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July 18, 2004

Why Venture Capitalists don't need any more money

The NYTimes.com had an article today about how fund size is going down. I remember in the "good old days" when VCs could raise $1B or more funds. The temptation was tremendous. But as we in the NortWest already knew, more money doesn't mean better deals. The actual number of quality business teams with good business ideas is fairly inellastic. Many times, it takes quite a bit of coaxing to get a great team to actually take the plunge and start a company. Starting a company is VERY risky. Most fail. It is not for everyone. From the article:

"The optimal fund size, Professor Kedrosky and others say, is a $250 million fund managed by four partners. "There's 25 years of data that shows that funds roughly this size give the best returns, but it's like everyone went temporarily nuts for a while," he said. (Paul Kedrosky, a professor at the
University of California, San Diego)"

We in the NorthWest already knew that. There are no $1B funds here. In fact, the number of VC firms in Seattle has decreased roughly 20-30% over the last 4 years (mostly as out of state firms closed offices). Today, there is plenty of money in the Northwest to fund all the good ideas that are around here. So what are you waiting for? Start a company!

The entire NYT story follows:

Why Venture Funds Don't Want Your Cash

July 18, 2004
By GARY RIVLIN

PALO ALTO, Calif.

THE partners at Sevin Rosen, a top venture capital firm,
were braced for the worst last November, when they began
passing the word that they wanted to raise a few hundred
million dollars to invest in a new generation of technology
start-up companies. After all, the venture capital business
had just experienced the worst slump of its 30-year
history. And if not entirely at fault for the bubble, the
industry was not exactly blameless, either.

"Given all that's happened in the last three years," said
John Jaggers, a partner at the firm, "I would've thought a
lot of people would've learned the lesson 'once burned,
twice shy.' "

Instead, Sevin Rosen was inundated by would-be investors.
On July 8, the firm announced a new $300 million fund, but
Mr. Jaggers said it could have raised at least five times
that much. Potential investors, many from Europe and Asia,
called out of the blue; some even provided references in
the hope of persuading the partners to take their money.
"We were just swamped with interest from new investors,"
Mr. Jaggers said.

Sevin Rosen, which has offices in Silicon Valley and
Dallas, is hardly the only venture firm to be deluged
lately with offers of money. After a hiatus, other top-tier
venture funds have also started raising new funds in recent
months, and some are turning away hundreds of millions in
potential investments.

That may seem a happy turn of events for the tech industry,
in sharp contrast to the jittery pronouncements of pundits
over the last couple of weeks, wondering if climbing
inventories and an assortment of other bad news portend
harder times. Yet even the venture capitalists seem a bit
nervous.

"Everybody wants into venture capital, but we'll have to
wait to see if that's a good thing or a bad thing," said
Ted Schlein, a partner at Kleiner Perkins Caufield & Byers.
Like Sevin Rosen, Kleiner Perkins rejected far more money
than it accepted when it closed on a $400 million fund
earlier this year.

The question is what will happen to all those millions that
do not get into top-tier funds like Kleiner Perkins or
Sevin Rosen - money that plenty of other venture
capitalists would be happy to accept but would not
necessarily be able to invest effectively, given a limited
pool of bankable ideas. And if too much venture money
chases too few deals, the industry may have another mess on
its hands.

"When the venture industry went from 300 funds to 1,000"
during the second half of the 1990's, Mr. Schlein said,
"everyone knew that didn't make sense, and assumed we'd
drop back down to 300."

So far, however, very few firms have shut their doors,
according to data provided by the National Venture Capital
Association. With all the capital that wants into venture,
Mr. Schlein added, "we could end up going from 1,000 funds
to 990."

The typical venture fund lasts five or more years.
Investors, called limited partners, contribute money to a
pool that a firm's general partners then invest in business
ventures. The aim is to choose start-ups developing a
technology so promising, or pursuing a market so
attractive, that the business will quickly go public or be
acquired by a more established company, parlaying a modest
investment of, say, $5 million into $50 million or more.

Once a venture firm has cashed out one of its investments,
it then splits the profits with its limited partners after
taking a share for itself - typically 20 to 25 percent.

