In this episode, we will go in-depth into the evolution of Venture Capital, including its History, the business model, process and operating model, and what its future holds.

Navigation:

• Intro (01:34)
  
• Section 1: History of Venture Capital (01:59)
  
• Section 2: The Business of VC (15:27)
  
• Conclusion (19:54)
  

Our co-hosts:

• Bertrand Schmitt, Entrepreneur in Residence at Red River West, co-founder of App Annie / Data.ai, business angel, advisor to startups and VC funds, @bschmitt
  
• Nuno Goncalves Pedro, Investor, Managing Partner, Founder at Chamaeleon, @ngpedro
  

Our show: Tech DECIPHERED brings you the Entrepreneur and Investor views on Big Tech, VC and Start-up news, opinion pieces and research. We decipher their meaning, and add inside knowledge and context. Being nerds, we also discuss the latest gadgets and pop culture news

Intro (01:34)

Nuno Goncalves Pedro

Welcome to Episode 41 of Tech DECIPHERED. In this episode, we will talk about the evolution of venture capital. We will start it with its history. We will discuss the business of venture capital, what is it all about, and we will go into the process of venture capital. How do venture capital firms and funds actually operate? Finally, we will talk about the future of venture capital, the immediate future and the more long term one. How will it change?

Section 1 – History of Venture Capital  (01:59)

Nuno Goncalves Pedro

Maybe starting with history. Venture capital actually goes back a long way. Obviously, we always like to go back to Second World War, the military complex in the US going full throttle, a lot of IP being generated, a lot of really useful things for defense that could be applied to the mainstream markets. In some ways, that’s the beginning of the history of Silicon Valley and the beginning of the history of venture capital at scale with public-private partnerships, grants and money from government, technology transfer into areas that were ultimately areas that went fully outside of defence and into normal markets, so to speak.

Nuno Goncalves Pedro

But actually, venture capital goes back even further. Venture capital and high risk projects go back to, for example, the time of discoveries, the time of trading by boat. Actually, that is where the term carried interest comes from. It is carried interest. What happened was the boat owners were going to take merchandise from one place to the other. Because a lot of these missions and projects had a lot of risk to them, not only they got paid to do it, but they also got paid in kind to do it with carried interest. They would keep some of their carried interest. That’s how the term carried interest really comes into these high risk profile projects.

Nuno Goncalves Pedro

Venture Capital is a very high-risk endeavor, or a higher risk endeavor than normal. Its history starts around World War II with private-public partnerships.

Bertrand Schmitt

I feel that between the age of discovery and World War II, there might have been the age of whaling in the US, from what I understand. Nuno, you want to say a few words on this?

Nuno Goncalves Pedro

Yeah. It goes back to whaling. It goes back to all these endeavors and projects and shipping. The military complex really expands it into private markets, so public-private partnerships, getting money into it. We started having, in venture capital, actually, early days, there was a lot of East Coast players in the market, which were more coming from the banking angle to it, just pushing into it.

Nuno Goncalves Pedro

Then we started having, because of a lot of aerospace defense projects happening around California and in California, there was a migration to players that were more, I would say, businessy, less banking. Some of the early VCs in this market, people like Pitch Johnson, Bill Draper, the granddaddies of us all. Bill was involved in a firm with Pitch. I think that was one of the original firms, if I recall correctly.

Nuno Goncalves Pedro

Bill went on, I think, to found Sutter Hill, which is still one of the oldest in continuity. Pitch went to found Asset Management, which if I’m not totally incorrect, is the oldest VC firm in Silicon Valley into continuity. A shout-out to the Asset Management guys, very good friends there. Obviously, from Bill, we had Tim’s son. Now we have his grandchildren, so that’s a bit of a dynasty. Sutter Hill is still around and doing very well, thank you. There’s definitely all these roots that go back to it.

Nuno Goncalves Pedro

Then in the late ’80s into the early ’90s, when we started having some really innovative companies that came into the market, Fairchild, Intel. There was a little bit of a search for the next wave of venture capitalist. And out of that search of the next wave of venture capitalist, we have people like Mike Moritz, who used to be a journalist, actually. John Doerr used to be a senior executive at Intel, coming into the market and really being some of the most known VCs of all time at Sequoia and Kleiner Perkins, call for them buyers.

Nuno Goncalves Pedro

Through those times, just to define epochs in venture capital, I think the epoch in venture capital that we move from was the very IP-driven, postwar epoch to an epoch that was all about what I call the country club proprietary networks.

Nuno Goncalves Pedro

I knew people that had done well. They were about to start their next company, an idea. I was willing to really feed them. Relatively low risk. I know they were successful. They had built stuff before, they had a great track record. It was almost like real risk. I was incubating the idea, giving you money and letting you go with it. Then for a long, long time, to be very honest, until probably the late ’90s, until really the Internet 1.0 movement happened, that was about it. That was the playbook in venture capital, country club, networks, etc.

