FundersClub Returns Data: 47.9% Unrealized Net IRR in the First Two Years
This is an update to our previous post on 2/17/14, which reflected our data as of 1/25/14.
On July 25, 2014, FundersClub celebrated its two year anniversary (you can see our update here). One piece of the update was our unrealized returns, which we’d like to present in more detail, and its accompanying methodology.
Since our launch, we’ve invested +$19M in +90 stellar founding teams and their companies across a variety of technology industries around the world. The capital came from our global community of over 10,000 accredited individuals and the investments were led by Alex Mittal (CEO and Co-Founder of FundersClub) and Boris Silver (President and Co-Founder of FundersClub).
Why are we analyzing and publishing our unrealized returns?
As proud as we are of the metrics above, we will be the first to say that returns matter: the quality of our product offering to investors and entrepreneurs alike is linked to the realized returns it provides.
After a lifespan of two years, it is too early to compare realized returns to our vintage year (for example, Cambridge Associates, a leader in aggregate venture capital returns, has yet to release data on 2012 vintage funds), but in an attempt to provide greater transparency, we want to benchmark our relative performance today as best we can.
Since our last update, we’ve experience realized returns for 5 companies: Three companies, TalentBin, Lovely, and Meldium****, have exited, one company has returned our capital at par, and one of our companies has shuttered. That said, we still lack meaningful exit data. Thus, we look to other signals: Many of our portfolio companies have gone on to raise follow-on funding from premier venture capital firms and who then set an equity valuation.
Besides our companies who have exited, we are using those third-party valuation events to calculate our unrealized return (see our methodology below). Of course, gauging performance of venture capital investments after two years is a bit like gauging the winner of a marathon after mile four: you can start to gather a sense of how things may unfold, but the journey has barely begun.
We also greatly admire the work that many in the industry have done before us to bring greater transparency and data to the innovation economy. We believe that sharing data about our early results can help better inform the startup community and further the dialogue around innovation, startup capital formation, and venture capital. To our knowledge, it is unusual for an individual venture capital firm to provide this type of data publicly, and, to be fair, there is little reason for them to do so, as their LPs are typically large, private endowments and institutions.
What did we find?
In summary, we found that a FundersClub member investing equally across all of our realized investments (four funds as of 7/25/14) and unrealized investments (43 funds as of 7/25/14) from launch would have yielded, after administrative costs* and carried interest**, an unrealized annual net rate of return (also called “Unrealized Net IRR”***) on their portfolio of 47.9% after our first two years. We withhold administrative costs to cover the normal course expenses of private investing (items like legal, accounting, banking, registration, etc.), and our carried interest is rationalized by our sourcing efforts to find promising companies, execution of deals, and supporting portfolio companies post-investment through to successful exit or IPO. Without these administrative costs and carried interest, the portfolio would have an unrealized annual rate of return of 58.0% (also called “Unrealized Gross IRR”).
It should not be assumed that recommendations made in the future will be profitable or will equal the performance of securities in this list.
We’ve had four investments experience realizations of value (IPO, acquisition or shuttering). For those realizations, we’ve marked our investments at the realized value.
- An acquisition would be marked at the acquisition price paid for FundersClub’s shares
- A shuttering would be marked at $0
For unrealized returns, we chose third-party valuation events. Based on data from the Kauffman Foundation, the average externally-backed investment exits 4.7 years after early stage funding (if it exits at all). Our average investment was funded on 9/11/2013, which is ~10.5 months prior to our two year anniversary, so it is too early to tell conclusively what our return data will show. Thus, most of our valuation figures are unrealized (i.e., inherently non-concrete).
We took several steps to maintain conservative estimates of unrealized valuation.
What we did NOT do:
- If a company received follow-on funding in the form of a non-priced round--namely, a convertible note--we did not increase the unrealized valuation of the company accordingly, even if the valuation cap of the convertible note was above the point at which we invested. For example, if we invested in Company A at a $5M cap, and then another note was issued for Company A at a $10M cap, we did not mark our investment up in carrying valuation.
- We did not use Financial Accounting Standards Board (FASB) Statement 157 fair market value reporting principles nor fair market value methodologies from Section 409(a) of the Internal Revenue Code. This type of fair market value would typically entail valuing our private investments off of public comparable companies, past transaction comparables (read: other acquisitions), and/or the discounted cash flow (“DCF”) analysis, among other valuation approaches.
- Those two points together mean that, even if the company has meaningfully progressed from a business and/or operational perspective, we do not capture the potential increase in value in our analysis until the point of a third-party valuation event (typically via pricing by an institutional investor) or a realization of value.
What we DID do:
- Only counted increases in unrealized valuation when it was a third-party valuation event. That is to say, we only increased the carrying value of our unrealized investment if the company received follow-on funding priced by an institutional investor. We increased the carrying value to match the post-money valuation, less the impact of any dilutive effects, such as employee option pools, convertible notes, etc. plus the impact of any anti-dilutive effects such as an active valuation cap or discount on a convertible note. For example: If we initially purchased stock in Company A at $10M equity valuation, and then Company A receives a follow-on round at a $50M post-money valuation, our investment would be carried at 5x the valuation of our original investment less any dilutive effects plus any conversion discount or valuation cap benefits.
- We subjectively marked down investments in which positive return outcomes did not seem likely.
- Those two together mean we were subjectively punitive on the downside and objectively conservative on the upside.
- We also included the unrealized impact of paid-in-kind (“PIK”) interest on convertible note securities, dividends on preferred equity, etc.
Even with these steps, the return outcomes below for our unrealized investments are highly uncertain and may, in the end, have no bearing on the realized return profile of the FundersClub portfolio. Additionally, our past performance is not indicative of future returns, so we can’t provide assurances that comparable returns (including those represented by applicable benchmark data) individually or in the aggregate will be achieved by any future FundersClub fund.
