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July 11, 2012

The Rise & Fall of Great Venture Firms [Part 1]

I happen to be fascinated by the history of the VC industry, and one
of the things we discussed at a recent offsite are the common threads
behind the rise and fall of great venture capital firms.  NextView’s
still in its infancy… we’re barely two years old and are just part of
the way through investing our initial fund.  But we strive and aspire to
build a firm that will excel and be around for awhile.

Many of the great VC firms of today have been around for decades.
 Firms like Sequoia, Greylock, Bessemer, and others.  One can study some
of the factors of their success and of course try to emulate them or
integrate their best practices.  I’ll save these for a follow-up post
because I think there are some interesting take aways and also some
firms that have found hacks to either propel success or avoid pitfalls.

But there are firms that were once great and have declined to various
extent with the passage of time.  There are also VC firms that were
once among the industry’s elite that no longer exist.  You can learn as
much from these cautionary tales as you can from the enduring successes,
plus studying a broad sample of firms helps avoid drawing false
conclusions due to survivorship bias.  The names of these once great,
now defunct firms may not be terribly familiar today but here are just a
few examples:

  • American Research & Development [Boston] –>
    Founded by George Doriot and depending how you count it, either the
    first or second formal VC firm in the US.  Big success was Digital
    Equipment Corporation (DEC), in which ARD invested about $2.1M in equity
    & loans which was ultimately worth >170x ($355M) when DEC went
    public about a decade later.  Some disgruntled younger partners left to
    go start a new firm in 1965 called Greylock.
  • Brentwood Associates [Silicon Valley] –> Founded
    in the early 70s and focused primarily on VC, Brentwood had big wins in
    both IT like Wellfleet Communications (big chunk of what eventually
    became Nortel) and WebTV (part of Microsoft) and healthcare (various
    businesses that make up a big chunk of what is now Medtronic and
    Baxter).  Some disgruntled younger partners left in the 90s to form what
    is now Redpoint Ventures (IT team) and Versant Ventures
    (healthcare team).  Brentwood also had a PE/buyout group which has
    continued on to today, still with the Brentwood name, with notable
    success in consumer retail businesses.
  • Burr, Egan, Deleage [Boston] –>  Huge wins in
    the 1980s and early 90s included Continental Cablevision (sold for $5.3B
    – now a big chunk of what is Comcast), Qwest Communications, Cephalon
    (biotech IPO, acq by Teva), and Powersoft (Burr, Egan made 35x when it
    went public and then was acquired by Sybase).  The firm ultimately
    disbanded after nearly 20 years and younger disgruntled partners went on
    to spawn Polaris Ventures, Alta Communications, Alta Partners, and Alta Berkeley.
  • Merrill, Pickard, Anderson & Eyre [Silicon
    Valley] –> Itself an outgrowth of the venture investing arm of the
    original Bank of America (based in SF), Merrill Pickard backed many
    startups that ultimately went public.  Some disgruntled younger partners
    left in the mid-90s… two co-founded Benchmark Capital (Bruce Dunlevie & Andy Rachleff).
  • Technology Venture Investors [Silicon Valley] –>
    Claim to fame… sole VC investor in Microsoft, which turned out ok.  But
    eventually some disgruntled younger partners left and two started August Capital (Dave Marquardt & John Johnson) and one co-founded Benchmark (Bob Kagle).

So what are the common threads that lead to a fall from grace?  I
don’t mean to pick on the firms above… they each achieved remarkable
success in their own right.  But each eventually faded from existence
and in studying these and other examples three general themes emerge:

1) Generational Succession / Division of Economics
- This is arguably the chief reason why some great VC firms eventually
stumble.  It’d be easy to just chalk it up as “the old guys are greedy
and the young guys are greedy/impatient” and see this issue as an
incurable human failing.  But it’s not quite that simple.  What’s a
“fair” split of fee income and carried interest when a partner joins
several years/funds after others?  Should there be a notion of “founder
equity” for those individuals who put in the hard work to start a firm
and build the brand?  How do you deal with a severely uneven
distribution of investment success between individuals or groups of
partners?

Dividing economic pies and handing
leadership off between different cohorts of individuals is rarely easy,
but the nature of the VC business makes it particularly tricky.  For
example carried interest takes years to accrue and is based on the
efforts and decisions of both the individual and the firm that happened
5-10 years ago.  And the economic rewards of VC comes almost exclusively
through the carried interest and fee income generated by individual
funds.  While ownership and control of the management company matters,
these stakes are rarely monetizable at least in the VC business (unlike
the buyout world where huge firms like Blackstone, KKR, and Apollo have
IPO’d to the great financial benefit of the founders).

