”  And when homeruns did occur – as was the case with AR&D’s investment in Digital Equipment Corporation, a deal that at least one author has called “the first homerun in venture capital” – VC pioneers like Doriot believed they should be looked upon as happy events rather than the main objective of venture investing.

However, a significant change crept into many VCs’ views of “baseball economics” to a lesser degree during the bull markets of the “Roaring Eighties” and to a larger extent in the effervescent markets of the late 1990s, a change that placed a much greater emphasis on the search for potential blockbuster hits. VCs began to talk about a model where nearly all of the returns came from the “high performance” third of their funds. As a consequence, “hitting above .300” came to mean “hitting above .300 with a massive slugging percentage” while accepting the writing-off of most or all of the remaining two thirds of fund’s original invested capital as a cost of doing business. As one article published in 2000 on Forbes.com remarked, “one-third of the companies in . . . venture funds go public or are acquired; the rest fail or deliver poor performance . . . [s]o the minority of investments that succeed really have to deliver the goods.” 

With this shift, the high performance third of a venture fund became the whole story. In the heady years of the late 1990s tech bubble, when companies with big dreams, funny Superbowl ads, untested business models, numerous me-too competitors and scant revenues could become billion dollar exits, the high performance third (or high performance 20% or high performance 10%) of some venture funds generated staggering returns. Indeed, in no small number of cases, one or two investments returned multiples of whole funds, and the individual venture capitalists associated with these “happy events” were celebrated, well, like rock stars.

Hit-Factory Mentality Takes Root

It is hard to paint any industry as multi-faceted as that of venture capital with a single brush. But, reinforced by bubble markets and the potential for any single investment to propel a fund, a kind of “hit-factory” model of venture capital had clearly taken root among many venture firms. And, unfortunately, it appears that this same blockbuster orientation pervades aspects of venture activity to this very day.

Last year, at a San Francisco technology summit, one VC contended that “the bottom line for VCs . . . is that every deal they invest in needs to hold the potential to grow in value until it equals the venture fund it is a part of.” This VC also argued that VCs expect “75%” of startups to die, and offered his view that “if a VC firm owns 10% of a startup at the time of exit, whether it be an acquisition or an IPO, those deals need to provide a 2x to 4x return on the fund so there’s enough profits to go around for the firm’s own partners and the limited partners.” In an April 2009 BusinessWeek article, VC Peter Rip of Crosslink Capital attempted to put this continued mindset in context:

Great Exits happened from 1982 to 2000 with a regular cadence. The strategy of going for the grand slam in every deal in every portfolio worked often enough during that bull market. The bull market gave public companies more currency to buy startups and often instilled public investors with confidence in the future of small growth companies. There were some spectacular successes among many long-forgotten failures . . .The bull market in technology ended with a bang in 2000. Nevertheless, most of the venture capital industry still executes the same playbook, ignoring the public market, which is why the industry has performed so poorly since 2000.  

Letting go of what Peter refers to as the “old, outdated playbook” of seeking big hits with every swing of the bat will be hard, if not impossible, for some firms that cling to this strategy based on its apparent success during previous boom markets. Many other venture firms, however, are exploring a number of creative variations on more classic venture capital strategies, as well as wholly new and hybrid models. And I have confidence that smart VCs will find more than one way to truly re-invigorate the venture model.

Still, during this period of soul searching and retooling for so many investors, I think it’s useful to look at some of the implications that hit-centric investing has had – and continues to have – for the venture industry.

Next – Puttin’ on the Hits (Part 2): Implications of “Hit-Centric” Venture Capital