Recently we have seen a very healthy debate on the merits of lean versus fat start-ups.
Ben Horowitz started the debate (here) and Fred Wilson struck right back (here) with his rejoinder. Not to be quelled Ben fired off another salvo (here) and between the comments and additional posts on other blogs (here) – we all got a good 360 degree view of the issue. Not to be outdone – TechCrunch is hosting these two guys at a TechCrunch Disrupt debate (here) – where they will slug it out live
It dawned on me that we should probably turn this debate on its head and look at the people who really decide whether a startup is fat or thin – and that would be the VC’s.
Groupon is by all means a tremendous winner in its space – with lots of revenue and highly positive cash flows. It is also in a business where I can see no discernible moat – thus the tremendous number of fast followers (read copy cats). Taking in another slug of capital at a high value here probably means that it needs to go for the big exit to make investors happy – which is certainly possible – but given the cash flow characteristics of the business – it might certainly qualify as fat right now.
I can understand why it might want to be fat – and who can argue with the success of the company. I have no knowledge – but with all the competitors out there – I would assume they will burn through the fat quickly as they ramp up more and more markets – and try and solidify their position to garner enough share to dissuade others from entering in the market. That would makes good sense – even though they could probably have accomplished this purely out of free cash flow and the positive working capital the business generates.
And why was Groupon able to get so much capital – success not withstanding – because there are certainly fat VC’s out there with large funds who need to write large checks. Just as some hedge funds can’t play in small situations due to their size – some VC’s can’t write small checks due to their fund size. The winners would not make a difference and the losers would just distract from the bandwidth.
Contrast this with the lean VC philosophy exhibited by Greycroft (founded by a fat PE firm founder no less). These guys seemingly have 5 investment people – 4 of them partners. Not a lot of fat there. They raised an initial $70M fund – and added to it with a $130M raise announced today. Given their focus on consumer and media investments – there is just no need for fat start-ups. That $130M can more than pay the bills at a 2% management fee (with the $70M they already have – that’s about $4M per year for under 10 people in 2 small offices) and they can probably make 20-30 full investments over the next couple of years – with full partner staffing on each one of them.
Obviously this model only works when you self select into early stage ventures and make sure the companies you invest in never need a significant amount of capital. Nothing capital intensive, nothing with a lot of music rights, no manufacturing, nothing with a large negative working capital position. Nothing but what you would consider to be a good business. In addition, you would probably need to make sure that the company had enough of a moat to make sure you were not going to burn a lot of $ marketing the service to your customers. If it is not viral – it is just not going to work out. So the funnel gets real narrow real fast – which is fine as long as you are actively putting more companies in the hopper.
So what is the verdict: to my mind there is certainly a place in the world for both the lean and the fat. I’ve worked at both (from a hedge fund standpoint) and there are merits to both. Both are somewhat limited in where they can play – but the fat have more options. However, the lean guys have less competition, and can certainly spend more time and partner energy on companies they invest in – which is fantastic if you really want to build businesses with the founders as opposed to simply being a slightly less than passive (perhaps passive aggressive) owner of a company.
In the end it really comes down to what VC firms and their partners want to do – and how they want to play. VC is not a business that scales particularly well. Our 15 person team where I work now could just as easily invest $500M as $1.5B – but triple assets at a VC firm and it will either have to add a lot more partners – or start going higher up in the cap structure and put more $ to work in later rounds.
Theoretically, I think the proper number for AUM at a venture firm is about $50M per partner or senior investment professional. That allows each partner to make perhaps 5-6 investments up and down the cap structure (seed to later stage) and allows that partner to be actively involved with each company. Over the course of say 7 years if you do manage to turn that into $150M – $200M it is a fantastic living. Much more than that and you are going to have to start swinging harder and looking at fewer pitches – which never really leads to a very high slugging percentage.