Don't Put Venture Capital At Risk

10 February, 2012

Who wouldn’t want to be a venture capitalist right now? Investment bankers may be reviled and private equity executives hammered but Silicon Valley’s billionaire elite can do no wrong.

Stephen Hester, chief executive of Royal Bank of Scotland, is forced by a public outcry to waive a bonus of less than £1m and Lloyd Blankfein of Goldman Sachs gains little credit for seeing his share bonus nearly halved to $7m. Yet no one minds that Jim Breyer of Accel Partners could gain $500m from Facebook’s initial public offering, alongside the $9bn his firm stands to reap.

Perhaps that’s fair enough. Mr Breyer risked his own money in Facebook in 2005, not knowing how astonishingly successful it would be, and Silicon Valley, although built on government-funded research, is not too big to fail. Venture capital firms are like Wall Street partnerships of a generation ago – their partners can do very well but no one saves them when they go wrong.

Yet Silicon Valley’s top-tier financiers – funds such as Accel, Sequoia Capital and Benchmark Capital – lost their halos before in the crash that ended the 1990s dotcom boom. That mistake could recur unless they are restrained in the face of this gold rush.

“Our greatest enemy is losing our discipline,” says one venture capitalist. “We did that once and it took a lot of time and work to rectify it. We know the consequences of binge investing and we don’t want to go back to rehab.”

Venture capital is now on the same threshold that both banking and private equity crossed before, with unintended consequences. It is a craft industry, hitherto small and private, that is increasingly dominated by a few “bulge bracket” firms, which are growing and turning global. Size has benefits but it will also put them in the spotlight, as an industry and as individuals.

Being disciplined, exploiting their brands and networks and keeping their heads down has worked well for the top venture firms during the past few decades. The industry as a whole is only now recovering from the damage wreaked on its long-term returns by the dotcom crash, yet the elite firms have flourished.

Some of their partners have gained hundreds of millions (John Doerr of Kleiner Perkins Caufield & Byers is estimated by Forbes to be worth $2.3bn) without attracting hostility. Venture capital has not yet faced the opprobrium that the 60th birthday party of Stephen Schwarzman, co-founder of Blackstone, and Mitt Romney’s presidential campaign have drawn on to private equity.

It has a better pitch. “A financial system that gives the best and brightest out of MIT an incentive to cure cancer and figure out the world’s information problems feels like a healthy area of the economy,” observes Chris Dixon, an angel investor and entrepreneur.

It is also small, which has been an essential ingredient in its success and good reputation. Venture capital firms did not raise large private equity-style funds because they could not put the cash to good use. Accel’s early-stage investment in Facebook was typical, albeit outlandishly successful – Mr Breyer invested $12.7m of his firm’s money (and about $1m of his own).

They scatter bets around many start-ups, most of which fail or produce mediocre returns, relying on a few big winners. It is done with equity rather than by piling on debt and it clearly involves risk-taking. Since the firms remain private, their partners’ wealth is well-hidden, save for occasional IPO filings.

This is a fine business for the best partnerships, despite some ups and downs – Accel was living on its past glories when Mr Breyer invested in Facebook. “All the action is in the top decile,” says Josh Lerner, a professor at Harvard Business School. “Their brands and connections give them a sustained competitive advantage.”

The problem is that others have noticed. The social media boom, and Facebook in particular, has brought lots of new money into Silicon Valley, both from “super-angels” (entrepreneurs turned venture capitalists who have raised seed funds) and outsiders such as Digital Sky Technologies, an investment firm run by Yuri Milner, a Russian internet mogul.

The bulk of new money has gone to late-stage investing, where the barriers to entry are lower – it requires less expertise to spot an established company than a start-up with potential – and so are the returns. Some companies have raised huge sums from late-stage investors – Groupon raised $950m last year as its last step before going public.

The leading venture capital outfits on Sand Hill Road have responded by getting bigger themselves. Khosla Ventures, Bessemer Venture Partners and Sequoia have each raised more than $1bn recently (Sequoia’s $1.3bn fundraising was split between three funds – two in China and a classic $425m US venture fund).

As they grow, they are starting to look like private equity firms such as Carlyle, which has a variety of funds in different countries and is now going public. They risk undermining the qualities that brought them both success and immunity from popular criticism – being small, private and entrepreneurial.

Bigger funds lead to temptation – a firm that wants to put the cash to work cannot simply make a series of small bets. Despite good intentions, some will dilute their early-stage focus and risk-taking credentials. That will reduce their returns and make them look like members of the financial engineering class.

The last time venture capitalists strayed into the public gaze, it was for floating immature companies with no real prospects in the dotcom boom. This time, the IPOs are more solid but the industry itself is at stake. If it gets too big, it could fail.

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Don't Put Venture Capital At Risk

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