Greycroft to Sevin Rosen: Think smaller

Sevin Rosen recently announced that it would return investors’ capital commitments for its current fund because, in Sevin Rosen’s view, the traditional venture model appears broken. The partners argued that too much capital is chasing after too few opportunities, with limited potential for exits due to a weak IPO market that shows no sign of returning.

Without a doubt, the current environment is highly competitive in the venture industry. But the model is not broken. So what is really going on here?

First, even excluding the excessive capital raised during the Internet bubble, traditional early stage venture firms have, in many cases, at least doubled or tripled their fund sizes in the past eight to 10 years without necessarily increasing their number of partners. This requires them to make much larger investments into each deal, particularly at inception, to be able to invest the fund and maintain a portfolio within the traditional fund cycles. While the incentives to manage ever larger pools of capital are clear, many of the high risk/high return opportunities exist today at valuations and with capital requirements below the radar of many venture funds.

Large funds ignore small opportunities because even stellar returns on a small investment just do not move the needle on a fund with hundreds of millions of dollars to invest. Instead, these large funds must compete fiercely for the smaller number of opportunities to invest in more established companies with larger capital requirements.

With larger funds, there is always the danger of overcapitalization, which can lead to inefficient spending and a lack of focus, driving down potential returns.”

Dana Settle and Drew Lipsher, Partners, Greycroft Partners

Get the balance right

Meanwhile, there is a dearth of capital available to very early stage companies or those that don’t require a significant amount of capital. These types of companies can present the best venture investment opportunities if appropriately capitalized. With larger funds, there is always the danger of overcapitalization, which can lead to inefficient spending and a lack of focus, driving down potential returns. Good venture capital is not just about money, but about the proper balance of investment and strategic time spent with the entrepreneur.

The second point cited for the venture model being broken is the current lackluster IPO market for growth companies. While it is true that the current IPO market is weak, given the cyclical nature of the public markets, one would expect the IPO market for growth companies to return in the next five years. Past cycles would certainly give credibility to this thesis. A strong argument could be made that this is, therefore, an excellent time to invest in order to create a pipeline of high quality opportunities for the next IPO window. The public markets have logically shied away from supporting the frothy growth companies since 2001. However, this does not necessarily limit the exit opportunities for venture-backed companies. In the absence of a public market, a compelling M&A environment has emerged as both private and public companies seek quality acquisitions to address growth objectives. Recent examples include Google’s acquisition of YouTube, NewsCorp’s acquisition of MySpace and Ebay’s acquisition of Skype.

Many of the most successful venture-backed companies have required very little capital. Examples include Flickr, xfire, and Truveo, proving that quantity of money does not ensure a successful investment.

Good venture capital is not just about money, but about the proper balance of investment and strategic time spent with the entrepreneur.”

Dana Settle and Drew Lipsher, Partners, Greycroft Partners

What the current environment calls for is a recalibrating of the business—smaller funds, smaller investments, hands-on investing and more carefully managed budgets. Those changes will align the interests of entrepreneurs, GPs and LPs. An indication of this trend is the recent increase of smaller funds founded by experienced venture capitalists. The savviest entrepreneurs understand that taking less capital from the right partners is not limiting, but rather provides them with options along the way.

Just as venture capitalists expect portfolio companies to be nimble and to react to changes in the market if needed, venture capitalists must adapt to the business climate to achieve success.

Dana Settle and Drew Lipsher are partners with Greycroft Partners, a venture fund that focuses on digital media investments. Settle may be reached at Settle@GreycroftPartners.com. Lipsher may be reached at Lipsher@GreycroftPartners.com.