Old VC firms: get ready to be disrupted

If the U.S. economy were a company, the VC industry would be the R&D department. The financing for the VC industry comes from so-called LPs (Limited Partners) – mostly university endowments, pension funds, family funds, and funds-of-funds.

These LPs wield tremendous power, yet very few of them understand how startups or venture capital actually works. I was reminded of this recently when I saw this quote from a prominent fund-of-funds, justifying their investment in a 30-year old venture firm:

“As the amount of money raised by venture firms shrinks, older firms that were around before the dot-com bubble will benefit,” said Michael Taylor, a managing director at HarbourVest. “These firms have track records, brand names and knowledge about how to avoid making mistakes that younger firms do not necessarily have,” he said.

These older firms do often have track records – they’ve survived precisely because at one point they delivered good returns. But it’s a mistake to assume that — because VC brands and institutional knowledge persist – past returns will predict future returns. Here’s why.

VC brand names do not persist. From the perspective of VCs and entrepreneurs, VC brands rise and fall very quickly. Given the excess supply of venture dollars, top tier entrepreneurs are frequently selecting their investors, not vice versa. The VCs most sought after are mostly new firms: big firms like Andreeson Horowitz, Union Square Ventures, and First Round, and micro-VCs like Floodgate (fka Maples), Betaworks, and Ron Conway.

VC firms don’t accrue institutional knowledge. VC returns are driven by partners, not firms. Studies have shown this, as will a quick perusal of the big exits at prominent VC firms. When key partners switch firms or become less active, VC firms retain very little residual value. Some service firms — for example consulting firms like McKinsey — invest heavily in accruing institutional knowledge by developing proprietary methodologies and employee apprenticeship programs. VCs develop no real IP and rarely have serious apprenticeship programs.

There is an old saying among big company CIOs that “no one gets fired for buying IBM.” It’s much easier for a fund-of-fund partner to defend investments based on a VC’s track records. It’s a safe but bad strategy.

To intelligently invest in VC firms, you need to roll up your sleeves and dive deep into the startup world. You need to learn about the startups themselves, assess the entrepreneurs, use their products, analyze market dynamics – all things that good VCs and entrepreneurs do. If you want to understand a VCs brand and abilities don’t look at their track record in the 90s – ask today’s entrepreneurs. The answer will likely surprise you.

Unfortunately, very few LPs do this. As a result, a massive amount of R&D capital is being misallocated.

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http://me-vc.com David

http://me-vc.com
http://www.5o9inc.com/ Peter Cranstone

Here's the VC's problem in a single word – Exit. Years ago the exits were IPO's. That door is now closed for 99% (If FB can't go Public then who can). Secondly VC's now face an exit in the area of $30m – $50m (less than 1% of deals get done above $100m) So it all boils down to how many shares are there outstanding when (and if) someone wants to acquire you. Let's say you have 10m outstanding then the exit price is $5 a share. If the VC's are in for more than that then guess what? No exit for you.

If VC's are to win again they have to get in earlier, do the hard work, and then help find the exit. Buying their shares for pennies on the dollar is real risk taking.

So many have simple forgotten what it's like on this side of the table.
http://lmframework.com/blog/about David Semeria

Sure. But this implies a VC's ability to raise capital lags by a full economic cycle, and so if this were true it would actually favour the old firms over the new.

Perhaps you're implying the lag is just beginning to hit the old guard, as the mega returns from the first bubble start to fall off the chart.

In which case, you're right. It's going to be interesting how the LP's behave: brand vs performance…
http://paul.kedrosky.com Paul Kedrosky

Great comments, Chris. I have made the same point repeatedly (and to little avail) to institutional investors around the world in last few years.

I made this point again on a Milken Conference panel last week in Los Angeles. Serial persistence is over. Old VC brands are dead. The members of the last Midas List to make money, a decade ago, are now all pushing 60 and older.

http://www.cdixon.org chris dixon

Thanks, Paul. Means a lot coming from you – you've had a big impact
on my thinking. I guess the temptation for LPs to view the firm as
the atomic entity is very strong…? Weird because seems like in
hedge funds they really believe in individual managers.

http://www.wac6.typepad.com William Carleton

Chris, as always, you're prying something open and in the process bringing new awareness to the fact that there's a jar on the table! Tempting to think that a good VC may be as flexible and mobile as other service providers in the startup space, ie lawyers, with all the considerations of boutique vs big/”established” firm that go along with that.
http://sisyph.us/ ErikSchwartz

