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Maximizing Venture Capital Investments

By Igor Sill

The recent capital markets have reinvigorated investor confidence in venture-backed companies to the levels of 2004, when the IPOs of Google and Salesforce debuted.  The pent up current IPO pipeline represents a significant liquidity window and exceptional returns for Venture Capitalists and their Limited Partner (LP) investors.

Of foremost interest to investors is venture capital’s emergence as an exemplary financial engine in the alternative asset class. The reasons for venture capital’s success are many.  The venture structure encourages innovation and gives entrepreneurs the tools they need to create, develop and launch their innovative ideas globally.  These inherent incentives facilitate the creation of breakthrough, industry disruptive ideas. The very best venture capital funds have consistently out-performed the industry and, of course, it’s everyone’s ambition to invest in the top names of these funds.  After all, some of the most successful public corporations such as Apple, Amazon, AOL, Autonomy (HP), Baidu, BusinessObjects (SAP), Cisco, Compaq (HP), eBay, Genentech, Google, Hewlett-Packard, HomeDepot, Informix (IBM), Intel, Linkedin, Microsoft, Netscape, NetSuite, Oracle, Salesforce.com, Skype (Microsoft), Starbucks, Sun Microsystems (Oracle), PayPal (eBay), Yahoo, YouTube (Google) and, soon to be public traded, Facebook and Twitter, were all financed by Silicon Valley venture capital funds.  The LP venture investors in these funds realized significant returns, well above capital market returns.

Over this past decade, the rate of technology innovation has rapidly accelerated, challenging traditional corporations’ ability to maintain a competitive edge.  The more established corporations are increasingly dependent on innovative new technologies in order to remain competitive, thus it would only seem natural that these corporations value venture backed companies with considerable above market premiums. The technology innovations and investment returns are obvious– venture-backed technology companies have consistently exceeded every corporate R&D outcome.  It’s no wonder that corporations try to acquire these start-ups at excessively high valuations, long before they can even launch their public debut.

And more recently, a number of corporate investments in this sector are growing at an increased pace, according to the National Venture Capital Association. Corporations represented investments in 214 venture deals for 196 Silicon Valley companies, up from 185 deals in 170 companies in 2010, and 165 deals in 147 companies in 2009, according to the NVCA.  These corporations are eager to optimize Silicon Valley’s tech talents into their R&D realizations. I’ve even noted an interesting trend in the number of multi-national corporations now opening up business development offices to capture access to the explosion of start-ups at a breath taking pace.  Corporate venture arms invested nearly $3.26 billion in Silicon Valley companies last year, up from $2.6 billion in 2010.

Keeping close tabs on venture portfolios has proven successful for acquisitive companies such as HP, Salesforce.com, Facebook, Oracle, Dell, Apple, EMC, Google, Cisco, SAP, AOL, as well as other tech companies.  Mature corporations are balancing their R&D exposure by funding some of their technology development through investment partnerships with venture capital teams. This approach exploits venture capital’s efficiency in developing technology, its access to new advancements, its capacity to respond quickly to changing technology, its ability to leverage additional resources throughout the development cycle all while returning favorable financial returns and creating significant value for those investors in the venture capital asset class.

David Swensen, the Chief Investment Officer at Yale University, has also realized great investment success in the alternative asset classes. When he arrived at Yale in 1985, its endowment was worth approximately $1 billion, and today the endowment is worth greater than $17 billion. Swensen increased investments in private equity funds, venture capital, real estate and hedge funds.  In numerous speeches, Swensen has championed such alternative investments. He argues that while beating the stock market is almost impossible due to the overwhelming available information about public companies and the subsequent valuations, astute managers can exploit inefficiencies in the value pricing of less familiar private assets. Diversification into alternatives, he added, reduces risk. He argues that keeping funds in investments that are more liquid is a tactic of short-term players versus that of endowments, which tend to hold until private equities are sold or go public.  Swensen says “investors should pursue success, not liquidity. Portfolio managers should fear failure, not illiquidity. Accepting illiquidity pays outsized dividends to the patient long-term investor.” Over the past 20 years, no educational institution has achieved a better performance record than Yale.

Playing it Smart in the VC Investment Arena

The decision of whether to invest as a Limited Partner in an available venture capital firm or participating in a “basket” of venture funds (Venture Fund of Funds-VFoFs) is a critical one.  Deciding between direct venture capital participation, or the more conservative Venture Fund of Funds path should entail research on each Manager’s respective track record of investments, investment access, actual hands-on value creation involvement within their investments, the fund managers’ lure and stature within the venture capital entrepreneurial community (deal flow access) the ethical reputation and transparency in reporting performance returns, and, most importantly, alignment with your long term strategy.

