Briefing_VC 2.0: Venture Capital Goes Retro

VC 2.0: Venture Capital Goes RetroFinanCinG innoVation SeRieS

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.

c o n t r i b u t o r s

Sean D. CarrDirector, Intellectual Capital, Batten Institute

[email protected]

Malgorzata GlinskaSenior Researcher, Batten Institute

[email protected]

Amy Halliday Writer and Editorial Consultant, Batten Institute

[email protected]

A ReseARch BRiefing fRom the UniveRsity of viRginiA’s DARDen school of BUsiness

“ouR biGGeSt ChallenGe today FoR VentuRe Capital iS to think SmalleR.”

Alan Patricof, a venture capital pioneer

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

in bRieF

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health care

education

businessi n n o vat i o n

entrepreneurshipresearch & development

emerging markets

sustainability

design

s u s t a i n a b i l i t y

creativityv e n t u r ec a p i t a l

economic develoment

technologygrowth

e f f e c t u a t i o n

entrepreneurial ecosystems

b at t e n b r i e f i n gbatten inStitute transforming society through entrepreneurship and innovation // apRil 2012

2 Batten Briefing financing innovation series

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 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 rea-sons, “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 mil-lion to $100 million, a small fund does make sense. Take Greycroft Partners, a VC fund established in 2006 by Alan Patricof, cofounder of private equity powerhouse 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-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 Greycroft.3

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-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.”

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.

the new math the loGiC oF Small FundS

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,

their returns increase initially—but

only until their fund size reaches

roughly $200 million. For funds

larger than $500 million, perfor-

mance begins to decline.4

$10 $20 $50 $100 $200 $500 $1,000

0%

PRED

ICTE

D RE

LATI

VE IR

R

VENTURE CAPITAL—FUND SIZEI N M I L L I O N S O F D O L L A R S

5%

10%

15%

20%

25%

VentuRe Fund Size and pRediCted RetuRnSSource: Lerner, J., Leamon, A., Hardymon, F. 2011.

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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

Craft-Style Venture Capital RediSCoVeRinG aCtiVe inVeStinG

3

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

6 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.

c o p y r i g h t i n f o r m a t i o n

BATTEN BRIEFINGS, April 2012, published by the

Batten Institute at theDarden School of Business,

100 Darden Boulevard, Charlottesville, VA 22903.

email: [email protected]

www.batteninstitute.org

©2012 The Darden School Foundation. All rights

reserved.


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 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 sup-porters. 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 at-tracted the endowments at Yale, Princeton and Northwestern universities.10

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.

totAl

investments

stARt-Ups With

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

touChed by an anGel Start-Ups Receiving Angel Funding

11

not Just angels—Super angelsmiCRo VentuRe Capital

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 inStitution-alized Seed inVeStinG.”

Paul Kedrosky, senior fellow, Ew-ing Marion Kauffman Foundation

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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 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 in-dustries 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 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.pro-quest.com/docview/238022996?accountid=34723. (Accessed 5 March 2012.)

the World Still needs 800-lb. Gorillas limitS to a Small-Fund FutuRe

you Can put $5 million into a Company like GRou-pon, and it Will pay baCk itS inVeStment in itS FiRSt yeaR, but to do a biophaRm Com-pany, it takeS $50 million to $100 million.”

chuck newhall, cofounder, New En-terprise Associates


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.seth-levine.com/wp/2010/03/the-new-era-of-venture-capital. (Accessed 12 March 2012.)

18 Ibid.

19 Garland, R. 2011.

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 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 big-gest 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-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.

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

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SMALL ($25 million to $250 million)

beSSemeR VentuRe

paRtneRSclosed $1.6 billion fund

in 2011

andReeSSen hoRoWitzclosed $1.5 billion fund

in 2012

neaclosed $1.25 billion

fund in 2010

khoSla VentuReSclosed $1.05 billion

fund in 2011

GReyloCkclosed $1 billion fund

in 2011

aCCel paRtneRSclosed $875 million

fund in 2011

Sequoiaclosed $1.3 billion fund

in 2011

FoundeRS Fund

closed $625 million fund in 2011

matRiX paRtneRSclosed $600 million

fund in 2009

benChmaRk Capital


SpaRk Capital


ChaRleS RiVeR

VentuReSclosed $375 million

fund in 2012

dCmclosed $400 million

fund in 2011

ReVolutionclosed $450 million

fund in 2011

union SquaRe

VentuReSclosed $135 million

fund in 2010

GReyCRoFt paRtneRSclosed $130 million

fund in 2010

FoundRy GRoup


tRue VentuReSclosed $213 million

fund in 2008

noRWeSt VentuRe

paRtneRSclosed $1.2 billion fund

in 2009

Small, midSize and meGa FundS and theiR FundRaiSinG eFFoRtS

MEGA more than $750M

MIDSIZE $250M to $750M

SMALL $25M to $250M

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

next in the Financing innovation Series

Briefing_VC 2.0: Venture Capital Goes Retro

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