If a FundersClub member had invested equally across all of FundersClub’s 47 funds since inception through 7/24/14 (some funds invest in more than one company), in two years the unrealized valuation of the investment portfolio would’ve increased at an annualized rate of 58.0% gross and 47.9% net of administrative costs and carried interest***.
As previously mentioned, it is too early to compare realized returns to our vintage year. Thus, for want of a more accurate benchmark, we compared our unrealized returns to the S&P 500 (large cap equities) and Russell 2000 (small cap equities) over various time periods (not including any brokerage or other fees):
Vs. S&P 500
- Over the same two year period, the S&P 500 produced a 20.8% annual rate of return
- Over the medium term (2003 through Dec. 2013), the annual rate of return of the S&P 500 was 9.2%
- Over the long term (1871 through Dec. 2013), the annual rate of return of the S&P 500 was 9.1%
Vs. Russell 2000
- Over the same two year period, the Russell 2000 produced a 22.6% annual rate of return
- Over the medium term (trailing 10 years), the annual rate of return of the Russell 2000 was 7.6%
- Over the long term (1987 through July 2014), the annual rate of return of the Russell 2000 was 7.3%
Public Market Equivalent (PME)
Beyond charting our returns against the S&P 500 and Russell 2000, the Kauffman Foundation’s 2012 report “We Have Met the Enemy… and He is Us” calls out the importance of measuring venture capital performance against public market benchmarks in a mechanism called a “Public Market Equivalent” (PME). Within PME the net returns of a fund are divided by the prevailing public market benchmark. So if VC Fund A had returned, net of fees and carry, 2.0x and the public market had returned 1.5x over the same time period, then Fund A’s PME would be 2.0x / 1.5x = 1.3x.
For FundersClub’s unrealized net IRR***:
- Over our first two years, FundersClub’s PME against the S&P 500 was 2.30x
- Over our first two years, FundersClub’s PME against the Russell 2000 was 2.12x
Select quote from “We Have Met the Enemy… and He is Us” (Kauffman Foundation’s 2012 Report): “Over twenty years in our portfolio...only twenty funds out of ninety-four exceeded a PME of 1.3.”
The Power Law at Work
You can see below the individual unrealized net IRR*** of each fund indexed to the highest performing fund. For example, if the highest returning fund, “Fund A”, was at 200% unrealized net IRR, then that fund would be indexed to 100% and Fund B, with a 50% unrealized net IRR, would be indexed to 25%. The following chart shows all 47 funds closed by FundersClub for the two years since launch (the names have been redacted). Also, some funds invest in more than one company.
Going back to our previous post on 2/17/14, which reflected our data as of 1/25/14 (32 funds), the indexed individual unrealized net IRR*** looked like this:
So what do we see? The “Power Law” distribution is continuing to play out empirically as a relatively lower percentage of funds drive the lion share of the returns.
Even relative to our post roughly six months ago, the power law distribution has become more extreme and better formed. Even still, we would note, as our average investment is only ~10.5 months old, investments currently hovering around a 0% return will jettison upward when and if they too have a third-party pricing event.
You can find the “power law” described in Peter Thiel’s lecture notes (as discussed by Thiel, Paul Graham of Y Combinator, and Roelof Botha of Sequoia Capital). To over-simplify, the Power Law states that financial returns of startup companies tend to follow highly exponential, not linear, distribution, and that the differences in returns will be heavily skewed.
To quote Thiel:
If you look at Founders Fund’s 2005 fund, the best investment ended up being worth about as much as all the rest combined. And the investment in the second best company was about as valuable as number three through the rest. This same dynamic generally held true throughout the fund. This is the power law distribution in practice.
Thus, if the power law continues to hold true, diversification is key, as only a handful of companies would be responsible for the bulk of the returns.
Note: Unless otherwise noted, analyses were run in the 24 month period from FundersClub’s launch on July 25, 2012 through to July 25, 2014. This data speaks only as of the date hereof, and FundersClub disclaims any obligation or undertaking to provide updates or revisions to reflect any change in its expectations or returns.
*Administrative costs: Costs reserved in each fund for banking, legal and accounting costs to curate the fund--this is not revenue for FundersClub and any remaining reserved capital is returned to members at the close of the fund
**FundersClub’s carried interest on gains on invested capital--this carried interest is only applied once gains are realized, but in this case we show the “effective” carried interest if the investment exited today at the valuation calculated using the methodology above
***Unrealized Net IRR reflects the realized returns (four funds) and unrealized returns (43 funds) of an investment portfolio of equal investment across all FundersClub funds since launch. These returns are net of any administrative costs* and carried interest** charged to the investor, which may vary from the carried interest and administrative costs payable by future FundersClub funds.
****Meldium’s acquisition by LogMeIn happened after July 25, 2014, and thus the acquisition was not included in the returns of this analysis
- S&P Returns (Recent and Medium Term) - Google Finance https://www.google.com/finance
- S&P Returns (Long term) - Money Chimp http://www.moneychimp.com/features/market_cagr.htm
- Russell 2000 Returns - Yahoo! Finance http://finance.yahoo.com/
- Angel investing performance - Kauffman Foundation http://sites.kauffman.org/aipp/index.cfm
- Venture Capital Index - Cambridge Associates
- Kauffman Foundation Report - “WE HAVE MET THE ENEMY… AND HE IS US - Lessons from Twenty Years of the Kauffman Foundation’s Investments in Venture Capital Funds and The Triumph of Hope over Experience” (source)
- “The Power Law” - Peter Thiel’s CS183 Lecture Notes http://blakemasters.com/post/21869934240/peter-thiels-cs183-startup-class-7-notes-essay