Felda Hardymon is a highly successful venture capitalist and popular Harvard Business School professor, where he teaches “Venture Capital and Private Equity”. Sharing research and examples from the 2012 edition of his textbook, Hardymon spoke at last week’s Journey conference in Tel Aviv about “Venture Investment- Trends, Cycles and Opportunities”. Spoiler alert: Entrepreneurs should choose a Tier 1 firm with a great track record and not the individual Partner. Also, most VC’s bleed money, with 70% of all profits accruing to the top 5% of firms (Lerner analysis of Thomson Reuters data).
“A VC does three things: selection, credentialing and governance. They do not run companies”. Selection and credentialing are important but “most of all, it is about GOVERNANCE- measuring, reminding and pushing things along. Angels have replaced the seed capital but they do not provide the same governance as VCs.”
Felda recommends an independent, outside Board that is small (5-7 members) and not dominated by management or VCs. It should be characterized by respect and adherence to process. However, the Board needs to encourage experimentation-“you can be wrong and fix it but be sure to hire and train great people. And measure everything”.
“Because of its structure, VC is a long latency business. It takes 15-20 years to know if a VC investor is any good. Only about 15% of all venture investments drive returns for the entire industry so access to great deals is key. More than any other asset class, a VC firm’s track record is directly correlated with future success”. Felda cites relevant research from Kaplan and Schoar (2005).
The result has been a severe tiering of the venture capital industry, with the sector characterized by either extremely large, global funds or small, specialized funds. “We saw this in China as well. Within 5 years, there was a measureable tier of VC firms”. More than any other asset class, experience of the Principals is correlated to returns. Felda and his colleagues Lerner and Leamon (2011) found a direct relationship between IRR (internal rate of return, the most widely used measurement for fund success) and fund sequence number. First time funds perform especially poorly while later funds perform better. These regression results control for vintage year effect, fund category and fund size.
Finally, there is a reason many venture capital firms are small- “there are diminished returns from larger fund size”. Because Partner time and judgment are the most valuable resources, funds do not scale (see data below from Lerner, Leamon and Hardymon, 2011). Results are even worse during periods when the industry is overfunded.
Despite the challenges confronting the sector, Felda is optimistic about Israel, where his firm Bessemer Venture Partners (www.bvp.com), has an office on the ground and a long history. According to the IVC, last year $2 billion was invested in over 500 Israeli start ups, with foreign funds accounting for 75% of the money deployed. Although there was not a single Israeli IPO last year, the decrease in global R&D spend by the major tech companies encouraged more than $2.3 billion in M&A exits and another $1.9 billion through the first 9 months of 2012.
“The decrease in corporate R&D is a good match for R&D centric Israeli companies. Israeli start-ups partner early with US companies, which is a form of early courtship. The US tech companies have more than $1 trillion in liquidity, much of it offshore and not easily repatriated. In many ways, it is easier for the big tech acquirers to buy than build”.
Felda offers the following advice for Israeli Founders. “Take on the hard technical problems, build a great team and then choose an experienced VC with a good reputation”. When asked what really makes a good investor, Felda responds instantly: “Track record…and luck”.