Size Doesn’t Matter


Paul Kedrosky’s report on the size of the venture capital industry is an important and interesting piece of work, but it misses the fundamental reason venture firms are not getting good returns: they’re not investing in good, differentiated companies.

The size of the venture industry — how many dollars are committed and invested — isn’t a particularly meaningful metric. What’s more, it’s not going to change over the next half decade.

There’s no question that the venture capital industry is too big for what it’s doing. It’s like a five-ton Ford Expedition roaring around the Atherton suburbs. But would you say a Ford Expedition was too big to carry you through the mountains of Montana?

Kedrosky writes that the venture industry’s “core markets” have matured and that new, “venture-ready” markets have not emerged.

He’s half right on that count, making money in information technology and telecommunications is going to be hard during the next decade. Some firms will make it work, they always do. Nobody thought there was room in the search engine market after Yahoo. In aggregate, there are too many dollars chasing too many all too similar deals.

I know we’ve all heard that before, so consider this recent example from the digital security sector. Five years ago, big companies started to worry about their employees sending critical data and information to company outsiders. Imagine someone in the billing department emailing all your customer records to your competitors.

Entrepreneurs responded by creating “extrusion protection” systems, or firewalls that kept information from leaving the corporate network. VCs funded three major competitors in this space: Vontu, Reconnex and Tablus.

I covered each of these companies when they got financing. I met with each CEO and heard how each company had amazing technology that was going to solve this big problem. Each had a good pitch but I couldn’t tell the technology apart.

I tracked the companies as they were bought by major public companies and calculated the return on each:

             

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Company VC Investment ($M) VCs Acquisition Value ($M) Buyer Multiple

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Vontu $35.05 U.S. Venture Partners, Venrock Associates, Benchmark Capital, General Motors Investment Management $350 Symantec 10x

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Tablus $23 Menlo Ventures, Trident Capital $5 EMC’s RSA division 0.2x

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Reconnex $36.04 Norwest Venture Partners, August Capital Management, Outlook Ventures, Levensohn Venture Partners $46 McAfee 1.3x

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Total $94.09   $401   4.3x

The right size for this investment opportunity was $35 million, not $94 million. The VCs that invested in Vontu made good money. The VCs that invested in the other companies should have looked for opportunities elsewhere.

Why didn’t they? Was the problem that other markets were not “venture ready” or that venture capitalists weren’t ready to pursue other markets?

It’s an important question because the size of the venture industry isn’t likely to change much during the next half decade.

There are some very good, rational reasons why the amount of money committed to venture firms should drop and Kedrosky hits most of them in his article—falling capital requirements in core VC industries and poor returns being the most evident.

The denominator effect should play a role in this as well. When a limited partner’s pot of money decreases, what it doles out to VCs will likely decrease as well.

But will commitments to venture capital fall any further than the aggregate fall in the stock market?

Kedrosky writes that it seems inevitable that the amount of money committed to venture firms will drop as investors flee from the uncompetitive asset class.

But that’s a bet on the rationality of portfolio managers. The same portfolio managers that have been making commitments to venture firms that haven’t been making money for more than a decade. The same portfolio managers that invest in non-top-quartile firms, fully aware that they are unlikely to make any money.

Venture capital, as an asset class, hasn’t been a rational investment for some time. It makes sense to put your money in the top firms and not to invest in the bottom firms, yet firms that don’t make money still get commitments. LPs flock toward VC, not flee from it—despite what common sense should dictate.

Don Valentine asked his limited partners why they invested in other venture firms they knew were unlikely to make money and came back with a candid assessment, recorded in the book Done Deals: “They think it’s fun.”

So what should VCs do with the commitments they are likely to continue getting? Invest in new industries, take their tech expertise and apply it to new places and new problems.

The number one problem venture capitalists face isn’t the size of the industry, it’s the institutional unwillingness to be different from each other.