We’re pleased to announced NextView’s investment in SkyVu Entertainment, along with Lightbank and angel investors. SkyVu is a mobile game company best known for their hit franchise BATTLE BEARS… a series of shooter type games that are action-oriented with an edgy theme, that still remain kid/teen friendly in terms of content.
There are countless mobile game studios out there, and we’ve looked at our fair share of gaming opportunities here at NextView. What made SkyVu stand out was that they already had significant traction before seeking institutional funding (18M+ downloads, seven figure revenue, etc). The company isn’t simply a game developer, but is pushing the artistic and technical boundaries of what a “mobile” game experience can be. For example Battle Bears Royale is a real-time, 3D, multiplayer shooter game than can be played on 3/4G cell networks. And SkyVu’s team is creating a truly cross-platform company… they built the first plug-in for in-app purchases on Android/Unity and made it available to other developers.
We also share SkyVu founder/CEO Ben Vu’s vision of the future of mobile gaming. As I blogged recently, to us “mobile” is in some ways a misnomer of a broader phenomenon of ubiquitous computing. Ubiquitous computing is creating more gamers overall, and increasing the amount of time, the types of devices, and the contexts in which we play games. As the adoption of these devices continues rapidly, and the computing power and network capability increases dramatically, mobile gaming (already a multibillion dollar industry) will catch up with the scale of other gaming platforms like consoles and PCs. It will also create unique, new opportunities for gaming companies by blurring the distinction of console vs mobile… imagine sitting on the couch with a few family members or friends where you can all be playing or spectating games across tablets or smartphones in your hand and the big TV on the wall. And “mobile” gaming won’t just be limited to simple 2D, turn-based casual games (e.g. Words With Friends) – SkyVu and others have been pioneering real-time, 3D, and new (for mobile) genres that appeal not just to casual but also core and mid-core gamers.
We’re excited to partner with Ben and the whole SkyVu team, as they continue to build the company and truly take multiplayer mobile games to new heights.
Zynga’s faced a lot of pressure in the public markets recently. The company’s lost nearly 80% of its value from the peak earlier this year, in the run up to Facebook’s IPO, and currently trades below $3/share… a fraction of it’s IPO price of $10.
That much we all know. We also know lots of valid reasons why the company could be valued at far less than it once was including:
- Stalled Growth – revenue essentially flat over the last 4 quarters
- Governance/Control – Founder/CEO Mark Pincus has sold a good amount of his stock and owns <20% of shares outstanding, but now essentially has unilateral voting control of the company
- Mobile Monetization – as consumer usage shifts from browser/desktop casual games to mobile devices, opportunities for both virtual goods and ad revenue may decrease
- Significant CapEx - Zynga expects to have $380M in CapEx in 2012, though it’s worth noting that the vast majority of that is related to its new corporate headquarters which Zynga (e.g. one-time purchase offsetting future leasing expenses)
- IP Litigation – EA is suing Zynga for copyright infringement, and regardless of the merits this is a headache Zynga will have to deal with and pay to defend itself
- Management Shake-ups – most notably the sudden departure of COO John Schappert and shuffling of Marc Pincus’s direct reports
You can read about all of this stuff in Zynga’s own SEC filings or the popular press. So I can appreciate why public stock investors would be leery of Zynga and why the stock price has been punished recently. It’s hard to be bullish as a public market investor about a closely held company (in terms of control not ownership) that’s barely growing and faces strategic risks.
But at what point does Zynga become a value play? Given Marc Pincus’s voting control, being acquired is presumably not in the cards for Zynga and a take private or LBO would be nearly unthinkable in the near term so there’s little chance of an M&A situation to arbitrage. But at some point the valuation of the company puts it squarely into “value” stock territory rather than the heady “momentum” stock multiples Zynga once enjoyed, not that long ago.
The “value” case goes like this:
A) Valuation Net of Cash – Zynga’s market cap sits at around $2.2-2.3B as of this post. But the company is sitting on a cash pile of over $1.6B. Strictly speaking Zynga’s cash pile is split into three chunks according to GAAP rules… a bit over $400M is in cash & equivalents (e.g. money market funds, bank deposits, etc that can be converted into cash essentially instantly), about $800M is in short-term investments, and another $400M and change is in long-term investments. All of these investments are held in high quality, highly liquid bonds issued or backed by the US Treasury and big corporations (see Zynga’s latest 10-Q). The GAAP distinction is short-term investments are those bonds or instruments that mature more than 90 days but less than 1 year from now, long-term is anything over 1 yr maturity.
