One of my current projects is to learn about the venture capital industry. Specifically I want to answer this question: Can venture capital investing be practiced in accordance with value investing principles as I define them?
Marc Andreessen is a very successful entrepreneur who has recently "moved to the dark side" and raised a venture capital fund. In this Tech Ticker interview he speaks candidly about how the industry actually works. Novice student that I am, I tried to take good notes:
1) On purpose, the fund is designed to invest anywhere between $50,000 and $50 million per deal, meaning it has the flexibility to invest in early stage to late stage companies. Unstated message: most venture funds are too rigid in their mandates.
2) The data say that in any given year there are only about 15 funded companies that will ultimately reach $100mm in annual revenues. These companies end up accounting for something like 97% of venture capital returns (!). Unstated message: If a VC fund can't get into these 15 deals, it has very little chance of delivering strong returns for the above-average risks it takes.
(As an aside, consider these political economy thought questions: It's often said, by people like Tom Friedman, that the United States' large venture capital industry is one of its greatest competitive strengths, since it promotes the formation of the great new companies that provide the jobs of the future and raise living standards, etc. If Andreessen's point above is true, however, is Friedman's argument true? According to the Economist, "VC funds have been investing, on average, a whopping $26 billion a year in start-ups since 2004." From society's point of view, does investing $26 billion a year (plus billions of the best and brightest person-hours we have) to produce only 15 "successful" companies represent a good return on society's resources, the necesssary price of creating the next Googles? Do we need to break that many eggs to make a few great omelettes? Or, is our VC industry perhaps TOO large, which implies that the true source of America's advantages in innovation lie elsewhere. Note to self: read this book and reread this book to learn more.)
3) The job of the VC investor must be to be able to invest in one or more of those 15 companies. That's the point of having the flexibility to invest across all stages.
4) To call venture capital an "asset class" is a misnomer, because only about 10 to 20 VC firms earn very good returns, and the rest of the 780 or so don't beat the S&P. The dividing line is who is able to identify AND get into the best deals, the magic 15. Andreessen thinks his firm can be one of those firms.
5) Many VC firms will go under--most likely hundreds. But the top 10 or 20 firms will do well and deliver pretty good returns.
6) Ideally the founder of a VC investee goes onto become an effective CEO. That's how you get the big wins.
7) Much less ideally is when the founder doesn't want to be the CEO, because that introduces a gigantic element of risk--hiring a CEO is an extremely dangerous proposition and usually fails.
Here is my question: If you were a "venture capitalist in venture capitalist firms," how would you go about determining which of the 800 VC firms in the country have the ability to be among the top 20 that justify their existences? My sense is that the strongest determinant of the ability to get access to the best deals of tomorrow is the ability to have gotten into the best deals of recent years. There is a "rich get richer" effect in VC that makes the top firms very good businesses. Which begs the next question? Why does this effect exist? I'll save my speculations for another post.
It also begs another question: If incumbent VC firms have such an advantage, why does Andreessen believe his upstart firm has a shot at breaking into the club?
Lots to learn . . .
Addendum: I recently had lunch with a person in the VC industry who made another point that furthered my education. He believes that a necessary element of a good VC fund, an element that is difficult for large institutional investors to stomach, is the ability to tolerate and even encourage great flexibility in the evolution of startup companies. Just as no battle plan survives the first contact with the enemy, no startup business model survives first contact with commercial reality. It's almost a rule rather than an exception that a startup will radically alter its original business model early on in its life, maybe more than once.
Now that I'm involved in a startup project of my own, I think about this stuff often these days . . .
Double Addendum: Check out this Fortune profile of Andreessen, perfectly timed of course. If getting your name front and center in the press and creating a strong public persona is one of the ways an upstart VC firm can compete with the big incumbents, then Andreessen has that part of it down to razor sharpness. The article offers some other answers to my question begged above (how can Andreessen compete with the incumbents for the extremely limited supply of good deals), namely:
- With his own money, Andreessen has been an active VC in the past few years.
- Mildly contrarian specialization: The new fund will be net-centric. "No clean tech, no rocket ships, no electric cars, No China or India."
- Technology and software have greatly driven down the cost of starting a tech company. However the incumbent VC firms, which serve institutional investors, by mandate must invest large amounts. In fact, per Andreessen, "Most VC firms don't see a high number of deals," which he defines as just five to 10 companies a day. So Andreessen has less competition in trying to find and fund one of the magic 15 in the early stages.
- Entrepreneurs and their venture capital investors should be like the Farmer and the Cowman, but they're not. As an enterpreneur himself, Andreessen hopes to bond better with his investees.
Triple Addendum: Marc, please bring back the old archives of your blog. Please . . .
Quadruple Addendum: There is another reason for someone like me to study venture capital (the first being that I'm trying to see if I can evaluate a VC fund): In venture capital, the ability to evaluate individuals is key. The CEO of a startup will impact its success much more than the CEO of Coca-Cola, for instance. The same holds true for manager selection in general--a hedge fund has little competitive advantage beyond the individuals who work there. So by studying how the best venture capitalists evaluate individuals, I hope to learn a few tricks that can be applied to the rest of what I do.