Nic Brisbourne crafted a clear and cogent post yesterday about the economics of venture capital. Nic also references a similar blog post citing Bill Bryant, a former entrepreneur and now one of DFJ’s US venture partners.
To be (almost unfairly) succinct, the VC model as practiced by the DFJ US is “for every 10 deals we do, we lose all of our money on 5 to 6, we make a modest multiple on 2 or 3, but we make a lot of money on 1 or 2.” Whereas DFJ Esprit leans more toward a 1/3, 1/3, 1/3 spread (according to Nic, explained mainly by Esprit’s slightly later-stage focus).
The common element in both of these models is that the GP’s expect to lose money on at least 1/3 of their portfolio. The gains from the other 50~66% of the portfolio more than compensate for the bankruptcies, rendering strong overall returns for the fund.
The vast majority of VC funds in France do not follow this model. I can recall an experienced and well-respected VC investor from a prominent French fund boast at a conference how in all his years investing, he has never had a portfolio company go bankrupt. This statement shocked me at the time (it was a while back) and still preoccupies me as its spirit still rings true today.
VC funds in France eschew bankruptcies. The common process of portfolio attrition practiced by our anglo-saxon counterparts is practically non-existent here.
A partial explanation is structural. Many French VC funds are essentially subsidiaries of banks or family offices. The fund “GP’s” are in reality employees of the subsidiary. Carried interest is difficult to implement and hence rare. Accordingly, the fund management team forfeits the strong alignment of incentives to produce capital gains that a carried interest mechanism promotes.
Furthermore, the head office of the fund subsdiary and by definition the employer of the fund management team, does not want the black eye of a bankruptcy marring their bank’s reputation. Which brings me to my second explanation…
There’s is a strong cultural element at play here too. Bankruptcies are anathema to reputation in French business. Failure is a scar for life. The preferred option is to support the zombies, drip-feeding them with an occasional capital infusion when in critical condition, or better yet, turn to the government for a quick fix in the form of a subsidy.
I would be remiss to disparage this VC model à la française without acknowledging the pain of attrition. Laying off headcount, for example, is technically very difficult in France, and even more importantly, is a very unfortunate situation for those employees who suddenly find themselves back in the throes of a glacier-like hiring market.
However, I question the effectiveness of the model over the long term, its direct ability to generate capital gains, and the subsequent indirect impact on economic growth and job creation.
There are of course exceptions. I can name a few French venture funds that genuinely practice the model of bolstering the high-performers and killing the zombies. But they represent a rare minority on the French marketplace… as do high 10-year VC IRRs.