The Case for Camels
Why backing innovators that seek sustainability and resilience over growth-at-all cost is good business and good investing
The Silicon Valley model for venture capital is built around finding and funding the next unicorn – what Silicon Valley refers to as high-growth billion dollar businesses. Success for venture capitalists in this arena often only requires one investment that experiences a large enough growth multiple to make up for the losses of the other companies in the larger fund. As fund sizes have become consistently larger in recent years, the hunt for the elusive unicorn outcome has become that much more critical for a chance at compelling financial returns.
Outside Silicon Valley, and particularly in emerging markets, the most successful entrepreneurs build camels – not unicorns – companies focusing on sustainable growth and resilience from day one. This translates to a more predictable and balanced risk and return outlook. Looking ahead, especially through these uncertain times in the market, this method of venture capital investment deserves another look in Silicon Valley.
Venture Capital is a Risky Business
Investing in startups is inherently high risk. Over 90% of startups fail. Venture capital’s return profile is dominated by a power law, which is visualized in the graphic below. Unlike normal distributions, in a power law the top few companies see outsized success, and the remainder see mild to no returns.
In Silicon Valley’s chase for growth-at-all costs style unicorns, when a business shows signs of success, startups raise a large sum of capital to capture market share rapidly before anyone else does. This leads to fierce competition, and usually only one or two startups will be successful in that market. For every Facebook, there was a Myspace.
Because of this concentration in so few so-called “fund-returners” and not everyone finds them, estimates suggest that after fees, half of all venture capital firms don’t return their capital (a zero or negative rate of return), and only 5% return more than three times the capital (the equivalent of 12% annualized return over ten years). This means that after ten years, half of venture capital firms provide worse returns than comparatively investing in low-interest checking accounts (at a much higher level of risk). Even when half of firms perform poorly, however, the average industry return remains quite attractive. That’s because returns are highly concentrated among a few firms and, within them, in a few deals that generate most of the returns.
Investing in Emerging Ecosystem
For the rest of the world, instead of chasing unicorns, I recommend seeking the next caravan of camels. Camels manage costs, have sustainable unit economics, and take a long-term approach to growth. They are built for the long haul. For the time being, many of these types of companies can be found in emerging startup ecosystems, because they have had to manage in ecosystems with less resources and prepare for market insecurity, currency fluctuations, and other risk factors. Camels have to survive harsher business environments and be resilient in the face of adverse market conditions.
Passing through the valley of death, the time when companies lose more money than they make is universal for most new startups. Unicorn chasers amplify the valley of death in the search for accelerated outcomes (see left chart below). Camels conversely, while still seeking long-term growth, manage the cash burn curve thoughtfully (see right side).
As a result, Camels have higher survival rates than the growth-at-all-costs startups in those in Silicon Valley. This was validated by research from All-World Network, an organization co-founded by Harvard Business School professor Michael Porter, which determined that entrepreneurs in emerging markets have an increased survival rate. Camels also ingest less capital but also take a long-term outlook. Because of these dynamics, venture capital investments are governed by an adjusted power law, shown below.
As you can see, a lower failure rate for companies (and thus venture capitalists) comes with a trade-off in the form of hyperscale success stories. Stratospheric success is rarer in emerging markets, but so is outright failure. Outside of the US and China, unicorns are a very rare breed (though this is starting to change as 10% of the world’s unicorns are from emerging markets for instance). However, this does not mean venture capital at the Frontier does not depend on outsized winners; it does. The theoretical portfolio mix is just different, creating a lower chance of astronomical returns (for now) but more consistent returns, with less capital intake and a lower risk of posting a loss.
Returns outside Silicon Valley compare favorably to their Silicon Valley peers. For example, a study by PitchBook Data demonstrates that venture capital returns in the US Midwest are among the best in the country. Remarkably, among successful exits, nearly half (45%) of Chicago investments have provided a multiple on invested capital (MOIC; the capital returned relative to the original investment) of 10x, compared with only 25% in the Bay Area. From 2006, the average MOIC was 5.6x for Chicago, outpacing the Bay Area’s 4.2x by a significant amount. This plays out globally with emerging market venture capital funds: Cambridge Associates, an investment consulting company, estimates that the average return for emerging-market venture capital and private equity over the past 15 years is more than 10%. Other, specialized indexes suggest that emerging market returns exceed US performance across multiple vintages. Incredibly this was done at more reasonable risk. To demonstrate this point, the Southeast Asia venture capital firm Asia Partners studied the Sharpe ratio (the amount of return for a given amount of risk) of venture capital in Southeast Asia relative to other asset classes. Venture capital was among the most attractive across any category and, remarkably, offering the same level of risk-adjusted return as real estate.
Bringing the Strategy Back to Silicon Valley
As the world shifts towards a more global startup ecosystem (with over 1 million existing startups and 480 startup hubs according to the Startup Genome), we will also need to see proliferation and adaptation of the venture capital model. It is not one size fits all approach. There is a lot to learn from venture capital models in emerging markets that are focused on funding and growing camels instead of blitzscale companies that take on heavy losses early in their lifecycle. More disasters like WeWork can be avoided, and the average VC fund will have a higher chance of generating positive returns.
The first way of working towards this goal for venture capitalists is to broaden the search to find more camels. VCs should be looking more to tools to help them find companies outside of their networks and typical search mechanisms. Born global funds that target many ecosystems at once are great ways to start to expose the portfolio to a wider range of global companies. By training the team to look for camels–with stronger unit economics and sturdier financials–VCs can start to build lower-risk and more successful funds.
Secondly, venture capital firms in Silicon Valley should expand their product suite to support different types of innovators globally. The mining industry, for example, uses a royalty (technically a revenue-sharing agreement) as the basic model for raising risky capital. Essentially, prospectors pay their investors a certain percentage off the top over time. Investors in the business must share in the ups and downs of the business. Venture capitalists could do the same. There is also an opportunity to extend the length of funds’ holding periods to reflect the longer-term horizon of scaling camels. Companies are as unique as snowflakes, and it increasingly seems arbitrary to set a holding period at ten years. Some of the best companies have growth timelines that extend beyond a ten year period and are built for longer-term success. Finally, the growth of computerized decision making promises a more unbiased tool to objectively evaluate underlying startup performance.
In essence, by changing the way VCs search for new investments and by valuing more economically stable companies over longer time horizons (our camels), venture capitalists can create healthier and less risky startup business environments, reward well-run startups, and mitigate their own high risks. It is a win-win-win, and in the face of current market instabilities, it seems like the right time to start adjusting venture capital strategies.