When Mega-funds Walked the Earth

In a bygone era, enormous funds sat at the apex of the venture capital food chain.  Seemingly, the mere size and power of these mega-funds was all that was necessary to transform any aspiring startup – from biotech firm to online purveyor of dog food – into a public company with a billion dollar market valuation.  Lesser species – small funds, angel investors, and investment bankers – flocked to the service of the mega-funds in the hope of sharing in the IPO feast.  There was plenty for all, though, and life was good.

Then, calamity struck.

Stockholders rediscovered that a business plan is not the same thing as a business.  Large corporations, after a decade’s long IT binge, went home to nurse their hangovers.  Stock markets retreated.  Interest rates had nowhere to go but up.  Moore’s law and recession conspired to threaten deflation.  The IPO drive-up window slammed shut.  The crowd that had gathered during the times of plenty now ensured fierce competition for deals.

Shut off from their food supply, the mega-funds are shrinking or have abandoned the early-stage technology hunting grounds.  As a consequence, niches are opening for smaller, more nimble funds that can find ways to prosper without the patronage of the mega-funds.

That, more or less, is the story told by Bill Reichert [1], the President of Garage Technology Ventures, a boutique investment bank for high technology companies, in his recent article, “The Outlook for Venture Capital and Entrepreneurship.”  As a student of the evolution of venture capital, Bill’s credentials are impeccable.  During his climb up the entrepreneurial ranks, Bill participated in some 250 pitches to VCs and co-founded Academic Systems, which was funded by the likes of Kleiner Perkins and Accel Partners.  Since 1999, Bill has helped companies raise over $380 million in funding.  He also manages a seed and early-stage technology fund with his Garage partners.  So, when Bill spoke to a group of Pioneer Entrepreneurs the other day, we listened.

The Unbundling of the Venture Capital Industry

Reichert’s thesis is, in effect, that the venture capital industry is going to become less vertically integrated.  A loosely bound network of boutique firms will increasingly characterize the VC business.  These boutiques will specialize along a number of dimensions including technology domain, investment stage, and geography.

Undoubtedly, the bursting of the dot-com bubble is catalyzing change, but the logic of specialization has been recognized for over two centuries.  After all, it was Adam Smith’s essential insight to recognize, “The greatest improvement in the productive power of labor…seems to have been the effects of the division of labor.”  In other words, in a competitive environment, a well-coordinated team of specialists will kick a generalist’s butt.  That’s true if you are an 18^th century pin maker or a 21^st century venture capitalist – or entrepreneur.

Whether one is designing software or a business, the concept of modularity is important, because modular design unlocks the value of specialization and enhances the adaptability of the system.  When coordination costs are high due to the existence of interdependencies, modules tend to be rather encompassing in their function.  John Hagel writes of “bundled” organizations that combine inherently conflicting business functions. [2]  Improved communication and well-defined interfaces enable greater focus and value creation.  Interfaces between humans – that is, relationships – are decidedly subtler than software APIs, for instance.  Nevertheless, the business essence of relationships is captured in the contracts, shared language, and expectations that bind people together to get work done.

Over the last few decades, the venture capital industry has deliberately funded the development of better communications systems, the Internet most notably.  A secondary impact, possibly unforeseen, has been more widespread adoption of effective business interfaces.  For example, the laptop computer I’m using to write this article has stored within it the entire Emerging Growth Company Series of documents prepared by the Menlo Park-based venture law firm of Gunderson Dettmer.  FedEx delivered it to me in Bozeman, Montana on CD-ROM.  For a song, someone living deep in the boondocks can quickly familiarize himself with the accepted contractual interface with the venture capital world: the convertible preferred stock instrument.

With the increased ability to become more modular comes the absolute necessity to become more modular.  Why would the venture capital industry be immune from this fundamental economic truth?  It’s not.  To create value – and earn their keep – venture capitalists, too, have to design their firms to be more focused and more effectively connected.

