In my previous post, I claimed that “Venture Capital is a people business in every sense of the word. It is therefore a boutique industry and it cannot scale.” Let me expand on that thought a little more to qualify what I’m saying.

Unlike investing in public markets, investing in early stage companies happens before those companies have a real business, when it is just a concept and a team, and sometimes not even a whole team. What early-stage venture capital is betting on is people. VCs have to be able to sum up an individual and make an educated guess as to whether that individual has what it takes to build a company around his/her concept, his/her dream. When it comes to helping portfolio companies grow, it is the people relationships that matter most — can you open doors to prospective customers, employees, partners, lawyers, accountants, bankers and of course other investors. The biggest challenges in building a company are: People, people and people. If you buy the people argument, then it follows that it is difficult to institutionalize and scale a venture firm since not everyone in the organization can have the same people judgment and people skills. Until such time that we can clone people as adults, with their knowledge and skills intact, venture funds are fundamentally people (time and bandwidth) constrained.

The other form of scaling in venture capital is that of the size of the venture funds. Limited partners invest in venture since it is supposed to be a high-return investment. Lets assume that Shylock Ventures is capable of producing a 20% IRR on a $100M fund. Those returns do not (and cannot) scale with the size of the fund! If Shylock Ventures were now to raise a $500M fund or a $1B fund, it probably will not be able to maintain its IRR. The historical returns were created by investing certain amounts of capital in companies at a certain stage. It isn’t possible for Shylock Ventures to simply put more capital to work in a company at the same stage — that would be over-capitalizing the company. At the same time, Shylock Ventures can’t easily find that many more quality investment opportunities because it is people (time and bandwidth) constrained. The only alternative is for Shylock Ventures to begin doing later stage deals that have an appetite for more capital. However, later stage deals have a very different flavor — they require a different set of skills and expertise to evaluate them and execute on them. Can the same firm that is doing early stage investing develop a competency in doing late stage investing overnight? While some very unique firms may be able to build/hire the competency needed for this, I would argue that most venture firms simply cannot scale the size of the funds without substantial risk to their strategy and returns.

Venture firms are like skilled artisans. Their products — successful companies — are most valuable when the firms remain small and have their own unique style. When you try to mass-produce this product or just try to make it really big, it loses its value. For sake of analogy, think of it as the chef at a top restaurant or the conductor of a fine orchestra — for each there is an ideal size and trying to scale it beyond that ideal size results in a degradation in the quality of the product. Venture capital is, and should remain, a boutique industry.