There was a great quote kicking around the Nantucket Conference a few days ago…

“It takes 10 years to kill a venture capital firm. (Even one that sucks a lot). “
http://twitter.com/dvitanov Deyan Vitanov

Good points Chris, however, I am not sure about your first point. Virtually all of the examples that you cite are “new” firms that actually have established entrepreneurs/investors behind them. If anything, success that translates into a brand is a great competitive advantage for VCs, which is hard to replicate and brings substantial benefits for long periods of time.

http://www.cdixon.org chris dixon

Some had (great) brands with entrepreneurs but few had brands among
LPs…

http://www.byrnehobart.com/blog/ byrneseyeview

>To intelligently invest in VC firms, you need to roll up your sleeves and dive deep into the startup world. You need to learn about the startups themselves, assess the entrepreneurs, use their products, analyze market dynamics – all things that good VCs and entrepreneurs do.

If someone can reliably and successfully do this, it sounds like they'd make a better VC than LP. Part of the point of institutional investors is to give non-experts access to expertise.

The weaker form of your hypothesis is probably “Only invest in specific people with a good record, not specific firms with a good record.”

In that case, it's interesting to ask why VCs don't tend to have successors who are as good as they are. Are they hiring the wrong people? Are the right people all starting their own firms?

http://www.cdixon.org chris dixon

I think there is a kind of leading man syndrome where great people
want to be one of the top people at their firm. No fun being 4th guy
at top firm when you can be top guy at close-to-top firm.

http://www.parkparadigm.com parkparadigm

Indeed. Fortunately (for 'blue chip' PE/VC) firms, their business isn't so much investing money but raising it. And from your LP quote above – which is entirely consistent with everything I know or have been told about traditional institutional LPs – these old guard firms are still doing a great job. ie They can raise lots of money.

Anyhow, completely agree that their is a big problem (misallocation of billions of dollars of capital) and big problems are just there waiting to be solved. I've been incubating a blog post on this (including a few ideas/disruptive solutions we've been playing around with), sounds like I should hurry up and publish it…see what folks think.

http://www.cdixon.org chris dixon

Looming forward to your post….

http://michaelewens.com Michael Ewens

Your comments on a VC's inability to accure institutional knowledge match some results in a paper on VC spinoffs that I am writing. There, I look at the impact of VC partners leaving their firms to start a new VC firm. I find that the impact of such exits is dramatic (some 25 – 40% lower probability of IPO outcomes). In fact, the econometrics show that the parent VC firms will likely underestimate the impacts because the leavers exit when things are going well. One of my conclusion is just what you write “VC returns are driven by partners.” If your conclusions about the importance of VC partners is correct, then the deal flow that many VCs tout to LPs is actually linked to individuals.

You point to a study about just such a phenomenon here:

http://cdixon.org/2009/08/19/its-the-partner-no…

Any idea if that study was made public?
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http://steamcatapult.com/ Dave Pinsen

“Some service firms — for example consulting firms like McKinsey — invest heavily in accruing institutional knowledge by developing proprietary methodologies and employee apprenticeship programs.”

How much value do those proprietary methodologies add, and how much of that is just spin to support the consultancy's brand? Did you see Matthew Stewart's piece on management consulting in the Atlantic a few years back? Any thoughts on it?

http://www.cdixon.org chris dixon

My guess is the apprenticship programs matter a lot more there than IP.

http://www.darrenherman.com dherman76

Chris, great post as always. Where this falls short is that over time, VCs build up goodwill with entrepreneurs. This helps VCs with solid deal flow and allows them to more easily raise capital for new funds since they can shown historical returns, even if past behavior doesn't represent future returns.

http://www.cdixon.org chris dixon

I think the goodwill is with the partner not the firm.

http://www.darrenherman.com dherman76

Most entrepreneurs remember Sequoia Capital of the 90s, not Michael
Moritz

http://www.cdixon.org chris dixon

I think a few firms like Sequioa are special. I could (but won't)
name 30 firms that were great in the 90s, LPs think are still great,
and entrepreneurs today barely know or generally dislike.

http://www.darrenherman.com dherman76

Point well taken. Not disputing because generally agree.

http://bsiscovick.tumblr.com/ bsiscovick

Great post.

