One major challenge when investing in venture capital is to remember to stay patient when facing a timeline that could take years to see positive cash flows. This illiquidity is mainly due to the amount of time it takes a startup to go public or even get acquired.
As of 2017, the median time for a startup to exit via an IPO was 8.2 years. As more late stage startups are choosing to raise more capital and lengthen their runway rather than exit, liquidity has become the single biggest challenge for venture capital firms. Even success stories like Buzzfeed, Qualtrics and AirBnB have chosen to raise more money late in the game instead of going public, despite consistent revenue and high valuations. The reasoning is simple: they want more time. By staying private longer, these startups hope to establish profitability and avoid the pitfalls they’ve watched other tech startups like Snap run into.
While the long road to an IPO can seem daunting, it actually doesn’t spell trouble for venture capital investing. In the beginning of a VC portfolio’s lifetime, it will see little to no net cash flow as investments are being made, resulting in greater cash outflow than inflow. As portfolio companies start to exit, the portfolio moves into a harvest period in which earlier unrealized gains are realized. At this point, a venture capital portfolio can be self-funding where the realized gains now fund the newer venture investments. By the way, this is the exact same j curve investment horizon that private equity and real estate experience. In this regard, venture capital investing is exactly the same as investing in private equity or real estate. More importantly, investment returns generally increase with the degree of illiquidity for which venture capital historically has had the best performance.
If the long-term outsized returns associated with venture capital investing don’t provide enough incentive to take on the risk associated with venture’s illiquidity and timeframe, there are other options to help reduce the investment frame and risk. However, it is usually done with a concomitant reduction of risk. As highlighted last month with the Spotify IPO, secondary markets for late-stage venture investments have matured and proliferated. These markets can allow you to either invest at a later-company-stage or achieve partial or even full liquidity on an early investment without an actual exit event like an IPO or acquisition. In addition, funds that focus on late-stage secondary transactions have also begun to emerge, offering smaller investors the chance to participate in later-stage venture opportunities with shorter investment windows.
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Originally published in the May 2018 LVAM Newsletter.