Briefing_VC 2.0: Venture Capital Goes Retro

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Briefing

transforming society through entrepreneurship and innovation // april 2012

VC 2.0: Venture Capital Goes Retro Financing Innovation Series

A Research Briefing from the University of Virginia’s Darden School of Business

in brief contributors

Sean D. Carr Director, Intellectual Capital, Batten Institute

“Our biggest challenge today for venture capital is to think smaller.”

1

Alan Patricof, a venture capital pioneer

carrs@darden.virginia.edu

Malgorzata Glinska Senior Researcher, Batten Institute glinskam@darden.virginia.edu

Amy Halliday Writer and Editorial Consultant, Batten Institute hallidaya@aol.com

A new breed of venture capitalists aims to reinvigorate their industry by taking it back

to its roots. Often capping their funds at $250 million and investing as little as $25,000 in a start-up, they believe that the way to generate competitive returns in today’s eco-

nomic environment is to think small. And like venture capitalists of days gone by, they

advocate a hands-on approach to helping their portfolio companies get off the ground.

If they’re right, then the future of venture investing might be discovered in its past.

Welcome to VC 2.0.

1

Patricof, A. 2009. 20th Annual Venture Capital Investing Conference, San Francisco, California.

The New Math the logic of small funds Josh Kopelman, managing partner of seed-stage venture fund First Round Capital,

is one of the best-known small-fund venture capitalists. He argues that “the math” of

The Bigger They Are…

Declining Returns for Bigger Funds According to a recent study, venture capital firms tend to stumble as they get bigger. Researchers at Harvard found that as VCs raise larger funds,

the large-fund venture capital model is broken. For a $400 million fund to gener-

ate a 20% annual return for investors, he says, its general partners must build several companies that will have at least $6 billion in combined market value. When you

consider how few companies have had billion-dollar exits recently, Kopelman reasons, “You sit there and say, ‘Holy [cow], that model doesn’t work.’”2

Considering that the valuation range for most start-ups acquired today is $20 million to $100 million, a small fund does make sense. Take Greycroft Partners, a VC

their returns increase initially—but

fund established in 2006 by Alan Patricof, cofounder of private equity powerhouse

only until their fund size reaches roughly $200 million. For funds larger than $500 million, perfor-

Apax Partners and an early investor in Apple, America Online and Office Depot.

Although he could have raised more, Patricof deliberately kept the fund small—only $75 million—so he could focus solely on financing early-stage digital-media com-

mance begins to decline.

4

panies. Greycroft invests $500,000 to $5 million in each start-up, and it can produce competitive returns at that level, whereas such a deal would be a loss for a larger fund. “You can actually make a nice venture return if you sell them for less than

$100 million; you just have to go in at the right price,” said Dana Settle, a partner at

Venture Fund Size and Predicted Returns

Greycroft.3

Source: Lerner, J., Leamon, A., Hardymon, F. 2011.

John W. Glynn, a founder of Glynn Capital Management and a professor at the

Darden School of Business, agrees. The optimum VC fund size, he believes, is be-

25%

tween $100 million and $250 million. “Anything bigger is tough to manage,” Glynn said. “You’re better off raising smaller funds more frequently on good results than raising funds in excess of $500 million.”

PREDICTED RELATIVE IRR

20%

15%

10%

5%

0% $10

$20

$50

$100

$200

$500

$1,000

VENTURE CAPITAL—FUND SIZE IN MILLIONS OF DOLLARS

2

Ante, S. 2009. “‘Super Angels’ Shake up Venture Capital.” Bloomberg BusinessWeek. http://www.businessweek.com/

magazine/content/09_22/b4133044585602.htm. (Accessed 12 March 2012.)

3

Miller, C.C. 2009. “Venture Capitalists Look for a Return to the ABCs.” The New York Times.

4

Lerner, J., Leamon, A., Hardymon, F. 2011. Private Equity, Venture Capital, and the Financing of Entrepreneurship:

The Power of Active Investing. New York: John Wiley & Sons.

2

Batten briefing financing innovation series

Craft-Style Venture Capital rediscovering active investing Over the years, critics have argued that VCs’ early-stage company-building function has atrophied, especially among firms that have focused on raising very large funds.

Today, however, a few smaller firms are taking a back-to-basics approach to their investing, acting vigorously as mentors and advisers to entrepreneurs.

The partners at the Foundry Group in Boulder, Colorado, for example, swore never

to raise a fund bigger than their current one of $225 million. “We said, ‘Let’s do the craft of venture capital, rather than scale up an asset management business,’” said

Brad Feld, the firm’s cofounder. “As you grow a firm and legacy, you spend time on the wrong things—managing the people and justifying to investors how to invest more money.”5

Another such early-stage VC firm is Silverton Partners in Austin, Texas; its initial

investments typically range from $200,000 to $2 million. “At Silverton, they have a

focus on building a company the right way from the beginning,” said Mike Maples, Jr., founder and managing partner of Silicon Valley venture capital firm Floodgate,

who has invested with Silverton in four deals. “They roll up their sleeves and get to

work. And when a big problem comes up, they don’t say, ‘Hey, that’s your problem.’”6 The small-fund proponents cite another important advantage of their approach,

arguing that it creates a better alignment between the interests of VCs and those of VC fund investors. “Our fees on this size fund can’t get anybody rich, so we have to make it on [the carried interest],” said Alan Patricof, whose second Greycroft fund closed with $130 million in 2010.7

co p y r i g h t i n fo r m at i o n BATTEN BRIEFINGS, April 2012, published by the Batten Institute at theDarden School of Business, 100 Darden Boulevard, Charlottesville, VA 22903.

