While American venture capital firms are coated with an aura of glamour they are also shrouded by a cloud of mystery. Just how do they operate? How do they raise their money? Why do some VC firms succeed while others do not? The authors of this article, who were given unprecedented access to key executives of prominent VC firms, answer these and other questions that will take readers inside one of the more mysterious, but critically important institutions in American business.

The United States is the creator and world leader of the venture capital industry. Twenty percent of all U. S. public companies were started with venture capital backing and today they account for over 30 percent of the market value of all public firms. Silicon Valley is the envy of a world that seeks to emulate its success. But the institution at the center of the VC industry in America—the venture capital firm—is not well understood. It is hard to access and gain insights into the inner workings of VC firms. The impression one gets is that this is because time, always in short supply in business, is priced at a premium in a world where deals may be won or lost, and talent recruited or poached, in a matter or hours or even minutes.

We were able to gain access to the private world of venture capital firms in America because one of the authors (Hatim Tyabi) lives in this world and could open doors to arrange interviews with marquee venture capitalists and serial entrepreneurs in Silicon Valley. This article will describe our research and the observations and conclusions that we drew from it, and provide readers with a glimpse into the occasionally mysterious, but always critically important workings of venture capital firms.

The caste system in American venture capital firms

Practitioners refer to venture capital firms as belonging to “first tier,” “second tier” and so on—with the implication that firms in the “top tier” consistently perform better than those in the lower tiers. In fact, many VC firms like to advertise themselves as “top-tier” (some times referred to as “bulge bracket”), because such a reputation gives them access to the best talent and the best deals, and the money to acquire both.

Many VCs can claim that they are “top-tier” because valid and visible performance data are not readily available in the world of private equity, and because it takes years for the returns from the firm’s current fund to become known. Even for data that are available on past performance, VC firms may try to put a favorable spin on poor past results while painting a rosy picture of future performance.

The presumptive tiers among venture capital firms—what we refer to as its caste system—have not been systematically examined by researchers. This caste system is one of the secrets of the venture capital firms in America. There are other secrets as well, as we reveal in this article.

Research methodology

Given the paucity of prior research on the rise and fall of VC firms and their inner workings, we undertook exploratory research to better understand this phenomenon.

We jointly conducted 17 interviews (22 hours in total) with 12 prominent players in the venture capital industry (VC firm partners, including those in top-tier firms; serial entrepreneurs; and two VC fund-of-funds managers). The interviewees were open and candid because they knew one of the authors either personally or by reputation, and felt assured that their names would not be mentioned when the research results were reported.

What is a venture capital firm?

The VC firm was invented in the United States after WW II as a partnership model that had a unique provision for facilitating the private funding of new ventures: The limited partners who invest in a venture capital fund created by the VC firm’s general partners must wait patiently— up to a maximum of 10-12 years as per the legal agreement—for their money to be returned, hopefully with a handsome profit.

Over one or two years, the general partners draw down the capital committed by the limited partners and invest it in promising new ventures, which they then try to steer to success. Fund sizes vary from tens of millions of dollars to several hundred million dollars or more, depending on whether the fund is focused on investing in seed and early-stage companies, or in later-stage companies and buyouts requiring greater amounts of capital.

A VC firm normally has five to eight general partners (GPs). The GPs receive an annual fee, typically 2 percent of the value of the fund, in addition to a percentage (called the “carry”, typically 20 percent) of the net profit. For example, for a $100 million fund, the GPs would receive $2 million in annual fees. If some of the companies in which the GPs invest ultimately “exit” via an initial public offering (IPO) or a merger or acquisition (M&A), so that the value of this fund grows to $500 million, for example, the fund’s gain would be $400 million ($500 million value minus $100 invested). The GPs would get 20 percent of the gain ($400 million x 0.2 = $ 80 million) as “carry”, with the balance of $320 million going to the limited partners as profit, in addition to their $100-million investment in the fund, which is returned to them.

The services for which the GPs receive this compensation are: (a) attracting and finding promising companies and entrepreneurs, (b) investing in them at attractive prices, (c) recruiting the right talent for these portfolio companies, (d) monitoring and advising management to help them grow—typically by serving on the company board—and (e) harvesting them via IPOs and M&As.

