Daniel Keiper-Knorr, General Partner, Speedinvest
Startups have a very high failure rate compared to most businesses. This means that the goal of a venture capital firm has to be to invest in those startups that will grow very quickly and will deliver outsized returns on investment and to make up for all the expected losses in their portfolio. It’s through the returns on these “unicorn” startups that VCs make their profits and justify themselves as investment opportunities.
While all true, the above has led to many funds predominantly focusing their investments into startups they believe will attract massive “exits” – such as billion-dollar IPOs or headline-grabbing acquisitions by larger corporates.
Whilst this approach is understandable from the perspective of short-run returns, this can come at the direct expense of other startups a VC has invested in, which are less likely to generate outsized returns. Most exits for VCs are typically due to portfolio companies being acquired or sold – at Speedinvest, we estimate that four out of every five European enterprise exits are valued at less than €50m, with the average venture-backed exit in Europe valued at €30m.
At best, these smaller exits will see a VC break even or make a very modest profit. This means that VCs will tend to neglect spending time with these portfolio companies and helping them to secure the best deal they can. Instead, VCs typically tend to focus more energy on potential large exits that will produce extremely large returns, which while great for every founder and VC who scores such an exit can limit the growth potential of the robust and sustainable technology ecosystem we need in Europe.
Sadly, this “unicorn obsession” has two unfortunate effects:
- Smaller exits end up being less common, which means that many modest startups end up failing and going defunct and their founders get no payout for their efforts.
- The market for smaller exits becomes less competitive, which means that smaller exits that do happen are valued lower than they could have otherwise been.
As a consequence, these factors lead to less capital in Europe’s startup ecosystem and less financially secure founders.
Why small exits should matter to VCs
While there is logic for VCs to focus resources on big deals, in the long-run however, this myopia with regards to small exits can harm the startup ecosystem as a whole and lead many VCs to miss out on invaluable opportunities.
Neglecting small exits ends up making the VC landscape more fragile. This is because, while these exits won’t necessarily generate big returns, they can enable a fund to break even on its investments.
Of course, breaking even on the “long tail” of startups that won’t generate an outsized return is a big hedge against risk. Even if a VC fund falls short in generating the small amount of oversized exits needed to generate huge profits, it is still vitally important to return initial investments to LPs, which can make all the difference when raising future funds.
Additionally, this neglect also stunts the startup ecosystem. While small exits may not be very profitable for VCs, they can be game-changers for founders. Our team estimates the average value of a European tech exit at €17m. Even a small fraction of such an exit payout can give founders and their families much greater financial security, which allows them to try out new businesses and build off what they learned from their previous startup. Such serial founders will reinject human and financial capital back into the startup ecosystem.
Why serial founders matter
All else being the same, serial founders are more likely to perform better than first-time founders – they have a huge advantage in terms of skills, relationships and insider knowledge. Serial founders can also afford to try out bolder ideas across their products and business plans having acquired start-up capital from previous exits.
This is great for both the industry and founders. For the industry, it means more high-quality startups to invest in and more experienced talent remaining in the startup ecosystem. In this way, there is a greater likelihood of companies with unicorn potential being built, delivering exceptional returns on investment.
Smaller exits are also a net positive for founders, since they align their interests with those of their investors more favourably. Rather than try to force every founder to create a unicorn, small exits allow most founders to get the best deal on the table. Focusing on small exits can transform the startup ecosystem to be a better place for founders, while also boosting the long-run prosperity of VCs. It’s a win-win that helps everyone.