In the Venture Business, Small Is Beautiful, Charles River Ventures Argues—And Funds Are About to Get Much Smaller
The average return on venture capital investments for the year ending June 30, 2009, was -17 percent, according to figures released by the National Venture Capital Association in October. The 3-year return was +1.3 percent, the 5-year return was +5.7 percent, and the 10-year return was +14.3 percent. Over all of these time frames, venture funds have performed significantly better than public market averages like the Dow-Jones, the NASDAQ, and the S&P 500. Still, even a 14 percent return isn’t exactly the kind of stellar performance that the term “venture,” with its air of high risk and high reward, once connoted.
And the picture is about to get much worse. As Kaufmann Foundation fellow Paul Kedrosky has pointed out here, the 10-year returns from venture funds will go negative in 2010 after the last of the dot-com exits drop from the rolls. All this has left plenty of room for sniping, from both insiders and outside observers, that the venture model itself is broken (or at least decrepit, as Xconomist Daphne Zohar puts it).
But if venture is broken, then what about it needs to be fixed? Pundits have offered any number of vague solutions. But if you talk to the partners at Charles River Ventures in Waltham, MA, you’ll get a single, definite answer. They’ll tell you that the problem is that there’s too much venture money chasing a finite number of good ideas. The solution? Venture funds themselves should be smaller—and there should be fewer of them.
“The number of great entrepreneurs and innovative products does not scale with more capital,” says Jon Auerbach, a general partner at CRV. “You cannot invest 10 times the capital into 10 times the number of startups and hope for 10 times the results.”
Auerbach has only been with CRV since 2007—he spent seven years before that as a general partner at Lexington, MA-based Highland Capital Partners—but this is actually an argument that the firm has been making since 2001. That was when the firm’s general partners suffered a drastic change of heart about the $1.25 billion fund they had just raised and gave $800 million of it back to the limited partners (LPs). Ever since, CRV partners have preached whenever offered the opportunity about the need to “right-size” the venture business and about the virtues of limiting each fund to roughly $250 to $300 million.
And many other voices are now joining the chorus. Back in April, Fred Wilson at Union Square Ventures wrote that the venture math just doesn’t work. LPs are putting about $25 billion into venture funds each year, but portfolio companies are only producing about $100 billion per year in exits, which, after venture funds’ fees and carry (the profits kept by general partners) are subtracted, translates into annual returns for investors of about 10 percent—far less than most LPs expect from venture funds as an asset class. Working backward from recent data on exits, Wilson suggested that venture firms should raise only $15 billion to $17 billion each year in total if they want to offer admirable, sustainable returns.
If you take Wilson’s math further and divide $17 billion by the number of truly active funds—which Auerbach estimates is around 400—then it becomes apparent that each active fund should only be raising about $43 million a year, or $212 million every five years. That’s not far off from CRV’s $250 million sweet spot.
So maybe the industry is moving in the right direction. Or maybe it’s still heading for a huge shakeout. Zohar says it’s time to end practices such as tranched funding and liquidation preference multiples that favor VCs over entrepreneurs, while Kedrosky argues that LPs should “force change on a broken industry” by demanding lower fees and more favorable repayment terms from venture partners. But what if there are many venture firms that should simply go out of business? If “the right number” of venture firms in today’s economy is around 400, as Auerbach asserts, that means another 400 firms classified as active by the NVCA should be shut down.
In a long conversation with Auerbach in early November, I asked why CRV is so adamant about the dangers of overfunding and overpopulation in the venture industry; how the firm’s own awakening to those dangers came about back in 2001; and how the venture industry needs to adapt going forward. I also asked him whether he feels entrepreneurs need to adjust to the idea that capital will be scarcer. “I’m not saying entrepreneurs should scale back their expectations,” he answered. But at the same time, he said that the venture business would be far better off funding just two or three companies in each market niche—not nine or ten, as we’re still seeing in sectors like networking hardware, database software, social media, or mobile advertising.
Xconomy: What’s the basic argument you’re making about the size of venture funds?
Jon Auerbach: As a firm with 39 years of experience investing in early stage startups, if there is one thing that we’ve learned, it’s that the industry functions best when it is a small, constrained industry. We fundamentally do not believe that there is scale in the venture capital industry. Unlike private equity or buyouts, which is really a science, venture capital is an art. It has a lot to do with people and judgment, a lot to do with identifying technical entrepreneurs who think in a totally innovative way and who need access to management teams, first and foremost, that we can pair them with. And we strongly believe that this is the biggest constraint in our industry—that the number of great entrepreneurs and innovative products does not scale with more capital.