Bertrand Schmitt

Another legend we might want to talk about, Don Valentine, who started Sequoia. I believe he was a very famous salesperson, head of sales at a big firm before funding Sequoia, if I’m not wrong. He was very successful in that endeavor. A lot of big guesses from these guys who started funds in the ’80s.

Nuno Goncalves Pedro

Yes, he was, I believe, at National Semiconductor?

Bertrand Schmitt

Yes.

Nuno Goncalves Pedro

Then it’s a little bit unclear how big was Sequoia when they started. I’ve heard that they started with five million. By a single LP, I’m not sure this is totally accurate and that capital may have been their first LP. I’m not sure again. But it certainly started in the early ’70s, I believe, 1972.

Bertrand Schmitt

Yes, you’re right, ’70s.

Nuno Goncalves Pedro

Everyone talks about Sequoia like it’s a brand new firm and they’ve been around for a long while. They’ve had obviously an amazing track record. They’ve gone through this. Mike Martz is a continuation of that route. But the playbook was really this playbook. It’s people that I knew, people that I knew were talented. I call it the country club thing is I’m not saying it in a nasty way, but it was direct access to people that otherwise it would be difficult to access. There was no Internet, there was nothing at scale.

Nuno Goncalves Pedro

Then the Internet happened and many things happened around that time. In some ways Sequoia, Kleiner, I believe, were at that time the guys. Benchmark started existing around then in the ’90s, but they were probably not as amazing and famous as they are today. Although, to be honest, I would say they’re probably the first big riders of the Internet movement. They made a lot of money in those early funds. But the playbook was still more or less the same. We started going from the country club into universities, into young entrepreneurs. That may have moved a little bit, but in effect it was a similar play.

Nuno Goncalves Pedro

It was proprietary networks. I have access to those people when they’re starting their next company. I have access to those professors when they’re starting. Vmware was started by Diane and her husband who were professors. There was a lot of this linkage to academia that filled very well with the whole country club, proprietary network, ethos of it and caught a lot of the early Internet plays because Google was at Stanford and Sergey and Larry were there, etc. That’s the first real big epoch of the professional VC. The postwar IP thing, that’s the first big epoch.

Nuno Goncalves Pedro

Then no innovation for a long, long time. I would allege that until probably mid-noughties, late noughties, there was almost no innovation in playbook. VCs were mostly inbound-driven proprietary networks in the sense of who do I know, what companies are they at, et cetera.

Nuno Goncalves Pedro

Then all of a sudden, something happened. The something that happened, I will credit it to two people, but I don’t think they’re the only two people or the only two firms that really did this. But I always credit Mark’s sister and what he did. Up front, it used to be called something else. I forgot the name. Mark will forgive me, I’m pretty sure. But Mark Suster, with both sides of the table and really answering these questions, was a very opaque space. People didn’t understand legal documents and he started demystifying and being the friendly VC. Brad Feld for sure was also part of that movement. Certainly, Union Square Ventures with Fred Wilson were part of that early movement. They started blogging about it. I’ve already said three names.

Nuno Goncalves Pedro

Then the guys we institutionalized it in some ways and said, “No, we need to have a brand and we need to have media and we need to reach out there,” because by and large, a lot of the VC firms were very stealthy or they were very much in their corner on Sand Hill and they did their thing. Benchmark had-

Bertrand Schmitt

No website.

Nuno Goncalves Pedro

Still does have a very poor… No website, like a splash page. If you know us, you know us. If you don’t know us, you shouldn’t be here type thing. But basically in recent or with Ben and Mark were the guys who shifted their own set and said, “No, we need to be known. We need to be known. People know who we are.” They launched, I think their first vintage fund is 2008. I might be wrong, but it’s around that time. The rest is history.

Nuno Goncalves Pedro

That playbook changed. Vc firms started branding themselves. They started really being out there having thought leadership. Now it’s almost a given that each associate principal, even partner at the VC firm is posting blogs every month about something that they know, something about whatever. People are very active on Quora. They speak publicly a lot. They get interviewed by journalists. It’s become a profession that is clearly more visible.

Nuno Goncalves Pedro

Then I would say the final shift we see in the history of VC in terms of epochs and playbook is probably also best described by Andrii Sonorowicz, or maybe by larger AUM players like NEA and others, which is the whole notion of shared services. Once we invest in the company, we’ll not only back the company with capital, but we’ll back the company with market development, recruiting, PR, and all these things, and we’ll make that available to our portfolio companies.

