Factors Affecting the Capital Gain in Startups
Exiting a startup is the last, most important, and most challenging step in the management of a venture capital fund and determines its Capital Gain. But what are the factors affecting the capital gain in startups?
In previous posts, we discussed the concept of startup exiting, its importance for both parties, and exit options. This article will deal with the factors affecting the capital gain after exiting the startup.
Systematic and Unsystematic Factors Affecting the Capital Gain
Capital Gain is affected by five non-systematic factors as well as two systematic ones.
Non-systematic factors include:
- GDP growth
- Industries and the laws and principles they follow
- Product globalization capability
- Technology advancement
- Public markets
On the other hand, systematic factors include the following:
- The exit time from the companies in the portfolio
- Investor ability to attract and select capable entrepreneurs
In the following, we will examine the systematic factors and how they affect the capital gain.
According to Macintosh studies, the timing and the strategy of exit is a function of the venture capital fund’s willingness to maximize stock value. Assuming an average investment period of 6 or 7 years, the final return is highly dependent on the time of each investment and the exit time.
An Example to Determine the Importance of Exiting at a Suitable Time
To explain the importance of exiting at a suitable time, it is enough to compare the capital gain of investing in an Internet company in 1999 between 2000 and 2005. Due to a 700% reduction in the internal rate of return and a 50% decrease in the income coefficients used in the valuation of Internet companies in 2005 compared to 2000, the fund’s capital gain if it left the company in 2000 is much higher than its rate in 2005.
Newly Founded Mutual Funds, Reputation, and Grandstanding Theory
Reputation carries credibility, and credibility is the cornerstone of any successful business. According to Grandstanding theory, newly established funds tend to list their shares before the appointed time. This exiting strategy helps them gain fame in a shorter time.
On the other hand, regardless of a fund’s ability to manage capital, the number of outflows made through the initial public offering of companies is a clear signal of the funds capability for investors and founders.
Therefore, a fund that has successful and high-yield outflows through an initial public offering in its portfolio, in addition to attracting the most capable entrepreneurs, can obtain the necessary capital for future investments by attracting capital from external investors and redefining limited liability partners. Furthermore, it improves its chance to re-participate in the next rounds of capital raising for companies in its portfolio.
On the other hand, the price of this potential reputation is the company’s stock lower price, and consequently, lower returns for the fund. According to studies by Megginson & Weiss, the likelihood of undervaluation of shares in the initial public offering decreases as the withdrawal time of the fund increases.
A comparison of newly established and old hedge funds in Armin Schwienbacher’s study is also a testament to Grandstanding’s theory. In this study, newly established funds placed a much higher value on the “reputation” factor in the event of an exit through an initial public offering.
Investor Ability to Attract and Select Capable Entrepreneurs
Studies by Kaplan & Schoer and McKenzie & Janeway show that a fund’s returns are stable.
Unlike other asset classes, the future performance or potential capital gain of a venture capital fund is predictable based on the expertise and skills of managers in selecting companies to invest in, manage and supervise them, as well as their past performance in previous outflows.
Studies also show that of the 63 venture capital funds that have invested since 1987 and have withdrawn from companies in their portfolios by 1997, the highest quartile in terms of return, the average internal rate of return is 17.6%, and the lowest quarter is the average rate of internal rate of return. It was 0.3%.
Other studies show that of the 35 venture capital funds that have been operating since 1996, the highest quarters in terms of return had an average internal rate of return of 113.9% and the lowest quarter had an average rate of internal rate of return of 1.4%.
In other words, with the improvement of the situation, not all funds will achieve higher returns.
This principle also applies in periods with unfavorable conditions for industry; Studies show that out of 57 funds that have been operating since 2001, the funds in the highest quarter achieved an average internal return of 9.6% in terms of exit returns. However, hile the average for the funds in the lowest quarter was 3.9%.
Skills and Capabilities of Managers
Regardless of conditions, economic status, and non-systematic factors, some funds have historically had much higher investment returns. That’s due to the combination of skills and capabilities of their managers.
However, the set of skills and expertise of the funds’ managers will be enriched over time. Therefore, the profitability or capital gain, in addition to the venture capital investment strategy, investment timing, and outflows (taking into account the general market situation and general economic conditions), is directly dependent on the ability and expertise of managers in selecting the best companies and monitoring them.
A vital component of venture capital is the expertise of the venture capital managers; indeed, this expertise is at the very heart of venture capital investing, since venture capital investors are value-added investors
(Gompers and Lerner, 1999; Sahlman, 1990)
investing in dynamic markets book, Henry Kressel
S. N. Kaplan and A. Schoer, “Private equity performance: Return persistence and cash flows,” Journal of Finance
M. D. McKenzie and W.H. Janeway, “Venture capital fund performance and the IPO market, University of Cambridge