One obvious explanation for the surfeit of cash trying to
get into venture funds is this: the firms are raising
considerably smaller funds. Sevin Rosen, for instance,
secured commitments for $875 million the last time it
raised a fund, in July 2000, and though the partners
collected only $600 million after realizing that they had
asked for too much money, that is still twice the size of
the firm's new fund.

Similarly, Kleiner Perkins, based in Menlo Park, Calif.,
closed on a $400 million fund earlier this year - half the
size of the pool the firm raised in 2000. Kleiner Perkins
spent only $625 million of that amount.

More dramatically, Charles River Ventures, a top firm in
the Boston area, raised a $1.2 billion fund early in 2001,
cut that commitment to $450 million, and earlier this year
closed on a new $250 million fund.

But venture is again a hot area for investment, mainly
because, with the exception of the late 1990's, it has been
a great bet. Notwithstanding all those billions that
venture capitalists invested in disastrous dot-coms and
telecom sinkholes in the bubble years - and lost when the
bubble popped in early 2000 - the average venture fund
raised from 1992 to 1994 earned its limited partners more
than 20 percent a year. Those fortunate enough to be in
funds raised from 1995 to 1997 earned, on average, more
than 50 percent a year.

"If you look at long-term returns over the past 10 or 20
years, you see that venture capital provides the best
returns," said Anthony Romanello of Thomson Venture
Economics, a research firm. As a result, Mr. Romanello and
others say, everyone from the wealthy of Europe and Asia to
pension fund managers who were late to recognize the value
of this asset class want into American-based venture
capital firms.

Until now, getting into a venture fund was hardly a
problem. At the start of the 1990's, funds larger than $250
million were considered megafunds; by the end of the
decade, even a $250 million fund was wholly inadequate,
given the demand, so the funds ballooned. The industry
raised less than $3 billion in 1992. In 2000, the figure
exceeded $80 billion, according to VentureOne, a research
firm.

"Firms absorbed money so quickly in the late 1990's that
the partners would be back on your doorstep 12 months after
raising the last fund, saying, 'Jeez, we've committed the
whole thing already,' " said Catherine A. Crockett, a
managing director at Grove Street Advisors, a firm in
Wellesley, Mass., that invests in venture capital funds on
behalf of wealthy clients. "So they'd raise a bigger fund,
but then be back 12 months later: 'Son of a gun, this time
we're going to raise $900 million or a billion so this time
the fund will last.' "

Thus was born the billion-dollar fund, an industry status
symbol in the final days of the boom - until it became an
embarrassment.

"In our view, those firms that raised a $1 billion, or a
$1.5 billion fund, to do early-stage investing were
delusional," said Paul G. Koontz, a partner at Foundation
Capital, an early-stage firm with headquarters in Menlo
Park, Calif. Despite the clamor of would-be investors,
Foundation Capital raised a modest $275 million fund in the
middle of 2000. "To our minds, venture capital isn't
something that scales. It's not like you can just go out
and hire 20 new partners or open five offices and expect
the same quality of returns."

That view was seconded by Paul Kedrosky, a professor at the
University of California, San Diego, who last month
completed a study that looked at the performance of the
billion-dollar funds. "It was disastrous," said Professor
Kedrosky, who teaches venture capital courses in both the
business and engineering schools. "Firms either returned a
lot of the money or they still have negative returns five
years later or a combination of both."

The optimal fund size, Professor Kedrosky and others say,
is a $250 million fund managed by four partners. "There's
25 years of data that shows that funds roughly this size
give the best returns, but it's like everyone went
temporarily nuts for a while," he said.

The smaller the fund, Professor Kedrosky said, the more a
firm's partners can focus on individual companies, which
often rely on venture capitalists as much for advice and
help as for cash infusions.

Today, venture capitalists talk about "right sizing" the
industry. Firms are generally raising funds in the range of
$250 million to $400 million at the same time that they are
laying off partners and closing down satellite offices. New
Enterprise Associates, another top Silicon Valley firm,
shed 4 of its 11 partners after it raised a new fund late
last year, said Peter Barris, a managing partner. Mohr,
Davidow Ventures, also based in the Silicon Valley, closed
its Seattle outpost less than three years after it opened.

