The new VC model: Small is beautiful

By Michael V. Copeland

Here’s the math problem facing early-stage venture capitalists today. The vast majority of “exits” for venture-backed software companies, those happy events where everyone gets paid, are acquisitions valued at less than $50 million. All those large companies that go shopping for startups — Google (GOOG), Microsoft (MSFT), Cisco (CSCO), eBay (EBAY), Yahoo (YHOO) and AT&T (T) — may be buying up dozens of companies every year, but mostly they arent paying out-sized prices and venture firms consequently aren’t getting out-sized returns.

As an entrepreneur, you might be very happy with someone buying your company for $10 million or $20 million. But if you are the VC who invested $2 million in the first round of financing, a return of 2x or even 3x the venture firm’s money doesnt move the needle much on a fund that might be anywhere from $250 million to $600 million. To compound the problem for venture capitalists, many startups these days simply don’t need much money to get off the ground, thanks to cheap hardware and software tools.

So if there is a tension between the needs of a typical software startup and the needs of a venture capitalist, what do you do? If you are Sequoia Capital, you don’t do anything. Of any early-stage firm on the planet, Sequoia gets first crack at the best ideas and the best entrepreneurs –- everyone wants to work with Sequoia — so the odds of them finding the next YouTube or PayPal along with the big returns they bring are as good as they get. If you are Kleiner Perkins Caufield & Byers you start focusing a good deal of your energy on areas like alternative energy which, unlike software, do need boatloads of cash to get products developed and to market.

The other option is to tweak the traditional VC model. Firms like Union Square Ventures, and First Round Capital size their funds and investments so that a relatively small exit is still a meaningful return. In the past few years, “super angels” like Ron Conway have used a shotgun approach putting small amounts of money into dozens of companies a year. The startup boot camp Y Combinator, and the knockoffs it has spawned also fall into this category — put a little money into a lot of companies. These might be seen more as institutional seed funds.

The latest twist on the VC model is Tandem Entrepreneurs. Started by three former big company guys who cut their teeth at places like Oracle and Xerox Parc and then went on to found their own companies, Tandem is putting small amounts of money, $850,000 per company over two years, into just six companies.