Why Venture firms below $250M cannot succeed

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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.

Management bonanza
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.

Forced subprime
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.

Fuzzy devotion
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.

 

We encourage comments that are relevant to our observations, conclusions and the specific topics discussed in this blog, either in agreement or disagreement. Leaving your insightful comments here will ensure others can learn from them too.  Keep in mind however this is not a place to spew your own theories (go write your own blog), but the best place to question or approve our observations.

About Georges van Hoegaerden

Georges is a serial entrepreneur, venture catalyst, 4x CEO, board director turned innovation economist (by fate). His ideas have raised $14M in venture capital and produced over $100M in returns. More.

  • Brian

    Just having this dialogue concerning build multiple (5-7) BioMass2Diesel and BioMass2Power Facilities in both US and Asia. One is already fully funded. Another waiting for funding. Each plant-build runs approx $60M. My perspective was to package as a larger scale project (BDC) @ $250-300M and fund as a system-build-out… There are number of other factors I presented that support this approach. Thanks for the strategy reinforcement.

  • http://venturecompany.com/ Georges van Hoegaerden

    I provided a response on Rev for those with a tendency to disagree at http://www.venturecompany.com/rev/files/against_small_funds.html

  • http://www.kyield.com/ Mark Montgomery

    George,

    By coincidence that’s the precise same number I cam up with when trying to raise our inaugural fund for Initium VC in the 2004 time frame. Unfortunate, among other challenges, we were based in AZ, and while we did make it on the global radar as an emerging leader– with interest from most leading LPs at the time, the lack of any regional support resulted in relocation– even though we were not really regional.

    You seem to have a bit of conflict in your positions, however — on one hand you argue that VC isn’t a viable model, and yet here you seem to be attempting to raise a fund, so it comes off a bit like “no one can succeed but me and my model”.

    Well, quite a few are still successful, even if a tiny percentage, and even if the majority are outsourcing to entrenched industries and/or offering very little in the way of economic value. We have decades of harvesters, few business builders, and perhaps most important of all we have structures in the EU and US that strongly favor the incumbent, regardless of innovation, economic, or social value.

    • http://venturecompany.com/ Georges van Hoegaerden

      No, there is no conflict Mark. VC the way it operates by virtue of its economic model can never succeed at scale. By economic principle. That economic model needs to be adjusted so every VC investor with verifiable merit can succeed. My goal is to have LPs (old or new) embrace that model. No longer will there be a place or a time for those who keep innovation hostage.

      Read more of my blogs and you’ll get the point, and review 2010: The State of Venture Capital for reasons why the current model cannot succeed, if minus 4% 1-year IRR for LPs is not enough evidence of systemic failure of Venture Capital.

      Best,

      Georges

  • Maarten NL

    Hey… It’s not only about the money to start with… maybee for new medicine or nuclear plant ideas… but for instance twitter. facebook, youtube etc. (ebusiness) didn’t need millions to start with… I would not say I am pro in investment, but when ideas are great and more or less easy to join, money can easily grow with the popularity. At the moment I have an idea which I found it was already tried but they were to early… right now none of the big players embrace this idea yet. Let me ping you the concept…

  • Ryan Hemingway

    Your title Venture Firms Below $250M cannot succeed is eye grabbing to be sure but that goes against the actual data. The following is right out of a Kauffman report.

    “Silicon Valley Bank conducted a study on VC Fund size and performance, examining Total Value to Paid in capital returns from 850 VC funds from vintage years 1981-2003. There are three main conclusions to be drawn from SVBs analysis

    1. The majority (51 percent) of funds larger than $250 million fail to return investor capital, after fees;
    2. Almost all (93 percent) of large funds fail to return a venture capital rate of return of more than twice the invested capital after fees
    3. Small funds under $250m return more than two times invested capital 34 percent of the time a rate almost six times greater than the rate for large funds.”

    While your arguments of attracting small ideas, fuzzy devotion, forced subprime, sound and management bonanza sound nice in theory and probably have some merit the advice to an investment committee or potential VC investor should be “placing your money with a fund greater than $250M does not make economic sense.”

    • http://venturecompany.com/ Georges van Hoegaerden

      Venture capital has been subprime for 20+ years, first in bull then in bear state. While with statistics you can prove anything (you are biased to), 99.4% of venture firms do not produce venture style returns to their limited partners. Clearly the returns reported by the firms you mention, do not necessarily equate to meaningful money-out for limited partners.

      First, little funds are no use to limited partners with serious money to deploy nor worthy of asset class returns, and even a great return of a small fund will do nothing to the return profile of less than 5% of assets under management to an LP.

      Second, success to limited partners is not a one time return but renewable capacity of a firm to outperform other asset classes. So, while your statistics may show many small funds have an opportunity to attract money and produce a viable return to the fund, few of them produce innovation with meaningful socioeconomic value that secure the trust of the public.

      So, the real point I am making in my blog is related to how you define success. If you mean by success the ploy to delay and rip off entrepreneurs with loan shark tactics, with downstream technology and highly temporal value, that you can then sell to a long chain of greater fools with the public as the last stop to find out its value has vanished, success has a very shallow meaning.

      To me, success in venture means producing innovation with tangible socioeconomic value the public can trust, so the reserves of the public are then comfortably deployed by limited partners to produce returns in line with 80% greenfield in technology adoption that blows other asset classes away.

      Don’t fall in the subprime trap of becoming the best of the worst, we need to build financial systems that can accurately trace the opportunity for innovation, not design the best trap that gives innovation a bad and finite rep.

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