Venture Capital Firms Are Too Big

Many bloggers have been saying recently that the VC Model is Broken. One of the most important reasons is Venture Capital Firms are just too big.

Why Venture Capital Firms Got Too Big

In the 20th century, technology companies often required tens or hundreds of millions of dollars to build out and prove. Companies like Intel, Microsoft, Amazon and Google required hundreds of millions of dollars to scale up to the size where they were proven winners. This was one of the factors that led to venture capital firms becoming ever larger.

Being a VC fund manager was also a great job for the fund principles, once the fund was large enough. Most VC funds are structured so the fund managers charge a management fee of about 2.5% of the value of the fund each year. The management fee pays the salaries of the fund managers and their support staff. A small VC firm usually has four partners and some support staff. This means that the annual operating budget for even a small fund quickly grows to more than $2 million per year.

Most VC managers believe a fund under $100 million isn’t economical. The goal of most VC managers is to grow the fund to several hundred million, in part, because then they can start pull down some very attractive compensations. This is another reason that venture capital firms have continued to grow.

The graph below shows how these trends have led to the phenomenal growth in the size of venture capital firms over the past 30 years.

Each VC Partner is Managing More and More Money

As VC funds have grown larger, the amount of money that each VC principle has to invest has grown even faster.

This graph shows that a typical venture capital firm principle was responsible for investing less than $3 million in the 1980s. Today, the typical fund principle has to invest almost ten times that much.

Which Means VCs are Investing More in Each Company

The amount of work a fund manager has to perform is directly related to the number of investments, not the size of investments. It takes almost as much time to manage a $1-million investment as it does a $10-million investment.

As the amount of capital each venture partner has to invest has grown, their natural tendency has been to make larger and larger investments.

The graph below shows how the amount of venture capital firm money in an average US VC-backed company has increased over the past ten years. The amounts shown are for companies that exited through merger and acquisition (M&A) transactions. As recently as 1996, the median equity raised before an M&A exit was only $5 million. Today, that has increased to $25 million.

This Is What Happened in My Venture Capital Firm

I didn't understand this tendency for venture capital firms to grow in size when I co-founded BC Advantage Funds. This drive for venture capital firms to get too big was one of the main reasons I started my angel fund, Fundamental Technologies II.

What This Means for Entrepreneurs and Angel Investors

This necessity for venture capital firms to invest more and more in each company has profound implications for entrepreneurs and angel investors.

For most startups it means that venture capital firms probably aren't the best source of funding - or that they aren't even a desirable source of funding. Future posts will explain why this is. This is also an important part of my upcoming book: "Early Exits - Exit Strategies for Entrepreneurs and Angel Investors - But Maybe Not VCs".

Trackbacks:

VC firms are not the best source of funding for startups by NZ Angels

Basil Peters wrote an excellent blog post today on why VC firms have got too big.

He argues that the VC model is broken, one of the main causes being that the focus is on ever-larger investments.
startups.