So theoretically if interest rates go up (aka duration risk) or the creditworthiness (aka credit spreads) of the US or the corporations Zynga owns bonds of changes dramatically, they could lose a small amount particularly on their long-term securities. But practically speaking Zynga could turn all $1.6B+ of this into cash overnight if it really wanted to. Tech companies which often have little or no debt of their own allocate their cash holdings in similar manner in order to prudently balance investment yield on these holdings… the vast majority of Apple’s $100B+ cash pile is held in long-term securities for exactly the same reason.
So the “value” case for Zynga has to start with the assumption that the business itself is worth more than $700-800M excluding its cash pile (i.e. $2.2-2.3B market cap minus $1.6B cash/investments).
B) Zynga’s Solidly Profitable – Yes, on a net income basis Zynga has been unprofitable the last 3 quarters though they did post net profit before they went public. But if you dig deeper, Zynga looks to be a solidly profitable company by several measures. Excluding non-cash expenses like stock compensation as well as revenue recognition timing (consumers pay it cash up front, but GAAP rules require them to recognize the revenue over time as virtual goods get “consumed”), Zynga generated over $150M in adjusted EBITDA during the first half of 2012. Same is true when you look at actual cash in and out the door… Zynga’s operations generated $146M in positive cashflow in 1H 2012.
In other words, on an annualized basis the company is trading at something like 2.5-3.0x multiple (net of cash) of either adjusted EBITDA or operating cashflow. Zynga’s trailing revenue is nearly $1.2B so its business (again net of cash) is valued at something like a 0.6-0.7x trailing revenue multiple. That’s pretty darn cheap, no matter how you slice it.
C) Zynga Has Decent Margins – Strictly speaking, Zynga’s gross margins are about 71% in the most recent quarter. That’s their revenue minus cost of goods, and keep in mind Zynga’s top line already excludes the 30% take from Facebook (which still accounts for >90% of revenues). 71% gross margins are not exceptional for a software/internet company, but they’re not terrible either. That being said, unlike a company that has essentially zero user acquisition costs (e.g. Facebook, LinkedIn, Yelp, etc) Zynga has to spend substantially on sales & marketing to acquire players. But even if you back out customer acquisition spend in addition to COGS, Zynga’s profit margins are still over 50%.
D) Casual Gaming Pioneer - Zynga still generates the majority of its revenue from US based players. They pioneered free to play social games in the US 3-5 years ago, and have helped make mobile games a mass market phenomenon thanks to hits like Words With Friends and Draw Something (thru OMGPOP acquisition). They face tons of competition in both realms and the shift from in casual gaming space from desktop/browser games to mobile presents challenges to Zynga and others. But I personally still wouldn’t rule out Zynga’s potential to grow both parts of their business, as well as continued growth internationally.
E) Free/Cheap Option on Real-Money Gaming – There’s a growing belief that at some point in the next 5 years, restrictions on playing online games for real money in the US may be loosened, whether full out casino games or something just slightly beyond existing legal skill games (call it gambling “lite”). It’s difficult to handicap these chances and I certainly wouldn’t invest in a company like Zynga for this reason alone. But given Zynga’s first hit was in virtual poker, I feel a long investor in Zynga essentially gets a free option on the potential upside from more legalized forms of real-money gaming. It still retains both a huge user base and strong internal DNA and technology to optimize online games, which IMO puts it in a stronger position than either physical gambling companies (e.g. Harrah’s, MGM, etc) or traditional video game companies in the even online gambling in some form becomes legal.
FWIW I have never had a position (long or short) in Zynga, and don’t intend to take a position in Zynga in the future… I already have ample personal exposure to consumer internet companies both public and private. I also recognize the myriad of risks that a public investor might see in evaluating Zynga and structural reasons they might want to avoid being an investor (e.g. dual class governance w/ founder having majority voting control). And given earnings misses and limited future guidance, Zynga’s relationship with public market investors has been a rocky one. But at some point you have to say that there’s a valuation for Zynga’s profitable core business and cash pile which makes it a cheap value play on not just a comparative but an absolute basis.
