In this section, I describe the ‘‘trigger events’’ that led firms to make chang- es,5the barriers they encountered in doing so, and some of the organiza- tional characteristics that seemed to increase or decrease the chances that they would make such changes.
I also use my large-scale dataset to present summary statistics to com- plement the qualitative findings and model that are the focus of this chapter.
More specifically, with regards to the triggers described below, I created data tables to explore whether the firms that experienced each trigger in- creased structural leverage more than firms that did not experience each trigger.6In those data tables, I split the firms into three major buckets, based on the histogram above: (1) those firms that decreased structural leverage by 0.25 or more (the 34 firms at the left half of the histogram above), (2) those that did not change (the 110 in the middle of the histogram), and (3) those that increased structural leverage by 0.25 or more (the 55 in the histogram).
I present each data table in the section that describes the field findings about that trigger.
Trigger Events
Among the firms I studied, I found three major types of events that pre- cipitate a fundamental shift in VC blueprints. On their own, none of these events was enough to effect a fundamental change in the firms I studied.
However, the firms that experienced more than one event were more likely to transition than the firms that did not experience them, since these events increased the benefits of pyramidalization. The three events are generational transitions, the raising of a second fund or of a fund much larger than previous funds, and a shift in strategy.
Generational Transitions
The first major event is when firms are approaching a generational transition in which a central GP or a group of GPs are nearing retirement and be- ginning to reduce their involvement in investing.
Upside-down Venture Capitalists and the Transition Toward Pyramidal Firms 165
In the early years of the industry, according to several GPs, firms were formed with the intention of raising a fund to invest, without worrying about building a firm that would last multiple funds.
Before, people thought firms were single-fund firms. One-offs, where ‘‘let’s do something together.’’ You couldn’t see that, ‘‘My career will be in VC.’’ Now, it’s built-in that firms are here to stay, that longevity is here to stay. {MP of Boston firm}
Even for new firms that plan to be around for many years, the founding GPs are often young enough that they do not worry about how their far-off retirement would affect the firm. However, as founding GPs near their re- tirement, their firms’ continued existence comes into question. As an in- creasing number of founding GPs have neared retirement in recent years, the issue of whether their firms would survive through a new generation has become more pervasive, as stated by a Principal in a Boston firm: ‘‘The generational problem is now a big problem in the industry.’’ This is par- ticularly true for GP-only firms that never hired and developed junior peo- ple. The retirement of their GPs is much more likely to imperil the future of these firms. According to the COO of a Boston firm, ‘‘Historically, GPs would leave and it would be a train wreck.’’ Their firms either neglected to proactively prepare for such a transition, or had powerful GPs who resisted any such preparations.
It’s like watching a thunderstorm in Texas – you see clouds forming, and then they’re used up all their energy and can’t sustain it, and then there are others that develop into a full-blown storm. {Industry consultant}
This problem is particularly salient for LPs, who commit their money to each VC fund for a decade. (The influential role played by LPs in this phenomenon resembles the power held by central resource providers in other contexts (e.g. Emerson 1962;Pfeffer and Salancik 1978).) According to the LPs I interviewed, such ‘‘generational problems’’ catch their attention and can make them think twice about investing in a new fund. One large California LP stated that ‘‘the reason we exist is primarily to monitor in- ternal dynamics, chief among which is generational transitions.’’
You’re giving them a lot of money. Once you sign on the bottom line, you’re stuck, so you want to make sure that they’re going to be around.yI don’t want to be age discriminating, but if you’re 65 years old and starting a new 10-year partnership fund or you’re the only GP, that’s a problem.yTo be a great VC firm you have to be able to make the transition. {LP in large university endowment}
When we’re looking at a fund that’s going to last 10 years, when we’re evaluating a team and their business strategy, we’re listening to and watching their current interactions but also wondering, ‘‘Is this an organization that’s going to be able to perpetuate itself?
Who’s the leader and if something happens to him, who would fill his shoes?’’ {LP in large Boston institution}
Furthermore, many LPs said that they like to invest in firms with the in- tention of continuing to invest in multiple funds the firm will raise over a long period of time.
We want to invest in the same firms throughout. We want a long-term relationship. In a ten-year period, we’ll have at least 3–4 funds from a firm on average, so it turns into a twenty-year relationship at that point. It’s not worth the time, effort, and risk of in- vesting in a one-time fund. {LP in large university endowment}
Therefore, LPs assess what each firm will look like throughout the next couple of decades or more.
To see this, we look at turnover, at the career development of the important people, and we meet separately with the younger partners to get their perceptions of where the firm is going and what role they’ll play in getting it there. {LP in large institutional investor}
Similarly, a COO I interviewed stated that, ‘‘LPs used to want to invest in a fund. Now, they want to invest in a firm, an institution.’’ This COO’s LPs were looking for longer-term relationships that would endure through mul- tiple funds. Other LPs made similar arguments for doing so.
