Success Breeds Success
A couple weeks ago I attended the annual meeting for HRJ Capital. HRJ stands for Harris (Barton), Ronnie (Lott) and Joe (Montana), the three principals of what was formerly known as Champion Ventures. One of the panels at HRJ's annual meeting was made up of limited partners in their funds. The panel was intended to give HRJ's investors' perspective on the current market and included principals from Cornell's endowment, the Henry J. Kaiser Foundation, GIC and Regis Management.
As part of the conversation, the LP panelists were asked whether they were still looking at potential investment in funds run by "emerging managers" (aka new funds). While they all stated that there was a certain appeal to getting in early with funds that might be successful in the coming decade, they were all equally skeptical that they had sufficient data to judge such emerging managers and pick the ones who would shine in the coming years.
Bob Burlinson, a Stanford classmate of mine and head of Regis Management Company, made an interesting observation. He said that he judged Venture Capital firms by 4 criteria: 1) their ability to attract interesting entrepreneurs; 2) their ability to recruit great teams; 3) their ability to assist with future financing for their portfolio companies; and 4) their ability to deliver beta customers. Given all that, Burlinson concluded that it would be very difficult to find emerging managers who he believed could meet all of those criteria.
While Bob's criteria are perfectly reasonable ones, I suspect that the very best way to judge the likely success of any venture firm (emerging or otherwise) is to look at its track record. Past success is an excellent indicator of the ability of a firm and its members to pick lucrative deals. That is not only because past success suggests a certain amount of prescience when it comes to picking winning teams and technologies but, perhaps more importantly, because it makes that firm more likely to meet all 4 of Bob's criteria: 1) VCs who have invested in successful companies in the past attract a larger number of potentially interesting new deals to look at; 2) a track record of success makes it easier for a VC to recruit executives into the next Microsoft (if you're August), Amazon (if you're Kleiner), Yahoo! (if you're Sequoia), etc. ; 3) just as VCs like to bet on entrepreneurs with a history of success, later stage investors like to follow venture funds with a history of success, making future financings less difficult; and 4) successful VCs tend to have deeper relationships that make it possible to line up relevant beta customers (perhaps those successful companies in which that VC has invested in the past).
I do not mean to suggest for a second that a firm with a storied past will always outperform a new fund. History has shown that great firms can have underperforming funds and emerging managers can deliver spectacularly. After all, all firms and investors with a great history were at one time or another emerging managers. Placing money early with an emerging manager who can meet the above criteria may result in dozens of highly profitable years for an investor. But putting money with a firm that has consistently outperformed its peers over a long period of time will assuredly be the best bet to make -- assuming you are able to make it.
Theoretically, I buy off on the argument that firms with a history of repeated success can attract top tier teams. It makes sense. If the guys from Google have a new idea after their current success, in all likelihood, they won’t be calling up Joe’s Auto Body Shop and Venture Firm for the money. That being said, what defines top tier teams? Is prior entrepreneurial success the sole marker of a successful team? Are there not new technology leaders being born everyday, or do the experience-rich get richer and those without a track record of creation destined never to innovate? What about the entrepreneurs themselves? What about when they go out and raise funds? There are too many scenarios that I can envision that could give rise to a new breed of top firms to think that what always was always will be. If a top tier operating group from Cisco decides they want to go out and be VC’s, is anyone to argue that they have better inroads to Cisco than they do? Plus… what about the technology itself? Is technology acceptance and purchase a matter of personal connection or does technology win on its own merit?
The other thing I have an issue with is that half of these top tier firms have serious transition issues. Is it the brand that attracts the entrepreneurs or the partners themselves? And what happens when Vinod Khosla goes and spends more time with his family. Does the partnership suffer or does it even matter who calls an entrepreneur from Kleiner, as long as they actually work at Kleiner?
“Putting money with a firm that has consistently outperformed its peers over a long period of time will assuredly be the best bet to make -- assuming you are able to make it.” Maybe true, but what is a long period of time? How many firms made their name during the mid 90’s period based on companies that may not even exist today? Does performance from the 80’s count and to what degree? Do two top quartile funds make an outperformer? Three? If that’s the case, how many funds indicate a broken model? There are many “top performing” brand names that haven’t had a good fund since the ’96 vintage.
In all honesty, I don’t have all the answers here… just a ton of questions. The cynic in me believes that what really makes the top tier funds a safe bet is the NY Times Test. Should I find a way to get into the next Sequoia fund, and that fund loses half my money, people would be hard pressed to blame me for making a mistake with that decision ex-ante. Is there such a thing as a smart decision with a bad outcome?
As I say, just because I believe that track record is the best indicator of future success, it does not for a second mean that it is the only indicator. There will be new interesting funds that emerge periodically. And there will be old successful funds that die quiet (or not so quiet) deaths. But I think that you are wrong about the top performing brand name funds not having good funds since the mid-1990's. While the best brand names may occasionally have a mediocre fund (certainly many of the 2000 vintage funds will not result in great returns to investors), they historically have outperformed the rest of the pack by a wide margin.
So why is that? I think it is because by and large if an entrepreneur has a choice between investment from a firm that does not yet have a track record or investment from a firm that funded a Fortune 50 company or two, they'll go with the firm that has succeeded in the past. In fact, I had this very conversation today with a VC friend of mine who recently lost a deal to a brand name firm. He was lamenting that he had spent far more time with the company, had helped them more with their business and, yet, when push came to shove and the company had to pick an investor, it went with the brand name VC over his less well known fund. Whether or not all top tier firms can deliver, the belief is that they can bring in good customers, get good press coverage, bring on good board members, attract attention from influential investment banks, etc. And much of this stuff is true because of the firm's success in the past -- brand name firms do tend to help get good customers because they've funded those customers in the past, do tend to know the reporters at the New York Times, Wall Street Journal, etc. because those guys have written about their successful companies in the past, do tend to bring on good board members because those guys have worked with their successful companies in the past, do have lots of friends at investment because those bankers have made a bunch of money taking their successful companies public in the past, and on and on.
Great VCs will manage to provide the same value to their portfolio companies with or without the leverage of a great brand name. But it is unquestionably easier to do your job when you are sitting at a firm that has a history of success.
While a brand name firm can "bring in in good customers, get good press coverage, bring on good board members, attract attention from influential investment banks, etc." doesn't the entrepreneur still need to weigh the increased cost (in terms of equity they have to give up) of going with a brand name?
As you wrote in "It's The People, Stupid!" (March 29, 2004), the most important thing is the people. So when considering which firm to take an investment from, shouldn't an entrepreneur weigh the fact that 50% of a partner's time from a less well known firm is more valuable than 10% of a brand name firm? Or, as a marketer would say, "It's the Brand, young man"?