Bill Reichert

Small is Beautiful

October / November 06 By: Bill Reichert Volume 4 Number 5

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Are venture capitalists, yesterday's rock stars, about to become tomorrow's dinosaurs? Not quite, but the venture capital ecosystem is severely out of balance, and it's time for some serious reflection on the venture capital model. Bigger is not necessarily better.

For the venture community, times are good. Among entrepreneurs and investors, the mood is optimistic and upbeat. The entrepreneurial spirit is alive and well. Innovation is back!

The published statistics, however, suggest things aren't so good, that funding levels are flat, and in some sectors down; but everyone agrees that the statistics are irrelevant, or just wrong. In spite of what the bean counters say, the numbers of startups are up; valuations are up; revenues are up; recruiting is up; acquisitions are up. Okay, the IPO market is still pretty sloggy, but who needs IPOs when you can sell your two year-old startup to Ebay for $2.6 billion?

Yes, times are good. But there is a pervasive anxiety lurking behind the BMW-filled parking lots and glass-framed entryways up and down Sand Hill Road. Venture capitalists say they are working harder than they've ever worked in their careers. Portfolio returns, which were nothing short of horrible in the early years of this decade, have recovered somewhat, but they are nowhere near robust. VCs know that there is no guarantee that portfolio returns will ever rise to the levels achieved in the good old days, and they are worried. As they look to the horizon, the skies are darkening. Could it be the chickens coming home to roost?

The venture capital sector is suffering from its own success, and from its maturation into a mainstream component of our capital markets. In the old days, back when venture capital was small and clubby, the sector enjoyed extraordinary economic returns as a class of investments—€”running at nearly double the return of public equities during the period prior to the bubble. And with success came more capital. Just a modestly increasing flow at first, in the mid-90s, but then it became a flood. The venture capital community absorbed that extra capital in two ways: The number of funds increased, and the size of funds expanded. In 1990, a $100 million fund was a big fund. In 2000, a $500 million fund was considered unremarkable. Meanwhile, the number of funds exploded—€”from a few hundred in 1990, to well over a thousand by 2000.

In the face of all this expansion, what is the No. 1 complaint in the venture capital community today? "There's too much money and too many venture capitalists." How can this be a bad thing? Surely the result should be more startups, more innovation, more new big things. But it isn't. Instead the result is more competition for the few deals that meet the increasingly narrow criteria of the traditional venture firms.

The irony of the success of venture capital is that it has created an increased concentration of focus on relatively fewer companies. It's simple math: As venture funds become larger, they need larger exits to generate good returns. If a company does not have a good prospect of reaching a billion dollar exit, it is very hard for a $400 million fund to justify investing time and money to own 20 percent of that company. The trouble is there just aren't that many companies that really have billion dollar prospects.

Meanwhile, the venture world has become much more transparent. You can keep some companies in stealth mode at the earliest stages of their development, but once a company has come out of the closet, if it has the right profile, chances are it will get overpriced and overcapitalized. And of course if two or three or nine new companies pop up with the same great idea, there are plenty of investors with plenty of money willing to bet on different horses. Good news, maybe, for those particular entrepreneurs, but bad news for investors.

At the same time, great entrepreneurs with perfectly good companies, and with the potential to be even more successful than the "home runs" of yesteryear, get passed by. A company that has a good prospect of reaching a $100 million exit just doesn't quicken the pulse of a large venture fund. It doesn't quicken the pulse of smaller funds either, because they tend to follow the lead of the larger funds, looking for billion dollar companies that they can take to Sand Hill Road for the next round. But there are many, many more companies that fit this profile—€” the $100 million exit—€”and most of these companies will have a better return on capital than the companies that are hoping for (but won't achieve) a billion dollar exit.

This is the great imbalance of the venture ecosystem:
—€ The problem is not that there is too much money in the venture sector. The problem is that the money in the sector is being deployed ineffectively by being concentrated on a narrow range of companies by a narrow group of VCs.
—€ The problem is not that there are too few good companies to invest in. The problem is that there are not enough good VCs who are willing to design partnerships to find and fund them.

This imbalance presents a wonderful opportunity for those venture investors who are willing to admit that the emperor has no clothes: Bigger is not better. Early stage investing historically has generated the highest returns, but the current generation of larger funds is allocating a smaller percentage of their funds to true early stage companies. Investors interested in generating disproportionate returns need to understand the new math of venture capital: Small is Beautiful.

I don't mean nano-tech; I mean capital-efficient tech. These are companies that are efficient at turning investment capital into products and services that create great customer value, great company economics and great shareholder value. There is a substantial population of companies with the potential for high growth and high profitability, but with likely exits in the $50 million to $100 million range. Some of these companies are in the traditional tech centers—€”Silicon Valley, Boston, Southern California. But there are also some brilliant entrepreneurs and great investment opportunities off the beaten path—€”in Denver, Portland, Chicago and Calgary.

These companies don't need $10 million to get off the ground; most of them only need $2 to $4 million. Some of these companies will turn into Googles and Skypes, Oracles and Dells. But most of the success stories won't make the cover of Business Week. Still, these successes will return 10 times and 20 times investors' capital, if not more, and they will enable nimble, smaller venture funds to generate rates of return nicely ahead of their behemoth brethren.
To be sure, there are disadvantages as well as advantages to the Small is Beautiful investment philosophy. But one thing is certain: Without a more balanced venture capital ecosystem, the returns generated by venture capital will decline and innovation, growth and the larger economy will suffer.

Bill Reichert is a managing director at Garage Technology Ventures, a seed-stage and early stage venture capital firm located in Palo Alto, Calif.