This is motivated by the Alok’s post on “Miniaturization of VC†that asked what technologies would enable VC’s to manage a large portfolio of companies to moderate exits. My contention is that for such companies no armchair quarterbacking will suffice, no matter how good the remote control is.
It is all about human capital – the team. When you build a company, to get reasonable odds of success, you need an outstanding team. The traditional model has been to get the core team together, go raise a pot money and then use that money to hire the rest of the team. This works for companies that are clearly going to go big or go bust – building an electric car for the masses, building a two way GPS system, building a 4G network, or even our very own Sanjay’s Eko project. But for companies that will require small investments and have moderate outcomes it is very hard to go down that path any more.
The reason is simple – Everyone wants to be a founder and no one wants to be an employee.
If all it takes to start something is an idea (everyone has one), a small amounts of money (maybe just go without a salaries for 6 months), and skills. Then the real barrier to entry is skills. Anyone that would make a good hire has skills. So they think – I have skills, I have an idea and I can go without a paycheck for a while and my uncle can put in a bit of money. Hey, I should do a company myself. It is much easier and more fun to nurture your child than someone else’s.
So a company that is going down the path of small investment, moderate exit will find it hard to build a team, even if they have the money they need to pay their employees a decent salary. Hence the abundance of founders and absence of employees.
Now switching to the investor side.
I have a lot of VC friends who have gobs of talent and energy but as an industry the VC’s have one broad core competency. Their ability to get institutions (pension funds etc) to trust them with 100’s of millions to invest. A small set of VC firms (less than 10) have a repeatable process of discovering and nurturing big hits. None have the human capital required to make many small investments and take them to many moderate exits and they most likely will not change their stripes.
The reason is simple – Their model is a hits centric model and it is very comfortable. Today a majority of VC’s are making most of their money from fees and not from the 20% carry (their share of the proceeds the fund gets from successful exits) and they are still living a good life.
For a VC firm to exist it must have the ability to raise gobs of money and they do. They then pay themselves a fee of 2% annually. So if you raise 200M fund (which in the US is not a big fund) then they get 4MM annually as a fee from which they pay themselves salaries. If they can keep the number of partners low then they can pay themselves great salaries and they do. Hence there is little lifestyle risk if they fail to execute, they still get a decent salary.
For VC’s to accommodate many small investments that result in many moderate exits they will have to lower the size of their funds by 10X or increase their number of partners. Consequently they will reduce their salaries substantially and increase their dependence on the “Carry” for their lifestyle. This is not going to happen unless there are no places to deploy large sums of money.
It is much better for a VC to find new places to deploy large chunks of money and continue to enjoy a good risk free lifestyle than find a way to change their stripes and deploy across a large number of moderate exits and put their lifestyles at risk. The best VC’s will find these opportunities and some but not many will be in web 2.0.
We created Tandem Entrepreneurs to address this class of company. Tandem has efficent deployment of human capital at its core. We are often confused with small funds. But these fund are often just VC’s with one partner or organized angels. Neither deal with the human capital issue. The best model for these funds seems to be to make many small bets. In some sense create an index fund of startups. It is a reasonable idea and one that has brought success to Ron Conway in the past.
We try and make it clear than Tandem is not a VC or an angel fund, but are a team with money from a powerful network of individual investors.
Since we invest human capital, this makes the number of deals we can do small , else we will be spread too thin. The areas we can invest are also narrow (based on where we can successfully add sweat and bring an unfair advantage of some sort – an edge). But when we do invest we serve as the extended team and address the human capital (team) problem as well as the financial capital issue. We make it possible to keep the number of people sharing the pie small, making it possible for the founders to make their million(s) with a moderate exit of 10-20MM and in a short period of time. The door to a big exit always stays open.
I think it is a great time for entrepreneurs to start companies but entrepreneurs need to think carefully about how they are going to build their team. A startup could succeed with an incomplete or subpar team, but they would have to be extremely lucky. Startups also need to be realistic about their exit value. I can make almost anything look big on paper but the inconvenient truth is that 85% of exits are less the 50MM.
Technology has been a big enabler for creating this environment. Amazon’s EC, Open Sources software, Social network api’s, Hosting services like Engine Yard all lead to startups not needing much in the way to enabling infrastructure and if it isn’t there today it will there soon. At Tandem we have made 3 investments in the last 3 months and not one of them has a machine to its name outside the founders’ laptops and their budgets for software spend is next to nothing.
