Will we ever see a hundred-year-old venture capital firm?

The venture capital legacy

NB: I will start with a minor, but potentially important clarification. In my posts so far, I have generally used “venture capital” to describe the investment in long-tail risk and the broad ecosystem of investors who undertake it. Here I will specifically focus on venture capital firms, or general partnerships. If our objective is to focus on legacy, they are natural candidates — venture capital investments are their raison d’etre, they are somewhat encapsulated, self-perpetuating, and have their own unique culture and values.

Those of you who have had the dubious pleasure of being there for my late-night ruminations will have doubtlessly heard me mention “legacy” once or twice. I tend to reference that as something I consider one of the desires that drives human behavior — up there with achievement, wealth, fame, power, and the like. Perhaps because I saw the example of my parents being teachers and educating several generations of students, the desire to leave a mark on this world that outlasts me is unusually strong. I hope you forgive me the indulgence of taking an entire post on the legacy of venture capital firms.

And so, here is a simple question that I have been curious about — will we see a hundred-year-old venture capital firm? Some are well on their way. CRV is celebrating their 50th anniversary this year. Venrock, Mayfield, Greylock, and Norwest are slightly older. Lightspeed, Kleiner Perkins, and Sequoia are not far behind. But, at the same time, those are the exceptions. There are hundreds of venture firms created each year, with the majority of them never raising a second fund. Even the lucky few who make it to their third or greater fund struggle to sustain performance, evolve strategies, and survive leadership transition. Below are a few reasons that the deck might be stacked against a centennial venture firm.

Risk/return profile

It is a notion that most people who have started a first-time venture fund understand well — the early years of a venture capital firm are much harder than anyone imagines. Very practically, it is an experience of scarcity. The basic expenses of a first-time fund are actually pretty high — salaries and benefits for the first few employees, general travel and entertainment, data subscriptions, and conference fees are only a few on a pretty long list. By the time you run the math there is not that much money left to pay the founding partners— and this is before we have actually started doing any deals!

Doing deals comes with structural disadvantages as well. Even if the founding partners have a good track record and reputation, the firm does not actually have one. In the beginning it is unclear if there will ever be a second fund, and not many entrepreneurs are excited by the prospect of being orphaned by their lead investor. And there definitely is not much extra cash to spend on operating experts and flashy conferences. All of this ties back to the fund economics — it is harder to land good deals, which means more capital is spent to land the deals you get, which further eats into the annual fees and partner compensation.

There is also the real kicker of the GP contribution. The founding partners are, at this point, already taking a lower compensation than their previous high-flying jobs. But their limited partners also expect them to have some actual skin in the game, so they pulled some real capital (at least a couple of million) out of their own pocket.

And this is just the money part! A lot of the risk is reputational, and thus hard to quantify. If you started a fund and things don’t go as expected, it is hard to hide the fact that you never raised your next fund. And you are still likely on the hook for “managing out” the rest of the portfolio. It is not likely to feel great, especially when you think that you could have had a cushy corporate job and just failed upwards (or, in the worst case, laterally).

This is not meant to be a public service announcement against starting a venture capital fund, rather a point of contrast. Compare this experience with the one of the partner who joins the venture capital firm at, let’s say, fund three. It sure seems like greener pastures. At this point you are likely drawing fees from at least a couple of concurrent vehicles, so there is more money to spend to build the franchise. You are beginning to benefit from an ever stronger firm track record and reputation. Things are still not easy, but the sure are not as hard as they used to be.

This creates an interesting risk/return disconnect between the people who started a firm and the people who joined it later in its life. The people who were there in the beginning had to endure lean times, put in hard work, and face the daily prospect that this whole thing might not work out. The people who joined later still work hard, but, you know, it does not feel like they took on the same risk. And then you start hiring some really smart kids out of the world’s best MBA programs and they all want to be full-fledged partners before they show up for their 5th year reunion.

This is tough on partnerships. How do you allocate the returns (compensation, carry, firm seniority) in a way that both incentivizes the next generation yet recognizes the tremendous risk that the previous generation took? If you are too stingy, you end up with a talent and motivation problem. If you are too generous, well, it sounds like someone is getting a free ride. For most partnerships this is an ongoing issue, but it usually boils over when young up-and-comers spin off to start their own funds (because there is not enough upside in their current organization) or when older partners need to transition out and assigning value to their stake becomes problematic. It’s a tough one.

