Redeye VC

Josh Kopelman

Managing Director of First Round Capital.

espite being coastally challenged (currently living in Philadelphia), Josh has been an active entrepreneur and investor in the Internet industry since its commercialization. In 1992, while he was a student at the Wharton School of the University of Pennsylvania, Josh co-founded Infonautics Corporation – an Internet information company. In 1996, Infonautics went public on the NASDAQ stock exchange.

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Monthly Archives for 2010

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VC - Back to the Future?

I just came across a great report by Industry Little Hawk entitled the Venture Capital Rebound (pdf).  In the report, the authors reach a similar conclusion to Paul Kedrosky (read Paul's great research for the Kauffman Foundation here) -- that too much capital has gone into venture capital.  Paul has argued that we need to shrink the amount of venture funding by 50% -- a statistic that almost every VC agrees with.  (Ironically, 100% of VCs would argue that their fund should be in the half that survives).

What is refreshing about the Industry Little Hawk white paper, however, is that they don't just advocate reducing the capital allocated to venture.  Instead, they advocate allocating capital to smaller funds.  And they articulate a number of reasons for their position (smaller funds are better positioned for the current exit landscape, better alignment with entrepreneurs (per my last post) and with limited partners, etc).

The "money stat" from the paper is that in the 1980's there were just 12 venture funds above $250M.  Today there are over 408 - and 30 over $1B.  And most of this fund-size growth took place in the last 10 years.  The chart is below:

Chart

What is interesting to me is that the proposed solution isn't a radical change.  It isn't a novel idea for re-structuring the industry.  Rather, it's a realization that venture should go back to it's roots.  So I spent some time researching the origins of many leading venture firms.  And I was surprised to see that they all started with small funds.  While venture is far from perfect, and can always improve, maybe we should spend less of our time working on "new solutions" to the "venture is broken problem" and spend more time working on old ones.

The data speaks for itself.  My favorite factoid: the initial funds of Accel, Kleiner Perkins, CRV, Mayfield, Venrock, Greylock, NEA, TA & Sequoia COMBINED were under $125M!  And even on an inflation-adjusted basis the average fund size is $55M.

VC sizes
 
 

Note: I pulled data from the web and from Udayan Gupta's book Done Deals -- if you think I have incorrect data, or you have missing data, just leave it in the comments and I'll update the post. 

UPDATE:  Thanks to Kent Goldman for running the numbers through an inflation adjustment tool.

Company Math vs VC Math

Fred Wilson has a great blog post today entitled The 'We Need to Own' Baloney.  In it he discussed the fact that many VC's apply arbitrary ownership thresholds to investments.  I couldn't agree with Fred more - but I'd take it even further.  This is not just limited to ownership requirements.  Rather, VC's often impose "VC math" on companies in three areas:

  • The amount VC's "need" to own
  • The amount VC's "need" to invest
  • The return VC's "need" to generate certain exit returns

These "requirements" are a direct result of the mathematical model that venture funds are optimized for.  And as fund's have gotten larger, their math has gotten more difficult.  We're now witnessing the conclusion of a "10 year experiment" where money invested in venture funds has exploded and fund sizes have more than tripled in size.  A decade ago, 75% of all venture funds raised were under $100 million.  In 2007, fewer than 25% of all venture funds raised were under $100M.  And I don't think it's a co-incidence that VC performance has fallen off a cliff during this time period.  Indeed, we're approaching a point where the 10-year return in venture capital is negative.  Paul Kedrosky recently authored a paper for the Kauffman Foundation which discusses this in great detail and proposes that the venture industry needs to be "rightsized" -- and suggests a 50% reduction.  It's a great paper -- but if you don't have time to read it, the money chart is below:

Kauffman
 

Fred Wilson has previously written about the VC math problem -- but he approached it from the macro/industry perspective.  I agree, and think it's even more scary when you look at it from a micro/fund perspective.  Take a $400M venture fund.  In order to get a 20% return in 6 years, they need to triple the fund -- or return $1.2B.  Add in fees/carry and you now have to return $1.5B.  Assuming that the fund owns 20% of their portfolio companies on exit, they need to create $7.5B of market value.  So assume that one VC invested in Skype, Myspace and Youtube in the same fund - they would be just halfway to their goal.  Seriously?  A decade ago, any one of those deals would have been (and should have been) a fundmaker! 