VC is unlike every other alternative asset class. In hedge funds, private e
Jayant Kulkarni

Fund of funds have been having a tough time over the last few years. The economist carried a readable article on their returns a few issues ago (http://bit.ly/9AxFCq) and it looks like people are shying away:

“Investors allocated nearly $26 billion of new capital to single-manager hedge funds in the first quarter of this year but withdrew around $12 billion from funds of funds.”

To believe that VC brand persist over a time-scale of thirty years in this day and age in the start-up world shows a significant level of ignorance of the ground reality.
http://www.webguild.org Daya Baran

The disruption is already happening. Today you can start a company with serious technology for 1-100K assuming you are an engineering – which is what is happening unlike the dot com era. Several VCs predicted that I would need $1-3 million just to get my current startup off the ground but I have done it for less than 100K. My goto market strategy is so focused I would not need the $8-20 million Series A round a $3-6 million round will do. This is new reality of internet startups.
Diogenes

Sorry, cdixon, but have to disagree with you on this one.

Old line VC firms may not deserve to live on, but live on they do, helped by naive, lazy and often dumb LPs. It's only when LPs stop funding do VC firms really expire.

They do actually have brand name power, again whether they deserve it or not. Those companies' tombstones that line their credenzas may have been deals done by partners long ago retired or dead. But still their ghosts have marketing power. Do entrepreneurs get all excited to get an investment from KP? Why, yes they do. Where are Messrs K and P? Who cares? Is KP a better firm than others? Even if analyze by specific sector and partner, not really. Do underwriters get excited? Yes they do. Do customers get excited? If they're enterprise, yes they do.

Do VCs accrue institutional knowledge? Depends how next generation partners are recruited and apprenticed. If you apprenticed under, say, Arthur Rock, and he didn't kill you, it might be useful. Note he doesn't really have apprentices. If you apprenticed under John Doerr, you might become a better salesman than VC.

http://gemm.com Roger Raffee

Sometimes it doesn't matter whether a firm merits an investment or not, and all the rules and assumptions about what makes VC money go 'round go right out the window. Read about my experience with John Doerr and his friends here: http://gemm-ayudahelper.blogspot.com/2009/10/in…

http://www.nikhileshrao.com Nik

Chris,

LPs seem to take a CYA attitude towards capital allocation. So, why not give data/report that will help them make decisions that they may intuitively understand but cant justify.

What if somebody starts a firm (or perhaps TheFunded.com could do it) where entrepreneurs are polled which VC firm they want to take money from. That rankings/data becomes like the Morningstar equivalent ratings for deciding how LPs put money into VC firms.

Would something like this work?
http://twitter.com/kpooya Pooya Kazerouni

Right on the money. I don't believe in VC firms Brands in general but I believe in People brands (partners as you put it) . And those successful people (Conways, Khoslas, Horowitzes, etc.) are the ones doing exactly everything you've mentioned in the very last paragraph. It's as simple as that and doesn't matter if you've been investing for a long time like Ron Conway or you're a relatively new face like Mike Maples.

So Chris, do you think since more and more start-ups bootstrap and also less and less money is needed for even a great exit, there would be any need at all (in Start-up/VC ecosystem) for those LPs who are to slow to learn?
http://how2startup.com/ Roy Rodenstein

Agree. One reason I see is that most of the newer firms you mentioned are so new they have almost no track record to speak of (exceptions being Khosla, Ron and USV). It would take massive guts as an LP to push for a firm with an “n/a” for the Returns column.

At the same time many of those firms are (not coincidentally) smaller funds so perhaps it should be easy for LPs to diversify and allocate a bit to the newer firms, or maybe they're too small for them to bother with.

(BTW small typo, Andreessen)
http://twitter.com/savivila Savi Vila

Agree.
http://blog.dylansalisbury.com/ Dylan Salisbury

Is the “misallocation” limited by how much each of these new generation of VC partners can manage, especially considering that they are mainly making small investments in dollar figures?
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http://www.vengo.wordpress.com Venugopal

Hi Chris,

Nice article. I like the arguments put forth.

You are absolutely right that most of the LPs who represent the fund of funds don't understand how the Startups or the VCs work.

Cheers,

Venugopal
Vengo Ventures.
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http://technbiz.blogspot.com paramendra

This is a great blog post. I guess I like the word disrupt.
http://KevinVogelsang.com Kevin Vogelsang

Given what I currently know, I can't agree with this. Do the numbers not show that the top-tier firms, which tend to be older firms, account for the majority of the venture industry's returns?