Bertrand Schmitt

Yes, that has been a dramatic change. I agree with you. Having been on the other side of the tech industry, I have seen a drastic change in term of information available on how it works, how this industry works, how does it work. On the VC side, from the entrepreneur side, I’ve seen that change over the past 25 years, where it has become way more open, way more transparent.

Bertrand Schmitt

Another actor that helped was Y Combinator. Standardizing term sheet, for instance, has been very helpful. Definitely significant trends.

Bertrand Schmitt

Anyone can become somewhat knowledgeable. Some great books, by the way, Secrets of Saint Hill Road by Scott Kupor, for instance, another one around deal terms. There’s been quite a few good books about this so that you can read books, you can read blogs, you can follow Twitter and get a good sense about how this stuff is working. I think that’s very helpful for everyone. As a VC, you want to understand how entrepreneurs are working, and as an entrepreneur, you want to understand how VC are working because it’s always important to be aligned when you are working together to try to achieve something bigger than just yourself.

Nuno Goncalves Pedro

In a correction, Don Valentine started Sequoia with three million from Capital. It was from Capital. It was Capital was excited because he was doing this angel investing on the side and they started paying attention to it and they decide to give him money. Capital, obviously, is a huge asset manager, one of the largest in the world. That’s how incredible things start with small amounts of capital, sometimes three million.

Nuno Goncalves Pedro

I think that’s the last epoch that we’re in. We’re still probably in that epoch. I think asymmetries of information to the point you were making are part of the past. In some ways, I as a venture capitalist, I believe it’s also my duty to actually educate even as we are negotiating because we’re going to be in a relationship for at least 5-7 years, maybe even longer. So if that realizes we screw them on the deal on some obscure clause or whatever, it’s sort of not very helpful. You can get away with it maybe once or twice in your career as a VC, but if you do it systemically, and we know a few players out there that sometimes do these funky things, if you do it systemically, everyone in the market knows. I think those asymmetries are slightly disappearing.

Nuno Goncalves Pedro

Obviously, it is still true that a VC will do a lot more deals than an entrepreneur. Of course, even if you’re still entrepreneur, you’ve raised money, I don’t know, 10 times in your life. If I’m a VC and I’ve invested in 50 portfolio companies, I’ve done 50 deals. I’m already ahead. I’ve done more deals. I have more experience. It’s part of my bread and butter. It’s core to my business in some ways because it’s where I do my returns.

Bertrand Schmitt

Maybe just on that point as an entrepreneur, that’s why it’s important to get very knowledgeable lawyers. That’s the one thing I’ve seen as a mistake from many entrepreneurs is to pick lawyers who don’t know VC, who don’t know how a term scheme is built, how it’s negotiated when you go to final document. And on the VC side, it’s horrible because you have to work with someone who has no clue and focus on the wrong points or even doesn’t understand the whole concept. So please, it’s as expensive to get a lawyer who knows VC as it is to get a lawyer who doesn’t know VC, but on the long run, the one who doesn’t know VC will have put you in trouble.

Nuno Goncalves Pedro

There’s definitely that. There’s the 10 or 15 law firms that everyone knows that are active in the startup world. You guys can ask your friends and your colleagues if you’re an entrepreneur, they all know who they are by no specific order. The Morgan Lewis’s of the world, the Wilson Sonsini’s, the Goodwin Procter’s.

Bertrand Schmitt

Gunderson.

Nuno Goncalves Pedro

The Cooleys, the Gunderson Detmers. I’m probably missing a bunch that will be pissed off. The DLA Pipers. There’s a bunch of them out there that just do a lot of VC deals. They’re experienced in doing it. They know how to deal with it. There’s an advantage to that as well because the likelihood is your VC will have another VC, another law firm that is in that list of 10 or 15. When both are talking to each other, they know each other’s draft. It’s actually much easier for them to do business. They won’t be looking for funky clauses, they won’t be having stupid discussions, et cetera.

Nuno Goncalves Pedro

That said, two other elements that I would highlight on the legal side. One is there are some law firms or lawyers that are exceptional at this and that’s the only business they do. There’s a couple of them that come to mind right now. They’re also exceptional. Those guys are still, although they’re not part of the top law firms, they’re exceptional at what they do. They also do it all the time, et cetera. They may be a lot cheaper, et cetera. Which is helpful.

Nuno Goncalves Pedro

Then finally, the last element is you have to manage your lawyers.

Bertrand Schmitt

Never forget that.

Nuno Goncalves Pedro

That’s the opposite error. I have Goodwin, I have Morgan Lewis, I have DLA Piper, they’re representing me. No. And entrepreneurs make this mistake all the time where at some point they’re being run by their lawyers. I’m like, “Sorry, is this our deal or is this a deal that I’m doing with your law firm?” Because my law firm is representing me and my VC firm. They don’t have a blank sheet to go and negotiate with your lawyers or with you. I don’t appreciate the opposite either.