5 6

Miller, C.C. 2010. “To Nurture Boulder, Back-to-Basics Venture Capital.” The New York Times.

Hawkins, L. 2011. “Silverton Is the Quiet Partner and Investor for Austin Startups.” Statesman.com. http://www.

statesman.com/business/silverton-is-the-quiet-partner-and-investor-for-1204977.html. (Accessed 5 March 2012.)

7

Garland, R. 2009. “Something Ventured: ‘VC 2.0’ Group Argues for Smaller Funds.” Dow Jones Venturewire.

email: batten@darden.virginia.edu www.batteninstitute.org ©2012 The Darden School Foundation. All rights reserved.

3

Not Just Angels—Super Angels MICRO VENTURE CAPITAL Today’s back-to-basics VCs have become known in some circles as “super angels” or “micro-cap VCs.” Traditional angel investors—affluent individuals who have often

been successful technology entrepreneurs or tech executives themselves—invest their own money in seed-stage start-ups. Super angels, on the other hand, have profes-

sionalized the practice, adding to their own investments by raising funds from other wealthy individuals.

The influence of super angels as seed-stage investors is growing, and so are their

We see the emergence of super angel funds, which are in many ways a blast from the past—a return to the early days of the venture industry, when you had institutionalized seed investing.”

numbers, up 40% from 2009, according to a recent National Association of Seed and Venture Funds study.8 The most successful ones are even winning institutional supporters. Aydin Senkut, a former Google executive, raised a $40 million super-angel fund from institutional investors Flag Capital and Weathergage Capital as well as

wealthy individuals such as PayPal cofounder and hedge fund manager Peter Thiel.9

The success of Josh Kopelman, who has transitioned into a full-fledged VC, has attracted the endowments at Yale, Princeton and Northwestern universities.10

Paul Kedrosky, senior fellow, Ewing Marion Kauffman Foundation

Touched By an Angel Start-Ups Receiving Angel Funding 11

8

Moran, G. 2010. “Do You Believe in Super Angels?” Entre-

preneur Magazine.

9

Ha, A. 2010. “‘Super Angel’ Aydin Senkut Raises $40M

Fund.” VentureBeat. http://venturebeat.com/2010/08/15/ super-angel-aydin-senkut-raises-40m-fund/. (Accessed 12 March 2012.)

10

Ante, S. 2009.

11

Sohl, J. 2012. “The Angel Investor Market in 2011: The

Recovery Continues.” Center for Venture Research.

4

Batten briefing financing innovation series

TOTAL

start-ups WITH

INVESTMENTS

ANGEL FUNDING

2011

$22.5 billion

66,230

2010

$20.1 billion

61,900

2009

$17.6 billion

57,225

2008

$19.2 billion

55,480

2007

$26.0 billion

57,120

2006

$25.6 billion

51,000

2005

$23.1 billion

49,500

2004

$22.5 billion

48,000

2003

$18.1 billion

42,000

2002

$15.7 billion

36,000

The World Still Needs 800-lb. Gorillas LIMITS TO A SMALL-FUND FUTURE In response to the critics who say that large funds have too much money to invest effectively, others argue that the small-fund model has its limits. Chuck Newhall, cofounder of New Enterprise Associates (NEA), a top-tier VC firm, says that

smaller funds are fine for funding e-commerce start-ups, which require very little

capital. “You can put $5 million into a company like Groupon, and it will pay back

its investment in its first year, but to do a biopharm company, it takes $50 million to $100 million,” Newhall said.

Newhall, whose firm reeled in close to $2.5 billion in 2009 and is looking to raise

You can put $5 million into a company like Groupon, and it will pay back its investment in its first year, but to do a biopharm company, it takes $50 million to $100 million.”

between $2 billion and $2.5 billion for its fourteenth fund in 2012,12 believes that

large funds are necessary for financing and then sustaining capital-intensive industries such as health care and clean technology. Case in point: Vinod Khosla,

who runs a Silicon Valley VC firm that backs alternative-energy companies, felt he needed to raise two funds that each totaled more than $1 billion to have enough capital to nurture clean-tech start-ups.13

Proponents of large funds also point out the superior performance of the firms in

Chuck Newhall, cofounder, New Enterprise Associates

the top bracket. However, when it comes to comparing their performance with that of the small ones, researchers run into persistent problems: performance obfusca-

tion, lack of sufficient data and lack of performance measures on which everyone can agree.

12

Marino, J. 2012. “New Enterprise: NEA Seeks up to 2.5B

Again.” PEHub.com. http://www.pehub.com/134451/ new-enterprise-nea-seeks-up-to-2-5b-again/. (Accessed 5 March 2012.)

