Is The VC Model Broken?

Sevin Rosen Funds has indefinitely postponed fundraising for its tenth fund, which had been scheduled to hold a first close this week. This is being treated as big news in VC circles – particularly among the battering blogbobs – because SRF is not citing the typical excuses of partnership strife or fundraising difficulties (i.e., Mobius, Worldview, etc.). Instead, it claims that the VC model is “severely damaged,” and that it will not raise additional capital until it funds a responsible solution.

Please forgive my impertinence, but SRF is wrong in its premise. The VC model isn’t severely damaged. It’s the VC firms themselves.  

I spent 40 minutes on the phone last night with Steve Dow, a general partner with SRF for more than two decades. He elaborated on a letter sent last Friday to prospective limited partners, in which SRF argued that the exit environment for VC-backed companies has fundamentally changed for the worse. Part of the blame will sound familiar to those who read last week’s discussion with MPM Capital’s Paul Brooke, in that VC-backed IPOs have been hindered by (A) Spitzer-promopted separations between I-bankers and analysts and (B) Impatient hedge funds becoming larger IPO buyers than more patient mutual funds.

 

Dow also does not believe that the M&A market can adequately make up for IPO market failures, because VCs have created a buyer’s market by over-funding just about every sector. Sure there are a few homeruns, but a surprisingly high number of M&A deals actually are $1 dispositions that don’t get included in the quarterly “disclosed value” data. And, without a viable exit market, VCs are setting themselves up for a second-straight decade of cash-on-cash losses (which could begin in 2008). SRF doesn’t want to be a party to that.

 

All good points, and ones that have been raised previously by Battery Ventures founder Howard Anderson, Matrix Partners founder Paul Ferri and Greylock partner Bill Hellman. The key difference, however, is that both Matrix and Greylock keep raising new funds, while Anderson continues to invest in them as an indivudal limited partner (even though he officially said “Goodbye to Venture Capital,” after shuttering YankeeTek Ventures).

 

Why? Because Anderson, et all realize that a strict early-stage discipline – with just a few opportunistic expansion plays — can still produce strong results. Even Dow acknowledges that some of SRF’s best hits lately have come from companies that it seeded, not from ones it jumped into bed with at Series B or Series C. Too many firms have spent the past few years rushing downstream in the name of risk aversion, without realizing that the water is actually safer up above. These shops might get shaken out when all is said and done, but that’s more on them than on the VC model itself (which they abandoned).

 

The exit environment is undoubtedly tough, but early-stage investing means that you don’t need your average exits to be quite so enormous (since your starting valuations are lower). This opens up plenty of alternative exit avenues, including reverse mergers with public shells, AIM-listings and sales to small-cap or mid-cap buyout firms. Marry a few of these with one or two homeruns – which VC funds of any era have required for success – and you’ve produced strong ROI for your limited partners.

 

I think that Dow and SRF realize all of this, and perhaps just began fundraising before giving the matter enough thought. SRF is properly asking investors for some alone time before returning to market, and I think that SRF’s LPs will stand by their firm. But, as always, there there will be some roadblocks:

 

  • SRF wants to add some young talent, to deal with pending succession issues. The difficulty, of course, is that few promising VC prospects are going to join a firm that offers no new fund carry in its foreseeable future. Dow seems unfazed by this prospect, and in fact claims that SRF’s decision in this matter will make the venerable shop even more attractive. Unless the average VC begins valuing market philosophy over compensation, I don’t see this happening.
  • There also is a concern that other VC firms could begin picking off existing SRF partners. Dow also is not worried about that, saying that the current group is remaining intact (save for Steve Domenik, who previously announced his intention to leave).
  • Finally – and this should be the most worrisome issue for SRF – I wonder if LPs will, indeed, come back. Why? Because SRF still has enough Fund IX dry powder to add between six and eight new portfolio companies, plus lots more for follow-on investments. If the VC model is so broken, why keep investing? Isn’t SRF throwing good money after bad? Dow didn’t really have an answer for that one, and my guess is that more and more LPs will be asking it as the firm’s self-examination goes forward.