Within the Boston VC community, there’s a new hot phrase running around when it comes to deal selection strategy. Four or five firms have recently informed me that they have concluded that a "barbell strategy" is the best approach for them and that they are uniquely positioned to execute it. No, that’s not a reference to some testosterone-induced competition amongst VCs over who can lift the most weight (answer to that trivia question below). It refers to the strategy funds take who want to keep a toe in the early-stage waters, while still trying to justify more assets under management through large deals.
The math for this multi-stage strategy is simple and compelling. The more assets under management, the more fee income the VC earns. If the goal is to build a large VC fund with, say, over $1 billion under management, it’s hard to write checks smaller than $10-20 million at a time per deal. The deals that have enough mass to absorb that much capital at a time tend to be later-stage opportunities.
Yet, the historical data shows that the >10x return opportunities lie in the early-stage, Series A deals, where less money is invested at a lower price. These companies commonly are looking to raise only $4-6 million at a time, often split between two firms. Thus, VCs have a conundrum – whether to stay focused on early stage, where it’s harder to put big money to work (and therefore earn big fees), or focus on later stage deals, where it’s harder to generate 10x returns.
When faced with a hard decision such as this, some firms look in the mirror and make the tough decision…to do both. They invest dollars at the early stage in small chunks hoping to get a >10x return, and then at the later stage in large chunks, hoping to get 3-5x. Partners within these firms may either specialize in one stage or the other, as the skills can be quite different, or play on both sides of the barbell.
Either way, it’s a risky strategy that many Limited Partners are complaining about. Their beef? Generally speaking, they prefer to have funds be focused on one stage or another, one market sector or another, even one geography or another. They prefer to make the allocation decisions across funds representing different focus areas as opposed to allowing the VCs roam across boundaries, often resulting in mediocrity across the board.
The frustration that VC managers have is palatable when they learn that their business simply doesn’t scale the way hedge funds do (see my "Circle of Envy" post). So perhaps VCs shouldn’t bother trying. Stick to your knitting, whatever it is you’re best at, and leave the portfolio allocation to the limiteds.
Oh – and the answer to the above trivia question? The strongest VC in Boston is without a doubt Rich d’Amore of Northbridge. Load up the barbells and watch him work: he can bench over 350 pounds. I defy anyone to outperform that benchmark!