13

Tam, P. 2010. “Painting Silicon Valley a New Shade of

Green.” The Wall Street Journal Online. http://search.proquest.com/docview/238022996?accountid=34723. (Accessed 5 March 2012.)

5

Venture Capital’s Barbell AN INDUSTRY IN FLUX Although the past decade has been hard for the industry, venture capital isn’t

going out of business. Even as some institutional investors divest from venture

capital, forcing many established funds to close, super angels and small innovative funds have stepped up. Small firms practicing back-to-the-basics venture capital

are attracting investors even in today’s challenging fundraising environment. “The

industry’s being disrupted from the bottom,” writes the Kauffman Foundation’s Paul

We’re in a shakeout.

I don’t know whether it’s the beginning, the middle or the end.” 19 Paul Maeder, general partner, Highland Capital Partners and chairman, National Venture Capital Association

Kedrosky. “As these toy venture firms come wandering in—with funds around $50

million—these are the guys who are structured in new and innovative ways and who are causing the incumbents headaches.”14

All this, however, doesn’t mean that mega funds—those with more than $750 mil-

lion of capital under management—will become extinct. On the contrary, the largest

venture players—elite firms such as Sequoia, NEA and Accel—are raking in the biggest pot in a fundraising environment that is particularly challenging for the broader VC industry. In fact, some VCs and entrepreneurs worry that too much money is flowing into the hands of a few firms who look mainly for large, later-stage deals that have the potential for significant profits.15

New money flowing into the industry resembles a barbell, with blue chip funds at one end and smaller, laser-focused funds on the other.16 As Seth Levine, manag-

ing director at Foundry Group, writes in his blog, the multi-sector and multi-stage marquee mega-funds will be able to raise “$750 million or more at one end of the scale, and smaller, more focused funds will raise $250 million or less on the other end—with a relatively small number of funds in the middle.”17

Some professionals predict that the industry is going to shrink and that midsized

funds will be squeezed out. “[My] hypothesis is that … [limited partners are going

to] move their money either to a smaller number of diversified, extremely large funds or the larger number of smaller, more focused funds,” Levine writes.18 If this predic-

14

Kedrosky, P. 2010. “The Bifurcation of the Venture

Capital Industry.” Infectious Greed—blog. http://paul. kedrosky.com/archives/2010/09/the_bifurcation.html.

(Accessed 12 March 2012.)

15

Garland, R. 2011. “Something Ventured: Start-Ups

Looking for Financing May Face Winter Chill.” Dow Jones Venturewire.

16

Kedrosky, P. 2010.

17

Levine, S. 2010. “The New Era of Venture Capital.”

Seth Levine’s VC Adventure—blog. http://www.sethlevine.com/wp/2010/03/the-new-era-of-venture-capital.

(Accessed 12 March 2012.)

6

18

Ibid.

19

Garland, R. 2011.

Batten briefing financing innovation series

tion is correct, the most important question is whether the emerging VC model is well suited to finance and nurture innovation in the years to come.

SMALL, MIDSIZE AND MEGA FUNDS AND THEIR FUNDRAISING EFFORTS

Andreessen Horowitz

Union Square Ventures

True Ventures closed $213 million fund in 2008

closed $400 million fund in 2011

Founders FUND closed $625 million fund in 2011

closed $875 million fund in 2011

Sequoia closed $1.3 billion fund in 2011

matrix Partners

closed $1.2 billion fund in 2009

closed $600 million fund in 2009

greycroft Partners closed $130 million fund in 2010

closed $1 billion fund in 2011

closed $375 million fund in 2012

closed $450 million fund in 2011

Norwest Venture Partners

Greylock

Charles River Ventures

Revolution

closed $135 million fund in 2010

closed $1.5 billion fund in 2012

DCM

Accel Partners

Spark Capital closed $360 million fund in 2010

Khosla Ventures closed $1.05 billion fund in 2011

Foundry Group

NEA closed $1.25 billion fund in 2010

benchmark Capital

closed $225 million fund in 2007

closed $425 million fund in 2011

Bessemer Venture Partners closed $1.6 billion fund in 2011

SMALL

$25M to $250M

MIDSIZE

$250M to $750M

MEGA

more than $750M

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Next in the Financing Innovation Series The U.S. federal government has been helping small companies get funding since

the passing of the Small Business Investment Company Act in 1958. The tradition

continues through various government-sponsored programs and initiatives, such as the New Market Venture Capital Program and the more recent Startup America.

But funding young, innovative companies, which are the drivers of innovation and

job creation, is risky. Obviously, not everyone agrees that the government should get involved in investing in high-risk start-ups; opponents point out many failed efforts

and poorly designed programs that wasted billions of taxpayer dollars. The next issue of this Batten Briefing series on venture financing will examine the emerging inter-

est in public initiatives to spur private entrepreneurial activity and economic growth, focusing on the U.S. government’s role as venture capitalist.

Previously in the Financing Innovation Series: What Ever Happened to Venture Capital? February 2012 Collapse or Comeback? The Venture Capital Debate June 2011