Ariva remodels early stage VC

Listening to Ajit Shah describe the model for his new venture fund, Ariva Partners, is a little reminiscent of the opening scene of Jerry Maguire.

In the 1996 Tom Cruise movie, a successful sports agent shakes up his comfortable status quo by writing a memo advising his employer to take on fewer clients. That way, he argues, agents will be able to provide more personalized service.

Shah has a similar vision for early stage investment. While early stage should be the most lucrative area of venture capital, its potential is hampered by the fact that VCs are spread too thin among too many portfolio companies. The job of a VC at that stage, Shah says, should be “to work closely with the entrepreneurs and to help them.”

While Maguire found himself the odd man out, Shah has found that Ariva, which takes its name from the phrase “a revolution in venture,” is resonating with other venture capitalists and entrepreneurs. The launch of Ariva comes at a time when some VCs have openly wondered if the traditional model for early stage VC is broken—or at least needs to be tweaked.

“This industry over our career has really changed, and one of the areas where there’s a big hole is really the early stage,” says Shah. “It’s really not practical for people who are sitting on 10-plus board seats to be investing a half a day or a day per week working with entrepreneurs in early stage companies.”

Shah, a former partner at Worldview Technology Partners, co-founded Ariva with Robert Simon, presently a partner at Alta Partners, in March 2006. Since then, the firm has recruited five industry vets as venture partners and launched a dozen companies, five of which have received institutional funding. Now Shah and his partners are pitching LPs on an inaugural fund of $100 million to $150 million.

Novelty shop

This industry over our career has really changed, and one of the areas where there’s a big hole is really the early stage.”

Ajit Shah, Co-founder and General Partner, Ariva Partners

The pitch to prospective investors centers on a smaller-is-better approach that includes some novel twists. “We recognized that the last thing the world honestly needs is yet another venture capital firm,” Shah says. “If we’re going to do this, we need to do something that’s differentiated.”

Ariva’s two key differences are its approach to portfolio size and compensation. To make sure its portfolio companies get plenty of attention, the fund limits the number of board seats to no more than three per partner. Each partner must also spend at least one day per week with each of his startups.

On the compensation front, Ariva has taken the unusual step of not paying a salary to its venture partners. The venture partners will be compensated by sharing half of the fund’s carried interest from portfolio company exits. The motive behind the pay structure is to ensure that the venture partners’ interests are aligned with those of limited partners.

Ariva’s incentive-based approach to pay bears some resemblance to the angel industry, in which backers commonly invest solely for returns rather than regular compensation. Shah says he is not aware of another venture fund that’s done away with venture partner salaries.

The pay structure holds appeal for Ariva’s venture investors—whom it refers to as “industry partners.” Says Industry Partner and serial entrepreneur Teddy Shalon: “I haven’t had a salary for the past 30 years; to me, that’s not something that’s very important. I’m interested in the upside, or the carried interest.”

(Shalon, who operates his own venture fund, called Shalon Ventures, will make Ariva his primary focus once it launches.)

Limited partners, however, won’t be saving up-front from Ariva’s arrangement. The fund plans to charge a standard 2.5% management fee to pay for office space, support staff, partner expenses and salaries for General Partners Shah and Simon. (Simon plans to leave his post at Alta Partners once Ariva raises its fund.) Shah says the fund’s decision to share more of its carry in lieu of salaries for its industry partners had more to do with creating incentives for its investment team than with saving on operating costs.

Given the time intensity of very early stage investing, limiting board seats has some real logic to it.”

Steve Dow, General Partner, Sevin Rosen Funds

A good start

Venture capitalists interviewed by VCJ had mostly positive things to say about Ariva’s plan to limit the number of portfolio companies per partner. “Given the time intensity of very early stage investing, limiting board seats has some real logic to it,” says Steve Dow of Sevin Rosen Funds, which last year chose not to finish raising a new fund due to a perceived poor exit climate and too over supply of venture investors chasing deals.

Still, limited partners would probably prefer a compensation plan that pays general partners more through carry than salary, Dow says, adding that it is “safe to say, for most of the VC industry for most of the last seven-plus years, most GP compensation has been fees.”

Ariva is set up so that each of its industry partners will get 6% of the carry on each of his investments. Ariva will also set aside 4% of its total carry in a pool to be shared by all industry partners. All of the industry partners will be allowed to co-invest in Ariva deals and be able to receive common shares for any value created in a portfolio company, a policy that isn’t typically allowed at other VC firms, Shah says.