Firm Growth and Evolution

This brings us to an interesting organizational problem — do venture capital firms actually have to bring on new partners? I mean, yes, eventually, as time comes for the original founders to retire and jet off into the sunset this will have to happen. But if in the immediate future, let’s say on the advent of the second or third fund, it is not a clear-cut question. After all, the founding team was perfectly successful in deploying the first fund. You may have worked harder than you wanted to, but with the extra fees from the next fund you can outsource a fair bit of that work going forward without bringing on new partners. There is some organizational pressure from the associates you may have brought on board as they expect to progress to the partner ranks, but you could be clear from the get-go that this is not an option and make sure they move on to greener pastures after their tenure with you is done. If you raised a larger fund you probably need extra partner-level help, but you don’t have to raise a larger fund to still do great for yourself. Finally, there may be some peer pressure from other venture funds that have large teams with fancy degrees and impressive resumes bringing operational support for their portfolio companies — but again, you were successful without all those things in the first fund, and besides, who cares about those other guys!

The fact is that you can build a tremendously successful firm by having a small, tight-knit partnership from day one, raising relatively similar size funds, having a limited, non-partner track for your associates (if you have any), only adding a partner when another decides it is time to move on, and only doing so after knowing and trusting the new partner for a long time. Union Square Ventures’ first fund was $125M in 2004, their most recent one was $200M in 2018. If you annualize it, that is 3% growth. Using the same (very crude) metric First Round is at 4% since 2008, and Menlo Ventures is at 5% since 1983. I am not saying that any of those funds have done exactly what I describe, but they show that you can be a successful franchise without growing the fund size.

On the other hand, there is Bessemer at 21% since 1995 and Insight at 23% since 1996. It makes sense to raise consecutively larger funds so that there is more space for growth for everyone on the team. Somehow, it seems like most venture capital firms are on this path of seeking to continuously grow their fund size and associated operations. There are several reasons why this might be the case:

• Uncertainty. Venture investing is a long feedback game and it is hard to know if you are doing well. Even if your first fund blew it out of the water with a few big wins, well, it might have been just dumb luck. Might as well raise a bigger fund if you can and seek security in numbers.
• Momentum. If you already hired a few associates and told them they were going to be partners, then it kind of makes sense to hire a few new associates to fill their spot as they get promoted. And since we are hiring more associates anyway, it might make sense to grow the rest of the team. And we need more funds to support all these people, so here we are.
• Growth. Yes, growth for growth’s sake. There is a saying that growth covers up a lot of problems. The most recent fund is not trending in a way we like? There is friction within the partnership? Culture is becoming problematic? Raise a bigger fund and try to either dilute the problems, or throw money at them. Or at the very least, feel like you got a win by raising a larger fund.
• Money. I mean, why turn down more money? Here’s the thing, the bigger the next fund, the more fees you get on it. And they stack. And, yes, you will have to have more people share in the economics to help deploy the bigger fund, but they are really not that expensive. It might be a bit harder to get high returns on a larger pool of capital, but as far as your carry is concerned, the extra dollars at work should compensate for it.

Where does it stop? If, by choice or by accident, the venture firm set itself on the continuous growth path can it get out of it? Or does it have to accept that at some point it will need to start drastically moving upstream or expanding its strategy, all the way up to becoming an asset aggregator? Or worse, will it just get ahead of its skis?

Alignment with Limited Partners

This is a constant discussion point and a lot has been written about it. In the long run, incentives between general partners and limited partners are not really aligned. Don’t get me wrong, I understand that they are at least partially determined by market economics — for every LP who doesn’t like Sequoia’s fee structure there are 10 others who would gladly take the spot. But there is a continuous disconnect. Early on in a venture firm’s life the fee structure (as we discussed at length) is pretty light. It does force a degree of scrappiness and hustle, which is probably good, but it also puts an unnecessary stress on the young fund. Later on in a firm’s life, the fee stream becomes so much larger than a reasonable operating budget, that it can become a priority in its own right and incentivize some pretty abnormal behavior. But that’s all I’ll write on that.

In sum, aligning the risk/return profile for partners, charting a sustainable future strategy, and aligning incentives with limited partners are all pretty significant hurdles in the road to that centennial venture capital firm — and, mind you, this is assuming that the firm delivers acceptable returns.

To wrap up my musings on legacy, if that were my primary focus and I were to ever start a fund, I would probably try to do something somewhat crazy. Something like tying fees to a cost-plus model of operating expenses, committing to fairly constant fund sizes, fixing the size of the partnership, and making sure that partners buy in and sell out of it at book value. Hell, I might even think that a maximum tenure is not a horrible idea. Luckily for the industry, I don’t think I’ll ever get around to that. But it is an interesting thought.