Small is Beautiful

By Todd Pietri

The early-stage venture capital industry needs to change the way it operates if it is going to maintain its impressive historical returns of 19% compounded for the past 20 years. Otherwise we are at risk of turning the venture industry into an asset-gathering and fee-generating machine like the mutual fund industry, an outcome we will all regret. The real problem is that our industry overfunds too many early-stage companies. The current norm is to invest $5 million in a first round and $15 million in follow-on rounds, which is too much money for the vast majority of companies.

Looking back to the 1980s and early 1990s, the data shows that venture capitalists used to invest a little more than $3 million per first round on average and over the life of the company a total of perhaps $5 million.

In other words, the amount of money invested per company today — even when you adjust for inflation — is alarmingly high. It is at least 3 times what it used to be.

Now I admit that if a company is thriving, the smartest thing to do may be to raise a ton of capital. This is true, for example, when a company is fortunate to enough to be in a large growth market with tremendous demand for its products and services, but there exists only a short window of time to capitalize on the opportunity.

The problem, of course, is that very few entrepreneurs — and very few venture capitalists, for that matter — want to admit that their company is not one of those fortunate few that merit a large capital infusion.

Like the children of commentator Garrison Keillor's Lake Wobegon, every company is considered "above average."

Therefore, too often the preferred course of action is to build expenses much faster than revenues, even when valuation has hopelessly outpaced the underlying fundamentals of the company. The hope is that somewhere down the road, the gods will be kind and everything will all work out as planned.

There are several reasons why this line of thinking generates lousy shareholder returns.

First, financial common sense tends to evaporate when a large pile of money is in the bank. The virtue of having very little money as a young company is that it focuses the mind, inspires resourcefulness and promotes wise decision-making.

Once the wire transfer clears, however, management can easily lose focus by pursuing new markets, new products and acquisitions before there is a rational business case.

But there is also an equally vexing structural problem with overfunded companies that presents a stark new reality venture capitalists must contemplate going forward: The venture capital market is in the process of reverting to its historical mean in terms of exit values.

When median initial public offering valuations for venture-backed companies crested above $300 million in 1999, it didn't matter if a company raised an extra $15 million or $25 million of capital; returns of 5 to 10 times were still very achievable, and the payoff came so soon that all interested parties were euphoric.

But if median venture-backed IPO valuations return to their historical norm — which I believe they will — of between $70 million and $110 million (total value), where they were from 1994 through 1997, then companies that raise more than $15 million of venture money are going to have a very hard time generating 5 to 10 times returns for their investors.

The historical mergers and acquisitions market paints an even worse picture. From 1994 to 1998, average venture-backed valuations for M&A transactions ranged between $45 million and $70 million. The outlier years were 1999 and 2000, at $156 million and $221 million, respectively. Given that 90% of exits for venture-backed companies are M&A events, not IPOs, an extra $5 million of unnecessary capital that goes into a company can make or break an attractive return.

We believe the market for small transactions, those between $1 million and $4 million, is the least competitive and thus the most attractively priced segment of the venture capital market. That's because there are very few firms that will consider such small investments.

In the context of that strategy, the best companies are those that have the option to build growing, profitable enterprises and generate 5 to 10 times returns from exits under $100 million in value with one or two modest rounds of investment.

As a result, we believe the brightest future of the asset class belongs to small funds and cheap entrepreneurs.

Todd Pietri is co-founder and general partner of New York-based Milestone Venture Partners.  Reprinted with permission from the January 10, 2005 issue of The Deal

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