Backing into 20%
Fred wrote today about the mytical 20% ownership threshold that most VCs have when they make early-stage investments. As he points out, there is no investment reason why a VC needs to own 20%+ of a start-up. The reason they want to own this much is that they want to put more money to work and have significant large dollar volume returns that are significant to their large funds.
The fundamental problem is the large size of early-stage VC funds. It makes it difficult for a VC to do a small early-stage deals. Each deal takes more or less the same amount of time. So, if you have to put in the time, you might as well put more money to work to try to get a bigger volume return.
The problem with this is that VCs should be in the business of generating a significant multiple on an investment. But, with a large fund, you tend to focus on the total dollar return so that it 'moves the pile', or makes a difference in a fund. Putting $2M to work and getting $20M back (10x return) doesn't matter that much to an $800M fund. It would be more significant to put $25M to work and getting $75M back (3x).
Take a look at the numbers at the end of Fred's post:
Don't get me wrong, I would love to own 25% of a company or more. But we don't make it a requirement. Our requirement is being able to get into the best deals, work with the best entrepreneurs, and be able to generate $40-50mm in proceeds when a deal works and return the fund, $125mm in our case, on the very best deal in the fund.
If Fred gets a $40M return on a company that they own 15% of, that implies (more or less, depending on deal terms) a $267M exit value. That's a pretty successful company, and I'm sure that Fred has had a bunch of those. If they get $125M (their fund size) on a 15% ownership, that's a $833M exit, which doesn't come along too often. If you change these exit values to be the same percentage of an $800M fund, that would imply a $256M return and a $800M return. Even with 25% ownership, these imply $1B+ and $3B+ exits. Don't hold your breath waiting for those.
You can see from this example that a smaller fund has a much better chance of generating a significant multiple than a big fund.
The fundamental problem is that there is much more money being put to work in the early stage space then there are great entrepreneurs that need that volume of money. This leads to three problems -- 1) too many copycat deals get funded as the money burns a hole in the VCs pocket, 2) VCs end up pushing more money onto entrepreneurs to raise their ownership and put more money to work and 3) smaller, very early stage deals have a hard time raising money because no VC wants to make a $1M investment.
The big funds force those investors to back into the 20% requirement, instead of making it a 'nice too have'.