About 6-12 months ago you could hardly throw a rock in the startup ecosystem without hitting a VC expressing their enthusiasm for “mobile”. Now the frenzy about mobile has extended into the mass media and public equity markets, though with trepidation as often as excitement.
The best example of this was Facebook’s disclosure during their IPO process back in May that “mobile” usage was increasing significantly but FB’s monetization of mobile users lagged considerably. This question has lingered for Facebook and other consumer internet companies in recent months.
I think it’s worth dissecting the frenzy around “mobile”, both the enthusiasm and the skepticism. First the enthusiasm. The growth of internet connected smartphones and tablets is truly astonishing. Business Insider had a good presentation if you’re looking for a primer. But a couple of data points for perspective… Apple sold more iOS devices in 2011 than all the Macs they sold in the combined 28 years previously. The iPhone is only 5 years old yet Apple’s already sold more than 150 million of them globally. You can bust out nearly as dramatic statistics for Android smartphones. And tablets are still a newer category but are off to significant adoption. No matter how you slice it, “mobile” is indeed big and we’re arguably still in the early-mid phases of the adoption curve.
But not all “mobile” devices are created equal. At NextView we talk about “ubiquitous computing” because we think it captures the broader technology adoption more accurately, and FWIW we’re incredibly bullish. It’s less that smartphones or tablets are replacing laptop/desktop computer usage, and more that people are now using 3-4 “computers” for different tasks and in various use cases. Our total “computing” time has increased significantly as these devices become more pervasive in our daily lives. Tablets are used differently than smartphones… longer session times, frequently in a “fixed” location (e.g. at home on couch, in coffee shop for an hour, at office, on beach on vacation), with a mix of app and browser based usage. Smartphones have shorter session times, are used more frequently “on the go”, and typically see a significantly higher percentage of app usage vs mobile browser usage. There’s also marked behavioral differences between iOS usage and Android usage (iOS consumers use their devices more and spend more on apps, commerce, etc).
So what about the skepticism? Again forget “mobile” in the sense of cell phones and think about ubiquitous computing with non-PC/laptop devices. Also divide the world among business vs consumer usage, and then subdivide consumer into the three business models of the internet… commerce, premium services, and advertising.
Businesses large and small are still figuring out how ubiquitous computing will impact their employees, customers, and business partners. There are lots of folks trying to capitalize on this wave, and some meaningful companies will be built that will essentially have “picks and shovels” business models… e.g. providing the tools and services for businesses to be more productive enterprises in a world with widespread usage of tablets, smartphones, wearable computers, etc. There will undoubtedly be some differences, but broadly speaking this will look roughly similar to other new waves of technology adoption within businesses. I know it might seem odd to some of you, but there was a time when only a handful of people in a company had a PC on their desk or who had a laptop for on the go usage or had an internet connection or email or whatever.
So what about consumers? Is the sky falling for Facebook and other consumer-facing companies since “mobile” is here? Well some consumer companies are actually prospering with ubiquitous computing. eBay is doing well again amidst a quasi turn around in part because of a surge of app-based commerce (both eBay and PayPal sides of the company) on tablets and smartphones. As my partner Rob (an eBay alum) put it in his post Why Mobile Works for eBay the “power of mobile has very little to do with mobility.” This is broadly true for commerce based internet companies. Ubiquitous computing is also propelling many premium services, primarily in the entertainment realm. Gaming is still the largest category, where you see multiple mobile game companies with $100M+ revenue (e.g. Gameloft, Rovio) and a couple $1B+ revenue companies in Asia (GREE, DeNA). But ubiquitous computing is also in part behind the rise of non-gaming services like Spotify and is likely to expand into other consumer categories (e.g. productivity – Evernote).
