Small VC is Beautiful

by Mike Feinstein

I've written many times about the impending structural challenges in the venture industry.  There is too much capital hoping for huge outcomes in an environment where a modest win should be considered a big win.  It's critical that VCs be careful with the amount of capital they meter out to portfolio companies, and, for larger funds, this makes it tough for them to participate in these capital efficient deals.

The folks at Industry Little Hawk agree.  They've written a white paper that describes why smaller venture funds (<$150M) offer the best returns.  They have historical numbers to back it up. 

The big question is what will happen to the big funds out there?  They have too many people who make salaries that are too large and spend too much money on fancy offices.  Limited partners in these funds are figuring out that these fixed comforts misalign interests between the General Partners in the venture funds and the Limited Partners who invest in these funds.  Look for continuing pressure on these larger funds and a steady exodus of partners from these funds as they attempt to get closer to 'right-sizing'.

Although I hear LPs talk about this quite a bit, it will take years for this to ripple through the venture industry.  For now, most venture funds will wait on raising a new fund, hoping for a better environment in a year or two.  The industry won't really shrink until these funds give up on their existing model after failing to raise funds.  5-10 years from now, the venture business should look much different than it does today -- smaller firms with more nimble partners.

Another shoe to drop will be the fee model that is employed by venture firms.  The more they can align their compensation with the LPs interest, the better.  LPs will insist that VCs can't get rich off of high fees and will instead have to deliver significant returns in order to make some serious money.  Look also for certain fund strategies to employ a very different fee structure when they can ensure that they only make money when the LPs do.  I'll write more about that in the future.