X: Various partners at CRV have been making this argument for a while now, right?
JA: If you go back to 2001, you’ll see that we began to take a very vocal stance that the industry was overcapitalized. It’s bad for the industry. Venture funds should be small funds, partnerships should be small partnerships. The message was received, but the industry continued to raise larger and larger pools of capital. The reason, I think, was that there were investors who saw the returns from the venture capital industry during the tech bubble and thought that they were compelling and started looking at venture capital as an asset class—which we don’t think it is, or should be. Although the credit crunch doesn’t affect venture directly, it certainly affects the people who invest in venture capital, and as a result, the best thing that could happen to our industry is now happening, which is it is getting right-sized. It’s happening involuntarily—but how many things in the world happen voluntarily?
X: But didn’t CRV itself raise one of these gigantic funds back during the dot-com bubble? Tell the story about that fund.
JA: In the 1990s, Charles River had some of the best funds in the country, with massive outcomes. For a brief period of time starting around 1999-2000, we came to the conclusion that the industry was scalable—that what we did could be scalable. So we raised a $1.25 billion fund in 2000. At that time the capital was flowing very freely, and we were one of the top couple of firms in the country as far as results, so we were able to raise the money. But very quickly we woke up with a hangover and said this is actually the wrong thing to do. The partners here pretty quickly figured out that it was a mistake, and they gave the lion’s share of the money back in 2001. The fund was downsized and the money was returned to the LPs.
The argument we made at the time—because we had in some ways a contrarian view of what was happening in venture—was that our job as an early stage venture firm was to be well aligned with both our investors and our customers, the entrepreneurs, and that smaller was better for both sides. I’ll give you an example on the entrepreneurs’ side. We feel no pressure whatsoever to put money to work. If a project we start only needs $2 million, and the business model is working, and they’re doing everything in a very cash-conscious way, that’s great with us. We thought the best way we could demonstrate that and to get the best entrepreneurs in the world was by being aligned with them, and saying we will do the right thing for the company. On the LP side, we were also very clear. How many great projects do we think are out there, and how many can we be active around? We found that smaller was the clear right answer for us. It had always worked in the past. And since then, all of our funds have been almost the same size. If you look at the last three, they were $250 million, $285 million, and $320 million.
X: You just said that back in 2000—before the decision to return most of the money in that fund to the LPs—the partners at CRV did believe that the venture business is scalable. Why do you think they believed that at the time, and what changed?
JA: During the bubble, it became very easy to convince yourself of a lot of things. The data was all there—the mean time to exit was very short, and there was a nearly insatiable appetite for interesting technology companies. Because of it, you could step back and look and say, “I think there are things we can do to help this industry become scalable.” If you remember back to 1999 or 2000, there was a strong view around helping put together entrepreneurial teams and providing marketing services and business services. That incubator model was prevalent at the time, and that was replicated broadly. Also, everyone wanted to be an entrepreneur—so you had thousands of people knocking on your door with some pretty interesting ideas.
We’re not saying that venture capital cannot play a role in trying to spark more entrepreneurship. There are entrepreneurs in the far corners of the earth who have the attributes and the technical knowledge that make them really backable. But at the end of the day, this is a craft, and our view is that we can’t meaningfully change the number of fantastic, world-class enterprises that come out the other side.
X: Was the reversal of course back in 2001 partly a matter of the firm realizing that it just didn’t have enough partners to work with all of the companies that would wind up as part of a billion-dollar-plus portfolio?
JA: I’m not sure it was as much people-driven. I think bigger funds led to bigger partnerships. But that the same time, the mean time to exit in 1998 and 1999 was low—companies were going public nine months after they got founded, so people didn’t have the large loads per partner. There was a broad view that said we could add partners, and a lot of people came into the industry at that time, including myself.
X: What goes on inside Charles River that’s so hard to scale up?
JA: We like to do our own work. We are not a big-back-office kind of place. It sounds like a Smith Barney commercial, but we do things the old-fashioned way. We’ve got a very small team, and we do all of the primary research ourselves. There is not a single associate at this firm. Our view is that we’re like glass blowers; it takes a while to learn the craft, and even explaining it is difficult. You kind of have to watch for a while, and develop your own style, and every glass is different. It requires constant reinvention and new thought about processes. And we think that has to be done on a small scale.
