The Big Squeeze Part II: How VC Firms Are Coping –

For the past two years, venture capitalists have been preaching the gospel of fiscal discipline to their portfolio companies. From recommending mass layoffs to foosball table removals, investors have urged portfolio company management teams to leave no cost-cutting stone unturned. Then they have walked out the door, electronically paged a car service and been ferried to the airport for some first-class travel.

Today, however, many venture firms are finally beginning to analyze their own rapid burn rates and bloated expense budgets. Chalk it up to good business sense and pressure from limited partners.

“The VC industry as a whole is beginning to look inwardly,” says Tom Crotty, general partner with Battery Ventures. “It’s a case of us taking our own medicine.”

The changes are not revolutionary, but they are significant from a budgetary perspective. Firms are canceling offsites, moving to lower-cost digs, cutting travel budgets, using electronic data delivery to cut postage costs, and more. For any one firm, the annual savings can be in the hundreds of thousands of dollars.

Battery Ventures, for example, is cutting back on marketing expenses, like the $50,000 it normally on spends to co-sponsor an annual tradeshow. And while it has traditionally hosted its annual meeting at an expensive Florida resort, it will treat its limited partners to something closer to the Wellesley, Mass.-based firm’s home office this year.

An even more dramatic decision has been made at New Enterprise Associates of Palo Alto, Calif. Unlike Battery and most other venture shops, NEA has a nine-person investment committee – made up entirely of the firm’s largest limited partners – that works with the general partners to establish an annual budget.

Before the start of this year, the investment committee and general partners agreed that two items on the 2002 budget were expendable. One was the firm’s annual offsite meeting, while the other was a formal get-together for NEA portfolio companies. The offsite was canceled altogether, while the so-called President’s Weekend was made a bi-annual event and postponed until 2003, saving NEA “hundreds of thousands of dollars,” says Dick Kramlich, general partner and co-founder. The firm has also begun using a WebEx video conferencing system and cut down on photocopying costs by letting LPs download certain documents electronically.

NEA keeps an especially close eye on its checkbook because it pays back all operating expenses at the end of each of its funds, keeping only the 30% carried interest. Due to that structure, it was unable to draw down $65 million in fees last year, Kramlich says. But you won’t hear him complain. “If we don’t do a good job, we ought to get dinged for that,” he says.

Another firm wary of spending its investors’ cash is Seattle-based Voyager Capital. The group has a 2.25% management fee on a $215 million fund raised in 2000, but doesn’t call down the money every quarter. Instead, it only takes what it needs and defers the rest. At the end of last year, Voyager was nearly two full sets of fees behind the official schedule.

“A huge forest fire came through and burned everything to the ground [in the land of high tech]. But the bigger the fire, the healthier the forest comes back. We started nine companies last year and we will probably start another 15 this year.”
Bill ElmoreGeneral PartnerFoundation CapitalYears as VC: 16

While partners at many venture firms have begun treating management fees like top-flight salaries, Voyager has kept frills to a minimum. Not only has it avoided costly room rental fees by holding its annual investor reception at an LP’s country club, but its Seattle-based partners don’t stay in fancy hotels when they travel into Silicon Valley. Instead, they all stay in a guesthouse behind the Woodside, Calif. home of Curtis Feeny, a Voyager managing director who runs the firm’s Palo Alto, Calif.-based satellite office.

“It may sound a bit strange, but travel to and from the Bay Area has increased, so it saves us a lot of money over the course of the year,” says Bill Hughlett, vice president of finance and CFO with the firm. “We also don’t do things like rent boats for parties, go out to many expensive lunches or fly first class.”

Voyager also spends little on marketing, has reduced its amount of office space and has cut down its headcount by eliminating a handful of administrative positions, such as an internal recruitment officer.

Real estate can be a real killer. Silicon Valley VCs still like the cache of being on Sand Hill Road, but a growing number of them are deciding it’s more important to save money on rent. Storm Ventures, which raised a first fund of $310 million last year, gave Sand Hill a look but decided to lease space on the second floor of a nondescript building off of bustling El Camino Real in Palo Alto. “We’re paying about half the price,” says Sanjay Subhedar, general partner and co-founder.

If Storm had signed on the dotted line at Sand Hill two years ago, it would have been on the hook for $25 a square foot, and it would have taken only as much space as it needed. By going with the Palo Alto locale, at $12 a square foot, it was able to lease 7,000 square feet – enough space to bring in entrepreneurs to incubate startups. It has started three companies under its roof since it began.