Here is data showing a nice paycheck inspite of dismal returns
VC Compensation: Rising
Private Equity Returns : Somewhat Questionable
- Muscle Capital : Delivered - May 22, 2013
- Visiting India - February 6, 2012
- ZumoDrive expanding team in Asia - January 26, 2010
Hi Deepak,
Don’t you feel that the VC pay has gravitated to a certain band because of demand-supply economics. There are probably only a few people who Limited partners would trust with significant amounts of capital. Combine this with the opportunity cost of these guys having to ‘sit it out’ through probably some very exciting times and my guess is thats why they get paid the amounts they do.
While getting paid well to get the one big hit is indeed a noble and laudable endeavour, I personally feel that the hits tend to be more based on luck and timing than on any skill or direction based measure. This is my opinion, so please feel free to disregard it.
True value is a theoretical measure. Hundreds of funded companies will never make it to their true value, regardless of number and pedigree of VCs investing. Some will break even on a distress sale. Others die into oblivion. Even ones with true value. The hit rate of a VC funded and a non VC funded company, percentage wise, is about the same I would believe, which may mean something.
I do not know why, if VCs are paid to make companies go into orbit, that they cannot wager their high salaries for a higher piece of the pie. I think that has more to do with the reality that it’s more likely that all the companies fail, than the one hit happens, or that there is a lack of luck or timing. Which means, the VC’s skill isn’t endearing enough to the VC himself to ask for a higher carry, so it’s entirely possible that investors, at some point, will take to ways to do the luck and timing themselves.
VCs perhaps do add value, but they don’t value their own efforts enough to cut their pay and take the carry instead (and most of them are already quite fascinatingly rich). As an aside, entrepreneurs are expected, by the very same VCs, to take lower than average salaries for doing the major part of the work, and get paid by the effective carry instead, and founders are generally not quite that rich yet. Founders agree because they actually believe they can make a hit out of their business, speaking probability wise. I don’t know what excuse the VCs have but my eyebrows stay raised.
Of course, who am I to question the salaries of VCs? I’m just a regular Joe asking questions, I don’t have any claim to investor or VC fame, or even entrepreneur fame. (yet)
On a relative scale
– it is easy to build a business that pay bills for a few people,
– it is harder to build a business that gets acquired for 20MM dollars
– and it is very hard to build a business that is worth a few 100MM dollars
VC are paid to do the last. They are paid to identify and recruit 10 companies that have a shot at the moon, then quickly hone in on the 1 that is the big hit, and shepherd it through the the ups and downs to get it to its true value.
When they do this they are not middlemen and their salaries are justified. If they do this they will also make most of their compensation off the carry.
It is unclear to me how their industry structure would support them focusing on the smaller easier problems.
So what you’re saying is: VCs make their moolah and high salaries from the management fee, not the carry. If this is true, effectively they are not taking the same risk as a) the investors or b) the entrepreneurs. So they’re the fat middlemen (and women) who add little value and transfer risk.
If you look at the history of all capital markets, middlemen make big money this way (value add + risk transfer) only in the beginning of a cycle. When stock and commodity markets were introduced, the brokers made hefty margins because of lack of transparency or technology. This changed with competition and technology, so much that brokers today even offer commission free trades.
The entire derivatives bazaar (currency swaps, interest rate swaps, “hedges” and the like) were huge margin products for a long time. Until competition squeezed out these margins and thus created “prop” trading – i.e. banks setting up their own trading arms instead of just being brokers. Essentially, fees are too small, so let’s work with carry instead.
More recently, P-Notes have been a huge margin product, and soon they will be underused as hedge funds find it cheaper to be more transparent and register with SEBI directly, eliminating the brokers (or at least the fat margins) from the picture.
The brokers in all the above can complain all they want about the new system destroying their margins, but they just *have* to get with the program.
If VCs at this point are just middlemen, and if their value add is essentially the money and very little of other stuff, then we can eliminate them too from the process by introducing a level of transparency and technology.
So how can then use technology to throw VC out of the process…perhaps a version of prosper.com for startups? Getting Investors to invest directly instead of through VCs, perhaps through a rating/book-built model? Bypassing complicated legal process (which is what the VCs major strength lies in, but legal is useful less than 1% of the time) by using convertible debt with standard agreement templates?
And in the interim, by creating VCs that will work for less fees and more carry.
Perhaps I oversimplify it. But there’s a niggling thought in there that will not go away.
Brilliant post, Sunil. You have clearly understood and articulated the human capital issues faced by small entrepreneurs.
Are you in India at present ?