Barriers to entry in Venture Capital 

How the VC industry has built-in barriers to entry for “Emerging Managers”

“Emerging Managers” is the VC industry speak for new teams raising their first or second fund where their track record as General Partners is still not proven. They are the entrepreneurs of the VC world, an industry with some high barriers to entry for new teams to enter and scale.

An event last week, hosted by the UK Government, a dozen or so “Emerging Managers” were treated to a fascinating fireside chat with Richard “Dick” Kramlich, the founder of NEA and a seasoned 40-year Venture Capitalist. Dick was famously a Seed investor into Apple and still serves as the Chairman of largest VC fund in the world ($13B raised since its establishment in 1977!).

Dick provided insightful and inspirational stories about the early days of the industry, the opportunity today and the potential ahead. Of specific interest was the story of the first external check that NEA received, a $1 million commitment from a US family office. NEA’s first fund had $16M and it was a telling story of how even the titans of today started small. Every single Emerging Manager in the room smiled empathizing with the feeling of that first external validation of their team and story.

Emerging Managers face a number of challenges in entering the VC industry, which also establishes a set of barriers to entry. These include:

- Entrepreneurial risk: Like with any other entrepreneurial venture, new managers are putting other sources of income at risk while they establish and raise their first fund. A 1 to 2 year fundraising period for a first time fund is not uncommon which effectively limits new entrants to those that can personally absorb their burn rate.

- Legal costs hurdles: Anyone seeking to launch a new fund will become friendly with lawyers… many lawyers. The establishment costs for a new fund require legal advice on regulatory oversight, the drafting of its legal structure (the “PPM” and “LPA”). If the new team is lucky enough to raise its fund some of these costs are absorbed by the Fund. If not, the founding Partners are liable for the substantive legal and advisory fees, which increase the risk of the entrepreneurial venture.

- First time funds: Like with early-stage startups, investors into a VC fund are as much betting on the team as on the idea or investment focus. In evaluating a fund, many investors will look at the track record of the investors: Have they been good at picking the right companies and supporting them through to the next stage? Does the team have experience working together and investing together? Will they make me money? Some investors, therefore, have blanket rules to shy away from first time funds and wait until later funds to evaluate track record and team dynamics.

- Brand: While the shareholders of a VC fund are its Limited Partners, its clients are the entrepreneurs. The VC’s role is to identify high potential clients, convince them to select their Brand (and money) and work with their client to achieve an exit and therefore provide a return to its shareholders. And so Emerging Managers need to establish their brand, both as a firm and as individual Partners. Be that through ambitious names (Thrive, ProFounders, Passion, Upfront), active Blogging and social media presence, events, and press activities. At the end of the day first time VCs will have to convince entrepreneurs why their money is better than a more established fund’s (or alongside an established fund). This creates a risk in terms of access to the best deals and therefore the best exits.

- Fund size: As with startups, Emerging Managers are told to start small, prove momentum and then scale. Thrive Capital has done this amazingly well, having raised a $10M first fund in 2009, quickly followed by a $40M fund in 2011 and $150M in 2012. A fund size of $10M with a standard management fee of around 2.5% means $250k for the investor to pay themselves, rent, travel, etc. Charlie at Brooklyn Bridge Ventures had a great blog on the real economics of smaller first time funds.

And yet despite these structural issues, we continue to see a growing momentum of Emerging Managers entering the fray. Be that the evolution of personal Angel investment vehicles into VCs like SofTechVC or White Star, the establishment of new partnerships by seasoned VCs like Theresia Gouw formerly of Accel launching Aspect Ventures and a number of other experienced VCs in the European scene currently launching new funds.

But all of the above is also starting to change with the a disruption of the early stage investment ecosystem with the likes of AngelList syndicates, crowd-funding platforms like Kickstarter and government incentives like EIS to support more Angel money supporting startups.

Venture Capital, like any other industry, should evolve and re-invent itself. The ability for “Emerging Managers” to enter the VC industry is, as evidenced above, limited by expensive and regulatory entry barriers, and yet we are seeing Limited Partners actively support new teams and seeing new teams (like Lowercase Capital, Floodgate, Thrive, Point Nine) begin to have meaningful exits proving that Emerging Managers deserved their seat at the table.