Square Peg was founded in 2012 and has grown into a global investment firm with teams in Sydney, Melbourne, Tel Aviv, and Singapore. Square Peg invests in emerging technology companies across the internet economy. So far, Square Peg has over US$1 billion in assets under management across multiple funds and has invested in companies including Fiverr, Canva, StashAway, Airwallex, Kredivo and Tomorrow. In 2021, Square Peg expanded into global listed technology investing.

The paragraph above describes Square Peg today… it is a long way from where we started.

In 2012, we were the first of the new generation of VCs to emerge, and I was part of that founding team, alongside Barry, Jus and Paul. Collectively we’d had an enormous range of relevant experience, but in the context of venture, we have come to realise how little we knew of the nuance required. For anyone thinking about starting in VC, please talk to us first. We have plenty of lessons we can share!

We are still early in our journey (one of the key lessons I’ve learned is how long the time frames in VC are), and in the last few years, we’ve only just begun to “close the loop” through the realisation of very significant returns (real $ back in the hands of our investors).

Today I am in the fortunate position to reflect against a backdrop of strong returns across all of our vintages. To give you a sense of our returns:

• our all-time IRR is 37%, and our TVPI is 2.9x.
• our longest track record, Fund Zero, has an IRR of 32%, a TVPI of 5.2x and a DPI of 2.4x.

(TVPI is essentially the value today versus the paid-in capital, and DPI is the amount distributed to investors versus paid in capital – see glossary at the end of this article)

Clearly, we are the beneficiary of strong markets which have helped with both valuations and realisations. But therein lies another lesson of venture – tailwinds (for example backing the right emerging themes) are an important part of what we do.

I’d like to focus the rest of this article on a few of the unique elements and peculiarities of the economics and structure of VC investing.

The vehicle

Let me start at the top with the vehicle through which investments into start-ups are typically made. Funds are a logical vehicle for early-stage investing, but there are many shortcomings of the fund structure too. Prior to 2016, we invested through a series of special purpose vehicles (“SPVs”), which each invested into a particular company (we call this 2012 to 2016 pool of capital “Fund 0”). Our investors typically had broad exposure across a range of these SPVs and thus the benefits of a portfolio exposure. The biggest issue with SPV investing was the impact on our appetite for risk; no matter how much you try to convince yourself to be sufficiently bold, it is harder to be bold enough when an individual asset, held in its own SPV, sits starkly on its own.

Mid 2015 was a pivotal phase in our investing journey as we were finalising our last two investments in our Fund 0 chapter: Property Guru and Fiverr. They have both been amazing investments. Fiverr has returned $100s of millions to our investors, and Property Guru, which we continue to hold some of today, will also produce excellent returns.

But both investments were clear demonstrations that we at Square Peg were at the end of a road as far as special purpose vehicle venture investing goes. There were multiple reasons: we were completely crushed by the coincidence of due diligence and capital raising and found ourselves personally underwriting positions to give founders certainty. Indeed, in the case of Property Guru, we were somewhat reliant on (and will be forever grateful for) the pragmatic generosity of our friend David Gowdey who helped us through a tricky place in final deal negotiations when the vendor questioned our capacity to complete. Yet more fundamentally, both these investments were larger investments, and in later stage rounds reflecting a drift away from the high-risk early-stage companies that provide true venture returns.

What drives VC returns – the winners or the loss-makers?

The special purpose vehicle approach had unconsciously steered us marginally away from the most vital principles in venture – focus on what can go right. Asymmetry in equity investing, and particularly in venture, is your best friend. Let’s look at some empirical venture investing truths for top-performing VC funds:

• ~40% of your investments will not return the capital you have invested in them (and, by the way, as good funds get better, the % of money-losing investments within those funds increases).
• Somewhere between 10 and 20% of your investments will generate over 80% of your entire returns.

Exploring those points a bit deeper.

Losing is hard, but it is an inevitable part of what we do. In some of our earliest letters to investors (in 2013), we wrote about the inevitability of investment losses and the likelihood that losses would materialise earlier than gains.

“The reality of early-stage investing is that your losers often become apparent quite quickly whilst it takes longer to realise gains on the winners… Our goal is to be hard-headed about our losers and continue to back our winners aggressively”. – Extract from Square Peg letter to investors, August, 2013.

Expanding on the asymmetry point, there’s a couple of obvious but important points to make.