Capital Efficiency and Network Orchestration

It’s worth repeating.  If transaction and coordination costs can be reduced, companies have the opportunity to become more specialized.  If they can specialize, they must, in order to remain competitive.  Consequently, companies are penalized for using capital to develop assets – tangible or intangible – that can be developed more efficiently by others.  To maximize return on investment, it makes more sense for a venture capitalist to invest $4 million in each of five specialized companies than $20 million in a single agglomeration.  The upshot is the need for capital efficiency, as Reichert calls it.  It’s not just about being frugal; it’s about being smart.

Hagel writes of process networks composed of modules and orchestrators that facilitate purposeful connections among modules.  It’s clear that Reichert believes venture capitalists will differentiate themselves by their orchestration skills, their ability to “accelerate the network” of portfolio companies.  In his view, the VC’s involvement with a company will be less about the basics of corporate organization and more on “providing leverage.”  Reichert credits Kleiner Perkins’ keiretsu as a harbinger, but also “questions whether it was implemented” to full effect.

What does all this mean for the entrepreneur in the trenches?

Speaking with Sam Pierce [1], co-founder of IdealsWork in Portland, Maine, Bill emphasized the purpose-built nature of venture capital.  To achieve his overriding return on investment objectives, a VC has to look for “rapid growth; meaningful size relative to required capital; and disproportionate, sustained, high profitability.”  Bill echoed themes he presented previously in a different forum:  “Not all small companies can become big companies.  Not all good companies are venture fundable.”  A VC firm has little or no structural latitude, though it has great flexibility when it comes down to how the job gets done.  Go ahead, execute as either a service provider or a seller of software, whichever works best.  Take us out with an IPO or a sale of the company.  We don’t care.  Just hit our return objectives.

John Pope [1] of The Blue Sky Group in Laramie, Wyoming, welcomed Bill’s call for a renewed focus on “the rules of the game.”  John explained, “Behavior is unpredictable,” when there is misalignment between the objectives of entrepreneurs and investors due to the lack of diligence.  When that happens, some worthy companies can be shut out from “even being able to play the game.”  In the face of increasing and continuous specialization by investors, the task of alignment will undoubtedly become even more complex and challenging.

But, if the emergence of new niches increases complexity, it also increases opportunity.  That’s because the creation of one new investor niche will, inevitably, spawn others.  Both Robyn Hampton [1], representing the nascent Montana Fund in Missoula, Montana and Lynley O’Donnell [1] of Flywheel Ventures in Santa Fe can attest to the truth of that proposition.  Robyn is intimately involved with the design of a pilot fund aimed at making participating debt investments in local ventures.  Her fund’s portfolio won’t have the attributes necessary to attract Bill’s attention, but they will be companies that have the potential to be cash flow positive and meet the definition of an “entrepreneurial growth company,” the source of most net job growth.  Flywheel, on the other hand, is raising a $30 million early-stage technology fund aimed at a swath ranging from New Mexico to the Sierras.  Bill acknowledged that both initiatives have a place under the sun – as long as their principals are clear about their objectives from the beginning and “don’t get confused” along the way about their respective measures of success.

What’s to be done?

Reichert isn’t a professional management guru.  He’s got a business to build.  So, how does he intend to put his theories to work?  Simply put, he’s looking to connect with other like-minded boutique investors in order to collaboratively find, fund, and build valuable technology companies across the western United States.  Consequently, the introductions to John, with his materials and energy technology expertise, and Lynley, a bridge between Sand Hill Road and Santa Fe, seem to have been an appropriate payback to Bill for the time he invested in us.

For entrepreneurs, the lessons seem clear.  First, ask yourself what bundle of business processes do you absolutely have to build internally, and how can you best leverage the expertise of others to fill in the rest?  Second, be as clear as possible about your objectives.  What class of investor is most closely aligned with those objectives?  (In 99.5% of the cases, it won’t be professionally managed venture capital.)  Third, among the investor class that offers the best fit, who are the specific investors that can best help you execute your leveraged growth strategy?  Answer all three wisely, and you’re likely to be successful.  Miss on any one, and you fail the test.

[1] Online profile available to members.

[2] Customer relationship management, infrastructure management, and product innovation and commercialization.