dangletech

Not all venture capitalists are created equally. In the VC industry, especially in the U.S; the bulk of the returns go to the “tier 1” funds. You’ve probably heard of these players: Sequoia, Draper Fisher Jurvetson, NEA, Battery & Bessemer - these are among the elite funds, responsible for household names such as Cisco, Google and many more. Their deal flow access and connections are unparalleled, giving them an “unfair advantage” and the lion’s share of the returns.

As a startup operator, I depend on plentiful sources of capital. And since Sand Hill Roadis very far away from Montreal, I am keenly interested in the success and longevity of all venture funds, not just those in the Valley ( editor’s note - Boston- I’m not forgetting you, just making my point).

As I think about what the industry can do to more evenly distribute its returns, not by simple redistribution, but by generating new returns, I keep coming back to the following facts:
- Funds are getting bigger
- Capital efficiency (raising less $ to and exiting quickly) still drives high returns
- Web 2.0 is still going strong. Web 2.0 startups need less $ to get to exit

Do you see a disconnect here? Big funds want to put more $ to work in each company, yet today’s companies need fewer $. This creates a funding gap for entrepreneurs and missed opportunities for the big funds to invest in smaller companies. I see an opportunity here for smaller funds to fill the gap.

Size matters
I recently spoke with a partner at a prominent east coast ‘early stage’ fund. He told me that they look to invest in companies that can someday be worth $500M. That’s a big nut. A $500M market caps coincidentally is what it takes these days to do a credible IPO on NASDAQ. So, basically I conclude that this fund is looking to back companies whose opportunity size, product & technology depth can be grown into a large, stand-alone company.

Most VCs I talk to these days are looking to put $5M - $10M into each company. To put that amount of $ in and get 5x to 10x back, they need to see between $25M and $100M back on exit - just for their portion of your company.

To build $500M companies and put $10M to work in each one, VCs are raising bigger funds. This makes sense given that they are compensated in part by the amount of money they manage. However, it creates a disincentive to do small deals. This is a problem because:

Capital efficiency drives returns

Companies that get to cashflow positive quicker, using less capital are worth more than their peers that raise more money. Why? Simple - they get to cashflow positive not just because they spend less, but because they hit a sweet spot in their particular market. If they didn’t hit that sweet spot, they’d need more equity just to keep the doors open.
The key to driving high returns for these capital efficient companies is not just that they raised fewer $, but that they moved quickly. The time from start to exit is compressed. Faster exits drive VC returns since their key return metric, Internal Rate of Return (IRR), is a function of the length of time that they invest. The same $ return will drive a higher IRR if it’s delivered quicker.

This return dynamic would suggest that VCs should make smaller initial investments and force their companies to quickly get commercial traction. But how do you do that as a VC when you can only do big deals?

Web 2.0: Still going strong

As Don Dodge succinctly points out in his recent post, despite some craziness (i.e. a $15B valuation for Facebook), the fundamentals for investing in Web 2.0 companies are still there and we are early in this cycle. Don states ” Most business cycles run for 10 years, and we are in the early stages of this social network cycle”.
This is great, except the big funds can’t put enough $ into these companies. For every Facebook and Twitter there are many other web 2.0 plays that you haven’t heard of, each of which could become great, albeit smaller, companies. The industry needs to find an efficient, scalable way to back these smaller companies. In so doing, I think there’s an opportunity for the non tier 1 funds to step up and capture returns that they are missing out on today.

Filling the funding gap

A VC will put the same amount of effort and due diligence into a $1M investment as they would in a $5M round. And they have to invest as much time in small and large deals alike afterwards sitting on boards, helping with recruiting, etc. This is why they like bigger deals. As Don points out: ” Many (VCs) still hold to the big dollar deals rationalizing that they can only manage and serve on 10 Boards at any given time, so they need to make their investments big”.

So, how can VCs efficiently do smaller deals? By focusing on web 2.0:

VC 2.0:

To put smaller amounts into a larger number of companies you need some commonality between these companies so that you can streamline your portfolio management. Web 2.0 gives this to VCs.
All web 2.0 companies have similar key metrics. If your service is free and advertising supported, then the key to your business is the CPM rate you can get by delivering a clear, focused and valuable demographic to advertisers.
If you offer a free and a paid version of your service (i.e. you have a freemium business model), then the key is conversion to paid and retention of paid customers.

In either case, you must also focus on usage (how often people use your service), virality (users bringing you more users) and work to get your business to profitable per user economics (where you earn more per user than it costs to acquire them).
As a VC, if you are focused on these types of companies, you can help your companies optimize these metrics. You will also build valuable relationships with advertisers, distributors, senior execs and exit partners that you can deploy across your portfolio.

To be clear, one size does not fit all, but I believe that a sector focus will drive synergies and efficiencies that allow you to do more deals. Web 2.0 is still going strong and I believe we’re just beginning to see what’s possible in this sector as it gets applied to the enterprise (a post for another time…).

The bottom line: if VCs can find an efficient way to do smaller deals, deals that have similar key success factors (i.e. metrics), they can create new returns for the industry. The smaller funds can step up and fill this funding gap. In so doing, I think they can generate new returns that the industry is missing out on today. As an operator at one such capital efficient startup, I’d love nothing more than to see these funds succeed.

This was originally published on http://www.startupcfo.ca