Moreover, the days when a venture firm might pay $10
million or more for a 50 percent share of a start-up, as
happened regularly during the boom, are also over, at least
temporarily. Several venture capitalists confirmed that
they would now pay perhaps $3 million for a half-share of a
young company that seemed rich with promise.

THERE'S no question that so far the general partners at the
top V.C. firms are right-sizing themselves and
demonstrating a discipline in their fund-raising efforts,"
said Ms. Crockett of Grove Street Advisors. The question
now, she said, is whether the investors in venture funds
can right-size as well. Ms. Crockett said she wondered if
the B-level and C-level venture firms that "don't look so
good today will be looking a whole lot better a year or 18
months from now" when eager investors keep hearing "no"
from funds in the top quartile.

Fund-raising in the venture world tends to occur in cycles,
but invariably the top-tier funds lead the way. The current
cycle began at the end of last year, when Sequoia Capital
closed on a new $395 million fund.

Sequoia, with offices in the Silicon Valley and in Israel,
is perhaps the industry's most daring firm: it invested $2
million in Yahoo and a little over $10 million in Google,
but it also invested tens of millions in two companies that
would later fail: Webvan, which delivered groceries ordered
online, and eToys, an online toy store. Still, it ended up
saying yes to only 82 of the 400-plus institutional
investors who sought to give it money this time, turning
away around $2.5 billion in potential investments,
according to Mr. Romanello of Thomson.

The hundreds locked out of Sequoia - and subsequently
rejected by other top funds - may well look at lower-tier
venture firms when they raise a new fund. But venture funds
are hardly alike. The University of California, for
instance, earned $200 million on the $13 million in
endowment money it invested in Sequoia Capital's 1995 fund,
but the endowment lost several million on the $10 million
it put into Hummer Winblad Venture Partners in 1997, a
banner year for venture capital.

"The differences in performance between funds in the top
quartile and funds in the bottom are profound," said Roger
B. McNamee, a longtime technology investor who recently was
a co-founder of Elevation Partners, a hybrid venture and
buyout fund.

Yet an oversupply of money hurts the performance of the top
firms as well as those at the bottom - as has been
demonstrated so far by the funds raised in 1999 and 2000.
Because five or more years can pass before a venture-backed
start-up goes public or is acquired, it is too early to
close the books on funds from those years. But even Sequoia
and Kleiner Perkins, which would make almost anybody's list
of the top five Silicon Valley venture firms, are sitting
on money-losers raised during that time, according to
performance figures from the University of Michigan.

IF there are 5 winners in a market sector and 10 losers,
the winners still make up for the losers," said Steven Dow,
a Sevin Rosen partner. "But what we saw happening during
the boom is that 30, 40, 50 companies would be funded in
the same market. Five winners don't make up for 20 or 30 or
40 losers."

Steven Domenik, one of Mr. Dow's partners, added: "Wall
Street only has so much of an appetite for technology
companies. There are only so many one-eyed jacks in the
deck. There are only so many high-quality management
teams."

Venture capitalists are now debating how much money the
industry can realistically invest each year. Estimates
range from $5 billion to $20 billion, but it is clear that
much more is itching to get into venture capital.

If investors appear not to be demonstrating the same
discipline as the top venture capitalists, one reason may
be the so-called funds of funds - essentially mutual funds
for the very wealthy. The professional money managers who
run these funds are paid a fee based on the money they
manage, but, of course, they cannot collect that fee if
they cannot invest the money.

"If you run a fund of funds and you can't move the cash
into venture, then you're out of business," Mr. Dow said.

Others fret over all those pension fund managers who did
not discover venture capital until the late 1990's.
Typically, those running a fund of funds invest their own
money alongside their clients', and are thus motivated to
choose only those funds that pass muster. Pension fund
managers, by contrast, are investing other people's money,
typically according to a formula set by a board.

"The real moment of truth for our industry comes in
mid-2005, when most of the top 30 or 35 firms will have
raised their funds," Mr. Jaggers of Sevin Rosen said. "At
that point, if you've got a big old fund of funds, and
you've got another $300 million to invest, you've got a big
problem. I'm very concerned."

http://www.nytimes.com/2004/07/18/business/yourmoney/18vc.html?ex=1091168879&ei=1&en=98dd815b250912cf

Posted by Martin at July 18, 2004 08:05 PM

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