That leaves advertising based consumer models. At present, ubiquitous computing does present challenges as monetization is harder than on the desktop web. But why is it harder? And will these challenges be persistent or temporal? Let’s dissect:
- Advertiser Spend – Mobile ad spend is growing, but is still currently a fraction of traditional web ad spend (display, search, video) or other mediums like TV. Yet companies like Facebook, LinkedIn, and others are seeing 25-50% or more of their users accessing their services via mobile device. Today ad spend on mobile is significantly behind the consumer usage patterns. But ad spend has always lagged consumer adoption of new media and there’s little reason to believe that smartphone and tablets won’t capture more ad spend in the comping years as they continue to capture more eyeballs. Remember there was a time not that long ago when people questioned the monetization of the desktop web relative to the consumer usage of it. Just ask any dead tree media company how that played out (and not just newspapers but yellow pages, magazines, etc). –> Almost certainly temporal
- Consumer Tracking & Targeting – A key differentiator, relative to other media, for web advertising has been the ability to track, target, and analyze ad spend at a much more granular level and essentially in real-time. At present tracking and targeting consumers on ubiquitous computing devices is inferior to the desktop web for a range of reasons, largely pertaining to the way third-party cookies are treated (the kind used by advertisers as opposed to the actual websites you visit) and the logistics of tracking IPs across wireless networks. Perhaps 80% of iOS devices don’t currently support third-party cookies because of default settings. There are a bunch of companies both large and small working on trying to overcome these challenges, some of which are technical and some of which are the result of coordination across mobile ecosystems (site/app publisher, advertiser, wireless carrier, device/browser maker, etc). –> Probably temporal, but may take awhile
- Form Factor & Behavior – A smartphone or even a tablet is inherently different than the desktop web or other ad-supported media like TV. Most commonly cited are the limitations particularly screen size though also bandwidth, mixed support for Flash, etc which limit the nature of advertising that can be conducted on these devices. But there are also opportunities which are yet mostly untapped… the fact that ubiquitous computing devices have a vastly higher penetration of capabilities like location based services (LBS / GPS) or speech input (thank you Siri). Also content consumption on mobile devices is fragmented across both apps and web browsers, and even the rise of HTML5 is unlikely to completely erase that. –> Most likely here to stay, though some opportunities in addition to known challenges
The current difficulties posed by advertising on tablets and smartphones are real, at least in the near to intermediate term. But ubiquitous computing (or “mobile” if you must) is indeed huge and only getting bigger. The enthusiasm is justified. So before falling for either the hype or the gloom when “mobile” is thrown around, think more critically about the underlying business and the timeframe under which you’re evaluating it.
Last week I wrote about some of the common factors that have led great VC firms to stumble or even fade from existence entirely. I wanted to follow-up with some observations of paths to greatness for a select group of firms. Also it’s also worth noting a few clever hacks that some firms have taken which may not assure greatness, but can help avoid the pitfalls that have ensnared past firms.
First and foremost, it’s worth emphasizing that greatness as a VC firm is derived primarily from helping exceptional entrepreneurs build enduring companies. While it’s possible to gain notoriety and even economic rewards for GPs in other ways in the short to intermediate term, the firms we regard as “great” over the long run derive their superiority from investing in and helping businesses grow… that’s where success for all of a VC firm’s constituents (LPs, entrepreneurs, GPs) flows from.
So assuming a VC firm is able to fulfill its core mission with distinction, what are some factors that can make it great?
1) Self-Awareness & Humility - These are of course virtues that transcend venture capital or even professional pursuits broadly. And yes… great firms are self-confident too. But being able to recognize and admit when you’ve slipped and then course correct as needed is often key to a firm’s ascent to or continued greatness. This is true not only in a firm’s dealings with entrepreneurs but also with it’s limited partners and even within the firm among its partners.
A good example of this was Charles River Ventures experience with their 11th fund. Back in the 2000-2001 timeframe, a flood of LP capital was coming into the VC asset class given the strong returns of the mid-late 90s tech boom/bubble. Like many leading firms CRV used this opportunity to raise a huge $1.2 billion fund (CRV XI), though the firm’s roots were modest (Rick Burnes started CRV back in 1970 with a $4M first fund) and until then CRV had mostly stuck to its knitting of early-stage investing with small-mid sized funds. In the midst of the internet & telecom meltdown at the beginning of the 2000s, as a firm CRV realized there were insufficient opportunities to profitably invest $1.2B. Though there might have been short term benefits to continuing to manage this fund, the long-run success of CRV would be hurt by doing so (there’s an HBR case on this). CRV ended up returning the vast majority of CRV XI to it’s limited partners (ended up being a ~$450M fund) which started a trend among some other VC firms and ever since they’ve stuck with early-stage IT investing out of funds in the $250-$375M range (they’re on “Charlie 15″ now).
