Holiday Greetings to all from K9 Ventures! I decided to post the greeting to our blog and website rather than sending it out via email to avoid the email-overload of holiday greetings that occurs every year. This way only those of you who come visit the K9 Ventures site (either on your own, or by seeing a link on the RSS feed, Twitter, Facebook, LinkedIn, Plaxo etc.) will see our greeting and it won’t be force-fed through email!

Update: Upon further consideration, I might send the greetings out by email to some of the people who may not be following any of the above sources.

In my previous post, I claimed that “Venture Capital is a people business in every sense of the word. It is therefore a boutique industry and it cannot scale.” Let me expand on that thought a little more to qualify what I’m saying.

Unlike investing in public markets, investing in early stage companies happens before those companies have a real business, when it is just a concept and a team, and sometimes not even a whole team. What early-stage venture capital is betting on is people. VCs have to be able to sum up an individual and make an educated guess as to whether that individual has what it takes to build a company around his/her concept, his/her dream. When it comes to helping portfolio companies grow, it is the people relationships that matter most — can you open doors to prospective customers, employees, partners, lawyers, accountants, bankers and of course other investors. The biggest challenges in building a company are: People, people and people. If you buy the people argument, then it follows that it is difficult to institutionalize and scale a venture firm since not everyone in the organization can have the same people judgment and people skills. Until such time that we can clone people as adults, with their knowledge and skills intact, venture funds are fundamentally people (time and bandwidth) constrained.

The other form of scaling in venture capital is that of the size of the venture funds. Limited partners invest in venture since it is supposed to be a high-return investment. Lets assume that Shylock Ventures is capable of producing a 20% IRR on a $100M fund. Those returns do not (and cannot) scale with the size of the fund! If Shylock Ventures were now to raise a $500M fund or a $1B fund, it probably will not be able to maintain its IRR. The historical returns were created by investing certain amounts of capital in companies at a certain stage. It isn’t possible for Shylock Ventures to simply put more capital to work in a company at the same stage — that would be over-capitalizing the company. At the same time, Shylock Ventures can’t easily find that many more quality investment opportunities because it is people (time and bandwidth) constrained. The only alternative is for Shylock Ventures to begin doing later stage deals that have an appetite for more capital. However, later stage deals have a very different flavor — they require a different set of skills and expertise to evaluate them and execute on them. Can the same firm that is doing early stage investing develop a competency in doing late stage investing overnight? While some very unique firms may be able to build/hire the competency needed for this, I would argue that most venture firms simply cannot scale the size of the funds without substantial risk to their strategy and returns.

Venture firms are like skilled artisans. Their products — successful companies — are most valuable when the firms remain small and have their own unique style. When you try to mass-produce this product or just try to make it really big, it loses its value. For sake of analogy, think of it as the chef at a top restaurant or the conductor of a fine orchestra — for each there is an ideal size and trying to scale it beyond that ideal size results in a degradation in the quality of the product. Venture capital is, and should remain, a boutique industry.

In my previous post, I talked about some of the reasons I felt that the venture industry was broken and needed reform. This has been something that I’ve been thinking about for a long time now (~1.5 years or more) and became the basis for me starting K9 Ventures. The logic there was that instead of just identifying a problem, do something to solve it. In the words of Mahatma Gandhi: “You must be the change you seek in the world.”

However, before I start writing about how I would want to change things, it is necessary to address the current economic climate. The bottomline is that this is the worst time in history for the venture capital industry. The stories of doom and gloom in the venture business are everywhere. Here are just a couple that I’ve come across recently:

• TechCrunch: The End of Venture Capital As We Know It?
• WSJ: Venture Capital Hits a Cash-Call Crunch
• WSJ: As Cash Stops Flowing, Venture Capitalists Get More Creative
• VentureBeat: Report from AlwaysOn Venture Summit: We’re not dead yet!
• Paul Graham: Could VC be a Casualty of the Recession?
• VentureWire: LPs, Firms expected to fall by the way side
• BusinessWeek: What Will the Crisis Mean for Venture Capital?
• GigaOm: VCs Must Woo Unhappy Investors, Too
• NY Times Dealbook: Beyond the Ivied Halls, Endowments Suffer
• BusinessWeek: College Endowments Deserting Venture
• NY Times Bits: I.P.O. Crisis Could Have Lingering Effect on Startups
• PrivateEquityOnline: Bankrupt WaMu Parent Defaults on Capital Call

