Paul Graham wrote an essay “Why There Aren’t More Googles” a little while back that addressed (among other things) the issue of why VCs aren’t bolder. Bolder in the sense of stepping outside normal groupthink to invest in bold, if unusual, ideas and investing at an earlier stage in smaller amounts.

First… I agree with much of what Graham has to say. But a few caveats worth noting. While it’s definitely true that the capital requirements of web / software / mobile startups have declined significantly, this is not necessarily true of other VC sectors. It still takes a ton of dough to develop cancer drugs or create revolutionary solar cells, and cloud computing and Ruby on Rails are unlikely to make a meaningful dent here 🙂 And just because a particular entrepreneur or startup doesn’t receive VC funding, it doesn’t follow that all VCs are hyper-conservative ninnies. There are in fact some ideas and teams that may never clear the bar for institutional investment. But again, I think Paul is spot on with a substantial portion of his analysis.

I started compose a post to delve into the question of “Are VCs less bold than they used to be?” and I still have some thoughts on that front. But I decided instead to try to pinpoint some of the issues which at least in my mind present structural limitations to innovation within the venture capital business. There are certainly reasons why only a modest amount of innovation occurs within existing firms, like the increasingly large size of many VC partnerships and changing composition of the professionals in the business. But most of the limitations are things that pose challenges to the creation of new VC firms employing unique strategies. All things being equal it’s usually easier to innovate by creating a new organization than within an existing one.

1) Experience Matters in VC… Probably A Lot
If you think about some of the wildly successful startups that have been built over the last few decades, more than a few were created by folks not far out of university. I’m talking about companies like Google, Yahoo!, Cisco, Apple, Microsoft, Facebook… all of which were founded by people either still in school or within only 2-3 years of leaving their undergrad or grad programs and little or no professional experience. With a revolutionary idea in hand and in most cases some technical ability to help create it, big things are certainly possible as a tech entrepreneur.

Contrast that with what it takes to be a successful VC investor. Experience matters to some extent or other in most things in life, but in venture capital it’s a virtual prerequisite. One needs to have a sufficiently large, high quality personal network from which to source interesting deals. Programs like Y Combinator are pretty innovative and differentiated approaches to sourcing but most VC investing remains driven by personal referrals. It also takes some level of experience and startup wisdom, at least to be a truly involved and value-added investor in the early phases of a company’s development. And it requires patience, to maintain a long view and uphold fiduciary responsibilities on behalf of limited partner investors. So it’s virtually impossible for a recent university grad to launch a new VC firm (unlike a startup), and still non-trivial even for an experienced team of people.

2) VC Economic Model Stacked Against Small Funds
The “2 and 20” model, whereby VC firms earn an average of 2% per yr on the funds they have under management plus 20% of any long-run investment profits, has a variety of significant implications for our business (e.g. incentive to grow size of funds or number of funds). But one of the most impactful is that it’s exceedingly difficult to actually operate a smallish VC fund of $10-30M, one that could more easily make investments in the $100K – $1M range in the capital gap Paul Graham and others have been highlighting for some time. Of course some large VC firms do make small seed stage investments but ultimately these aren’t their raison d’etre and don’t “move the needle” unless the firm can invest much larger sums as the company matures.

Rob Monster of Monster Ventures had a recent blog post which was very thoughtful in questioning whether it was time to rethink this model. The rough math is as follows… the annual “budget” for a $10M VC fund would be $200K, for a $20M fund $400K, and a $30M fund $600K of course. In practice, management fees are often tiered over the full 10yr life of most VC funds. So they might average 2% over the life of the fund, but might initially be 2.5-3.0% during the early yrs (active investing period) and decrease to 1.0-1.5% during the later yrs (“harvesting” period).

Either way though, a small fund with the traditional economic structure makes it hard to cover even a modest salary (see #1 above… again we’re not talking 24yr olds subsisting on Top Ramen) for 2-3 partners , pay rent on an office space, cover costs of travel (meeting w/ companies, attending conferences, etc), and generally keep the lights on. It’s of course possible to do, but certainly not easy. Back in the early ’70s Kleiner Perkins started with an $8M fund followed by a $15M second fund; Sequoia Capital had a $14M first fund followed by a $20M second fund, though of course you have to adjust a bit for a couple decades of inflation there.

3) Institutional LPs Willingness to Back First Time Funds
We can have a legitimate debate on the willingness of VCs to back first time (often young) entrepreneurs, but the evidence clearly indicates that it happens with at least some frequency. The dynamic that exists between venture capital firms and their LP investors is meaningfully different in most cases. If you think the “first time entrepreneur” label is tough, see how far the “first time VC” actually gets. In the traditional LP community (pension funds, endowments, corporations, funds of funds), an “emerging” firm (i.e. one still considered in a an unproven, startup phase) might be one that’s been around for 7-10 years and on it’s 2nd or 3rd fund. And in fact many of the “new” VC firms that have been started over the years represent experienced partners at existing VC firms setting up their own shop rarther than true de novo organizations. So for a would-be VC who wants to start their own firm with a different strategy and approach, the initial fund often has to come from either your own assets or a lot of individual investors rather than traditional instutional LPs.

So what does this all mean? Well, a lot of folks have been predicting that a shakeout in the VC biz will occur, at which point a handful of older firms with proven superior performance will remain and a handful of newer firms will launch and grow. We shall see… predictions of such a shakeout have been made since the beginning of this decade and the bursting of the internet/telecom bubble, yet only a handful of VC firms have disappeared. And the aggregate flow of investor capital to the VC sector (in absolute dollar amounts) has grown steadily for the last five years.

But the factors above do pose real limitations in the creation of new VC firms. Collectively, they’re among the reasons that most of the new modestly sized “funds” that have been created are being launched by successful entrepreneurs with a substantial portion of their own ca
pital (like First Round Capital, Founders Fund, Monster Ventures, or the European Founders Fund). I think this can be a great approach, and as successful entrepreneurs all of these these investors can offer a great deal to the startups they back beyond just capital. But short of having a substantial personal personal assets to launch a new fund and sustain it with the traditional economic model, it’s not easy for innovation to occur in this business through the creation of new firms.