If some of the portfolio companies do well so that the entrepreneurs and the limited partners are rewarded, the GPs gain visibility and recognition in the VC world, and they can raise money for the next fund to repeat the cycle.

Based on our research, we concluded that VC firms share ten secrets that define their operating style. We identify and describe these secrets below, and in so doing provide a window into the inner workings of VC firms in America.

Secret #1: It is hard to create a VC firm

According to the National Venture Capital Association, there are about 1000 active venture capital firms in the United States. Given the potential for high GP compensation, there would be many more, if only it were easy to launch a new firm.

The limited partners (wealthy individuals, university endowments, pension funds and other institutional investors) do not normally give their money to a VC firm whose general partners do not have a proven track record as successful entrepreneurs or venture capitalists. Thus, it is very difficult for those without a proven track record as an entrepreneur or venture capitalist to create a VC firm.ⁱⁱ

Secret #2: For two-thirds of the VC firms, the first fund is their last fund

We had access to a unique database for this research. It was constructed by one of the authors of this article, in collaboration with two of his academic colleagues, by merging two different public sources of data on U. S. venture capital.ⁱⁱⁱ We shall refer to this as the SPS database (after the names of the three authors who constructed it—Smith, Pedace and Sathe). It contains information on 2,917 U.S. venture capital firms and on the 6,206 funds these firms launched during the period 1970-2006.

Two-thirds (66.4 percent) of the VC firms in the SPS database launched only one fund. Why? The research indicates that VC firms founded by GPs who have limited venture capital experience are less likely to be successful than firms created by those who have proven themselves in the VC world.^iv And firms that do not succeed with their first fund are not likely to raise a second fund.

Secret #3: Only 10 percent of the VC firms launch more than four funds

The results for a first fund may not be known by the time a VC firm is ready to raise money for a second fund, three to four years later. In all likelihood, these results will only be known six to eight years after the first fund was launched, when the firm is trying to raise a third fund, or certainly by the time a fourth fund is launched a few years after that. As a result, it will be nearly impossible to raise these funds if the results of the first fund are below expectations. This is one reason why only 10 percent of the 2,917 VC firms in the SPS database raised more than four funds.

Another reason why the vast majority of VC firms do not get to a fifth fund is that, since it takes 8-12 years to get to the third and fourth funds, even a successful VC partnership may break up before then, if the partners leave for personal or other reasons. For a VC firm to raise more than four funds, it must not only be successful with its first funds, but it must also implement governance and succession mechanisms that will enable the firm to survive beyond the founding partners.

The survival and continuity of the firm beyond the founding partners’ involvement is a critical issue for a VC firm because many limited partners prefer to invest in a firm for the long term. As one limited partner from a large university endowment put it, “We want a long-term relationship…. It is not worth the time, effort, and risk of investing in a one-time fund.” In the words of one VC: “LPs used to want to invest in a fund. Now they want to invest in a firm, an institution.”^v

Secret #4: VC returns, on average, are comparable to risk-adjusted returns for the S&P 500.

Contrary to popular perceptions, the evidence indicates that the risk-adjusted returns for VC funds are, on average, no better than returns for the stock market indices.^vi

Many VCs believe that larger funds and a more passive investment style lower fund performance.^vii However, contrary to VC conventional wisdom, there is no solid evidence that VC firms that focus on seed and early-stage investments earn higher returns than those who invest in later stages or buyouts.^viii Neither is there any empirical support for the notion that VC firms that actively manage their portfolio companies are rewarded with higher returns than VC firms who make passive investments.

However, VC fund returns are highly skewed toward the high end; a small number of funds do far better than the rest. For the 1,285 funds in the SPS database for which net internal rate of return (IRR) data are available, the simple average of the fund IRRs is 13.7 percent. However, the top 10 percent of these funds have IRRs of 39.2 percent or greater.^ix

Secret #5: Luck matters, but reputation and skill matter too

VC funds with portfolio companies that happen to be in the right industries, with the right technologies and products, for the right markets, and at the right time will do better than others.^x Whether having the right portfolio comes from being lucky or from the reputation and skill of the VC firm’s GPs who manage the fund has been debated for a long time. The weight of the evidence now available indicates that—surprise—success derives from luck as well as from reputation and skill.^xi

There is evidence that young VC firms take companies public earlier than older VC firms in order to establish a reputation and raise capital for new funds.^xii If a VC firm is successful with its first fund, it gets noticed and the firm begins to acquire a reputation. As well, the personal reputations of the successful GPs are boosted. The experience with the first fund also increases the skills of the GPs. The heightened skills and reputation increase the chances of attracting limited partners for the firm’s second fund, of getting reputable VC firms to co-invest in its portfolio companies, and of motivating promising entrepreneurs to seek the firm’s investment. If the firm’s second fund is again successful, the skill and reputation of the VC firm build further, and the cycle can be repeated.

