Palico Blog Member Viewpoint by David Teten (Teten.com) - Partner, ff Venture Capital; Founder and Chairman, Harvard Business School Alumni Angels of Greater New York
Lots of venture capitalists claim to add value to the companies in which they invest. But how do they do it? And does it really produce better returns for their investors? We recently published in the Journal of Private Equity a study on best practices of venture capitalists in creating portfolio company value, exploring exactly these questions.
We found that certain VCs are aggressively building a portfolio operations skill set and recruiting more people with operational backgrounds. Based on a range of sources, we believe that most funds with well-developed portfolio operator models have top-quartile returns (typically above 20 percent IRR in the relevant time periods).
Given the mediocre median returns of the VC industry and the high failure rate of the typical entrepreneur, techniques to improve the odds of success are highly needed.
VCs can add more value to their portfolios by applying the “TOPSCAN” framework. It consists of:
- Team Building: Designing and recruiting for a startup’s most important asset, its human capital base.
- Operations: Enhancing administrative, accounting, legal, and technological capabilities.
- Perspective: Bringing a fresh view to strategy, competitive positioning, defining the target market, and scoping the product.
- Skill Building: Building the right skills, especially for senior management.
- Customer Development: Identifying and gaining access to the right customers.
- Analysis: Leveraging a VC’s typically much larger set of experiences to help entrepreneurs measure, understand, and optimize their companies’ performance.
- Network: The cheapest and sometimes most value-added service that an investor can provide is access to his/her network, particularly to potential investors and acquirers.
To date, we have seen more later-stage private equity funds than early-stage VC funds building portfolio operations groups. However, a company’s need for these services is greatest in its earlier life, and we forecast more VC funds building out portfolio operations infrastructure.
Our thesis that greater participation correlates with higher returns is consistent with two formal studies of angel investors: “Returns to Angel Investors in Groups” and “Prediction and Control Under Uncertainty: Outcomes in Angel Investing.” The studies both found that higher levels of angel participation - measured by number of angel hours spent per week interacting with a portfolio company - lead to better returns.
In addition, VCs (particularly those focused on Internet investments) live in a social-media-enabled world where almost every investor has a very visible public resume on LinkedIn; many have a public blog; and blogs and sites such as TheFunded.com closely track their behavior. Social media footprints make it easy for entrepreneurs to assess how much value a potential investor can add. Social media also makes it simple to reach out to those investors. Deal origination becomes very easy for firms with a strong reputation for adding value, and a strong portfolio operations team enhances that reputation.
VCs have five main resources with which to increase portfolio company value: cash, brand, industry network, funding network and in-house expertise.
- Cash. A significant operational toolkit is expensive. Given the low average returns of the VC industry, and the modest assets under management of VCs relative to the assets under management of a typical private-equity fund, many VCs simply cannot afford to invest meaningful dollars in a large portfolio acceleration infrastructure.
- Brand. The fact that a company has been funded by a well-respected fund/partner alone can increase a company’s odds of success, because that brand makes it easier for the company to attract talented employees and follow-on investors. By definition, startups have no brand at launch.
- Industry network. One entrepreneur observed about one of the most prominent VCs in America: His “default response to all problems is to email introduce you to 3 to 10 people in his network who can help.”
- Funding network. Later-stage VCs pay careful attention to the earlier funders in a company, using the reputations of the funders as a proxy for their own diligence. The next-best asset to a large pool of capital in-house is the ability to easily help raise more capital in later rounds.
- In-house expertise. VCs can provide consulting, accounting, or operational resources, both directly and from preferred service providers.
All of the resources above are synergistic, i.e. more success creates more cash, which strengthens the brand, which increases the industry and VC network, which strengthens This is one of the key reasons that venture capital is one of the few asset classes in which past performance is predictive of future results.
There are three common categories of VCs in terms of attitude and practices toward investing and portfolio company support: Financiers, Mentors, and Portfolio Operators.
- Financiers: “I’m a banker, not an operator.”
The Financiers are the most traditional group of VC investors. The relationship to their portfolio after making investments primarily consists of monitoring, and sometimes serving on board seats.The most perfect example of a Financier is Correlation Ventures, which some have called the “Moneyball” of venture capital. Even though the firm’s two managing partners are both former startup entrepreneurs, Correlation never takes board seats and has only modest operational involvement. They gain access to investment opportunities by offering a very rapid investment decision (two weeks or less), with a very low hassle process, leveraging their large investment in predictive analytics. They have $165 million in assets under management. Other examples are Right Side Capital Management and i2x.
- Mentors: “I try to be the CEO’s consigliere.”
Most VCs can be classed as Mentors. The most important asset they bring to the table is their personal and professional network, which they leverage to strengthen portfolio companies. Throughout our research, we observed many examples of this: introductions to potential customers, suppliers, partners, and executive-level employees.What distinguishes the Mentors from the Portfolio Operators, however, is that they deliberately choose not to institutionalize the support they give to their portfolio companies. Support is almost always initiated by the entrepreneur coming to the mentor with a challenging issue and does not involve preset systems or processes. As one mentor said, “My entrepreneurs have my cell and email address – and I always answer them.” As a result, Mentors assessing a new investment need to be comfortable that their input will be heard by the companies; they search for coachable CEOs.
- Portfolio Operators: “We have a structured, standard process for adding value.”
Portfolio Operators act like Mentors but in an institutionalized and structured way. Whereas Mentors tend to be reactive in their support, Portfolio Operators pro-actively look for ways to improve the performance of their investments through systems and processes. We know of numerous instances in which companies took lower valuations to win Portfolio Operator VCs as investors versus other categories of VCs, because the entrepreneurs so valued the resources a Portfolio Operator could bring to bear. In other cases, entrepreneurs have offered board options or other sweeteners to highly attractive Portfolio Operator VCs.
We find that portfolio operator VCs are building teams of employees that are unusually large for the VC industry and include many people with strong operational backgrounds. These larger teams tend to be accompanied by a transition toward pyramidal organizations.
As an example, ff Venture Capital has 20 employees on a capital base of approximately $80m. This is infrastructure more typical of a half-billion dollar firm. We believe that this large team has made our portfolio companies more successful, easily justifying the extra expense. We offer our portfolio companies extensive resources, including a job board, recruiting assistance, strategy consulting, software engineering support, PR/communications guidance, a mentor network, a pool of preferred service providers, a portfolio executive community and accounting services.
While there are highly successful examples of VC firms following each of the models, we believe a systematic focus on operational improvement has the greatest chance of success in an increasingly competitive industry.