2) Be Willing to to Experiment – I described the risks of strategy drift in Part 1, but often great VCs still display a willingness to experiment in their business model. Even when sticking to your core strategy, there are lots of ways to change up a firm’s model with the goal of delivering better value to entrepreneurs, LPs, and the firm’s GPs.
In recent years firms like First Round Capital and Andreessen Horowitz have experimented with creating a “platform” of services for entrepreneurs that go beyond the traditional investor / board director relationship between VCs and startups. For example FRC launched a founders equity exchange fund and various programmatic forms of knowledge sharing like list serves, CEO summits, conferences, etc. The point isn’t that FRC was necessarily the first firm to do any one of these things, but rather they’ve had a willingness to experiment.
In eras gone by, VC firms experimented with other concepts which seem commonplace today. Entrepreneurs in residence (EIRs) and in-house recruiters were a novel thing for most VC firms back in the 80s and 90s. Even the notion of hatching / incubating a company was once unusual. One of the earliest examples of this turned out pretty well when one of Kleiner Perkins’s young investment professionals (29yr old Bob Swanson) bugged a UCSF professor in the last ’70s about starting a company to develop medicines using recombinant DNA. Genentech of course pioneered what we now know as the biotech industry and KP made >200x on their investment.
A willingness to experiment also means you’re prepared for the risks of failure or looking silly in the ecosystem. Rightly or wrongly, Sequoia has received a lot of flak about their “scout” program recently. But one has to respect their willingness to experiment in this fashion before other firms did the same.
3) Competitive Intensity - At both an individual partner and a firm level, great VCs find a way to retain an intense drive to win. Winning in the sense of finding the most promising startups and earning the right to invest in them. Winning in the sense of helping entrepreneurs they’ve backed build great companies. That being said the venture business is a multi-turn game… good firms will often work with teams of entrepreneurs or certain co-investors multiple times over their history, so a healthy competitive desire is not the same thing as being a jerk just to “win” in a particular situation. And internal competition within a partnership can be a double edged sword.
But when a firm or a meaningful group of a firm’s partners has lost that hunger and drive to win, day in and day out, their days of greatness are usually numbered no matter what their prior successes. Keeping those competitive fires stoked requires a sustained commitment by the firm’s partners and also a fair yet honest reckoning when individual partners find their hunger is dulled whether by age, life changes, or interest in other pursuits. In addition partnerships have to keep pushing their boundaries of risk tolerance since the natural tendency of any organization as it matures is towards risk aversion.
4) Hacking Potential Pitfalls - Another approach is to simply find a way to avoid potential pitfalls like generational succession. Foundry Group is one such firm which has clearly and publicly stated that the four founding partners will continue to invest together for the balance of their VC careers, but after that Foundry essentially will be no more since they never plan to add additional partners. Though they only started in 2006, Foundry’s obviously off to a great start with investments in Zynga and AdMeld and a promising portfolio of others. While their model isn’t necessarily to create a firm that endures after the founders, they have avoided at least one of the biggest reasons why great firms fail.
5) Don’t Be A Victim of Your Own Network’s Success – A byproduct of a VC firm’s success is the creation of a strong ecosystem around it of prior and would-be entrepreneurs and long time co-investors (in fact this can be cultivated intentionally too). This is obviously a good thing since it creates opportunities to back experienced serial entrepreneurs and work with a trusted group of other VC firms as co-investors. The downside is it has the potential to close off a firm from newer entrepreneurs. Also while you might be able to use the same “playbook” for a game or two, in the quickly changing and highly competitive world of technology innovation VC firms risk blindly following a template beyond it’s useful life.
A firm that’s continuously managed to look beyond it’s network has been Sequoia. While they’ve also invested in repeat entrepreneurs they’ve previously backed, Sequoia realized many moons ago that their biggest successes were often by first time entrepreneurs. Think Apple, Cisco, Yahoo!, Google, Dropbox, AirBnB. So the firm assiduously finds ways to form these new connections through and beyond their existing network even relying on that existing network would be an easy thing to do.
