In July, Marc Andreessen and Ben Horowitz announced the launch of a new $300M venture capital fund, Andreessen Horowitz (AH). Between them, Andreessen and Horowitz are the guys behind NetScape, Opsware, Ning, and many other smaller but no less notable ventures. Anything they decide to do together is big news – and when that project involves shaking up the venture industry, it’s a very big deal.
You can find great coverage of the launch by Kara Swisher, Henry Blodget, and the Wall Street Journal, among many others. At a time when the VC model is under tremendous stress and most industry observers are predicting massive contraction, Andreessen and Horowitz had the capability and vision to launch a new major fund that leverages a few key insights – insights that I think are relevant for venture capitalists everywhere, and particularly here in Israel.
Recently, Fred Wilson wrote that “the VC business is not broken. Some of the participants in it are.” The launch of AH was a clarifying moment for me because it represents a proactive and constructive attempt to reinvent certain aspects of the venture capital model. Here are a few of the highlights, as I see them:
- From $50K to $50M. This is the most dramatic and important insight that AH is sharing with us. Lots of VCs have some sort of seed program, effectively enabling them to buy an “option” on the opportunity to invest in the future. AH, however, is explicitly stating its willingness to deploy very small amounts of capital – far smaller than most VC seed programs will seriously contemplate. On the other hand, they are not afraid to commit large amounts to support their most promising and capital intensive investments. This may seem like a trivial matter – but it’s not. Most VCs imagine the ideal deal structure for their model (“no less than X% at exit and no more than $X million committed per company”) and then try to invest around that model. In addition, VCs will often say that they can’t do small ($50K) investments because those investments are unlikely to generate exits large enough to impact the fund. Undoubtedly, there is a value in such investment discipline. But AH has a different message – and they are reminding us of what the VC business is supposed to be about. VC is about financing innovation and rapid growth. It’s tough for even the best VC to find great opportunities that precisely map to a single rigid theoretical model. Instead, VCs need the flexibility to find and finance innovation at whatever stage and at whatever scale allows them to invest in the best entrepreneurs with the most potential for creating value. They need the flexibility to make very small risky investments, and they need the guts (and the fund size) to be able to make much larger investments in a few massive but capital-intensive opportunities – including helping some of their successful seed investments grow. In her piece on AH, Kara Swisher suggests that the AH portfolio is going to end up looking different from a typical VC portfolio: 60-80 seed investments, 15 that need follow-on rounds, and 2-3 later stage investments. Sounds good to me.
- Rethinking board membership. One of the reasons that VCs don’t like small deals is that small investments take the same amount of work as larger investments. This time commitment typically includes board meetings, extensive contact with the CEO and senior management, and efforts to add value through introductions and strategic consultations. A VC partner’s time is a valuable commodity and he/she is typically reluctant to spend that time on a small investment, because the cost/benefit doesn’t work out. In Andreessen’s blog post on the fund’s launch, he states that Ben and he will join boards where the fund has made a significant investment ($5M or more) but that they will “generally not go on boards of raw startups — in fact, in many cases, we don’t even think today’s raw startups should have boards.” Andreessen and Horowitz are describing a VC model that enables a large fund to actively make small investments. The key to their model seems to be investing in entrepreneurs that they trust and that do not require deep partner involvement, at least not in the early stages. This frees up partner time to focus on big existing investments where that partner’s time can make an impact on fund returns – and it enables AH to invest in many more start-ups that the traditional VC model would allow.
- Flexibility. Throughout, AH is emphasizing flexibility. They are willing to invest in any information technology company, at any stage, and through any structure (traditional equity,, founder’s shares, LBOs, and even public equity).
- People and product. In his post, Andreessen repeatedly emphasizes the type of people they are looking to back (a founding team that includes technical founders and at least someone who intends to be the long-term CEO), as well as their preference for backing entrepreneurs (at whatever stage) with a clear product vision.
- Recognition of new realities of start-up costs. In his blog post on the fund’s launch, Andreessen also argues that “the process of building a new technology company is changing rapidly,” with many start-ups requiring less capital up front and much more later on. Andreessen is right. This is certainly true for software and internet start-ups, where new software architectures, third party apps and services, and cloud-based infrastructure have combined to dramatically reduce both initial development costs as well as the costs of scaling a computing infrastructure. It also can be true for certain (rare) types of hardware companies who are able to leverage externally resources effectively. Rapid growth in the expansion phase does, however, often require lots of capital. AH has the mindset to enable small initial investments and the capital to help them grow later on.
- Geographic focus. Given their reputation, Andreessen and Horowitz will attract deal flow from around the world, but they have chosen to focus on Silicon Valley. This is a validation of what Israeli VCs have been saying for a long time. Venture capital is a local business. It depends on great access to deal flow, an understanding of local dynamics, and engagement with the local market for talent and opportunities. Never underestimate the advantages of being able to meet your VC for a cup of of coffee without getting on a plane.
- Fund size. AH decided on a $300M fund size. This may turn out to be their most controversial decision. After all, its not easy to generate 2X (let alone 5X) return on $300M. Assuming average holdings of 20% at exit, you’d need to generate $3B of total enterprise value from the portfolio just to return 2X. This is doable, but it’s far from trivial. That said, given their access to outstanding deal flow, their track record, and their reinvention of the venture model, AH has as good a chance as any to generate real venture returns.
What does this mean for Israeli entrepreneurs and VCs? Broadly speaking, AH’s approach to venture capital makes sense for the Israeli landscape. In Israel, we are blessed with a large number of very talented early-stage entrepreneurs. Some are pursuing vastly capital intensive projects, but most are not. Lots of these ventures are potentially promising. Often they stand to generate very attractive returns on small initial investments, and – if things go well – they create the opportunity for a larger investment to fund rapid scaling. These start-ups would benefit from being under the wing of a large established VC that could offer some guidance and assistance from time to time, but they don’t necessarily need the close supervision of a formal board meeting given their early stage. At the same time, there are a multitude of later stage opportunities that require larger investments and more creative structures. This is exactly the sort of environment in which Marc Andreessen and Ben Horowitz find themselves – and I think we could all benefit by studying their playbook.
The bottom line, I think, is that the quest to “fix the venture model” may be fairly straight-forward after all. This business about the finance of innovation – about generating opportunities to invest in great entrepreneurs who can create tremendous value quickly. Doing so consistently requires the right mix of professional discipline and thoughtful flexibility. Andreessen and Horowitz, it seems to me, are arguing that a shift towards a bit more flexibility is in order. I think they are right.