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June 13, 2005

Size Matters (But Not In The Way You Think)

One of the most popular things for VCs to do when describing their funds is to brag about how much capital they have under management.  "We have $XXX gazillion dollars under management" sniffs one VC at a recent cocktail party looking down at his poor brethren, "and they only have $YYY."

But does VC fund size really matter to the ultimate "customer", the entrepreneur? Is bigger actually better?  I would argue size does matter, but perhaps not in the way that you might think.  To explain my perspective on this, let me first give a bit of history.

Kleiner Perkins, arguably the best of the best, had a consistency to their fund sizes in the 1980s and early 1990s.  In 1982, they raised a $150 million fund (their 3rd).  In 1986, another $150 million.  In 1989, you guess it, another $150 million.  And then in 1992, $173 million.  Then, something odd happens to the pattern.  The Kleiner fund sizes jump in size beginning in the mid-90s, all the way up to $625 million in 2000.  Other funds were even more aggressive during that brief, five year period.  With the rush to raise bigger and bigger funds in the midst of the bubble, there was even a ludicrous moment in time where VC partnerships argued with their LPs that they needed to have a $1 BILLION fund in order to stay competitive as a top-tier firm.  What happened?  In sum, the NASDAQ bubble.  VCs began to see exit valuations with billion-dollar potential, not just hundred million dollar potential.  And so rather than deploy $100-200M over 3-4 years into start-ups at a clip of $5-10M at a time, VCs tried to invest $1-2 billion over the same period by forcing $50-100M at a time into companies.  And we all know how that movie played out.

But with the return to normalcy in the capital markets (there's an oxymoron), things obviously have changed.  Or have they?  After all, the more capital under management a VC has, the more money they make in fees.  So, the natural incentive is to keep fund sizes large, and therefore fees large, even if the fundamentals behind new investment opportunities is more similar to the 1980s and early 1990s than to the bubble.

Let's look at Kleiner.  They cut their next fund, raised in 2004, to $400 million.  Smaller than their 2000 fund, but still nearly 3x what they used to raise.  Is the 2005 exit potential for a start-up 3x what it was in the early/mid-90s?

So why should an entrepreneur care about any of this?  Well, a critical thing for an entrepreneur when fundraising is to find a firm that's going to fit their capital profile.  After all, if a VC is trying to force too much money down the entrepreneur's throats, it will mean more dilution than they'd like.  And not having deep pockets means there's a risk of getting caught short just at the moment when a few extra million might be needed to get to the next level.  Thus, the Goldilocks Rule applies to VCs and fund size:  not too big, and not too small, but just right.

How much capital does fund X really want to put in behind each company?  The marketing materials may say one thing (I once saw a VC claim they would do deals from $50K to $50M!), but the reality is there's a sweet spot that every firm has and if you are in their sweet spot, you're better off than if you're not.  The nature of that sweet spot comes down to the size of their current fund, not their total capital under management, for all the reasons discussed above.  Thus, always ask a firm what their current fund size is, not what they have under historical management.

Some early stage VCs use a short-hand calculation that there should be $50 million deployed per partner in each fund.  This figure comes from the equation that each partner can effectively make 1-2 investments per year over a four year fund deployment period and early stage deals are typically $5-10 million over the life of the company.  Thus, 1.5x deals/year x four years x $8 million per deal = $48 million per partner.  Later stage VCs prefer more capital under management because they look to deploy $10-20M per company.

Thus, the size of a VC fund really does matter.  And if you don't find that "just right" fit, you might be sorry in the long run.

Comments

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You are spot on with this post! It is very inportant that entrepreneurs understand the dynamics of working with VCs. VCs with large funds, need to place larger bets. In many cases, large bets, create over-funded companies. Over funded companies become "soft landings" for VCs in the event of a micro-acquisition (a sub $50M exit). Soft leands return invested capital to the VC, but very little to the entrepreneurial team.

For more on our thoughts on this subject matter, read our post, Venture Capital, 2.0 at:
http://www.vpfund.com/archives/2005/06/venture_capital.html

I understand the point you make overall, but perhaps Kleiner is not the best example to use. Afterall, they have been consistently first or second quartile compared to their peers. I would argue they could effectively manage whatever amount of capital they want to raise. Plus, what good is more fees when your carry is 30% of the amazing investments they have realized? Truly the fees are insignificant for most of their funds.

I would agrue that a better example to use would be Austin Ventures, whose early funds have done well, but lately have not done nearly as well. They raised a couple of billion dollar funds in the bubble era (which were in half after the burst).

Turk - great comment. I was going to say the same thing myself.

As for me (first-time entrepreneur currently raising capital), I think a smart entrepreneur has to pick a smart VC who will be a "survivor" in the super-competitive world of venture capital.

In talking to a few early stage VCs with small funds, all of them are trying to "go bigger" even if they are continuing to invest in early stage. The reason is "cram-down baggage".

What's "cram-down baggage"? This is when a VC does everything right with his investment (although at the height of the bubble, the VC might have paid a slightly-too-generous valuation) but the company is still not cash-flow positive and needs additional capital. So the VC goes to other VCs to raise more capital. But rather than "giving credit" (i.e. increased valuation), the new VCs "cram-down" the old VCs by diluting them (diluting the management team would be stupid b/c then the managers would "walk").

So new-and-improved VC funds are "going bigger" so they can continue to fund their winners, instead of getting "crammed down" by rival VCs who do follow-on investments.

I wouldn't fly an airline that is in bankruptcy, even if the service is excellent.

I wouldn't choose a doctor who didn't manage his office finances properly.

And by the same token, I wouldn't choose a VC who couldn't prevent a "cram-down", especially if he experienced it before.

Just my thoughts.

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