But just because it isn’t easy doesn’t
mean it isn’t incredibly important.  Firms where there ends up being a
material imbalance between which folks are putting in the hard work and
generating investment returns versus those that aren’t put themselves at
huge risk of decline.  There are some great news stories from the mid
90s like this one in Wired and this one in NYT regarding
generational conflict (generally centered around economic
disagreements).  And sometimes generational succession fails not because
older partners are unwilling to reach equitable economic arrangements
with younger ones, but simply because the newer partners they bring in
simply aren’t as effective as the old guard.

While this is a key driver to the
downfall of great VC firms, there are also small handful of examples of
firms that have managed generational succession sometimes many times
over.  Greylock is probably the best example of this… there are at least
four meaningful transitions of leadership over the firm’s nearly 50
year history that have gone pretty darn well.

2) Falling Behind Innovation Shifts -
Strategy drift, i.e. expanding into unfamiliar stages, sectors, and
geographies of investment is a real problem (see #3 below).  But
separate from mission creep / strategy drift is failure to keep up with
changing waves of innovation.  On the IT side of VC investing, we’ve
seen countless waves crest and fall… mainframes to
minicomputer/workstation, workstation to PC, copper to optical
networking, client/server software to cloud, the fabless semiconductor
model, magnetic tape to hard drive, etc.  VC firms that have been unable
or unwilling to stay ahead and abreast of these waves start to lose
their prominence (at best) or go the way of the dodo (at worst).

There are a number of VC firms that had
extraordinary success in enterprise software, telecom equipment, and
semiconductors in the 1990s.  And while the internet created both
tremendous reward and tremendous investment carnage leading up to and
after the 2000 tech bubble, it’s created long run disruption of broad
sectors of media, advertising, business software & computing, and
retail commerce and VCs that missed this shift have faced real
struggles.  As a corollary the VC industry has matured in ways that
greatly favor sector specialization, so at both an individual and a firm
level prior “generalist” models have generally performed less well.

3) Strategy Drift / Over Expansion -
Many of the largest and most successful firms around today have become
“platforms” in that they are investing in a wide range of stage, sector,
and geography whether through a single fund (e.g. NEA, Bessemer) or
family of related funds (e.g. Kleiner).  Depending on your POV Bain
Capital didn’t start as a pure VC firm, but they’ve been making VC and
growth equity investments since the firm’s inception and arguably
they’ve been among the most successful “VC” firms at platform expansion
over their nearly 30 year existence (buyout, pure VC, mezz debt, hedge
fund, international, etc).

But for every firm that’s successfully
grown beyond their core strategy into a platform, there are 3-4 that
have been unsuccessful at it.  The impulse to expand beyond the strategy
that makes you initially successful is powerful.  To a lesser extent
the desire for greater industry prestige is a factor.  But primarily
it’s the allure of growing assets under management (AUM) by raising
larger/more funds since financial reward for VCs is tied to AUM.  The
fixed ~2% management fees of course scale directly to AUM but the
performance based ~20% carried interest also scales with AUM.

Here’s a slightly perverse scenario… Acme
Ventures starts out as an early-stage VC investing in US-based IT
companies.  They achieve an excellent fund-level return on their $100M
debut fund of 4x gross (i.e. they generate $400M in proceeds from that
$100M).  That means the partners of Acme will have $60M in carried
interest to divide among themselves (20% of the $300M profit).  But then
Acme’s partners say to themselves… “Aha, based on our success at
early-stage US IT now we can raise a $500M fund that will do late stage
investments, and also do cleantech investments, and maybe some in
China.”  Even if they deliver a mediocre 2x gross return on that $500M,
they’ll actually generate more absolute dollars of carried interest
($100M in this case) than they did with their much more successful
early-stage IT fund in addition to generating more management fees.

But usually what makes a VC partnership
great in its early days doesn’t easily translate into other new
strategies down the road.  You either start trying to invest in stuff
you know less well or you hire a bunch of other partners who you hope
know that stuff better than you.  Like any other form of diluting your
focus… it occasionally works, but usually doesn’t.

So if these are the factors that lead to the fall of once great VC
firms, what are some of the common aspects of their rise to success?
 I’ll tackle that question next week in a follow-up post.

Lee Hower is a Partner & Co-Founder with NextView Ventures.  You can find this blog post, as well as additional content on his blog called AgileVC.  You can also follow Lee (@leehower) on Twitter by clicking here.

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