During a panel at a tech conference several years back, a seasoned and respected French early-stage VC that I will not name boasted about how he (of course it’s a ‘he’) had never had a portfolio company go bankrupt. Needless to say, this remark was an eyebrow-raiser for me about France’s venture capital sector.
My recollection of this incident was triggered the other day when I read Fred Wilson’s crisp explanation of what he defines as loss ratios. At the risk of summarizing far less eloquently than Fred does (and I encourage you to read his piece), loss ratios are defined as a percentage of VC investments that end up being worthless. They are measured either in: a) number of investments or b) value of investments, and divided by either a) the total number of investments, or b) the total value of investments, respectively. So for example, a VC fund that invests 100M€ in 20 companies, of which 8 companies go bankrupt, would have a Number Loss Ratio of 40%. If the VC invested exactly 5M€ in each company, the Value Loss Ratio would also be 40% (8 bankrupt companies * 5M€ / 100M€ = 40%).
Ideally, Fred argues, the Value Loss Ratio should be far inferior to the Number Loss Ratio. This makes perfect sense, because a good VC will take a “real options” approach to portfolio management. In other words, the art of being a good VC is to be smart enough to double-down on the winners and stop spending money and time on the losers. This simple theory is of course difficult to implement in practice, which is why it’s the primary notion that “separates the men from the boys” in venture capital as the adage goes (and hopefully one day the expression will be something more like “separates the women from the men”). Sticking with bad investments for too long is fraught with opportunity costs at many levels: it consumes funds which could generate a better return on another investment; it depletes time and mental bandwidth of the VC, it constrains talented employees of the startup in dead-end jobs, and it prevents ambitious entrepreneurs from moving on to the next venture.
Now back to the French VC’s boast (which, by the way, I ranted about four years ago here). “Never having a single portfolio company go bankrupt” would translate into a Number Loss Ratio of 0%. For a VC, this should not be something to brag about.
Don’t get me wrong. Bankruptcy represents an extremely unfortunate situation for the stakeholders of a company, even a startup. The entrepreneurs and employees who were dedicating most of their waking hours in relentless pursuit of a dream suddenly find themselves out of work. Particularly in France, whose job market is far less fluid than in most developed countries, bankruptcy is a painful event for the employees.
The silver lining of the cloud for these stakeholders, and admittedly it’s a not a cure-all, is that hopefully the bankruptcy liberates these people to migrate their talents into a more fulfilling career in a more promising business venture. And unless you’re in complete denial of free-market fundamentals, more capital allocated to the winners will translate into a larger pie and thus more opportunity for everyone.
Fred Wilson suggests a Number Loss Ratio around 40% for an early-stage VC fund and cites examples of some of the best-performing funds that hover around this level. This ratio should undoubtedly be lower for growth stage funds, but certainly not insignificant. Here in the French VC sector, to the extent that such talk characterized as ‘heresy’ five years ago is merely considered ‘shameful’ nowadays, I guess we’re making progress. But I’m not satisfied.
Sometimes you have to know when to walk away…