Fixing the Venture Capital Model: PFB Revisited

Posted on January 26, 2006

I know that I said I was coming out with Fixing the VC Model: Part 3 this week and now you are seeing PFB Revisited. Please consider this Fixing the VC Model: Part IIa. I had to write this post in response to a great post written by Fraser Kelton today. Fraser writes about fixing the VC industry as a whole and includes a section on partial founder buyout (PFB) with a link to Paul Graham’s essay which is where I first saw the idea. Fraser also hits on other topics like customer service, raising less money, etc. Definitely worth a read. The ony piece of the argument which may be a tough sell to VCs is the following:

Focus on a Niche. By focusing on a small niche market, the VC can exploit the long tail of venture investing and enjoy a positive median return. The venture capitalist may have to give up on the ‘hit’, but they should be okay with that. They’re leveraging their expertise in the niche market to make a number of smaller investments, that will yield a positive median return.

A venture capitalist who doesn’t rely on landing a hit to prop up their other investments, and instead aims for a number of smaller returns that yield a positive median return, will be able to compete against entrenched VC firms. By going long tail, and being happy with it, the venture capitalist develops yet another competitive advantage.

Having worked in Venture Capital analytics for a while I know the returns well and I know what LPs (the VC’s investors) pay for. LPs are paying for the homerun fund (homerun compared to a mutual fund). Many times they won’t get it but that is usually what they go into VC funds looking for. To make my point I am going to have to call on two of my best friends from undergrad, alpha and beta.

With the typical 2% management fee and 20% carried interest VCs charge for their services they need to make a large return above the market or a high alpha. They are also taking a lot of risk and have a high beta which drives the desired return even higher. The combination of these leads to expectations of at least a better-than-median return.

While a VC median return is not bad at all (compared to a mutual fund), investors may be upset since they paid for better. However, all of this can be solved if a VC, trying to disrupt the market, takes a lower management fee and/or carried interest with the plan of focusing on a niche for a modest median return. Definitely something to think about. It would mean less money in the short term but could lead to a much better industry in the years to come. Let me give you a glimpse of the future. Possible headline from the 2015: Happier entrepreneurs, better VC returns and more money being made by all! Sounds good to me.

Again, kudos to Fraser for putting together such a comprehensive article. I am glad to see the discussion really picking up. Now, if I only I had some money to start putting PFB (and the other ideas) to work as an angel investor…

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