Again #1-5 don’t guarantee greatness for a VC firm… only investing in and helping transformative companies does. But in observing great VC firms over the decades, all of the above both support the core mission of backing great entrepreneurs and distinguish great firms from the rest of the pack.
I happen to be fascinated by the history of the VC industry, and one of the things we discussed at a recent offsite are the common threads behind the rise and fall of great venture capital firms. NextView’s still in its infancy… we’re barely two years old and are just part of the way through investing our initial fund. But we strive and aspire to build a firm that will excel and be around for awhile.
Many of the great VC firms of today have been around for decades. Firms like Sequoia, Greylock, Bessemer, and others. One can study some of the factors of their success and of course try to emulate them or integrate their best practices. I’ll save these for a follow-up post because I think there are some interesting take aways and also some firms that have found hacks to either propel success or avoid pitfalls.
But there are firms that were once great and have declined to various extent with the passage of time. There are also VC firms that were once among the industry’s elite that no longer exist. You can learn as much from these cautionary tales as you can from the enduring successes, plus studying a broad sample of firms helps avoid drawing false conclusions due to survivorship bias. The names of these once great, now defunct firms may not be terribly familiar today but here are just a few examples:
- American Research & Development [Boston] –> Founded by George Doriot and depending how you count it, either the first or second formal VC firm in the US. Big success was Digital Equipment Corporation (DEC), in which ARD invested about $2.1M in equity & loans which was ultimately worth >170x ($355M) when DEC went public about a decade later. Some disgruntled younger partners left to go start a new firm in 1965 called Greylock.
- Brentwood Associates [Silicon Valley] –> Founded in the early 70s and focused primarily on VC, Brentwood had big wins in both IT like Wellfleet Communications (big chunk of what eventually became Nortel) and WebTV (part of Microsoft) and healthcare (various businesses that make up a big chunk of what is now Medtronic and Baxter). Some disgruntled younger partners left in the 90s to form what is now Redpoint Ventures (IT team) and Versant Ventures (healthcare team). Brentwood also had a PE/buyout group which has continued on to today, still with the Brentwood name, with notable success in consumer retail businesses.
- Burr, Egan, Deleage [Boston] –> Huge wins in the 1980s and early 90s included Continental Cablevision (sold for $5.3B – now a big chunk of what is Comcast), Qwest Communications, Cephalon (biotech IPO, acq by Teva), and Powersoft (Burr, Egan made 35x when it went public and then was acquired by Sybase). The firm ultimately disbanded after nearly 20 years and younger disgruntled partners went on to spawn Polaris Ventures, Alta Communications, Alta Partners, and Alta Berkeley.
- Merrill, Pickard, Anderson & Eyre [Silicon Valley] –> Itself an outgrowth of the venture investing arm of the original Bank of America (based in SF), Merrill Pickard backed many startups that ultimately went public. Some disgruntled younger partners left in the mid-90s… two co-founded Benchmark Capital (Bruce Dunlevie & Andy Rachleff).
- Technology Venture Investors [Silicon Valley] –> Claim to fame… sole VC investor in Microsoft, which turned out ok. But eventually some disgruntled younger partners left and two started August Capital (Dave Marquardt & John Johnson) and one co-founded Benchmark (Bob Kagle).
So what are the common threads that lead to a fall from grace? I don’t mean to pick on the firms above… they each achieved remarkable success in their own right. But each eventually faded from existence and in studying these and other examples three general themes emerge:
1) Generational Succession / Division of Economics - This is arguably the chief reason why some great VC firms eventually stumble. It’d be easy to just chalk it up as “the old guys are greedy and the young guys are greedy/impatient” and see this issue as an incurable human failing. But it’s not quite that simple. What’s a “fair” split of fee income and carried interest when a partner joins several years/funds after others? Should there be a notion of “founder equity” for those individuals who put in the hard work to start a firm and build the brand? How do you deal with a severely uneven distribution of investment success between individuals or groups of partners?
Dividing economic pies and handing leadership off between different cohorts of individuals is rarely easy, but the nature of the VC business makes it particularly tricky. For example carried interest takes years to accrue and is based on the efforts and decisions of both the individual and the firm that happened 5-10 years ago. And the economic rewards of VC comes almost exclusively through the carried interest and fee income generated by individual funds. While ownership and control of the management company matters, these stakes are rarely monetizable at least in the VC business (unlike the buyout world where huge firms like Blackstone, KKR, and Apollo have IPO’d to the great financial benefit of the founders).
