Venture capital is built on a single inevitability: only a very small percentage — perhaps only one — of a firm’s investments will generate outsize returns.
The remainder of companies will go to zero, or simply not achieve the hypergrowth that VCs require — and find themselves out in the cold.
Every VC portfolio has these slower growers; some call them VC orphans — companies that have lost investor support.
Oliver Holle, CEO and managing partner at Speedinvest, says that the “traditional way of venture is to ignore” the companies that aren’t the top performers, letting them languish.
But, he adds, VCs can “build a lot of reputational capital in these moments” by going out of their way to, for example, find a company a new home or figure out next steps.
“Being founder-friendly does not mean helping [the founder] run the company forever,” he says. “The most important resource founders have to protect is their lifetime. The worst thing is for them to run the company for another five years and then realise it’s not working.”
What’s different about the market now, he says, is that some VC orphans have raised hundreds of millions of dollars amid a fundraising flurry earlier this decade — let’s call them “fallen unicorns”. “Most VC orphans are companies that never really went anywhere, never raised a Series A, let alone a Series B or C.”
How do VC orphans come about?
Chris Wade, partner and cofounder at Isomer Capital, says there are two ways in which VC orphans can come about. In the first situation, a company isn’t performing — the team may not be working, it isn’t growing as fast as before, or it hasn’t hit product-market fit. The VC may decide not to put more money into that company.
In the second situation, he says, a company may be performing well, but its investor may have limited funds and decide to commit more capital to even better-performing companies in a portfolio. That’s increasingly the situation companies are finding themselves in now.
Numbers shared on X by David Clark, investment director at fund of funds VenCap International, show just how big this “VC orphan” cohort is. Of the 11,350 companies backed by 259 funds backed by VenCap from 1986 to 2018, 53% returned less than the investor put into them. 19% returned between 1x and 2x cost, while 16% returned more than 2x and less than 5x. That leaves just 12% returning at least 5x more than was invested in them; one in nine companies.
GP Bullhound data from December found that half of European SaaS businesses with €5m or more but less than €25m in annual recurring revenue in fiscal 2022 were growing less than 35% on year. Investors tell Sifted they would be looking for something like 100% ARR growth at that stage — so that means more companies are looking at an “orphan” situation.
What happens to VC orphans?
Founders of VC orphans have a few options: look to be acquired — or continue operations without getting further investment.
Investors, meanwhile, can help facilitate an acquisition of the whole company or try to sell their stake in the company. In many cases, VCs are incentivised to act because they themselves require capital. That’s especially true today when VCs are looking for ways to return cash to LPs amid a tougher fundraising climate and few exits.
Secondaries funds — companies that buy existing stakes in startups from employees or earlier investors, or parts of portfolios — can be acquirers of VC stakes in these cases. Many secondaries funds also have more modest return expectations than VCs, potentially making them a good fit for companies that have become orphans but are still performing well.
Staffan Mörndal, partner at growth investor Verdane, which also does some secondaries investing, says that his firm had discussions with “super good investors with really good portfolios who overdeployed” in recent years, meaning they risked being diluted when they couldn’t put in additional capital in future rounds.
He says some of the companies that would fall into the “fallen unicorn” camp are “still very hard to do deals around”, given many might have cap tables with complicated financial structures that make it hard to value them or align incentives.
In Mörndal’s view, it will take a few years for it to become clear which VC funds won’t be able to raise again and hence need to sell remaining company stakes — citing the example of Verdane’s purchased shares in companies from German investor Neuhaus Partners, which struggled to raise again post-great financial crisis — Verdane purchased those stakes in 2016. In the meantime, VCs will continue to simply prune portfolios or wait to sell until the end of the fund life, he says.
Working with VC orphan founders
In the case that a VC thinks a sale is the best-case scenario, Isomer’s Wade says the VC has to get the founder on board with the idea — a hard pill to swallow for people who have “become so religiously passionate about making their company happen”.
“The challenge comes when the founder says, ‘Screw you, Mr or Mrs VC, I’m carrying on.’ And then you get this ‘Walking Dead’ type of scenario,” he says.
He says VCs only have leverage to force founders to sell in one scenario: in which they put more capital into the company with the understanding that the company will look to be acquired.
Speedinvest’s Holle says that given how many portfolio companies the early-stage investor has — the firm has over 300 portfolio companies — it can’t run complete sales processes itself, but can introduce founders to boutique M&A firms, leverage their relationships with corporates to find a match and provide best practice advice on a sales process.
“Yes it will help us create a little bit of DPI, that’s nice,” he says, referring to a measure of cash VCs return to LPs. “But also the founders will remember us for it. That’s why we’ve dedicated two full-time senior resources to this effort.”
Is it financially worth it for VCs to spend time on VC orphans?
There are reputational implications that come with how VCs approach “orphans”; founders talk, word gets out about how they were treated when they were no longer the favourite child.
But can it make financial sense to spend more time on these companies?
Jan Voss, managing director at Cape May Wealth, says one could make the case for hiring one or multiple people to help “non-winners”, given how much impact that could have over the life of the fund. He provided Sifted with a few back-of-the-envelope calculations (link to the spreadsheet here) to show the impact of lifting the performance of companies where there was a partial or significant loss of capital.
In the case of a slight increase in the performance of these underperformers, the firm could see as much as a 5.42% increase in fund-level returns, or a bit more than €8m if we’re talking about a €50m fund with 40 portfolio companies. A little more work to bring the performance of those companies up, and that net return increase rises to an additional €16.25m. Not terrible.
“Especially at that ‘inflection point’ of a fund close to its preferred return hurdle, even a small outcome can significantly drive carry,” he adds.
On the other hand, he notes, a VC could also decide to focus on increasing the performance of the one home-run company in its portfolio. They would need to increase the performance of that asset by 13% to get the same impact as a bit of uplift on the lowest-performing companies. In other words, VCs could make arguments for both sides of the equation.
