The business of venture capital is relatively young. The birth of modern-day venture capital (not considering the European monarchs financing explorations and projects as venture capital) can be traced back to American Research and Development, which was started by Georges Doriot. Spencer Ante‘s book Creative Capital provides and in-depth history of the life of Georges Doriot.
Without getting too much into the history of venture capital, which you’re welcome to peruse on Wikipedia, it seems safe to say that venture capital has really evolved as an “industry” over the past 30 years or so. However, even though this is a young industry, I’m going to posit that “early-stage” venture capital as it exists today is broken and in need of reform. I refer to this as the Venture Spiral. What follows is my analysis of why this is the case from three different points of view. I would welcome a discussion on this topic and invite any interested folks to either leave their comments below or email me directly if they prefer.
Background
Venture Firms are typically structured as partnerships. The General Partners (GPs) are the operating guys. They run the show on a daily basis — sourcing dealflow, evaluating opportunities, making investments, serving on board etc. The money that the GPs and other employees of the firm invest comes from Limited Partners (LPs) — typically the big university endowments, retirement funds, charitable organizations, family offices and high net-worth individuals. In return for the operational role the GPs play, their firm receives a Management Fee. Industry averages for the management fee are expected to be around 2.5% of the size of the fund. In addition, there is a performance incentive — the Carried Interest or Carry. The carry is typically around 20% of any gains on the fund. Here’s an example:
Shylock Ventures invests $10M in Little Fish and gets say 33% of the company. A couple of years into it, the friendly neighborhood search giant, Big Kahuna, shows up and decides to acquire Little Fish for $100M. Glossing over preferred rights and preferences, Shylock Ventures’ take would be $33.3M, a gain of $23.3M over the initial investment of $10M. So the carry for the GPs would be (20% of $23.3M) $4.66M and the balance would be the return to the GPs ($10M + $18.64M).
But, the carry only kicks in if the investment returns money. And the data suggest that most VC firms don’t return the money. Then why be in the business? Well, for one, you have to try and secondly, the management fee makes for a nice perk. Lets see how that plays out:
Let say Shylock Ventures raised a $500M fund. At 2.5% annually that equates to a management fee of $12.5M per year. The fee is generally paid throughout the life of the fund (generally 10 years, though some fund structures will reduce the fee after the “investing life” of 5 years). In total, over a period of 10 years, the management fee is going to be a whopping $125M.
Now that’s nothing to snicker over, especially considering that well-reputed and established firms could often have multiple overlapping funds. These partnerships last for a long time and are hard to unravel. The management fee becomes an “accelerant” in the firm’s incentive to raise bigger funds.
The VC perspective
Let’s continue with our example of Shylock Ventures. Assume Shylock Ventures has 10 partners who are going to invest the $500M fund over 5 years. On average, each partner needs to deploy $50M over 5 years, or $10M per year. The most constrained resource for a partner at a venture firm is time. The venture business is a people business — it’s all about meeting people, networking, evaluating ideas (and people) and making educated bets (on people). This is what makes it more difficult to scale. It requires the time and attention of the partners, but time is a funny thing – despite every effort, there are still only 24 hours in a day and 7 days in a week.
To justify the management fee, Shylock needs to deploy the capital that it has raised. Theoretically, the capital could be deployed anywhere in the spectrum of 10 investments of $1M each or a single investment of $10M by the partner. The money side is flexible. What is not flexible is time. Doing 10 investments at $1M each would mean that the partner would now have a gigantic portfolio to manage and there just isn’t enough time in the day, or week, or year to manage that many investments, serve on boards and help companies grow while still continuing to look for new investments. Therefore, the motivation is really to look for startups that have an appetite for a larger, chunkier investment. The industry average for the number of investments per partner is between 1-2 deals per year. VCs are therefore going to pick companies that can use up a larger investment.
Let’s assume Shylock invests $20M over the life of the company and ends up with about 20% of the company. For them to see a 5x return the company needs to exit at a valuation of $500M. For a 10x return that exit valuation needs to be $1B! To summarize, the incentive in a venture fund is to make sizable investments in companies that have the opportunity to become billion dollar companies, or in other words, the incentive is for venture funds to move up the venture spiral.
The LP perspective
Institutional LPs typically diversify their portfolios by investing in multiple asset classes. Venture is just one of the asset classes they invest in. LPs have invested in Venture Capital because as a class venture capital is both a high-risk, but high reward asset class. The expectation is that while venture investments are more risky than other forms of investments (though that is open to speculation in the current financial meltdown), they also typically have a high Internal Rate of Return (IRR). For what I’ve seen/heard the tops VC funds typically have an IRR of over 20%.
Institutional LPs are managing large amounts of capital, which is typically not their own money. To safeguard their investments, minimize risk and abide by their fiduciary duty, LPs perform extensive due diligence on the venture firms they invest in (just like the VCs do on the startups they invest in). Key components of this diligence is (obviously) on the team — how long has the team been together and what is their track record. In addition, LPs also want to invest a substantial amount of capital in a fund and have guidelines (that may vary considerably across institutions) for what percentage of their money under management can be invested in the venture asset class. The incentive amongst traditional LP sources is to invest in venture funds that have been around for a while and have a track record. However, as described above these day funds are the ones which have evolved to now be managing larger and larger venture funds.
If the venture firms that move up the venture spiral are doing larger and later stage investments, the LP expectation of high returns on this risky asset class are likely to not be met. Several LPs have already started seeing this effect across their venture asset class portfolios. There will be some notable exceptions here — the top 10-20 venture funds may still be able to have a good IRR on their funds since they get access to a higher quality dealflow and because of their reputation have a higher probability of investing in the quality teams and concepts that are likely to be successful. However, for the vast number of the remaining venture funds out there, the returns to LPs are going to be disappointing.
The Entrepreneur perspective
For entrepreneurs the problems occur at multiple levels. First, VCs are only interested in doing investments that have the potential to require a sizable amount of capital and also have the potential to be big markets. That means that VCs become ultra selective in the types of deals they consider to be venture fundable, leaving several otherwise great concepts and teams struggling to find venture money. As established funds move up the venture spiral, they leave behind a vacuum for true early stage venture capital.
Thus far, this vacuum has been filled by friends and family (or sometimes know as the 3Fs — friends, family and fools), angels and an increasing number of angel groups. This poses it’s own problems. First, for entrepreneurs, raising money at the very early stage becomes an exercise in herding cats — getting large number of funding sources to agree and individually contribute small amount of funding to pull together the amount of money the startup needs. This is both time consuming and sometimes frustrating for entrepreneurs. In addition, in most cases no one angel has enough capital invested in the company to be “on call” when the company hits hard times (and invariably, every startup does!). The entrepreneurs may lack access to the advice, oversight and expertise that they really need in order to take the fledgling company to the next level.
Follow-on funding for these companies also becomes an issue for two reasons. First, these sources of funding may not have the capacity to sustain the company till it begins to bring in revenue or is ready for a professional round of financing. Secondly, if the VCs are looking for the billion dollar opportunities and the company doesn’t fit that criteria, venture funding may be hard to come by at all.
The intent here is not to paint an all too gloomy picture, but to try and point out some of the deficiencies in the current state of venture capital. The design of K9 Ventures takes these issues into consideration. In the following post, I will outline how and why K9 Ventures hopes to address some of these deficiencies.