The recent announcement by US venture firm Sevin Rosen that it would abort its most recently raised (tenth!) fund has sent a ripple through the venture industry. And set off a minor firestorm among some VC blogs (and awkward silence from others)...
In contrast to the recently publicised fundraising difficulties faced by some firms, Sevin Rosen had no trouble raising a $300m fund. But then the company dropped a minor bombshell by deciding to return the capital to investors based on the belief that it could not deliver adequate returns:
In a letter Friday to prospective investors, Sevin Rosen, a firm started 25 years ago by legendary tech investors S.J. Levin and Ben Rosen, said it will manage its existing funds, but raise no new capital for the foreseeable future.
"The venture environment has changed so that overall returns for the entire industry are way too low and even the upper quartile returns have dropped to insufficient levels," the letter by Sevin Rosen general partners stated.
"For every discussion about a YouTube or a MySpace or Facebook, what people don't talk about is the hundreds, if not thousands, of start-ups who will not get anywhere near that much," said Sevin Rosen general partner Steve Dow.
Wow. This is a very courageous position. It will be difficult to argue with the view of investors as experienced as these. The structural issue here is that while the cost of building businesses has declined, and exit values have topped out at below $100m (see Why You Have To Build Companies for Less), huge early-stage funds remain in the market. These funds of $300m to $800m were raised in the belief that building home-run businesses requires $20-40m of capital. Not only is this no longer the case, but if you do invest that amount your returns on winners are likely to be like buyout returns (2-3x) albeit with far higher risk.
There simply isn't any way around this imbalance if you're sitting on a large fund with an early-stage strategy. DFJ Portage investor Matt McCall concludes that funds simply need to invest less (which usually means they need to shrink) and focus their companies on capital efficiency. Will Price of Hummer Winblad believes there is scope for funds like his to adapt to this model within the existing industry structure. He is right to point out that there are many strategies in VC and the challenges of one strategy don't imply that the whole market is broken.
The alternative to having a smaller, more capital-efficient fund is to reduce the portfolio loss ratio so that fewer 10x hits are required to deliver a 3x portfolio return. The reason early-stage funds make big bets is because a handful of winners more than make up for the 50% or higher loss ratio. But in a market where so many investors are chasing scarce home runs, it pays to think about increasing the number of survivors in the portfolio. Making 2-5x returns on more than half the companies in the portfolio, with the rest split between home runs and wipe-outs will deliver top-quartile returns with reduced risk.
I do hope the best early-stage venture firms will stay in the market -- they are critical to the industry. But the fact is they need to adapt to the conditions of a new capital-efficient growth model with smaller, more focused funds. Sevin Rosen has taken a bold step at significant sacrifice to themselves. It's not likely to be the last.