There is a lot of talk about Angels, Super Angels and Venture Capital firms (VCs) these days who are playing the startup field with small sums of money coming from small funds. The majority of those VCs now stuck in their self propagated ten-year mantra of capital efficiency have seen average Limited Partner (LP) returns dwindle down to minus 4% IRR. Which subsequently instills more fear, uncertainty and doubt in the asset class and gives ample reason for LPs to mistrust and under-commit to Venture firms and reduce fund sizes even further.
Fund size matters
Now the reasons for underperformance in Venture firms are a multitude (as we described in The State of Venture Capital), and not in the least embeds a systemic lack of relevant General Partner experience in guiding startups across the chasm to massive market adoption (by way of Social Economic Value). Without that relevant experience, fund size is irrelevant.
But if a LP assumes he has hired the right team to distribute the public’s cash reserves to gain glorious returns, a Venture fund size below $250M (or play-funds as they are called) makes no economic sense. Here is why:
Asset and risk fragmentation
A fund of less than $250M induces extreme fragmentation of dollars and risk to LPs. With sizable commitments from LPs dedicated to other asset classes, a deployment of (usually) less than 5% of assets fragmented to less than 0.1% upon startup investment yields unacceptable fragmentation-to-risk ratios in Venture. In addition, an 80% technology greenfield deserves the opposite commitments from LPs compared to hundred year old asset classes with less than 10% growth. That is, if you have the knowledge and guts to tell VC General Partners (GP) how to deploy risk correctly.
Small Venture funds are unlikely to be managed by Institutional Investors directly and can only economically be managed through a Fund-of-funds in-between the LP and the VC firms. But yet another layer of (bottom-heavy) diversification, fragmentation and accountability deflates the risk associated with an asset class that is supposed to deploy risk. Hence Venture has turned into (micro) Private Equity with similar return ratios. Yet another layer of management fees skims not just the risk in Venture but also increases the cost of doing business.
Venture firms with less than $25M devoted to a single innovation are forced to syndicate, as most successful innovations take more than $25M in financial runway support to make a serious dent in the market. Hence VCs are subject to socialization of innovation with their peers, which is the opposite of the anarchy required to drive innovation. Lack of investor competition also removes the free-market principles required to attract the best entrepreneurs and VC collusion turns startups into investor owned-and-run companies, with less disruptive returns on the backend. Subprime VC at its finest.
Venture firms that need to make more than six investments per GP front-loaded in the first 4 years of the fund to deploy its full fund commitment forces the fund to swap quality for quantity, yielding fashionable innovation alternatives and inevitable commoditization of “innovation”. As a result, GPs can no longer diligently support the few innovations that truly subscribe to the unique investment thesis described in the Private Placement Memorandum. Hence entrepreneurs do not get sufficient GP face-time necessary to make the proper board decisions needed for the company to reach upside with GPs frequently unaware of the dangers looming. Success therefore has just become more predictable, predictably bad.
Attracts small ideas
Venture firms with smaller funds also have a need to mitigate risk and fragment dollars and risk extensively and thus is predominantly attracted to small entrepreneurial thinking. As a result the Venture business is flooded with utilities in search for value, rather than contacted by unique companies that can change the world. Instead, entrepreneurs are forced to go to market with half-baked propositions and premature revenues, neither one as an accurate indicator to ever reach meaningful upside.
Deploy risk again
Many investors in Silicon Valley have by virtue of their fragmentation of risk and dollars deflated the definition of Venture. In a product of their own making Venture has become subprime or micro Private Equity, with economically compatible returns. The key to bring Venture back to its glorious beginning is not to avoid risk but to deploy it to entrepreneurs and Venture Capital investors at the same time and intentionally, and to hold both accountable for producing generous returns.
So, as an LP do not even bother entering the Venture sector with a granularity in VC funds below $250M. And as an entrepreneur do not even bother engaging with a Venture investor who cannot monolithically support the vast majority of your financial runway to upside. Either one is a waste of time and causes further destruction of a sector that continues to hold such incredible promise.
The evolution of 80% of the world’s population depends on it.