In such a fast-paced environment, with over 3,500 venture capital funds competing for the most promising start-ups, FoFs are a very efficient way to construct a balanced portfolio for investors seeking to participate in this market segment through the very best performing venture funds.  Essentially, a good FoFs can offer an investor access to top tier performing venture capital fund managers not otherwise accessible directly.  Do some serious research here, as the term “success has many fathers” applies in spades to self-published venture performance stats. You may wish to consult with an experienced venture law firm or venture advisor who can draw on substantial limited partner (LP) and general partner (GP) expertise and expose the many significant incongruities and styles in how LPs and GPs generate and distribute returns.

I’ve come to learn that consistent, successful returns are achieved from only a few select venture capitalists who diligently identify and invest in technologies and markets on the leading edge of disruptive innovation. They tend to focus on building companies at the forefront of market forces, creating outstanding growth and exit opportunities. These particular venture capitalists are notorious for sourcing and developing fast-growing companies in large market growth sectors. They’ve also built a substantial reputation for value creation and thus are sought after and welcomed into the hot startups by seed angel investors as well as the best founding entrepreneurs.

Venture Fund of Funds

The rationale behind investing in a Venture FoFs versus directly in a venture capital firm is simple, there are only 14 venture funds out of those approximate 3,500 which have historically delivered consistent out sized returns. Makes sense, as the smartest and most capable entrepreneurs will only seek the top tier venture partners as investors before pitching the remaining venture “herd”.  The leading firms, consistently topping Red Herring’s Top VCs, Preqin and Venture Economics performance lists are Accel Partners, Andreessen Horowitz, Benchmark Capital, Founders Fund, Goldman Sachs Investment Partners, Greylock, KPCB, NEA, Sequoia, Union Square Ventures, Index Ventures (non-US) and, in the seed investment class, Ron Conway’s Silicon Angels.

FoFs are a very efficient way to construct a balanced portfolio for investors seeking to participate in this market segment through these top venture funds.  Essentially, FoFs can offer an investor access to the very best performing venture capital fund managers not otherwise accessible directly.  Generally, a FoFs has greater leverage in scrutinizing a venture firm’s financial reporting, actual money-on-money returns multiple and negotiating terms, resulting in a better risk-return ratio than individual direct investments. They’re also looking for more than the conventional venture model has traditionally delivered – multiples of cash back rather than straight IRR. They seek a safer, more diversified investment base from which to drive reasonable returns, across shorter investment cycles. The reasons for the impressive growth of FoFs is that they provide diversity among venture fund managers, reduce risk and hold out the promise of net returns higher than the average venture capital return rates by accessing the top venture firms.  Investors are more willing to invest in FoFs for the benefits provided by this pooled investment structure, continual due diligence and on-going oversight compared to investing in a single strategy venture fund.  A balanced, properly allocated venture capital/private equity portfolio generally tends to provide higher returns with less inherent risk.

The brand name venture firms provide a low-risk foundation for consistent top-quartile performance albeit with higher fees to their LPs. Emerging fund managers focused on rapidly growing market sectors offer outsized return potential for their portfolios. But, emerging venture fund managers who follow a more capital-efficient investment model can deliver industry-leading returns while reducing risk with shortened investment cycles at competitive fees to LPs.

The Epicenter of Venture Capital

As to where these venture funds exist and where they generate their magic, well, though there are bright pockets of venture activity globally, the epicenter of premier technology innovation continues to emerge from Silicon Valley. This is a very unique place with a supportive ecosystem ready to back entrepreneurs’ requirements for launching startups successfully. The weather is excellent, the lifestyle is wonderful, and the scenery exquisite. Stanford University, UC Berkeley, USF and University of Santa Clara provide an abundance of research and continually spin off new patents along with a steady flow of budding intellectual entrepreneurially driven graduates. Hence, 80 percent of venture capital and angel investors operate in Silicon Valley, and, not surprisingly, 90 percent of the highest venture returns occur here.  It is also the reason behind Swiss-based Index Ventures’ move to Palo Alto, CA last year.

There exists a massive market with a strong rising tide for quantifying this new venture capital paradigm, one with increased efficiencies, better probabilities and lowered risk.  The opportunities of advanced innovations, globalization and the internet’s disruptive na­ture make it a period of significant transformation that is creating extraordinary value creation and great returns.  Playing the venture capital investment game can be incredibly rewarding, if played astutely.  Seems that learning from success tends to create more success- it’s not merely just a coincidence.

Igor Sill is managing director of Geneva Venture Management LLC, a Venture Capital Fund of Funds advisory firm.  He is also a Silicon Valley venture capitalist and founder of Geneva Venture Partners. Igor manages his own angel investment fund at Geneva Ventures and is also a Limited Partner in Goldman Sachs Investment Partners, Benchmark Capital, Norwest Ventures, Granite Ventures, The Endowment Fund and ICO Funds through his Family Office. Igor resides in Silicon Valley and has 23 years of tech investment expertise. igor@genevavc.com

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