While it is certainly true that any venture firm with an active fund has a guaranteed revenue flow, the way in which management fees are structured is central to the overhead-cutting conversation. This is why the strategies of NEA and Voyager Capital are as important as where they hold their next investor gathering.

Assuming that a venture firm does not reduce its fund size or management fee, any cut in the firm’s overhead may be viewed by LPs as a case of getting less bang for their buck if the firm doesn’t reduce its overall fee.

Such a concern is especially salient when it comes to layoffs or ousting partners, a pair of cost reduction measures that are becoming increasingly popular within the venture industry (see chart, page 30).

“We recently got a letter from one of the funds we invest in telling us about how they were saving money,” says Larry Mock, president of Mellon Ventures, a venture capital affiliate of Mellon Financial Corp. that makes direct investments and is an LP in about 50 venture funds. “They seemed to be proud of it, but for us it just makes us wonder where the extra money we pay is going [because the VC hasn’t reduced its fees].”

“We went to our portfolio companies and told them to hunker down and reserve cash for going forward. Our objective for 2001 was simply to have our companies survive. This is also not a bad goal for 2002.”
Kevin LandryCEOTA AssociatesYears as a VC: 35

Mock is particularly sensitive to overspending because he claims to have kept his group’s operating expenses at less than 1% of Mellon Venture’s $1.3 billion capitalization. While it is true that he gets breaks on real estate from the parent company and doesn’t have to deal with hundreds of institutional investors, Mock also saves his group money by emphasizing carried interest rewards over base salaries for his 22 deal professionals. Even starting associates at Mellon Ventures get cut in on the deal.

Some venture firms, particularly those with GPs who are also LPs in their own funds, have set up performance milestones to ensure that fees aren’t excessive. Storm, for example, draws a 2% fee, but if it returns a certain amount of capital, it can raise the fee to 2.5%. It’s a good carrot, “because smaller funds like us really need the management fee,” Storm’s Subhedar says. Storm employs 12 people, including four partners.

While the venture industry is taking steps to reduce costs, there is one area that has not been affected: salaries. “Compensation has stayed fairly consistent in terms of starting salaries,” says Adam Zoia, founder and senior managing partner of executive recruiting firm Glocap Search. “Salaries are very sticky downward, although it’s possible that there may be a bit of a change at year-end.”

Salaries have continued to climb even as VC firms struggle to cut costs. The base salary for general partners last year reached $785,400, up 15.3% from $680,769 in 2000, according to the 2002 “Private Equity Compensation” report co-published by Venture Economics and Glocap Search. Add in an annual bonus, and total compensation for GPs, excluding any carried interest reward, hit $1.13 million last year compared with a total compensation package of $946,769 for general partners in 2000 (see chart below).

Since the bulk of any venture capitalist’s compensation is derived from the carry on an active fund under management, those figures may not accurately reflect what’s going on inside venture firms or how well the partners are doing. Salaries may even have gone up to compensate for carried interest that went down with the close of the IPO window and the frigid M&A market.

Zoia adds that cutting overhead through layoffs has happened more among partners than associates. “The sentiment seems to be that there are certain people who the partnerships wanted to get out anyway, and justifying it as saving money is a good excuse to do so,” he says.

It really comes down to the manner in which a venture firm pitches its cost-cutting rationales. If it can convince investors that the savings are really doubling as improved efficiencies, then it will likely avoid LP complaints. In other words, call your new corporate LAN system a way to reduce man-hours spent on photocopying. Say that you’re not sponsoring a conference because you’d rather have your analysts sourcing deals than handing out brochures. And, if all else fails, remind LPs that they invested in you because you know how to raise the bottom lines at your portfolio companies, by any reasonable means necessary.

GeneralPartner Principal SeniorAssociate Associate Analyst
2001 Base Salary $785,400 $192,464 $116,437 $104,587 $65,720
2001 Bonus $342,000 $117,807 $72,153 $64,404 $44,479
2001 Total* $1,127,400 $310,271 $188,590 $168,991 $110,199
2000 Base Salary $680,769 $194,909 $103,250 $98,138 $58,343
2000 Bonus $266,000 $175,962 $54,829 $43,446 $32,746
2000 Total* $946,769 $370,871 $158,079 $141,584 $91,089
* Total compensation exludes carried Interest.
Source: Venture Economics/Glocap Search 2002 “Investment Benchmarks Report.”

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