Tito's Blog

A New Venture Capital Model

Lackluster track record in the past few years, closing IPO windows, fewer M&A exits, maturing IT and software industries and lower capital requirements of startups spurred discussion on the sustainability of the economic model of the Venture Capital asset class. Below are the analyses that I found most insightful.

Alan Patricoff, manager at Greycroft Partners and a veteran in the VC business, last February wrote a thoughtful analysis on how VC economics have changed in the current scenario. He calls for lower entry valuations and smaller VC funds to accomodate for lower exit valuations and no IPO windows available.

Fred Wilson showed that the number and size of successful exits from VC investments can not sustain the current industry size (about $25 billion a year in fundraising), in his post The Venture Capital Math Problem.

Paul Kedrowsky authored a Kauffman Foundation Study (pdf) and adds that market sectors that provided most opportunities to VC investment (IT, electronics, telecom) are now mature and/or less capital intensive sectors. All in all, the VC industry needs to shrink by half in order to deliver sustainable performance.

In the context of a shrinking industry with fewer, smaller funds, I think that a new venture capital model is emerging. A model where a fund does not specialize in a stage in the company life (seed, early stage, A and B rounds, late stage) but enters very early in many early-stage companies with little amounts of equity and has the muscles to double down on the winners to finance their growth in a global market without incurring costly dilution.

A model where a fund is small enough to be consistent with the current startup capital requirements and exit valuations, but is large enough to fulfill all financing needs of a fast-growing company until a liquidity event. A fund should also be large enough to cover operating expenses and attract a top-notch team of investment professionals with a 2% management fee. A size that seems sustainable to me is between $125 and $250 million.

At the same time, a large number of small early-stage investments will expose the fund to the option of gradually increasing its equity commitment without getting diluted on a posteriori successes: only few winners will put to work sizable amounts of capital (concentrating the efforts of the investment team), selected over a number of small, low-involvement, early bets.

Some VC funds such as Mark Andreessen’s and Ben Horowitz’s fund and True Ventures seem to be following this path.