X: If venture funds are too large right now, how do you think they’re going to get smaller? Will firms just raise smaller funds, or will they have to write off big portions of their existing funds as their poorer bets tank, or will a lot of venture firms just liquidate?
JA: It’s hard to predict, but I’ll do it anyway. I think that you will see a large downsizing in the number of firms over the next couple of years. It doesn’t mean that some firms won’t end up raising successful funds. But if you take a high-level look at the numbers, there are somewhere around 800 active venture capital firms in the country. And if you look at what percentage of those are really active—and the easiest way to measure that is by new deals per year—the numbers will show you that there are only about 400 active firms. And half of those have done four projects or fewer. That’s probably the right number [of firms].
Entrepreneurs are an incredibly smart and perceptive group, and they know how to avoid firms that they think won’t raise capital. Probably the easiest proxy for them to figure that out is whether the firms have been active recently. In each of the recessions that we’ve invested through, what we’ve seen is an automatic flight to quality. During a bubble, there are so many people who are interested in funding each entrepreneur that the capital becomes in some ways a commodity. But during times of constrained economics, your best entrepreneurs will very quickly make decisions as far as what name-brands they want to work with.
X: You said earlier that at CRV you don’t feel pressure to “put money to work.” Can you explain that phrase?
JA: Sometimes you will hear large venture capital or private equity funds say, “Look, because we have a billion-dollar fund it doesn’t make sense for us to get involved in a project where we can’t invest a minimum amount of money.” $20 million, $30 million is oftentimes what you hear. That’s something known in the industry as putting money to work. They’d look at a new project and if it only needs $4 million, ever, they’d say that’s too small. We didn’t want to be in a position to ever have to say that. The right amount of capital might be $2.5 million, or $5 million.
X: So you’re saying that the reason the firm gave all that money back to the LPs in 2001 was that it didn’t want a fund so large that it couldn’t invest just a few million dollars.
JA: It’s certainly one of them. We didn’t want to look at projects and have to say, “That’s too small for us.” We’ve done years of homework on this issue of what is the right size, and we think it’s exactly where we have it now. We went out with the objective this time around to raise $300 million. We took just a little bit more, and we stopped it.
X: Some angel investing groups would argue that even a $300 million fund is too large—they’d say that it precludes you from funding companies that are good bets but might only need $1 million or $2 million.
JA: In our world of disruptive technologies, that is somewhat rare. It’s not as though we plucked this number, $4 or $5 million, out of thin air. We’ve done a lot of homework on that. We do see some companies on the West Coast, especially in the Internet space, that only require a small amount of capital, maybe ever, and that’s great, and we do have the ability to play in those projects. We have a program called QuickStart where the checks are much smaller—usually $250,000—and that might be all they ever get, and that is fine with us. But by and large, in the space where we historically invest, you can’t really build a high technology company for a couple million dollars.
X: A glass-half-empty way of characterizing what you’re saying might be that there really aren’t that many good ideas out there, that entrepreneurs should scale back their expectations about finding funding, and maybe even that we shouldn’t count on venture-funded innovation to help with economic recovery.
JA: I’m not saying entrepreneurs should scale back their expectations. I’m saying that a key part of economic recovery is disruptive innovation. If you look over the twentieth century and what happened in the postwar period [you see that] semiconductors and the aircraft industry and just a few other key innovations were huge drivers. My point is that there is a finite number of these drivers, and because of that there should be a finite amount of capital investing in them. You cannot invest 10 times the capital into 10 times the number of startups and hope for 10 times the results. If there is one true entrepreneurial breakthrough and one true management team in a given sector, then maybe that is all there should be.
The problem in the last 15 years has been that the signal-to-noise ratio has gotten out of whack. Having 10 startups in one space isn’t good for anyone; it’s not good for the nine that don’t survive or for the one that thrives, because it’s dealing with competition from companies who are ultimately going to go out of business. So our point is that maybe there are two or three that should be funded, not 10. The way to do that is to control the capital going into the industry.
X: How do you control the flow of capital in a free market?
JA: This business doesn’t run like a cabal. We don’t call each other and say, “let’s only invest in three startups in this area.” I think every firm will make its own decisions. Ultimately, the providers of capital for our industry [the limited partners] are a very important constituency right now, because they, I believe, understand very clearly that smaller is better. When we meet teams, we try to back the very best and the ones with the proven results. LPs are making similar decisions.