Large venture firms are in trouble. The combination of too many dollars to deploy coupled with the rapidly declining costs of starting companies has largely rendered their models obsolete. While there are exceptions, e.g., Cleantech, most venture-stage companies require very little money to prove their viability, often less than $2 million (made up of an angel round or an angel plus a “light” Series A round from a small venture firm). So where does this leave the big firms running assets of, say $250 million and above? Either relegated to a dwindling number of later-stage deals where large amounts of capital are required or a concentration of capital-intensive sectors such as Cleantech and Biotech. As either a GP or an LP of these funds, this is not where I’d want to be.
But all is not lost for these funds, if they are willing to adapt and if their LPs are able to wake up and shake off their hidebound ways of thinking about venture investing. It will require a change in staffing, due diligence methods and capital allocation. Big stuff to be sure, but essential if the legacy leaders of venture want to stay relevant and on the cutting edge. The way forward is what I’m calling the Pyramid Principle. It contemplates a three-tiered approach to venture investing, but through a structure that is almost the inverse of what larger venture firms are doing today.
The base of the pyramid – where firms will spend the lion’s share of their time – will be in true early-stage venture investment. It will involve leading rounds that are as small as $250,000 and up to $2 million. It will also include incubation, which will pair a small, high-performance, tightly-knit group of agile developers that can churn out rapid prototypes of entrepreneurs’ ideas. The base is a bubbling cauldron of deals, experiments and innovation. Where will the ideas come from? Either internally by looking at gaps and trends across the investment portfolio, bringing on Entrepreneurs-in-Residence that have specific ideas they’d like to work on or by being approached by an entrepreneur with a compelling idea but would benefit from the structure of working within a venture firm. The goal of investments in the base is to assess viability, e.g., whether the product or platform can demonstrate commercial relevance and traction. I would expect the staffing of the base to be with wicked smart, young-ish entrepreneurs, who want to step back from working on a single idea and to develop their chops as investors. The more experienced venture professionals, the Mentors, could provide advice and counsel to these up-and-comers and, in the process, get mentored themselves in bleeding edge technologies, business models and development methods. Entrepreneurs would get carry for both bringing in deals and working with companies, and Mentors would get carry for bringing in deals, advising the Entrepreneurs and directly working with some of the young companies. Some companies out of the base will be sold early, generating super-high ROIs but not large absolute dollars. If it turns out that growth will either cost too much or take too long to achieve, then it might make sense to take the money and run. That will be ok under this model. It will require a culture that pushes rapid assessment and admission of mistakes, rewards innovation and compensates heavily for successes that can be broadly applied. Most large venture firms find this activity too time-consuming and capital inefficient to warrant much attention. In the future I believe that getting the base right will be the key to success in the large-scale venture field.
The middle of the pyramid – where less time but more capital will be deployed – will be in B-round growth capital investments. These source of these growth-stage investments will largely emerge from the base, in companies that require $2-$5 million to aggressively go-to-market. Money will go towards bulked-up engineering and operations teams, key management roles and creation of a sales and account management infrastructure. This has been a very competitive stage in the venture world for the past 3-5 years, where plenty of funds are happy to write checks for $5 million to help a company grow. The problem is, there will be fewer of these companies requiring fewer dollars as bandwidth and storage costs approach zero, yet these larger VCs are traditionally reliant on these deals and even later-stage investments to put their bulging LP commitments to work. By cultivating and nurturing companies in the base, the new-age VC can hang onto their winners and build a strong stable of growth-stage companies in their portfolio.
The top of the pyramid – with a small number of deals consuming large amounts of capital – will be in C and D-round growth acceleration investments. These will be for those companies that are runaway successes which can benefit from large ($10-$100 million) investments to rapidly achieve scale and dominate the space. They will be graduates from the base and middle of the pyramid, and will have been nurtured from inception to explosion within the firm. These investments represent “venture firm nirvana” – winners that have been on the books from the beginning with the ability to put progressively larger dollars to work throughout its life cycle. This enables those C and D round returns to be augmented by cheap A and B round valuations, creating the optimal mix of ROI and capital consumption.
I imagine that making these changes will be very difficult for most large venture firms, as it requires an internal culture change and a different team coupled with an external shift in messaging. It may be that a number of brand-name VCs go into run-off mode, taking their chips off the table over time and focusing their efforts elsewhere. Perhaps some of these firms could segregate their businesses into a run-off book and a new fund, with the LP commitments at a fraction of their levels in the heyday. Maybe we’ll see yesterday’s $1 billion fund as today’s $200 million fund, with a number of $75-$150 million funds started by the venture stars of the late 1990s/early 2000s. This would be a good thing for everybody except the old-line venture firm GPs, who will no longer be collecting management fees on mega-asset pools that are no longer necessary. That’s ok; they’ll get over it. But if the major VC players want to remain relevant and in the game, they will need to dramatically scale back assets and modify their approach to the investing business.