Download this article, initially published in Corporate Livewire, here. Venture Capital is usually thought of as a sub-class of Private Equity designed to provide financing to emerging companies with high growth potential in exchange for equity and some ownership stake. Initially reserved to rich families, it became a professional industry thank to the Small Business Investment Act of 1958[i] and the ERISA Act of 1974,[ii] both of which allowed venture capital fund managers to access sources of capital beyond private wealth. Today, it has become a thriving industry with ~900 firms managing ~$300Bn according to the National Venture Capital Association.[iii] Venture Capital is no longer a rich man’s game, or a cottage industry, it has become a complex ecosystem. As this shift has taken place, several shrewd venture capitalists (VCs) have set themselves up in distinct segments as a way to differentiate their risk-return profile –a concept once unimaginable in venture capital. These new VCs are meeting the demand of investment managers in new ways, and generating superior returns. Who are they and what funds are they building? Here are three categories I find particularly compelling: the whale, the dolphin and the minnow. #1. The Whale: All-In, All-Alone, Swinging for the Fences. Every few years, a company emerges that will return investors’ money 100 times or more, this is what whales are designed to capture. Consider Facebook. The network effect of the platform makes it a quasi-monopoly with tremendous opportunity for growth and monetization. I had the chance to work there in the early days; it was thrilling to be part of a company with such prospects. There was a sense of urgency and excitement everywhere, so much so that employees didn’t feel they were working. Instead, they were changing the world. As a VC, it didn’t matter how much and at what valuation you invested in, you would make a lot of money and return your fund to your investors no matter what. Whales are out trying to catch the next Facebook. When they believe they have found it, they go all-in. They don’t want or need to syndicate their deal with other VCs, they go all-alone. They aren’t valuation-sensitive because they know the returns will be extraordinary, they swing for the fences. But the returns of whale funds are declining, and asset managers should be prepared for a 1.5-3X cash-on-cash multiple. So they need to carefully pick which whale(s) to invest in. I suggest they consider the following criteria:
- Bigger is better.
- Brand matters.
- Look toward Asia.
- Defensible differentiation is everything.
- Smaller is better, with co-investment opportunities for limited partners.
- Focus on Silicon Valley.