The goal of a VC fund is to discover startups that can grow very quickly. Given the high failure rate among startups, it is these outliers — the businesses that can scale and produce a tremendously large return on investment — that make LPs willing to take the risk to invest in VCs in the first place.
That’s the industry’s conventional wisdom, and there is some truth to it, since VC profitability is driven by the small fraction of startups that deliver outsized returns. However, this conventional wisdom is also holding Europe’s startup ecosystem back.
We need to do more to generate exits among the long tail of startups that aren’t going to become outsized.
For the sake of founders, the industry and VCs themselves, we need to do more to generate exits among the long tail of startups that aren’t going to become outsized.
How VCs treat the long tail
Venture capital is risky, and investors rightly want rewards that are commensurate with that risk. To offset the risk of startups failing, VC funds are thus incentivised to sink most of their energy into those outliers that are outperforming.
This means that the exits that VCs often eye are billion dollar IPOs or headline-grabbing mergers, instead of more modest exits that come about from a startup being sold or acquired by a larger business. The second type of transaction represents the bulk of exits, with 80% of European enterprise exits being valued at less than €50m, according to data from i5invest and Speedinvest.
80% of European enterprise exits are valued at less than €50m.
These 80% of exits will not drive the returns VCs and LPs are looking for, so funds tend to neglect them in favour of the bigger fish. This has two effects: the first is that these smaller exits end up being less common than they could be, with founders missing chances to exit and more startups failing and going defunct; the second is that the market for these exits is less competitive and therefore less lucrative than it should be.
In short, the result is less capital in the ecosystem and less financially secure founders — either because they missed their exit, or their exit wasn’t valued as highly as it could have been.
Why funds should change their approach
While there’s short-term logic to prioritising resources to the big deals, this can actually be counterproductive for VCs in the long run for two reasons.
The first is that it makes VCs less resilient. While small exits aren’t necessarily generating big returns, they help a fund to break even. With small exits, VCs can focus on returning the bulk of their fund’s capital, which is invested in the long tail of startups. This means that if risks don’t pay off and the fund falls short in harvesting the oversized outliers, it can still return a large portion of its capital to its LPs — which may make all the difference when raising future funds.
These small exits... can be life-changing for founders.
The second is that it starves the startup ecosystem. These small exits may not be particularly profitable for the VCs, but they can be life-changing for founders. The average value of a European tech exit is €17m, and even a relatively small slice of that money can make all the difference for a founder’s personal and professional life. It gives them and their families financial security, which means they have more freedom to experiment with new ideas and businesses. This means more serial founders, who can re-inject capital — both human and financial — back into the ecosystem from which they came.
What nurturing serial founders means
All else being equal, it’s likely that a serial founder will perform better than a first-time founder. Serial founders bring their earlier experiences to the table, including skills, relationships and insights. Backed by the additional capital that their previous exit has provided, these serial founders can start and scale their next venture without worrying about financial security, which in turn can spur much-needed entrepreneurial boldness in the European startup ecosystem.
This is great for founders, and also for the industry as a whole. It means more — and better — startups, more talent staying in the industry, and more capital circulating from founders, who can also become angel investors. Returning small or average exits is crucial for the cyclical flow of capital around the startup ecosystem.
Learning from their previous startups, serial founders can move to build better startups, avoid pitfalls they may have made in a past life and capitalise on their connections. This means better companies for VCs to invest in — with much better chances that, this time, a founder will create one of those outsized outliers that can transform a sector and deliver exceptional returns.
A model of small exits is also great news for founders, as it better aligns their interests with those of their investors. Rather than try to force all founders to create unicorns, embracing small exits means the majority of founders who leave the venture path get the best deal they can. This means investors do greater justice to their founders, which is only right — VCs should feel an obligation to ensure they get the best deal possible for the founders they take under their wing.