In a previous blog I noted that “alpha” was not a common term used in private markets, particularly venture capital markets, because there is no reliable or widely used benchmark of private companies.
Instead, most investors focus on two measures of success:
Multiple of Capital
The Multiple of Capital (“MOC”) is the simplest measure of return - it is defined as the money returned relative to the money invested. For example, if you invest $100k and the investment returns $500k, the MOC is 5.
Internal Rate of Return
While MOC is simple, it doesn’t take into account the time horizon of an investment. An investment that yields 5 times in 3 years is better than investment that yields 5 times in 10 years. Hence, investors use Internal Rate of Return (“IRR”) to account for the time horizon. Effectively, the IRR is the annual growth rate of the investment. In the previous example, the IRR of an investment that yields 5 times in 3 years is 71% vs. 5 times in 10 years is 17%.
A third measure of success
I believe that VC investors should be judged on a third metric: How many founders would accept their investment again.
Venture is a people driven business and early stage companies fail for a myriad of reasons, some out of control of both the investor and the founder. Thus a great metric to judge the ability of an investor to add value post investment (one of the key sources of “Alpha” in VC) is whether the founders would accept an investor’s capital again, irrespective of whether the initial investment performed well or poorly. VCs will seldom complete this survey of founders or report this statistic, but as part of DD investors should speak to handful of portfolio company founders to understand how much value the VC provides (relative to any claims) and whether they would accept the VC’s capital again.
Equally, I often ask myself “would I invest in the founder again” irrespective of whether the investment performed well or poorly. This question helps a) refine my initial investment due diligence and b) decide whether to back founders again in the context of another opportunity.
Other measures of success?
I’m curious about other measures of VC or portfolio company success beyond the above. Leave a comment with your alternative measures of success.