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February 24, 2009

Government Stimulus and the Venture Industry: It’s Not the Bankroll, But the Chip Size

What is the optimal size at which to do real venture capital, the kind of investing that nurtures tomorrow’s Googles, Amazons, Ciscos and Microsofts, as well as the loads of applications and technologies that add real value to existing companies and customers? The answer to this question has undoubtedly changed over time, as the cost of enabling technologies has plummeted and massively scalable businesses can be built for a fraction of the cost of even 10 years ago. But still the debate rages on, particularly given the problems of the large-scale branded venture players and worries over a sharp drop in the availability of start-up capital. The topic has recently bled into the political arena, with President Obama’s tech-friendly bias and the hundreds of billions of dollars going towards programs many feel will lack real job-creation power. Perhaps a portion of these funds can be intelligently deployed across the venture capital arena?

My friend Matt Harris, his partner Bo Peabody (both Managing General Partners of Village Ventures) and I have been talking about the right way to scale the venture business for quite some time. The issue: while the most attractive risk-adjusted returns are available at the early-stage end of the venture continuum, and it arguably hold the promise of creating more and better jobs than at any other stage, it is very hard for institutions to access this asset class due to scalability problems (read: can’t deploy enough capital in a single fund to be material). Therefore, when problem-solvers think of throwing big dollars at venture industry, they immediately migrate to the larger, later-stage venture firms. The problem is, as Matt explains below, simply providing large firms with more dollars isn’t going to facilitate more and better job creating, higher returning investments. The solution required is more complex and textured than that.

While Matt doesn’t have a blog, he frequently has terrific thoughts and powerful ideas, and this is one of those times. While we were all struck by Tom Friedman’s recent Op-Ed in the New York Times about deploying big stimulus dollars into venture capital, Matt put thumbs to Blackberry and came up with the following thoughts:

Tom Friedman recently advanced a proposal to deploy $20B in $1B chunks to the country’s leading VCs, to spur investment in start-ups.  The problem with Tom’s plan isn’t that injecting $20B into the entrepreneurial economy is a bad idea, it’s that giving it out in billion dollar chunks merely exacerbates the problem, which is that managing large funds drives VCs away from being early stage company creators, and towards being financiers.  VC firms only have so many talented check-writers, who are typically pretty fully employed investing in 2-3 companies per year.  If you give those firms more money, they can’t (or won’t) make more investments; they will make larger investments.  As a result, their deals will be less likely to be raw, early stage, potentially game changing start-ups, and more likely to be expansion stage companies who might otherwise raise debt capital in healthier times.

Most thoughtful amendments to Tom’s plan have involved using the capital to subsidize seed and angel investing, which can be interpreted as VCs wanting more “prepped” deal flow, in that angels and seed funds tend to be feeders to established vc funds … This is not a bad thing. But it may not solve the entire problem.  One area of inefficiency in the venture business is the paucity of funds with between $50MM and $150MM under management.  Because of the large size of most Limited Partners, they want to invest a minimum of $20-30MM in the funds they invest in.  But most of them aren’t allowed to constitute more than 10% of any fund.  So by definition, they can’t invest in funds with under $200MM under management.  This makes raising modest sized funds challenging, and as a result the % of VC funds of this size has dropped. In the 1990s, 42% of funds raised were between $50MM and $150MM. Since 2000, only 23% have been in that range.  This is despite relatively clear data that funds in this size range outperform; in fact, they have out-performed larger funds by almost 25% over the past 18 years (data: Cambridge Associates). Of course, it’s also more profitable for the VC to raise a larger fund, but it’s hard to blame them for failing to resist this temptation when their own LPs are asking them to grow.

A productive application of government funding to the world of entrepreneurial finance requires a nuanced understanding of where the inefficiencies are.  While I agree that angels could use some incentive to be more active, I also think that there is no replacement for a focused and sophisticated venture investor.  It probably comes as no surprise that some of the most talented young GPs would rather have their own small, focused fund than be in the way back seat of a larger fund, where carried interest has the feel of a mythical animal. Government funding, thoughtfully applied as an anchor Limited Partner in funds managed by these young stars, could spur entrepreneurship in one of our country’s least innovative sectors:  the venture capital industry itself.

Heresy? I think not. Matt touches on several themes I’ve written about for a long time, and places it in the context of the current debate around how to best stimulate economic growth. I think these ideas and others raised on this blog warrant some serious consideration. Given the impact a small allocation of the stimulus budget could have on creating vibrant new businesses, increasing our economic efficiency and laying the foundation for strong economic growth, I think it is a no-brainer. But brains are needed to make sure the capital gets to the right place - the early-stage end of the venture capital industry.



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