Persistent good performance convinces others that success was not entirely due to luck.^xiii If a VC firm consistently performs well from one fund to the next, its success will be increasingly attributed to its reputation and skill rather than to luck.^xiv

Secret #6: What successful VC firms do

The conventional wisdom among those who live in the VC world, as well as those who study it, is that VC’s success and reputation mainly come from hitting “home runs.” The funds that produce the highest returns for their investors are believed to be those whose portfolios include a few high-value IPO exits. IPO success is commonly used as an indicator of a VC firm’s reputation.

As revealed in Secret #4, there is strong evidence that a relatively small percentage of a fund’s portfolio of investments often yields a disproportionately large percentage of the fund’s ending value.^xv Home runs are obviously valuable, both for the success of the fund and for the firm’s reputation. However, no one has figured out how to hit home runs consistently. As well, the presumed association between home runs and fund IRR has not been rigorously tested. An obsession with IPOs and home runs distracts VC firms from focusing on other things they can do to improve fund IRR. Four such things are described briefly below.

1. Fund IRR is higher if a VC firm quickly abandons early investments that no longer show promise.^xvi Though such “shooting of the wounded” is one of the tough actions that draws the ire of the affected entrepreneur and gives the VC the label of “vulture capitalist,” the evidence indicates that this painful action is often necessary. So is the firing of a CEO who does not seem to be performing. As one seasoned VC said, “I never fired a CEO too early.”
2. Fund IRR is higher if the VC firm has experience in those industries in which the fund’s portfolio companies are invested. It is also important to have the capacity to switch into industries that are becoming “hot.” The firm that is able to do so early produces higher fund returns.^xvii
3. The VC firm’s relationships and networks matter a lot. There is compelling evidence that the better-networked VC firms experience significantly better fund performance.^xviii And a VC firm that can hop onto a deal led by a marquee firm — even if it is at a later stage and has a more expensive valuation — can gain some of the marquee firm’s luster, particularly if the company in which it has co-invested does well and becomes visible.
4. There is evidence that M&A exits are almost as important as IPO exits in achieving high fund IRR. Thus, it pays to develop the relationships, networks and skills required to do both types of exits well.^xix

Secret #7: Older VC firms are not necessarily top-tier

Older VC firms tend to be better known because they have been around longer. Also, it is impossible to become older if a VC firm is unable to raise successive funds. And, as revealed in Secret #3, it is not possible to raise successive funds if the firm has not delivered good prior results. So, older VC firms do tend to have a track record of success. Nevertheless, this does not mean they are top-tier.

Secret #8: How VC firms become top-tier

Since the VC industry goes through boom-and-bust cycles,^xx relative internal rate of return (fund IRR minus the mean IRR of all the VC funds that were launched in the same year) is a good indicator of a VC fund’s performance relative to other funds launched at the same time.

A venture capital firm becomes top tier by consistently delivering high relative IRRs for its funds, through boom-and-bust cycles. It requires the staying power of a marathon runner.

A big IPO or M&A deal may catapult a firm into the limelight for a while, but it will not become top-tier if it does not deliver persistent high performance relative to other firms.

One research study found that some second-tier VC firms had attempted to leapfrog into the top tier by using what they believed was a more efficient “pyramidal organization” model found in other professional service organizations such as accounting firms, investment banks and consulting companies. But these efforts were unsuccessful.^xxi

Secret #9: How top-tier VC firms continue to stay on top

Top-tier VC firms behave differently. First, they have the bargaining power to get better terms from the entrepreneurs they invest in than other firms. For example, one study found that offers made by VC firms with a high reputation were three times more likely to be accepted, and at a 10-14 percent discount.^xxii

Second, because they have better deal flow and/or greater skill in choosing the portfolio companies to invest in than other VC firms, they tend to be more patient with the companies they bet on.^xxiii Not all partners of top-tier firms are top-notch, but the best of them are skilled in advising without giving advice!