Investing in a venture capital fund is very labor intensive for an institutional investor.y To put a billion to work in VC requires scores of separate negotiations and due diligence on dozens of private equity teams. When an institutional investor has gone through the effort to establish a relationship with a private equity team, they want to be able to reuse all of the research and relationships for future funds. It makes sense than an institutional investor would be looking to forge a relationship with an institution. {California LP}
Other VCs report, and the LPs I interviewed confirm that their LPs have begun asking such questions as, ‘‘Do you have a long-term infrastructure in place?’’ in an effort to assess whether the firm is susceptible to the loss of a single GP, or if it would be able to survive the retirement of the current generation of LPs. They are particularly concerned by firms that depend on a single GP – or on a group of GPs who are close to retirement – for much of their success.
When you look at the GPs in the industry, there’s a select group that’s rich now and moving on. There is a real need to grow people with real experience, to have people who can step into their shoes. Otherwise, there’s knowledge that hasn’t been passed on, board seats that haven’t been transitioned.yIndividual portfolio companies can be hurt by the abrupt retirement of a key board member before another member of that VC’s firm has been able to take over the reins. {COO of Boston firm}
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One COO, who had just returned from his firm’s annual meeting with its LPs, said that the LPs had been very supportive of the firm’s efforts to transition toward a pyramidal structure.7
Our LPs were very supportive of our current transitioning efforts. They like that we’re making our GPs leveragable and that we’re developing an infrastructure. They were very supportive of the fact that we’re developing a scalable organization – with a larger fund, we need to create more capacity for our people, and all the things we’re doing are helping that. They also feel good that when a senior partner leaves, we won’t have to go outside to hire someone to replace him. {COO of Boston firm}
Sometimes, the impetus for the older generation to hand over the reins comes from the senior GPs themselves, who realize that they will soon need to reduce their involvement in the firm.
How does a GP know when to move down? It becomes readily apparent. Especially on the tech side, you have to be younger. The sweet spot is when you know enough to know what you’re doing, but you’re fresh enough that you’re still current. It’s usually about a 15-year period of time. {GP in established Boston firm}
There will be a Greylock 37, and Henry McCance [Greylock’s MP] knows he will have nothing to do with it. {MP of Boston firm}
However, as described later in this chapter, the senior GPs can also resist changes for several reasons.
When it comes to making a smooth transition, one solution might be to hire GPs from outside when the need arises, rather than having to take the time to develop people into GPs over a number of years. However, many VCs I interviewed saw such a solution as sub optimal. The main reason is that firms emphasize maintaining their tight-knit cultures, and avoid impe- riling these cultures by hiring senior outsiders who might not fit.
Especially when you have a number of partners who will be retiring within the next five years, you need to have people who can step into their shoes, and it is better to grow them from within than to bring them in from outside. Just having a certain number of years of direct experience in the firm is important. {COO of Boston firm}
In addition, some firms see the hire-a-GP approach as a riskier solution because, ‘‘We can’t rely on getting lucky and hiring a future star,’’ as one Principal stated.
Therefore, firms that want to proactively develop a new GP often hire an Associate and develop him or her into a GP over a series of years. Such firms try to develop the next generation of firm leadership in advance and plan for a smooth transfer of leadership to the new generation. An Associate in a life-sciences firm said that such approaches were relatively common in
past years, and may still predominate among firms that want to remain small.
The historical model for generational shifts is based on a one-to-one mentor model: after some number of years, some number of funds, the person is brought up to GP. This is the ‘‘slow-growth model.’’ You’re just looking to replace yourself. {Associate in health- sciences firm}
To LPs, such an approach shows that the firm is concerned about how it will be able to continue investing the capital committed to it.
The better firms, you can see them planning it. There’s a partner who’s 50, another 48, another 41, and a partner-to-be who’s 35. It’s very hard if there are four guys who are 55–65 and one guy who’s 40. {LP in large university endowment}
You have to have a commitment to bring people in and developing them. It can be one per decade or three per decade, but you have to be bringing them in. {COO of California firm}
For instance, one prominent Boston firm recently hired its first new Asso- ciate since the current MP was hired as an Associate in the mid-1980s.
According to the Associate, a big reason he was hired was a generational transition that would occur in a few years.
The forcing event was the need to get in some young people and take care of some long- term succession worries. The GPs realized, ‘‘We’re not going to be around forever.’’
{Associate in prominent Boston firm}
However, many other firms believe that they do not have the luxury of hiring a single Associate who will become a GP. Doing so leaves them vulnerable to the Associate’s leaving the firm and setting back their tran- sition-preparation efforts by several years. Therefore, when they get within a few years of needing to transition to a new generation, these firms begin hiring multiple Associates for each future GP slot, and then ‘‘weed out’’ the best candidates.