But just because it isn’t easy doesn’t mean it isn’t incredibly important. Firms where there ends up being a material imbalance between which folks are putting in the hard work and generating investment returns versus those that aren’t put themselves at huge risk of decline. There are some great news stories from the mid 90s like this one in Wired and this one in NYT regarding generational conflict (generally centered around economic disagreements). And sometimes generational succession fails not because older partners are unwilling to reach equitable economic arrangements with younger ones, but simply because the newer partners they bring in simply aren’t as effective as the old guard.
While this is a key driver to the downfall of great VC firms, there are also small handful of examples of firms that have managed generational succession sometimes many times over. Greylock is probably the best example of this… there are at least four meaningful transitions of leadership over the firm’s nearly 50 year history that have gone pretty darn well.
2) Falling Behind Innovation Shifts - Strategy drift, i.e. expanding into unfamiliar stages, sectors, and geographies of investment is a real problem (see #3 below). But separate from mission creep / strategy drift is failure to keep up with changing waves of innovation. On the IT side of VC investing, we’ve seen countless waves crest and fall… mainframes to minicomputer/workstation, workstation to PC, copper to optical networking, client/server software to cloud, the fabless semiconductor model, magnetic tape to hard drive, etc. VC firms that have been unable or unwilling to stay ahead and abreast of these waves start to lose their prominence (at best) or go the way of the dodo (at worst).
There are a number of VC firms that had extraordinary success in enterprise software, telecom equipment, and semiconductors in the 1990s. And while the internet created both tremendous reward and tremendous investment carnage leading up to and after the 2000 tech bubble, it’s created long run disruption of broad sectors of media, advertising, business software & computing, and retail commerce and VCs that missed this shift have faced real struggles. As a corollary the VC industry has matured in ways that greatly favor sector specialization, so at both an individual and a firm level prior “generalist” models have generally performed less well.
3) Strategy Drift / Over Expansion - Many of the largest and most successful firms around today have become “platforms” in that they are investing in a wide range of stage, sector, and geography whether through a single fund (e.g. NEA, Bessemer) or family of related funds (e.g. Kleiner). Depending on your POV Bain Capital didn’t start as a pure VC firm, but they’ve been making VC and growth equity investments since the firm’s inception and arguably they’ve been among the most successful “VC” firms at platform expansion over their nearly 30 year existence (buyout, pure VC, mezz debt, hedge fund, international, etc).
But for every firm that’s successfully grown beyond their core strategy into a platform, there are 3-4 that have been unsuccessful at it. The impulse to expand beyond the strategy that makes you initially successful is powerful. To a lesser extent the desire for greater industry prestige is a factor. But primarily it’s the allure of growing assets under management (AUM) by raising larger/more funds since financial reward for VCs is tied to AUM. The fixed ~2% management fees of course scale directly to AUM but the performance based ~20% carried interest also scales with AUM.
Here’s a slightly perverse scenario… Acme Ventures starts out as an early-stage VC investing in US-based IT companies. They achieve an excellent fund-level return on their $100M debut fund of 4x gross (i.e. they generate $400M in proceeds from that $100M). That means the partners of Acme will have $60M in carried interest to divide among themselves (20% of the $300M profit). But then Acme’s partners say to themselves… “Aha, based on our success at early-stage US IT now we can raise a $500M fund that will do late stage investments, and also do cleantech investments, and maybe some in China.” Even if they deliver a mediocre 2x gross return on that $500M, they’ll actually generate more absolute dollars of carried interest ($100M in this case) than they did with their much more successful early-stage IT fund in addition to generating more management fees.
But usually what makes a VC partnership great in its early days doesn’t easily translate into other new strategies down the road. You either start trying to invest in stuff you know less well or you hire a bunch of other partners who you hope know that stuff better than you. Like any other form of diluting your focus… it occasionally works, but usually doesn’t.
So if these are the factors that lead to the fall of once great VC firms, what are some of the common aspects of their rise to success? I’ll tackle that question next week in a follow-up post.