It’s about the People, People

This is motivated by the Alok’s post on “Miniaturization of VC” that asked what technologies would enable VC’s to manage a large portfolio of companies to moderate exits. My contention is that for such companies no armchair quarterbacking will suffice, no matter how good the remote control is.

It is all about human capital – the team. When you build a company, to get reasonable odds of success, you need an outstanding team. The traditional model has been to get the core team together, go raise a pot money and then use that money to hire the rest of the team. This works for companies that are clearly going to go big or go bust – building an electric car for the masses, building a two way GPS system, building a 4G network, or even our very own Sanjay’s Eko project. But for companies that will require small investments and have moderate outcomes it is very hard to go down that path any more.

The reason is simple – Everyone wants to be a founder and no one wants to be an employee.

If all it takes to start something is an idea (everyone has one), a small amounts of money (maybe just go without a salaries for 6 months), and skills. Then the real barrier to entry is skills. Anyone that would make a good hire has skills. So they think – I have skills, I have an idea and I can go without a paycheck for a while and my uncle can put in a bit of money. Hey, I should do a company myself. It is much easier and more fun to nurture your child than someone else’s.

So a company that is going down the path of small investment, moderate exit will find it hard to build a team, even if they have the money they need to pay their employees a decent salary. Hence the abundance of founders and absence of employees.

Now switching to the investor side.

I have a lot of VC friends who have gobs of talent and energy but as an industry the VC’s have one broad core competency. Their ability to get institutions (pension funds etc) to trust them with 100’s of millions to invest. A small set of VC firms (less than 10) have a repeatable process of discovering and nurturing big hits. None have the human capital required to make many small investments and take them to many moderate exits and they most likely will not change their stripes.

The reason is simple – Their model is a hits centric model and it is very comfortable. Today a majority of VC’s are making most of their money from fees and not from the 20% carry (their share of the proceeds the fund gets from successful exits) and they are still living a good life.

For a VC firm to exist it must have the ability to raise gobs of money and they do. They then pay themselves a fee of 2% annually. So if you raise 200M fund (which in the US is not a big fund) then they get 4MM annually as a fee from which they pay themselves salaries. If they can keep the number of partners low then they can pay themselves great salaries and they do. Hence there is little lifestyle risk if they fail to execute, they still get a decent salary.

For VC’s to accommodate many small investments that result in many moderate exits they will have to lower the size of their funds by 10X or increase their number of partners. Consequently they will reduce their salaries substantially and increase their dependence on the “Carry” for their lifestyle. This is not going to happen unless there are no places to deploy large sums of money.

It is much better for a VC to find new places to deploy large chunks of money and continue to enjoy a good risk free lifestyle than find a way to change their stripes and deploy across a large number of moderate exits and put their lifestyles at risk. The best VC’s will find these opportunities and some but not many will be in web 2.0.

We created Tandem Entrepreneurs to address this class of company. Tandem has efficent deployment of human capital at its core. We are often confused with small funds. But these fund are often just VC’s with one partner or organized angels. Neither deal with the human capital issue. The best model for these funds seems to be to make many small bets. In some sense create an index fund of startups. It is a reasonable idea and one that has brought success to Ron Conway in the past.

We try and make it clear than Tandem is not a VC or an angel fund, but are a team with money from a powerful network of individual investors.

Since we invest human capital, this makes the number of deals we can do small , else we will be spread too thin. The areas we can invest are also narrow (based on where we can successfully add sweat and bring an unfair advantage of some sort – an edge). But when we do invest we serve as the extended team and address the human capital (team) problem as well as the financial capital issue. We make it possible to keep the number of people sharing the pie small, making it possible for the founders to make their million(s) with a moderate exit of 10-20MM and in a short period of time. The door to a big exit always stays open.

I think it is a great time for entrepreneurs to start companies but entrepreneurs need to think carefully about how they are going to build their team. A startup could succeed with an incomplete or subpar team, but they would have to be extremely lucky. Startups also need to be realistic about their exit value. I can make almost anything look big on paper but the inconvenient truth is that 85% of exits are less the 50MM.

Technology has been a big enabler for creating this environment. Amazon’s EC, Open Sources software, Social network api’s, Hosting services like Engine Yard all lead to startups not needing much in the way to enabling infrastructure and if it isn’t there today it will there soon. At Tandem we have made 3 investments in the last 3 months and not one of them has a machine to its name outside the founders’ laptops and their budgets for software spend is next to nothing.

Here is data showing a nice paycheck inspite of dismal returns

VC Compensation: Rising

Private Equity Returns : Somewhat Questionable