AGILEVC My idle thoughts on tech startups

July 9, 2009

As the VC industry goes through a certain level of upheaval, one of the frequently cited issues is the growth in fund size over the last 5-10 years. All other factors aside, VCs themselves have an incentive to grow the size of funds (or raise add’l funds focused on other strategies) because of the potential for the partners to “get rich on management fees”. People like Fred Wilson and Chris Duovos have highlighted the challenges associated with generating strong returns with an industry composed of many large funds, the “VC math problem” so to speak.

Many people in the VC ecosystem (including me) believe the industry as a whole will contract in the coming years. After years of seeing $20-30B committed annually to VC as an asset class, in the first half of 2009 LP commitments were half that much. But an open debate remains as to what size funds will compose a VC industry that’s materially smaller than the recent past. There are a couple schools of thought regarding this issue.

1) The VC “Index” Fund –> These folks suggest that $1B+ funds may be large in absolute terms, but in reality these funds are often pursuing mutiple sectors, geographies, and/or stages of investment. So in essence, these funds often describe themselves to LPs not as one huge fund but as an “index” of reasonably-sized VC funds or a “basket” of different strategies. Invest in our billion (or multi-billion) dollar fund, and in reality it’s like buying a $200-400M life sciences fund, a $200-400M IT fund, and a $200-400M cleantech fund all rolled in one. Or a US fund plus a China fund plus an Europe fund all in one. Or an early-stage plus late-stage or growth equity fund. You get the idea. Firms like NEA, Oak, and others which have organized themselves in this fashion and are investing out of $1B+ funds tend to advance this perspective.

2) “Back to Basics” Small Funds –> This group believes that virtually all VC funds have grown too large. The capital requirements for launching and operating a startup (at least in IT / digital media) have dropped precipitously. Similarly most of the recent exits for VC-backed companies have been through M&A rather than IPO, and on average they are $100M or less. Therefore, the future of VC will look a lot like the early days of VC (starting in the late ’60s running thru much of the ’80s), with small partnerships managing small funds (< $250M or so). These will often be focused early-stage VC investing and often with a specific sector or perhaps geographic focus. Long-time, highly successful VC Alan Patricof (who launched Greycroft, a small $75M fund, a few yrs ago) is firmly in this camp as well as many others.

3) “Big” Funds Still Where It’s At –> This group believes that the reasonably big VC fund (say $400-600M) still makes a lot of sense. Launching a startup may have become a lot more capital efficient, but building a big company (exit value of hundreds of millions or billion+) still requires significant capital prior to exit (tens of millions). To those who say the days of $1B+ exits are behind us, look no further than recent examples like Data Domain (IPO then >$2B acquisition), Equalogic (>$1B acquisition), athenahealth (IPO), or YouTube (>$1B acquisition). Unsurprisingly VCs who have “big” funds currently and want to continue to raise “big” funds in the future typically advocate this view. Not to pick on him, but David Hornik (GP at August Capital, which just raised a $650M fund) is just one example.

Having reflected on this issue quite a bit recently, I’ve come to the conclusion that they’re all right to some extent and the future of VC will involve at least some firms of all three types. I think there’s a great opportunity for smaller funds managed by smaller partnerships (including my own firm). These firms can capitalize on the fact that many startups don’t need a great deal of capital, and at inception may be unclear whether they can (or want to) become a $1B+ company someday or are more likely to be a $100M company. Modestly sized VC-funds can generate attractive returns in whichever of these outcomes might ultimately occur. We’re also seeing some firms that grew to have fairly large funds in the recent past revert back to investing with smaller funds (CRV, Atlas, et al).
But by the same token, I think several “big” funds in the VC ecosystem will continue to be very sucessful. I tend to agree most that few startups can become very big companies without requiring tens of millions of capital (and I don’t see this changing anytime soon). The future Google’s, Skype’s, eBay’s, and Genentech’s of the world will still be created in the coming years. The VCs that can source, select, and win these investments will generate many multiples of invested capital and hundreds of millions if not billions of proceeds. I don’t think the $500M VC fund in and of itself is a problem… I think the proliferation of many $500M VC funds is what’s unsustainable. Presumably if LPs truly do pursue a “flight to quality”, the industry won’t see 30+ firms with funds of this scale but perhaps a dozen or thereabouts.
So while the VC industry may contract by as much as 50% in the near future, there’s probably a place for us all… the small funds, the big funds, the index funds. Every VC just wants to be sure they end up in the “right” 50% when it’s all said and done.