If that isn’t enough doom and gloom so far, I’m sure you can dig up a lot more. There are several reasons for all this doom and gloom. I’ll try to list at least some of them here:

• Lack of IPO and M&A exits: Q2 2008 was the first quarter in 30 years in which not a single venture backed company exited via an IPO (see NY Times article). The blame is attributed to adverse incentives of legislation like Sarbanes Oxley and the bad financial markets. Mergers and acquisitions have also been down, especially the large deals. What does this mean? Well, VC firms have not been able to get exits; money that was invested in venture capital is locked up in illiquid private investments in portfolio companies and cannot be returned to Limited Partners.
• The Denominator Effect: The big endowments, pension and retirement funds, charitable organizations, family offices and high net-worth individuals who are the Limited Partners in venture funds have all seen their portfolios take a severe hit. Several of these funding sources have managed asset allocations, meaning that their investments in venture capital are supposed to be a certain percentage of their portfolio. However, when the value of the overall portfolio (the denominator) decreases, the percentage of the portfolio allocated to venture capital increases. The commitments to venture capital are therefore now a much higher percentage of their total portfolio than they originally started with.
• Deferred/Unmet Capital Calls: Portfolios have taken a beating in this market. For any LPs that were not sitting on cash, and few were, a capital call in this market would typically require them to create liquidity by selling some of their holdings. However, with the market this depressed, no one really wants to sell in the down market. Therefore, several of the large LPs have advised their venture funds that they really don’t want to see any capital calls in the near future. This ties the hands of venture firms. To make sure they have enough money for their existing portfolio companies, they first start reducing any new investments. In some cases, LPs have actually defaulted (see WaMu) on their capital calls.
• Venture Asset Class Performance: Venture capital as a asset class has produced disappointing returns. In fact, most venture firms actually lose money! It is only the top tier venture firms that are able to maintain good returns year over year. And in the current climate, even that is suspect. But, venture is a long term play. LPs have to give it at least 10-15 years to see see what the returns on venture will be like. Well, a lot of LPs have now been in the business that long and they’re not happy with the high-risk low-return performance of venture capital. To the extent that several LPs are considering pulling out of venture capital altogether.
• Stock Market vs Venture Capital: If you’re sitting on a pile of cash right now, would you rather invest it in the depressed stock market, where several publicly traded companies look like they’re in the bargain basement, OR would you rather invest it in a highly risky, completely illiquid venture investment in a private company? The stock market is liquid, typically less risky than a startup (though some would argue that) and if and when we pull out of this recession, the returns from the stock market may be even better that most venture investments. This applies both to angels and to the big money LPs.
• The Trickle-Down Effect: The total venture investment in 2007 was around $29B dollars. If the stock market has declined over 40% in the current year, and if we hold the asset allocation numbers constant, then next year the total money going into venture capital will be down by at least 40%. Add to that that several LPs are pulling out of venture capital altogether, it means that the total money in venture capital will be reduced even more. Without doing a full scientific analysis, I’d say a 50% reduction is not inconceivable. That equates to hundreds, if not thousands, of startups that will no longer be funded simply because of the effect of trickle-down economics.

So where does this leave us? Well, lets just say things are not looking good for the startup funding environment in the near future. The venture capital industry is getting beaten from all sides. Projections say that several venture funds (presumably the non-Tier 1 venture funds) will actually start shuttering their doors in the near future. Even the top funds are having to rethink their strategies and especially their headcounts. The “layoffs” in venture happen quietly — but they can, will and are happening in these times.

I’m going to make some bold and (I hope) controversial statements: Venture Capital is a people business in every sense of the word. It is therefore a boutique industry and it cannot scale. In my humble opinion, it doesn’t make sense for LPs to be funding multi-hundred million dollar funds and sometimes even billion dollar funds that claim to be “early stage” venture capital funds. The word early-stage has been misused to such an extent that it’s hard to even say what it means any more.

For small upstarts like K9 Ventures this is a bitter-sweet time. On one hand the macro-climate will certainly make things harder in the venture industry for the foreseeable future. On the other hand, such industry-wide disruptions are the best time to try something different. Without abusing an already overused line for 2008 I’ll say: It’s a time for change — even in the venture capital industry.