Venture capitalists (VCs) get plenty of good press -- but it's hard to figure out how much money they're making for their investors. That may be because you'd be better off putting your money in an S&P 500 index fund than giving VCs 2 percent of your investment plus 20 percent of the profits.
To be fair, the averages tend to gloss over the outliers who outperform the industry.
Last month, I spoke with a math genius with MS in computer science from Princeton who says he's figured out an effective algorithm for beating the odds.
Is Venture Capital A Good Investment?
Before getting into that, let's take a look at the performance of VC funds. What I've learned is that VC fund performance used to appear regularly on the website of the National Venture Capital Association (NVCA). It usually appeared there in the form of 10 year internal rate of return calculations for funds -- based on the year they started investing. For example, in the early 2000s, I would visit the NVCA site and find that the average IRR of a fund started in 1989 was a whopping 86 percent.
But in the last few years, those performance figures have been difficult to find.
Fortunately, the firm that calculates these IRRs is still around and I recently found a site posting the returns for VC funds as of September 2016 In a nutshell, their performance after fees has been pretty mediocre. For the 10 years ending September 2016, the pooled return for multi-stage funds was 9.43 percent. If those limited partners had instead invested in an S&P 500 index fund, they would have paid a fee of 0.05 percent and their money would have appreciated at a 5 percent annual rate -- not taking into account dividends
It is hard to compare the two because of the much bigger fees that VCs charge. But limited partners have really suffered the most if you look at the performance of VC funds during the five years ending September 2016. For that time period, the VC rate of return was 13.7 percent after fees -- compared to a 13.8 percent compound average growth in the S&P 500 for the five years from September 2011.
In short, since the dot-com boom, venture capital has not generated enough return compared to a stock market index to warrant the much higher fees and risk.
Math Genius Boosting VC Returns
But Paul Martino, founder of Bullpen Capital -- which provides post seed stage financing, after an institutional seed fund but before a Series A [a multimillion dollar investment round to help a company expand the market for its product] -- thinks he can do better.
He sounded to me like a math and computer science prodigy which I found intriguing. As he said in a November 7 interview, "I grew up in Lansdale, Penn. and got my undergraduate degree in computer science and mathematics from Lehigh in three years, earned an MS in computer science at Princeton and dropped out of its PhD in high performance computing program. I hated being in school and entered graduate school at 19. It was the default option. I wish I had been born 20 years later. I wanted to be an entrepreneur since I was five years old."
Seven years ago, Martino worked with Mike Maples, Jr., who founded of early-stage VC-firm Floodgate in 2006. Martino was developing a model to predict whether a startup had a good product/market fit -- meaning that it had developed a product that customers were eager to buy. The failure to obtain such fit is a big determinant of whether a startup succeeds or fails. "We have a huge database of 2 million startups six months after they have a product. After we proved the analytical approach, Mike asked me to be his partner. That was when I decided to start Bullpen -- which is my fifth startup," Martino explained.
As Martino told tech news site Vator, "I'm a four-time founder. I was CEO of Aggregate Knowledge, as well as Ahpah Software, which was a security company, and also started a modem game company. I had no desire to go to VC, until Mike Maples called me and invited me to join Floodgate. What got me going was doing data and analysis of value and stage. In 2009, I was able to see the Series A crunch. I didn't want to be a venture guy, but I saw that the Series A crunch was going to be big, and that there was an opportunity, so I started a fund. I reluctantly started Bullpen."
Bullpen's approach is working. As he said, "We are outperforming our peers by two standard deviations. We have raised three funds -- $25 million in 2011, $35 million in 2014, and $85 million in 2016. Since we are raising a fourth fund now we are not allowed to talk about actual numbers but we are in the top decile. The model has worked for different companies from HR software to dog walking. We are looking for companies that could be bought or be IPO candidates in 12 to 18 months."
One of Bullpen's most interesting differences from other VCs is its decision not to become an expert in a specific market, product, or business function as most other VCs do. As Mr. Martino explained, "Traditional VCs put the first check in and help build the first products. We mentor startups in a different way. We are not students of the business. We just want our models to work and make money for investors. Now we're trying to examine whether we can apply what we've learned to later rounds of financing."
4 Tests To Win Martino's Money
If you want Bullpen to invest , make sure the following are true about your company:
- It's in one of four industries -- consumer, marketplace, e-commerce, or software as a service;
- It's generating revenue of $1 million a quarter growing three to four-fold from the year before;
- It's burning through about $300,000 a month; and
- It forecasts three-fold growth in the next 12 to 18 months.