Venture Capital “Orphans”: Exploring an Emerging Search Fund Investment Thesis

Listen to this Blog Post

---

Since their inception in 1984, Search Funds have largely targeted a very particular profile of company: Targets tend to be mature, enduringly profitable businesses with recurring revenue profiles, low capital requirements, and straight-forward operations. These businesses are often still run by their founders, and these founders tend to be later in their careers, seeking retirement, or lacking a formalized succession plan.

While this company profile continues to serve as a fruitful and foundational source of opportunities for Search Funds, I’ve observed that a new profile seems to be popping up with an increasing degree of frequency, particularly from prospective searchers seeking out new and creative ways to generate propriety deal flow. In the blog post that follows, I will refer to this emerging profile of company as the “VC orphan”. That is, a healthy and modestly growing company that has raised at least one round of institutional venture capital, has achieved product/market fit, but has failed to produce the triple-digit growth rates and exponential scalability potential that’s all but required for them to continue to command the time, attention, and capital of their VC-backers.

Might searchers also consider this very different company profile, in addition to that which has served as the foundation of the Search Fund investment vehicle over the past three decades? The remainder of this blog post attempts to explore this question, presenting observations that both support and refute the thesis.

It should be noted that I am no Venture Capital expert (to put it lightly), which may become quickly apparent in the paragraphs that follow. Indeed, countless others have likely forgotten more about venture capital investing than I will ever know. Accordingly, readers are encouraged to scrutinize this thesis for themselves, and know that all retorts and criticisms are welcome.  

Observations That May Support the Thesis

The Other Side of “Irrational Exuberance”

At a high level, the thesis posits that, prior to year-end 2021, the VC ecosystem had enjoyed many years of “irrational exuberance”, characterized by high levels of fund formation & investment activity, record levels of dry powder looking to be deployed, a flood of new entrants into the VC ecosystem (many of whom were of the less experienced and sophisticated variety), high valuations, and a seemingly never-ending sequence of up-rounds. These dynamics, combined with the rather abrupt and acute reversal that began in 2022 as interest rates began to soar, may now have created a rather large universe of soon-to-be-orphaned VC-funded companies who:  

1. Never should have sought out VC-funding in the first place; or
2. Never should have been funded in the first place; or
3. Over-raised; or
4. Are now worth less than the preferred shares in their capital stack; or
5. Are run by founders who no longer see a path to liquidity for themselves; or
6. Have good businesses but bad balance sheets; or
7. Are otherwise healthy and growing, but not at the level that’s required to make sense within the very particular VC funding model

On the surface, the following observations seem to coalesce in support of the thesis:  

• It has been estimated that approximately 40% of venture-backed companies are now worth less than the value of the preferred shares in their capital structure. Not only does this means that the preferred shareholders in these companies (i.e., the VCs) would lose money if the companies were to be sold today, but more importantly means that the founders would get nothing for what was likely years of punishingly hard work

• Importantly, the data point above assumes only a 1.0x liquidation preference for VCs (said another way, VCs need to get 1.0x the value of their original investment back before the founders or other common shareholders are able to see a penny). The picture gets significantly bleaker when one considers that, according to a report by PitchBook, approximately 35% of venture capital deals done over the past 3 years had more than a 1.0x liquidation preference for investors (meaning that VCs need to get ~2-3x their original investment back before founders or other common shareholders see a penny)

• Of those venture-funded companies that have raised more capital over the past 12 months, approximately 15% of them have raised money at a lower valuation than their previous round of funding.

Stage	% of Down-Rounds
Seed	10%
Series A	15%
Series B	20%
Series C	25%
Series D	30%

• Average valuation multiples have also trended downwards (across all stages) since 2018:

Year	Series A	Series B	Series C
2018	14.0x	16.5x	19.0x
2019	12.5x	15.0x	17.5x
2020	11.0x	13.5x	16.0x
2021	9.5x	12.0x	14.5x
2022	8.0x	10.5x	13.0x
YTD 2023	7.2x	10.1x	12.0x

The Importance of the “Power Law”

The “power law” is a foundational principle in venture capital that describes how a very small number of investments almost always account for the very large majority of a VC fund’s performance. Indeed, in most venture capital funds, one would expect only 10% – 20% of investments to generate approximately 90% of the fund’s total return. Once it becomes clear which portfolio investments are likely to fall within the top 10-20%, and which are likely to fall within the remaining 80-90%, VCs understandably tend to dedicate the majority of their time, attention, and follow-on capital to the former at the expense of the latter. It is within this latter category that the potentially “orphaned” companies are likely to reside.

Due to the unique characteristics of the VC model, orphaned companies are not necessarily experiencing financial or operational difficulties. Indeed, companies that are consistently growing revenues at 10-15% per year are often viewed as growing too slowly for the VC model, and as a result often tend to fall out of favor with their funders. In any universe outside of VC however (Search Funds chief among them), consistent revenue growth of 10-15% per year sounds very attractive on the surface.