Contrary to the findings for VC firms in general,^xxiv we find that top-tier VC firms do not co-invest with other firms in order to pool resources and risk, share the burden of due diligence, or to acquire expertise. This is because they focus their investments on industry sectors where they have the necessary expertise. They also have the resources and staying power to bear the investment risk on their own.

If a top-tier VC firm does co-invest, it is typically with another top-tier VC.^xxv Sometimes this happens for reasons of reciprocity and relationship building; at other times, it happens because the entrepreneur of a highly sought-after deal insists on having more than one top-tier firm on board! Top-tier firms also tend to work only with top-tier investment banks for IPOs and M&As.

We refer to the pattern in which top-tier VC firms associate primarily with other top tier players in the VC world—whether limited partners, investment bankers, entrepreneurs or VC firms—as venture capital’s “caste system.” Though it is not as rigid as the original caste system in India, and though it is based on natural selection rather than on inherited selection, it is a caste system nevertheless!

Secret #10: How VC firms fall out of the top-tier

Being recognized as top tier gives the VC firm some breathing room if a fund occasionally performs below expectations. However, a top-tier firm’s star will begin to fade if it does not continue to deliver high performance relative to other firms.

One reason a VC firm may fall out of the top tier is because its key partners leave—for personal reasons, or because they are not happy with the firm, or because they see better prospects elsewhere. Another reason is that the partners begin to behave like teams in decline, as described by Jim Collins in, How the mighty fall.^xxvi

Conclusion

Despite the importance of venture capital to the U. S. economy, the institution at the center of this industry—the American venture capital firm—remains shrouded in mystery. With its “secrets” revealed, it is possible to see why so few VC firms get started and why even fewer survive. Luck plays its part, but success also depends on the firm’s reputation and skill. Successful VC firms do a number of things that the less successful ones do not, and persistent success is needed to become a top-tier firm. Once in the top-tier, reputational effects draw money and talent to the VC firm and make its continued success more likely.

The VC firm is an uncommon institution but it is still a human enterprise. It rises on the reputation and skill of its people and falls because of common, human foibles—hubris, arrogance, and drinking one’s own bathwater among them—that undo all enterprises. Countries and venture capital firms seeking to emulate the success of VC firms in America can learn from the secrets that are revealed in this article.