The venture industry shows positive feedback–prior success leads to success. A firm that invests in Apple and Google is the firm you want to get invested in. These top few firms that have had success get their pick of the lot.

US Universities are an analogous system. Any coincidence that the oldest schools are the most recognized and most prestigious? They had successful people come through their doors early and built up the best networks. You look in history books, and all you see is Harvard and Yale. They then get their pick of the best people, which perpetuates the reputation.

Of course, in any competitive market, there is room for innovation. I think MIT did this. They're young compared to Harvard and the Ivies. But it's a completely different type of institution. Now, when you read anything about science or technology, MIT is all over it. They own the prestige in that realm.

In my book, Union Square is turning into the MIT of Venture Capital. They've done things differently. (Coincidentally, the firm also has a strong affiliation to MIT.)

http://www.cdixon.org chris dixon

You've done a good job articulating what LPs believe. What I'm saying is seeing it from the ground it's just not true. Of the 30 or so firms considered “top tier” by LPs, only about 5 are respected by entrepreneurs. I probably have a discussion once per week with entrepreneurs about which firms to pitch and this fact comes through loud and clear again and again.

http://KevinVogelsang.com Kevin Vogelsang

I felt the reasoning was different. Brand is different than network. But no matter. Bunch of questions I'd love to have some answers to in order to clarify the issue.

First, is it simply not true that the older firms have historically held a big presence in the top tier (throughout the industry's history)? I feel many are under this impression. I didn't see this discounted directly anywhere.

Second, what about the partners? Do they respect certain firms more than others and want to work for them? It seemed in one of your comments you alluded to a pecking order amongst firms, which means sub-selection is happening.

Third, do you think the brand names of the companies that a VC firm has invested in carries weight with entrepreneurs? (Indirectly creating respect for the firm). Not long ago I had never heard of Bessemer, I looked at their portfolio and it put them on the map.

4th, would you say that this isn't a network game? and a firm's network solely lies with the individual partner? It seems networks do get shared to some degree.

5th, the fact that only about 5 firms have active respect from entrepreneurs doesn't mean the others are discounted, and it doesn't mean the entrepreneurs aren't looking for reputation in other ways. Most people can't name more than 10 of anything in general. Most entrepreneurs are pitching a lot of VCs and will look for reputation in many ways.

And if reputation is important, and it definitely is to entrepreneurs, I think it's hard to say that there is no positive feedback at work.

Feel free to disregard any questions that you feel have already been answered in the comments/ on the post.

I'm not convinced that the system doesn't exhibit positive feedback across time periods. Any semblance of a pecking order creates positive feedback. Getting in bed with investors is a big committment, and I think people are sensitive to any indication of reputation.

I think there could be a good argument made as to why this could be changing, however.
http://KevinVogelsang.com Kevin Vogelsang

The main thing that isn't clear is whether what you've presented indicates a change in the venture capital industry (“there isn't positive feedback anymore”, which is very possible) or if you're pointing out a misconception (“positive feedback never truly existed”).

The internet has changed everything, especially the nature of “branding.” I could see your argument much more if you were saying that things have shifted, and positive feedback no longer exists.

http://www.cdixon.org chris dixon

Well, the VC industry hasn't been around that long. You had the “golden era” when capital was scarce and entrepreneur community small 70s-80s. 90's you had the silly dot-com bubble that distorted everything. then you had a flood of capital into the asset class. cost of starting IT startups dropped dramatically. venture-style entrepreneurialism seems to be proliferating, with most of their information coming from the web. so it's a new era. I suspect things have indeed changed. But mostly I'm just reporting the difference between what I see “on the ground” and what I read and observe about people who invest in VCs.

http://KevinVogelsang.com Kevin Vogelsang

Got ya. Thanks, Chris. From my vantage point, I still see positive feedback at work,but it's definitely a new era. Faster information flows and better connectedness change the ecosystem dramatically. Your observation and its meaning is quite curious, and could be very indicative.

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http://www.zelkovavc.com/ Jay Levy

The old firms are safe for a few years longer from a money raising perspective as the new age of vc has recently started. Institutional investors (endowments, pension funds, etc) need to see 5 years of track record to invest. Us newer firms need a few years to get there.
http://twitter.com/phbenjaminchang P.H. Benjamin Chang

Nothing is absolute. It is always that incalculatable balance between the institution and the athelete.
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