Why VCs Should Take Their Own Advice

2147141363-SDLlgThe way venture capital firms are structured makes it almost impossible for outsiders to see what’s really going on inside those 1970s lodge-like Sand Hill Road offices. A firm is nothing more than a collection of partnerships around certain funds that run for ten years or more. So if a partner gets fired? Well, he or she is still technically a partner in an earlier fund, so firms don’t really have to talk about it if it isn’t in their best interest.

And if a firm was one of many that couldn’t raise a new fund last year, who needs to know they were even trying? Unlike a startup, any firm that’s been around for a cycle or longer still has enough money under management from previous funds to keep the lights on. If they failed to raise a fund in 2009, they can always try again in 2010. It could take decades for even the worst firms to “go out of business.” Like generals, bad VCs don’t die, they just fade away.

It’s an industry perfectly structured for sweeping problems under the rug, and as its fundamentals have declined over the last decade, that’s just what it’s been doing. But those big, lumpy problems are getting harder and harder to hide. Aside from rumors, it’s hard to know exactly who couldn’t raise a new fund in 2009, but we know the numbers were down precipitously. And slow economic recovery aside, it’s not going to get easier in 2010.

Limited partners, the institutions that invest in venture funds, are finally accepting what almost every VC I know has been saying for a decade: There’s too much money in the industry and it’s killing the kind of early stage investing the asset class was founded on. And that’s killing returns.

But just as we’re finally starting to see limited partners make the hard decisions to throttle back investments in private equity, so too are some VCs grappling with their own hard decision: Stick with a broken asset class and try to fix it or just leave and start anew.

Vinod Khosla was one of the first to make that decision: Leaving Kleiner Perkins Caufield & Byers at the peak of his and the firm’s power to get back to real, risk-taking early stage investing. Of course, his recent $1.1 billion fund flies in the face of the too-much-money argument, but it bears noting that Khosla invests in some capital intensive sectors like cleantech. Web 2.0 is a different matter. The capital needs are low, and, YouTube aside, the returns are low too.

In the last few weeks, another investor who I respect has made a similar move. Simon Levene of Accel’s UK offices has resigned the firm, despite an impressive track record that includes investments in MyHeritage, Seeking Alpha and Etsy. I spoke with Levene this week about the decision and unfortunately for me, it’s not a particularly juicy story. This wasn’t an intercontinental Accel battle royale. This wasn’t an issue where he wanted to invest in sectors the firm deemed dead. Nor was it a case where Levene wasn’t pulling his weight. And, of course, with investments in as varied and successful companies as BBN Technologies, Marvel and Facebook, Accel itself isn’t in any trouble.

It simply boiled down to the fact that, like many of the world’s best Web investors, Levene doesn’t see the best deals out there needing many millions of dollars. And structurally, a small partnership investing a $525 million fund with $1.5 billion actively under management can’t do a large number of tiny deals and still give each investment the attention it needs. As he puts it: “You see something that needs half a million or a million and you think, ‘That’s a good investment,’ but there are only so many you can do given the structure of these larger funds.”

In London, Accel takes a classic VC approach of putting at least $15 million in each company. That doesn’t leave a lot of room for the kinds of micro-deals that Levene saw netting better returns and frankly, the ones in which he had more fun investing. “I enjoy the bigger deals too, but they are fewer and far between, and they tend to be very competitive, so you have to pay up for them,” Levene says. “When it comes to early stage I’m just seeing a bigger market opportunity in Europe and Israel.”

That VC angst—while similar to what you hear about in the Valley—has a different twist in markets like Europe and Israel. In the Valley, it’s largely a reaction to more nimble angels and seed funds beating traditional VCs in the market. Funds have been forced to adapt or lose.

Witness Greylock’s hiring of uber-angel investor Reid Hoffman. Indeed, even before Hoffman’s arrival, forward-thinking partners like David Sze had been doing less-traditional deals. In 2006 Sze did two deals that didn’t seem to fit with the venture model and had peers scoffing that he’d never make money off either. One was Digg, where he could only invest $2 million, a fraction of the normal-sized series A deals at the time. The other was Facebook, where he invested at a whopping $500 million pre-money valuation. At the time, he shrugged and said, “I don’t know how I’ll make money, I just believe in the teams and believe it’ll work out.” In hindsight, he looks like a genius on both.

Sze’s approach —not just downscaling to do seed-deals, but investing without spreadsheet-induced restrictions at all — is similar to that of newer firms like Andreessen Horowitz, which does tiny deals as well as mammoth deals like the recent investment in Skype. Andreessen has said he wants a piece of the best tech companies in the world—no matter when they’re started, what stage he can get in and what price is necessary to make it  happen. (After all, it was pure, math-based investing that helped wreck the public markets.)

But in Europe and Israel, there’s not that same level of experimentation on the part of venture funds, nor are there many investors like Andreessen or Hoffman who have the clout, confidence and star power to say they’re just going to invest in what they want and trust it’ll work out.

The closest is Saul Klein’s firm Index Ventures, which has had plenty of traditional venture hits with Skype, MySQL and Last.FM, but has been open to plenty of experimentation too—much of it lead by Klein himself, a long-time angel investor and entrepreneur. Index has not only supported Klein in continuing to do investments from his seed fund, The Accelerator Group, it’s encouraged him on a project called Seed Camp, that scours Europe and Israel for good companies and makes Y Combinator-style investments in them.

So far Seed Camp has invested in 21 companies and mentored nearly 300. Klein brought a crop of them over to Silicon Valley this week to meet with investors, get grilled by the press, and get mentored by success stories like Google. “Given that the raw natural material for venture capitalists is entrepreneurs, I find it strange that the venture community does nothing to help develop those raw materials,” Klein says. (There’s much more on his blog about this topic here.)

For Levine’s part, he sees the venture industry in Europe and Israel as “still a work in progress.” He continues, “There’s more of an opportunity to pioneer and strike new ground. That’s part of what was exciting to me when I moved back here seven years ago.” Not surprisingly, Levene spent a lot of time talking with both Hoffman and Klein as he was mulling the ballsy decision to leave one of the top firms in the venture universe.

What’s he going to do now that he’s unemployed? He’s not saying yet. (My guess is he’s not saying because raising a seed fund takes some time, but that’s only a guess.) But the more investors who follow their heart in this uncertain time for the asset class, the better for startups here and in Europe and Israel. After all, that’s what top investors would advise entrepreneurs to do during a downturn.