As a result of this new math, VC's end up super-focused on the longbets (or moonshots) and frequently remove optionality for mid-tier exits.  It has, as Super LP Chris Douvos has written, become a game of finding the next Curtis Sharp.  It is because of the challenges of "VC math" that First Round Capital chose to raise a relatively small fund -- allowing us to continue to make initial investments that average $600K. 

I understand the importance of aligning one's time and capital to the upside opportunity, and recognize that there is some minimum threshold of ownership that is required for a VC to commit the time and attention to an opportunity.  Does it make sense for an investor to spend the time and join the board of a company they own 2% of ?  Probably not.  However, the difference between 25% and 20% ownership -- or even the difference between 20% and 10% -- should not prevent a VC from investing in a promising opportunity. 

It is the same "VC math" which drives a VC to seek to deploy a larger amount of capital into a company.  (Often taking a capital efficient company and helping it become capital inefficient).  And it is the same math which sometimes creates a lack of alignment between a founder and a VC around exit opportunities.  I have previously written these issues when I discussed the "unwritten terms on a term sheet". 

A company's outcome should drive VC returns.  When VC's required returns drive company's outcomes, it's a recipe for trouble.

First Round Capital to open NYC office


NYC2

I believe that as the world has gotten “flatter” over the last decade, it’s created a big opportunity for venture investors who recognized that great entrepreneurs can come up with great ideas in almost any location.  Indeed, over the last several years, First Round Capital has invested nationally and has funded companies in over a dozen states. 

However, I do believe that certain ecosystems provide real leverage when it comes to the hard work of turning those ideas into reality.  Take acting for example.  Despite the fact that Philadelphia has some great theaters (like the Kimmel Center, the Walnut Street Theatre, the Arden Theatre, the Prince Theater, the Forrest Theatre, etc), I’m pretty sure that almost every young Philly-based actor recognizes the unique opportunities to really hone their craft on Broadway or in Hollywood -- and those who have big career aspirations typically move to NYC or LA.

The right ecosystem can take good raw materials and set it lose on a new trajectory.  That’s why Stumbleupon moved from Calgary to San Francisco, why Jimmy Wales moved from Florida to San Francisco to start Wikia, and why Jingle Networks moved from Michigan to Boston.  And that’s why, four years ago, First Round Capital set up our west coast office (led by Rob Hayes) to firmly plant ourselves in the silicon valley ecosystem.  Today more than half of our portfolio is based in California. 

Over the last several years, we’ve found that the New York City ecosystem has been particularly strong for Internet and media-based startups.  In fact, we’ve met hundreds of really talented New York-based entrepreneurs and funded over 10 NYC-based startups in the last few years – including Appnexus, Knewton, On Deck Capital, Pinch Media, DoubleVerify and others.  And while First Round Capital already spends a lot of time in New York, I’m super excited to announce our plans to increase our presence in the big apple by opening a First Round Capital office in New York City (led by my partner Howard Morgan) -- and the addition of Charlie O’Donnell to our team as an Entrepreneur-in-Residence (EIR).

The obvious strength of the NYC community was on display in the incredible conversations I had at our Office Hours event at Live Bait and in those between entrepreneurs at Meet-Ups around the city, at ShakeShack, at the quality of entrepreneurs involved in First Growth, and in the NextNY community to name a few.  As we looked for ways to support this community, to listen to and learn from entrepreneurs and to help them build great companies in the city, I could not think of a better way to begin than by working with Charlie as our first Entrepreneur in Residence. Charlie’s belief that great companies are lead by great CEOs but also are born from great communities matches my experience as both an entrepreneur and an investor. His work as an organizer, supporter, and participant in the NY tech scene over the past several years has been amazing and I could not be happier to have him join the First Round team.

As seed stage investors we have the privilege of working with entrepreneurs as they establish the DNA of their business and we hope you will work with us as we put down deeper roots in the city.