• you can only lose 100% of the $ you invest in a company
• your upside from any $ you invest in a company is theoretically uncapped

To date, our experience has differed slightly from venture norms in two respects. Firstly, our loss rates have been lower than industry norms. And secondly, we have a relatively large number of portfolio companies driving our returns. Yet like all good performing VC managers, our returns are being largely driven by a few companies. For us, every pool of capital (other than the very recent pool of course) has multiple companies which by themselves could return the entire pool of capital.

To put it in context, we have generated gross returns to date of 37% p.a. (realised, unrealised and write-offs across all pools of capital). Our lawyers would probably like me to caveat that past performance isn’t indicative of future performance – the usual drivel that’s included in disclaimers. But, in the case of VC investing, there is actually a very high correlation between past performance and future performance. No, I don’t have a crystal ball… but empirical evidence from multiple studies show that success begets success in VC investing, much more than in other asset classes. Why? Because the key distinguishing feature for VC investors is access; great founders can choose the investors they partner with and that forms a reinforcing loop of access to the best opportunities for leading VCs (and makes it harder for emerging VC investors to get access).

Venture investing is hard, but it does have its advantages – you can legitimately invest with proprietary information.

We work really closely with founders; we get to see them in action, and we get the chance to invest off the back of such insights. Somewhere in the order of 50% of the capital per fund is set aside for such follow-on investments. In short, there are two reasons for setting aside this amount for following on: firstly, because its important that we give our founders clarity that our support will be more than one-off and secondly, we can back our winners. This is a huge advantage, although it’s interesting that the initial decisions (the decision on which company to invest in) remains the dominant determinant of returns. As an aside, the practice of following on is less suited to the SPV structure of our Fund 0 vintage and was another contributing factor to us evolving away from that model.

Opportunities for change

There are still some weird things that persist in venture that are harder to explain, and I’d love to play a part in changing some of the accepted norms. I’ve talked about the merits of the “fund” concept but one of the oddities is embedded in the relationship with limited partners (LPs). Unlike many other forms of investing, LPs in venture don’t have significant access to liquidity until underlying investments are sold; although there are secondary sales of LP positions and various restructures that can lead to liquidity for LPs, but it is not an implicit part of VC investing.

As a result, VC funds are in a constant cycle of asking for money from LPs and giving it back to them. I’d love an evolution to this model, whereby as we mature, there’s a more embedded liquidity through greater secondary activity. I suspect changing the practice will take a lot of time – cycles in venture are incredibly long (something else I’ve learned!), and for an industry that invests in cutting edge innovation, we are pretty slow to iterate on our own practices.

An evolving model for investment

In our tenth year, we’re optimistic that the future of early-stage investing is bright. In Australia, Israel and Southeast Asia, where we have built investment teams and a portfolio of exceptional founders, we’re grateful to play our role as investors in the ecosystem. Internally, we’re excited by the possibilities of compounding our knowledge and approach across the investing and company lifecycle and are evolving, as we did in 2016. This year we have set up a listed equities investment fund to back the best, listed tech companies globally–which we’ll have more to say about soon.

For those learning about the ins and outs of venture investing, I strongly recommend you read:

• Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist. via Amazon
• 16 Definitions on the Economics of VC. via a16z
• Performance Data and the ‘Babe Ruth’ Effect in Venture Capital. via a16z

• If you enjoyed this article, I recommend you sign up to All Signal, where you’ll get a weekly hit of insight and inspiration from my colleagues and our founders. Otherwise, if you’d like to discuss this article, you can find me on LinkedIn, or email: tony@spc.vc.

Glossary:

• Distributed to Paid-In (DPI): The ratio of Distributions to the total contributions of Limited Partners to date (i.e. Paid-In Capital).
• Distributions: Cash and/or securities paid out to the Limited Partners from the Fund.
• IRR Internal Rate of Return: The annual rate of return.
• Paid-In Capital: The cumulative Limited Partner capital called for investments and fees (i.e. total capital called to date). Note this may exceed total committed capital due to recycling of capital.
• Residual Value: The current value for all remaining investments.
• Residual Value to Paid-In (RVPI): The ratio of the Residual Value to Paid-In Capital.
• Total Value Residual Value plus Distributions.
• Total Value to Paid-In (TVPI): The ratio of Total Value to Paid-In Capital which is net of management fees and expenses.

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