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Notes

1. Paul A. Gompers and Josh Lerner (2001), The Money of Invention. Boston: Harvard Business School Press, 2001, p. 69.
2. “Shasta: How to Start a VC Firm” (Red Herring, 27 July 2005) provides an account of how three VCs working in established firms created a new VC firm. http://www.redherring.com/Home/12949, accessed June 4, 2010.
3. Richard Smith, Roberto Pedace, and Vijay Sathe (February 24, 2010), “Venture Capital: Performance, Persistence, and Reputation”. The abstract as well as the article are available at SSRN: http://ssrn.com/abstract=1432858, accessed June 4, 2010.
4. Rebecca Zarutskie (2010), “The role of top management team human capital in venture capital markets: Evidence from first-time funds, Journal of Business Venturing, Vol. 25, Issue 1, January, pp. 155-172. Zarutskie found that first-time funds whose founding teams possessed venture investing experience exhibited greater percentages of portfolio company exits. Further, the strength of this relationship doubled when the founding team also had experience managing a start-up. Overall, measures of task- and industry-specific human capital were stronger predictors of fund performance than were measure of general human capital, i. e., fund managers with MBAs.
5. Noam Wasserman (2005, p. 167), “Upside-down Venture Capitalists and the Transition Toward Pyramidal Firms”, Entrepreneurship: Research in the Sociology of Work, Vol. 15, pp. 151-208.
6. John H. Cochrane (2005), “The Risk and Return of Venture Capital”, Journal of Financial Economics, Vol. 75, pp. 3-52. Steve Kaplan and Antoinette Schoar (2005), “Private equity performance: Returns, persistence and capital flows”, Journal of Finance, Vol. 60, 1791-1823.
7. Wasserman (2005), p. 187.
8. B. Elango, Vance H. Fried, Robert D. Hisrich, and Amy Polonchek (1995). “How Venture Capital Firms Differ”, Journal of Business Venturing, Vol. 10, pp. 157-179. Based on a questionnaire survey of 149 VC firms, Elango et al. (1995) report that earlier stage investors sought ventures with higher potential returns—a 42% hurdle rate of return for the earliest stage investors versus 33% for the late-stage investor. However, they do not report data for actual returns realized. Jennifer M. Walske and Andrew Zacharakis, (2009), “Genetically Engineered: Why Some Venture Capital Firms Are More Successful Than Others”, Entrepreneurship Theory & Practice, Vol. 33, No. 1, pp. 297-318. Walske and Zacharakis (2009) found that stage of investment did not significantly predict firm success in the various models they tested.
9. Smith, Pedace and Sathe (2010).
10. Population ecology would predict such an outcome. John H. Vadermeer and Deborah E. Goldberg (2003), Population Ecology: First Principles, Princeton, NJ: Princeton University Press.
11. Smith, Pedace and Sathe (2010). Zarutskie (2010) also presents evidence that skill has an important influence on fund performance, and is one reason why performance persists from one fund to the next.
12. Paul Gompers (1996) refers to this as “grandstanding” by young VC firms. “Grandstanding in the venture capital industry”, Journal of Financial Economics, Vol. 42, 133-156.
13. Nicholas Rescher (1995), Luck: The Brilliant Randomness of Everyday Life, Pittsburgh, PA: The University of Pittsburg Press. Nassim Nicholas Taleb (2005), Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, New York: Random House.
14. Dimo Dimov, Dean A. Shepherd, Kathleen M. Sutcliffe (2007), “Requisite expertise, firm reputation, and status in venture capital investment allocation decisions”, Journal of Business Venturing, Vol. 22, Number 4, 481-502. Dimov et al. (2007) measured firm reputation with four items: total amount of capital invested by the VC firm, the total number of companies in its portfolio, the age of the firm, and the number of times the firm was mentioned in The Wall Street Journal over the period of study (1997-2002).
15. Wlliam A. Sahlman (1990), “The structure and governance of venture-capital organizations, Journal of Financial Economics 27(2), 473-521. Smith, Pedace and Sathe (2010).
16. Smith, Pedace and Sathe (2010).
17. Smith, Pedace and Sathe (2010).
18. Yael V. Hochberg, Alexander Ljungqvist, and Yang Lu (2007), “Whom you know matters: Venture capital networks and investment performance”, Journal of Finance Vol. 62, No. 1, pp. 251-301. Hochberg et al. (2007) measured fund performance by the percentage of successful exits, either via IPO or sale to another company.
19. Smith, Pedace and Sathe (2010). Zarutskie (2010) shows which VC firm characteristics matter more for exits via IPO versus M&A.
20. Paul A. Gompers and Josh Lerner (2004), The Venture Capital Cycle, Cambridge, MA: The MIT Press.
21. Wasserman (2005), p. 192.
22. David H. Hsu (2004), “What do entrepreneurs pay for venture capital affiliation?”, Journal of Finance, Vol. 59, Number 4, pp. 1805–1844.
23. Top tier firms continue to invest in a higher % of companies in the second stage.
24. Sophie Manigart, Andy Lockett, Miguel Meuleman, Mike Wright, Hans Landstrom, Hans Bruining, Philippe Desbrieres, and Ulrich Hommel (2002), “Why Do European Venture Capital Companies Syndicate?”, ERIM Report Series in Management Reference No. ERS-2002-98-ORG, Rotterdam, The Netherlands: Erasmus Research Institute of Management. Manigart et al. (2002) report that desire to share risk and increase portfolio diversification is a more important motive for syndication than the desire to access additional intangible resources or deal flow; access to resources is more important for non-lead than for lead investors; and syndication intensity is higher for young VC firms.
25. Josh Lerner (1994.), “The Syndication of Venture Capital Investments,” Financial Management, Vol. 23, Number 3, Autumn, pp. 16-27. Lerner (1994) found that experienced VC firms primarily co-invest with other VC firms with similar levels of experience in first round investments. In later rounds, established VCs syndicate investments to both their peers and to less experienced capital providers.
26. Jim Collins, How the mighty fall, New York: Harper Collins, 2009.