Extreme Venture Capital

Venture Capital

At several places on this website certain issues are raised regarding what we call "conventional venture capital." Is ICISLT opposed to venture capital or at least to "conventional venture capital?"

No, venture capital has been successful and has created billions of dollars of wealth for high-tech entrepreneurs and their investors. We are no more opposed to conventional venture capital than we are opposed to conventional speech research. In both cases, however, we also see a need for some unconventional approaches, which we label with the adjective "Extreme." In particular, we present an alternative venture capital model, called "Bootstrap Capital," that increases the expected return on investment as well the probability of success of individual portfolio companies.

Conventional Venture Capital

The typical venture capital fund raises money from institutional investors to invest in small private companies. The fund typically has a lifetime of ten years. The first five years are spent building up the portfolio and the last five years are spent liquidating and distributing the proceeds. As a slice across this triangle, the lifespan of the typical portfolio investment is only five years. A successful investment for a venture fund should have strategy for an exit within five years of the initial investment and is expected to return at least ten times the investment.

The typical fund charges a carry of 20% of the capital gains achieved from its investments, but tries to cover its operating expenses by also charging a management fee of, say, one per cent of committed capital. Thus, not only do fund managers make more if the fund is larger, there is a need for the fund to have a minimum size of around a hundred million of dollars just to make sure operating expenses are covered. But it is not easy to invest hundreds of millions of dollars in small investments. Therefore, a venture fund expects over time to invest a million dollars or more in each portfolio company. Since most venture capital backed companies have several venture investors, the total investment is usually at least several million dollars.

The rule of thumb for a successful venture investment is that the investment lead to an exit paying back at least ten times the investment within five years. If a total of five million dollars is invested by several venture funds for fifty per cent of the company, then the company must be sold or have an IPO within five years at a valuation of at least one hundred million dollars. Thus, as soon as a company accepts venture funding it is in a race to get to an exit event and a hundred million dollar valuation. There are no sinister motives in this scenario. All the key factors are inherent constraints in structure of the way venture capital funds are organized. When it succeeds, it works very well. It can make successful entrepreneur as well as venture capital fund managers and their investors all very wealthy.

However, as explained on the business home page, it maximizes the expected return, not the probability of success. It is generally not the best strategy for the individual portfolio company, its founders or its employees.

Bootstrap Capital or Extreme Venture Capital

Bootstrap Capital opens up an alternative by making a radical change in the structure and timing of the capital investments. Instead of being tied to a five year exit strategy, Bootstrap Capital generates returns continuously but optimizes over a ten to fifteen year period. Combined with a general bootstrapping strategy, Extreme Venture Capital maximizes the probability of each individual portfolio company surviving and thriving, rather than just the average return caused by a few spectacular successes.

By facilitating small investments, it also maximizes the return on investment in part by reducing the size of the investment rather then by requiring a hundred million dollar exit event. Thus, Bootstrap Capital produces a better result for all parties:

It increase the probability of success for each portfolio company

It doubles the expected ROI to fund investors

It increases the expected carry paid to the fund general partners

It both reduces the infant mortality rate and diminishes its effect on the ROI

It uses a longer planning horizon, allowing more rational planning of long-term research and development

An example showing the higher ROI using an Extreme VC strategy is computed in the Arithmetic of Venture Capital.