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Why Even The Best VCs Lose Money – But Are Ok With It

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Most venture capitalists (VCs) will tell you that around half of the investments they make return less than 1x the money invested… if anything at all. 

The surprising stat is that even the best VCs share this performance.

Let’s Talk About Sports

Many Silicon Valley venture capitalists like sports.
If you follow them on Twitter (you should, by the way), you will quickly realize that they often tweet about Trump, their daily lives, startups (every now and then) and yes, their NCAA or NBA teams.
But the sport that is closer to their business model, and often to their hearts, is baseball.
The best VCs are often compared to Hall of Fame hitters
Baseball and venture capital have a lot in common: just like baseball hitters, financial investors are thrown a lot of balls, but they very rarely hit a home run.
Hall of Fame hitters and Midas-List VCs share another feature: they are able to repeatedly make big bets that pay off.
And why is that? Because they play the slugging percentage, not the batting average.

Measuring Efficiency, Not Activity

The best VCs often pass on deals that others take.
They are looking for above-average returns, a feat they will achieve only by taking more risks than their fellow investors.
In baseball, the batting average indicates how active a hitter is. It is calculated by dividing the number of hits by the number of times the hitter was “at bat”, i.e. in front of the pitcher (1).

Batting Average = Hits / “At Bats”

A comparable statistic in venture capital would be the number of times the investment returns at least the money, divided by the number of deals realized.
Since most VC investments end up losing money, a good batting average would mean the VC firm is playing it relatively safe.
As Fred Wilson outlined in a post already ten years old, such a strategy is fine for VC teams investing at a later stage: they get their money back and change, in line with the “lower risk/lower returns” principle.
For early-stage VCs though, who promised at least 25-30% IRR to their own investors (LPs), the best way to succeed is investment productivity.
Given that half the portfolio will burn to ashes (strikeouts), and a good chunk will make 3-4x the money invested (second- or third-base hit), a couple of bets need to return the entire fund 1x or 2x (home run).

Slugging Percentage Should Be The Focus

VC firms can’t reach those kinds of returns by playing it safe.
Limited both in time and capital, investors therefore need to carefully pick which startups they invest in.
The best VCs wait for the right opportunity.
Just like Hall of Fame hitters, the top venture capitalists are patient enough to let a good – but not great – investment opportunity pass by.
They want to make sure they have enough time and capital to commit to a potential home run.
In baseball, the statistic that best captures the ability to take risks that pay off is called slugging percentage.
It is calculated by multiplying the number of base positions by that position, and dividing the total by the number of times the hitter was at bat.
The mathematical formula is:
What the slugging percentage captures is, therefore, the players’ hitting efficiency: when they hit, they hit big.
A high slugging percentage requires more than just hitting mastery. The key qualities are patience, the willingness to take huge risks, and the capacity to absorb strikeouts.
These qualities don’t come naturally to venture capitalists, who often feel they need to invest as much as they can to tip the probability scale in their favour.
In an industry where losing money is part of the job, many believe they should go for quantity over quality.
But not experienced venture capitalists.
US venture capitalist Jules Maltz compares the experienced hitter, who carefully studies the opposing pitcher’s style to win an edge, to the experienced investor, who becomes knowledgeable about a market’s trends and dynamics before investing in it.

The Best Investment Strategy

If you are still not convinced that holding off until you make a big play is the right strategy, take a look at the table below.
We analyzed a variety of statistics for the five MLB players with the highest number of strikeouts.
Two of them are Hall of Famers, two more have at least one MVP title.
Make no mistake: these are star players.
Interestingly, although their batting averages are less than impressive (two of them are not even in the top 1,000 players ranking), their slugging percentages are among the best.
They are all in the top 150, three of them even in the top 50.
The “angel swinger” has the highest number of strikeouts in baseball.
What this analysis shows is that the willingness to make big bets pays off over the long term, even though you hit less than others.
For VCs, this is probably similar to having less Techcrunch articles citing your name.


Instead of ranking investors solely based on the amount of money they return on their investments, we should look at their slugging percentage: what is their investing efficiency?
The formula could look like this:

(a*1 + b*2 + c*3 + … + j*10 + etc.) / (number of deals realized)

Where “a” is the number of times an investment makes a 1x return, “b” the same number for 2x return, etc.
Such an approach should normalize for luck and expose the playing-it-safe approaches.
Oh, and if you like baseball and statistics, watch Money Ballone more time! It will remind you that what matters in baseball is going beyond the obvious and getting together a team that plays well together.
Just like in venture capital.

(1) Diehard baseball fans will object that “at bat” is not the same as “at plate”. They are right, and the difference is explained here.

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