While it’s possible that these types of companies failed to execute in some fundamental way, it’s equally possible that these companies simply never should have sought out venture capital funding in the first place. In today’s entrepreneurial ecosystem, raising money from VCs is mistakenly seen as the first thing that one ought to do to get their companies off of the ground. While VC is the right capital source for a small minority of companies (notably those who are likely to grow into an enterprise value of ~$1B or more), it is decidedly the wrong source of capital for other companies who are unlikely to grow anywhere near that size, but are otherwise healthy and vibrant operations.

If the founders of these companies see that they are unlikely to get any liquidity for themselves (because the enterprise value of their companies has fallen below the value of the preferred shares sitting on top of them in the capital stack), then it is fair to assume that at least some of them might welcome the opportunity for a quick and orderly exit, which may allow them to pursue their next entrepreneurial project while they’re still young and unencumbered enough to comfortably do so.

Further, if the VCs who funded these “slow growth” businesses are now choosing to spend their time and money on the small number of portfolio companies that have managed to achieved exponential growth, then it’s reasonable to assume that getting some amount of liquidity on these “other” investments could represent a palatable outcome for them. 

Observations That May Refute the Thesis

All of the above is not to suggest that attempting to acquire VC orphans is likely to be an easy or straight-forward process. Namely:  

1. The whole point of raising venture capital is to spend it, particularly in the pursuit of growth. As a result, most venture-funded companies are unlikely to be profitable, which violates a fundamental tenet of the Search Fund model (this particularly true for earlier stage companies, as they often rely on continuity in external funding – and not operating cash flow – to fund their day-to-day operations)
   
   
2. Most orphaned companies within a given VC portfolio aren’t orphaned because they’re healthy and profitable but growing too slowly. Instead, the overwhelming majority have likely been orphaned because they never achieved product/market fit, have bad unit economics, or are built upon a thesis that is fundamentally flawed in some way
   
   
3. If the company in question is indeed healthy and growing (albeit modestly), but doesn’t fit within the unique confines of the VC model, there are likely more appropriate capital partners for them than Search Funds (growth equity comes to mind as a possible example)
   
   
4. Targeting earlier stage companies (Seed or Series A) is likely to be problematic, as these companies are unlikely to be mature enough, may still be far too founder-centric, and in many cases may still not have achieved true product/market fit. For these reasons and more, they’re unlikely to represent suitable acquisition targets for search funds
   
   
5. Targeting later stage companies (Series B to Series D) is likely to yield more mature companies that are less likely present the particular problems presented above, however the purchase price will almost certainly reflect that, and will likely command a valuation well outside of the Search Fund norms.
   
   
6. The true profitability profile of a VC-funded company may be difficult to tease out. Even for those companies who demonstrate good unit economics, there is likely a lot of overhead spending beneath the gross margin line that obscures the true profitability potential of the company (these inflated expenses often reside within sales, marketing, development, and R&D, but not necessarily exclusively so). If the only way to bring a company to profitability is to lay off half of the staff after acquiring it, I’d suggest that a searcher (who is very likely a first-time CEO) is better off spending her time on other opportunities where such drastic actions are not required
   
   
7. Even if the founder of a VC orphan does want to exit, chances are that her Board (i.e., the VCs) are in control of the decision of if, how, when, and to whom they sell. Most VCs are sophisticated financial professionals, and as a result, pulling the proverbial wool over their eyes isn’t a likely outcome. They may reasonably prefer to hold onto their portfolio companies to see if market conditions improve, to see if the company is able to pivot into a different and more lucrative line of business, or to receive a higher offer from a strategic acquiror (among other options)
   
   
8. While VCs are supposed to ardently adhere to the behaviors encouraged by “power law” dynamics, many do not, particularly those whose funds are underwater (I suspect there will be a greater percentage of funds underwater relative to historical norms, particularly for those funds that were mostly deployed between 2019-2021). These types of investors are more likely to choose to hang on to “slow growth” companies as they likely have fewer (if any) “fund returners” in their portfolios.

In Sum

While this thesis does present several merits (particularly at an intellectual level), it also presents several issues that are likely to challenge its effectiveness. I suspect that the vast majority of orphaned companies have been classified as such due to a fundamental flaw in their product, market, or business model, not because they’re simply growing too slowly.

With that said, due to the sheer number of companies that have sought out VC funding over the past 5 years, I suspect that some companies like those described above may exist within certain VC portfolios, however the upside of uncovering them ultimately may not be worth the time, trouble, and volume of outreach required to do so.

To be clear, this isn’t a thesis that I’ve seen tested with any degree of volume in the field, so it is still very much subject to real-world/common sense test.  For this reason, I would welcome feedback from searchers who have actually pursued this thesis, if for no other reason than to better understand just how misguided my musings are.  

---

Thanks to our Sponsors