Watch CBSN Live

Angels Go Where VCs Fear To Tread

Paul Kedrosky got a lot of attention yesterday for a paper he wrote showing that venture funds are not providing investors with enough returns and suggesting that the venture capital industry should essentially right-size itself by half.

The sector must shrink its way back to health if venture capital is to provide competitive returns and secure its own future as a credible asset class and economic force.
The trouble with Kedrosky's position is that it lumps all VC firms in the same basket, whereas not all VCs are created equal -- and I really do mean "created." Funds that are endowed with huge sums of money to invest -- funds managing $500 million and more -- behave very differently than firms with $100 million or less. As I've written before, investors in those bigger funds demand disproportionate percentages of stock from company founders in exchange for, in many cases, more capital than fledgling companies really need.

Larger VC funds are also more risk-averse than smaller VC funds. A study by Deloitte and the National Venture Capital Association showed that more than half of VC firms with over $500 million in assets under management will cut their investments this year. Mark Jensen, the national managing partner of Deloitte's venture capital services division, told me that the larger firms are pulling back because of the poor economy, but also because they're unsure of how quickly they can get their money back out. "They don't know when the IPO market, or any of the exit markets, will improve," he said.

Not only are the smaller firms less likely to cut investment levels, they are far more likely to increase their levels of investment, despite the poor economic environment. Smaller firms are also showing a far greater degree of agility (53 percent of firms with under $100 million under management plan to shift their investment strategies, compared with just 35 percent of firms with over $500 million). The smallest VC firms are also four times more likely than the largest ones to recalibrate their portfolios towards companies in the early stages of development.
Jensen also confirmed something I've heard elsewhere -- that start-ups are looking to other sources of financing. Some entrepreneurs create companies with the expectation that they'll eventually be acquired by an established firm, and raise financing directly from the likes of Intel, Google and Microsoft. Yet other firms solicit funds from successful entrepreneurs and wealthy individuals -- known as angel investors. Giles McNamee, founder and general partner of Boston-based investment bank McNamee, Lawrence & Co, told me that angel funding is a better deal for many start-ups because angel investors aren't looking to get a controling interest or soak the founders; they're "mostly successful CEOs that can help with advice -- it's a good process."

Getting back to Kedrosky's report, it's one thing to declare that something is desirable, and quite another to make it happen. Fund managers aren't going to read Kedrosky's paper, look at themselves in the mirror, and say, "you know, I should go ahead and shutter that fund I'm running." Especially since they earn something along the order of 6 percent of the value of funds under management.

What is going to happen, however, is that an increasing number of individuals who typically invest in venture funds are going to invest directly in start-ups instead, and the most promising start-ups will themselves look for alternatives to getting soaked by large VCs. That will create the kind of attrition that Kedrosky is calling for, and the disappearance of larger funds from the tech landscape would be no great loss.

[Image source: Wikimedia Commons]

View CBS News In
CBS News App Open
Chrome Safari Continue