Olson’s Observations

McCall is on a roll lately with his posts on the VC industry. In one of his latest posts he talks about the VC industry restructuring that appears to be underway and how a consolidation may be ahead. More and more funds are raising more and more money and while it all seems well and good, the under $100mm funds are being completely wiped out. Here are the stats compiled by VentureOne that Matt quotes:

…barring a second half flurry of small fund closings, 2006 as a whole is shaping up as the year that funds under $100 million were all but forgotten. In the first half of this year, only 28% of the funds closed have been less than $100 million. If that trend continues throughout the year, 2006 would have the smallest portion of double-digit funds raised since 1992, the earliest period tracked by VentureOne.

The percentage of sub-$100 million funds raised has been falling steadily on an annual basis for the past four years, the data shows, from some 71% in 2002, to 63% the following year, 52% in 2004 and 44% in 2005. The median fund size this year sits at a high $170 million.

You may be asking yourself: Why does this matter? More money is better for everyone, right? Wrong. It has been proven time and time again that more money is not necessarily better and here’s why.

Investment Scale:

As VCs raise larger and larger funds the subsequently have to start placing larger and larger amounts of money to work. This is typically done either by placing a lot of small bets and creating a larger portfolio of companies (meaning more competitors for start-ups to deal with) or sticking to roughly the same amount of deals and injecting more cash into each deal. To inject more cash in each round the VCs have to move later stage. However, if some early stage deals are still getting funded by these larger funds the next scenario can take place.

Mo Money, Mo Problems for Entrepreneurs:

When companies that should take on $5mm rounds are now taking on $20mm rounds problems are not far in the future. Taking too much money allows entrepreneurs to become complacent and less scrappy. It allows them to hire too many people, spend a ton on marketing and schwag, and buy that super-mega champion edition foosball table they had their eye on.

Hey, there’s tons of the money in the bank. We’ll be fine, right? Wrong again. That money will run out and when it does you better hope you have a business model that works. However, now you have gone through years of being flush with cash and have not needed to fight to stay alive so your drive has slowed. (Disclaimer: every entrepreneur will not have this issue.) Not only that, you’ve taken on a lot of money which means you have lost a large chuck of your company to investors. Now, even if you have you business together, you own less of it.

VC Effectiveness Wanes:

Lastly, if investors move to later stage investment due to the windfall of money they now need to invest they may be moving to an area that they are not effective in. Just because they were great early stage investors it does not mean they will be great later stage investors. The ballgame is completely different when you switch investment stages. It is akin to the difference between a small-cap growth investor and a large-cap value investor. While one may be able to make the transition there are no guarantees that it will work smoothly or at all.

As you can see, more money does not solve problems and it effectively creates more problems when you look at the start-up arena. However, there is a silver lining in the dark storm cloud looming overhead. There is now a lot of room for VC firms to enter the market in the sub-$100mm category and prove themselves. Forming a smaller fund can now be a significant differentiator for VCs.

Where once VCs were fighting over the small companies there are now only a handful of firms capable of funding them properly. Those firms will now get better deals and the entrepreneurs will be better off as well since they will get the right amount of cash and will hopefully have a closer relationship with the firm(s) that invests in them. Now, if we can only get the institutional investors on board with this and coerce them to take some risk on some small new funds we’d be golden.

As I mentioned in my post a while back on mega funds, I am excited to see how this all pans out. This is an interesting time for VCs and for entrepreneurs and, while there will be a lot shake ups in the industry, I also think there is a lot of opportunity to be had if you know where to look.

Update: I was talking with a friend about this post recently and they brought up a great point.  The fund size doesn’t matter as much as the fund size divided by the amount of investment professionals.  Each investment professional acts as their own fund in a sense so even if a fund seems large dollar wise they may have a lot of investment professionals.  This means each professional is responsible for a smaller portion of the overall fund and because of that they can do smaller deals.