To the extent you hire more than one or two junior people for each future-GP position, you have to be looking at culling some of the junior people. {COO of Boston firm}
We will have 4 more Associates over the next four years. For every two, one will make it to Senior Associate, and then maybe makes it to Principal. So we’ll have 2–3 more Principals. Our steady state is to have 6 partners. {Principal in small California firm}
One large California firm has spent a considerable amount of time planning its next generational transition. Most of the current GPs experienced rocky transitions in their previous positions, both within the firm and at other firms, and seem to be determined to avoid a repeat.
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Many of the second-generation guys left their previous firms because the senior guys there didn’t focus attention on generational issues. The foundation of the firm are people who had been at other firms. They hated the cultures there and how the firms were being built, and decided to do it differently. {Principal at large California firm}
The transition plan crafted by the firm’s current GPs calls for the devel- opment of two new levels of leadership within the firm, in an effort to ensure that the firm will be able to continue its success for atleast two more gen- erations.
The second-generation guys are running the admin side of the firm, setting compensation and titles, managing the infrastructure. They’re now bringing along the third-generation guys on the administrative side, and bringing along the fourth-generation so in 3–4 years, when the second generation slows down, they’ll have two generations incredibly active at the GP level. It’s also very well thought out at the sector levels. {Principal at large California firm}
One approach, used by three of the firms I studied, was to hire COOs from industries that had learned how to make smooth transitions. For instance, one COO had been a partner in a law firm. He pointed to the predominance in that industry of large law firms that was able to transit from their found- ing partners to later generations of partners, and to one prominent venture firm that had been able to do likewise.
Thinking about large institutional law firms, if you name the fifty most prominent law firms in America, the people with their names on the door have been dead for decades, so the current head guys – the ‘‘law firm GPs’’ – inherited it. They didn’t start it.yAt KP [Kleiner Perkins], Byers is the only one still there. The rest have moved on, and the most prominent people don’t have their name on the door. {COO of California firm}
In helping his firm make a similar transition, this COO hoped to draw on lessons from his legal career.
Among the firms I studied, the best transitions were those where the senior partners proactively reduced their involvement and share of the carry (profits). They hired promising junior staff on a regular basis while they could still mentor them and develop them into GPs, and delegated work to them. Easing out the senior partners while developing a new generation of GPs enabled these firms to live for another generation, and enabled them to gain the confidence of LPs.
In the clubby, congenial atmosphere of a VC partnership, it’s a way for [senior GPs] to exit without an abrupt transition. It’s good for both the individual and for the firm, because it’s hard to abruptly change who is sitting on boards and LPs don’t like abrupt changes. {COO of Boston firm}
Market Uptick: Fund Raising, Scale, and Growth
The second major trigger event is the raising of a new fund. For both legal and practical reasons, VC funds are almost always limited to a life of 10–12 years, forcing VC firms to raise a new fund every few years (Gompers and Lerner 1999). In the late 1990s, the funds invested by LPs in VC increased dramatically. In such an environment, it becomes much easier for firms to raise large funds to invest. At the same time, it also became more necessary for firms to have large funds. For instance, in ‘‘boom’’ markets, the val- uations of start-ups increase dramatically. With an increase in valuations, VCs have to invest more money in a start-up if they want to maintain the same percentage ownership as before, so it becomes more necessary for VCs to raise larger funds.
I found that fund raising affects firms’ structural choices along several dimensions. Sometimes, the number of fundsthe firm has raised is the im- portant factor. In some of the firms I studied, when they raised their first funds, the GPs could not be sure if their firms would survive to raise a second fund. Therefore, they delayed hiring other people to work with them.
However, once the firm had raised its second or third fund, the GPs became more willing to build a full organization. More generally, once GPs have gained confidence that their firm will continue beyond the first fund, they often look to ‘‘scale up’’ quickly.
[Our GPs] couldn’t make long-term plans with the first fund because they weren’t sure how it would go. Now, we can start to see about hiring Associates. {Principal in young Boston firm}
However, beyond the number of funds that have been raised, theamount of capital raised is also critical. Many of the GPs I interviewed stated that having a lot of capital was important in the industry for several reasons.
These reasons include the desire of entrepreneurs to have VCs with ‘‘deep pockets’’ who will be able to fund all of their needs while they are still a private company,8 the desire of the VCs to have a large stream of man- agement fees,9 and the desire of large LPs not to spread small amounts of capital across a huge number of VC funds.10 In addition, firms began using the increased management fees to broaden the range of services they provided to portfolio companies, both to increase their attractiveness as investors and to increase their portfolio companies’ chances of success.
These services – such as helping set up systems and policies, performing market research, and assisting with executive recruiting – could often be performed by non-GPs, leading firms to hire junior people and become more pyramidal.
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