The concept of rewarding venture partners for successful deals isn’t new in venture circles, says Paul Kedrosky, executive director of the von Liebig Center for Entrepreneurism and Technology Advancement at U.C. San Diego. Lots of firms have what he calls an “eat-what-you-kill ethos” to distributing returns. However, “institutionalizing it and make it predictable is unusual,” Kedrosky notes. “It’s usually fairly ad hoc.”

Still, Ariva isn’t the only firm raising venture partners’ share of carried interest. Over the past few years, the general trend in the private equity industry has been for more carry to move downstream from general partners to others in a firm. While early in the decade close to 90% percent of carry typically went to GPs, recruitment firm Glocap Search projects that 75% to 80% will be a more common range as venture firms seek to retain and motivate their most talented members.

Expert opinion

People used to ask me, ‘How many boards is too many?’ I’d say, ‘One’ if it’s the wrong one.”

Ari Ginsberg, Professor, New York University’s Stern School of Business

Like Shalon, Ariva’s five other industry partners each has a background as a senior executive or company founder. They include Andy Ludwick, former CEO of Bay Networks, which was acquired by Nortel; Mike Pliner, co-founder of software developer Verity; Kumar Ganapathy co-founder of VxTel, which was acquired by Intel; and Sass Somekh, former president of semiconductor equipment maker Novellus.

The Ariva team also includes an advisor, Jeff Clavier, who writes a popular VC blog and has his own venture fund called SoftTech VC.

In comparison to its innovative approach to paying partners, Ariva’s strategy for investing in startups is decidedly old school.

The firm plans to begin investing at the seed stage, with funding rounds of as little as $500,000. For later rounds, it plans to partner with top-tier venture firms and corporate investors. Ariva will cap its total investment in a single portfolio company at around $8 million. Focusing on seed and Series A, the firm’s founders say, makes sense from a “show me the money” perspective.

“The best returns come from having a large ownership percentage in a market-leading company,” Shah says. “And the way you do that is you’ve got to get in early.”

For the past year, Shah and Simon have been giving the Ariva model a trial run. One early investment was Virident Systems, which is developing low-power servers for Internet applications. Another was Osteogenix, a developer of bone therapy products incubated by Shalon and later folded into the Ariva portfolio.

A couple of Ariva’s companies, both stealth mode IT startups, have already attracted follow-on investments from large funds: Astor Data, which industry partner Pliner has been working with for about a year, raised funding from Sequoia Capital earlier this year. And Asterpix raised money from New Enterprise Associates late last year after getting funding from Ariva several months earlier.

I haven’t had a salary for the past 30 years; to me, that’s not something that’s very important. I’m interested in the upside, or the carried interest.”

Teddy Shalon, Industry Partner, Ariva Partners

Help wanted

Ariva’s entry into the venture fray comes as VCs are putting a smaller portion of investments into early stage deals. In the first quarter of this year, investments in seed and early stage companies totaled $1.1 billion, down 30% from the same period a year ago, according to the MoneyTree survey by PricewaterhouseCoopers, the NVCA and Thomson Financial (publisher of VCJ). Meanwhile, investments in later stage companies increased significantly in the first quarter, with $3 billion going into 245 deals—the largest dollar amount in over six years.

One reason less venture money is going to early stage is that partners at larger funds don’t have the time to manage investments in a large number of immature startups, says Stu Phillips, managing director at Ridgelift Ventures, an early stage fund. Although some of the seed-stage shortfall is covered by angel investors, “I think there is a vacuum at the true early stage,” Phillips says.

Shah maintains that most large funds aren’t well-suited for nurturing early stage companies. A VC who’s working with a dozen companies, he argues, doesn’t have the ability to give a seed-stage startup the attention it needs.

Academic studies on the relationship between portfolio size and returns indicate that limiting the number of investments per partner can boost profits, says Ari Ginsberg, a professor at New York University’s Stern School of Business. He cited a 2001 study by researchers in Finland and Switzerland that found that the optimal portfolio is small enough for VCs to play a significant advisory role with each company in it.

Just how many companies an optimal portfolio should contain, however, is harder to pin down, Ginsberg says. It depends on such factors as whether a VC firm took part in a round on its own or if the deal was done in syndication.

It’s also hard to tell just how much time a startup will require. While limiting the number of portfolio companies and board seats may seem like a sensible way to lighten one’s workload, that’s not always the case, says Phillips.

“People used to ask me, ‘How many boards is too many?’” he says. “I’d say, ‘One’ if it’s the wrong one.”