“How to hit home runs: I swing as hard as I can, and I try to swing right through the ball… The harder you grip the bat, the more you can swing it through the ball, and the farther the ball will go. I swing big, with everything I’ve got. I hit big or I miss big.” –Babe Ruth
Babe Ruth was one of America’s finest baseball batters, having played 22 seasons with 714 career home runs and 1,330 strikeouts out of 10,622 pitches. While venture capitalists face vastly different types of pitches, the home run mentality coined “the Babe Ruth effect” has seen widespread permanence throughout the venture industry. In Chris Dixon’s article, “The Babe Ruth Effect in Venture Capital,” he analyzes the performance of successful venture capital funds and determines that higher multiple fund performances are derived from higher proportions of investments returning >10x. As expected, there is also a strong correlation between investment return size and overall fund performance.
What makes the Babe Ruth effect difficult to come to terms with for many unfamiliar with the venture asset class is the high level of “strikeouts” that come with the strategy. Dixon analyzed the same cohort of funds and found that even funds with great performance had a relatively high proportion of investments that lost money.
A dangerous trend, especially with earlier funds, is emulating the investment strategies of billion dollar funds such as Sequoia, Andreessen Horowitz, and Softbank without building a differentiated competitive advantage. Often this imitation manifests itself in competition for “unicorns”, defined as privately held companies valued at over $1 billion. Regarding this “unicorn fever”, PitchBook noted that in 2018, startups achieved billion dollar valuations in less than 4.5 years, down from an approximate seven years in 2013. While unicorn valuations are nice to flaunt at dinner parties and are generally positively correlated to fund performance, there are many other key drivers of fund returns. What these funds need are not necessarily unicorns with billion-dollar valuations, but high exit multiples on select portfolio companies that can return the fund. Dan Primack, a business editor at Axios, recently tweeted:
One thing that I think gets lost in the VC vs. non-VC discussion is that VCs don't need a company to become a "unicorn." At least not the early-stage VCs. They might want it, but unicorns weren't really a thing until a few years back, and VCs "settled" for much shorter home runs— Dan Primack (@danprimack) January 11, 2019
To Dan’s point, some key factors to consider when defining your investment strategy to hit multiples include (but are not limited to):
Ownership stake (driven by check sizes, pre-money valuations, pro rata rights, and follow-on reserve capital)
Projected exit value
Deal terms (such as liquidation preferences)
Portfolio company capital efficiency
Rather than hunting for unicorns, investors and fund managers should focus on conducting proper due diligence (market opportunity/size, capital efficiency, potential upside investment returns), obtaining attractive deal terms (ownership stake derived from investment size, initial valuation and available follow-on capital), and providing portfolio company support to achieve higher multiples at exit. It’s also critical for emerging funds to properly define their investment thesis from a stage, industry, and business model perspective, enabling them to hone in on a competitive offering.
In addition, if you are investing in venture funds, make sure they have a distinct strategy to capture a unique segment of the VC pie whether it be in sourcing, vertical expertise or post-investment value-add. If you are interested in learning more about the Babe Ruth effect and the world of unicorns, please feel free to contact us at email@example.com.
Originally published in the February 2019 LVAM Newsletter.