Nuno Goncalves Pedro

And many times there’s just business decisions that need to be made. I find most of the stuff between lawyers, if there’s someone on at least one of the sides that is assertive around managing lawyers gets done. Again, they’re amazing, they’re great. Using the top ones is important. Managing their cost is important as well, but you have to be thoughtful how to manage them.

Nuno Goncalves Pedro

Obviously, with experience as an entrepreneur, you’ll get better at it. It is part of our core job as VCs, certainly, to manage our lawyers and to make sure that we get exactly what we want out of the deal and the dynamics of the deal. These are funky deals, as I mentioned before, because they’re long term deals. We’re going to be together for a long time. If we screwed you on the deal and it becomes very evident on the next round that you raise because some lawyers are going to look at it again, they’re like, “What is this thing here?” There’s seniority on the waterfall to these guys, whatever. You’re going to get in trouble. It’s really you have to be a good actor.

Section 2: The Business of VC (15:27)

Nuno Goncalves Pedro

Maybe even switching to the business of venture capital. What is the business of venture capital, Bertrand?

Bertrand Schmitt

That’s a big topic. Ultimately, as a VC, you get money from other people. It’s not your own money. There would be your own money, but just a small piece of it, maybe 1-2 %. Ultimately, you are getting money from other investors, limited partners, as they are called. These limited partners, they are pension fund, they are family offices, wealthy individuals. So they might be of different types. Your goal as a VC is to give them returns. They give you money so that you give them money back and that you give them money back, obviously, while beating some measure of success.

Bertrand Schmitt

This measure of success would be probably returns on the S&P 500. And this measure of success will have to take into account the fact that their investment is not liquid so that it’s money that they will only get back after 5, 7, 10, 12 years. So they have to beat returns from an S&P 500, for instance, because this one is liquid. You can take your money out whenever you want. So your business is to make money for other institutions.

Bertrand Schmitt

Obviously, in order to achieve that, you have to do something with that money and so you are going to invest. You are going to invest in entrepreneurs, in startups. And for that, you have to find the best ones. You have to convince the best ones to work with you. And ultimately, once you have convinced them and signed a deal and obviously a good deal, and a good deal means win-win, as we just said, there has to be win-win between the VC firm and the entrepreneurs because this is a repeat game. You will invest multiple times in that entrepreneur, in that startup, and you will have to make multiple investments in multiple startups, and the word get out quickly if you are not fair.

Bertrand Schmitt

Then once you have invested, you need to support your investment. As we say, some firms have different levels of support. Some have literally teams of people that you can get access for free. Some have teams of people you get access for a fee, and some don’t have teams of people. It’s just the partners and the analysts supporting you as part of their job.

Bertrand Schmitt

From there, ultimately, you have to exit the investment you have made. Obviously, you need to exit with some level of success. When you say you have to exit, you have to find opportunities, or the startups you invested will find opportunities themselves so that there is liquidity for everyone involved.

Nuno Goncalves Pedro

Although there are different structures out there, the normal structure of venture capital is a fund. We venture capitalists are fund managers. To all the points that Bertrand said, we are about returning that capital to the investors in that fund. The majority of that capital normally is put in the funds by the limited partners, by the investors, could be corporations, family offices, endowments, pension funds, high net worth individuals. There’s a variety of different players that could be limited partners.

Nuno Goncalves Pedro

To your point, there’s a GP contribution. GP contributions vary quite a bit. One to 5 % seems to be the magic number of the size of the fund, the 1-5 % number. But there are, for example, funds that have a significantly more of GP contribution because they’ve been around for a long time. There’s different structures. We were talking about Sutter Hill earlier that goes all the way back. Sutter Hill operates as a capped organization. They’re not really a fund in that sense. You are in it and then you can leave, but it’s almost like you’re in a cap table rather than you’re in a fund. Whereas we’re managing normally funds that are 10 years plus 1 plus 1, so maximum 12 years and it’s like that fund needs to return at some point. To your point, relatively illiquid, unless there’s exits and liquidations and there’s all these strange and funky dynamics around it.

Nuno Goncalves Pedro

The main objective is clearly the returns. If you can’t return the fund above a certain amount, you’ll lose the right to exist as fund managers going forward. The value piece of what you bring to entrepreneurs has become more crucial in this last epoch of the Andreessen Horowitz, et cetera, of the world. It is pretty vital. The elements of distinctiveness, am I a super well-known person in the market that’s just starting a VC firm? It’s like the celebrity VC fund or the person who was an entrepreneur who’s done really well is now starting a new thing.

Nuno Goncalves Pedro

Normally, the business of VC gets basically scaled through time. Even if you’re a superstar, you’ve done very well in your past life, the odds that you’ll start with a stupidly large fund are very small. Don Valentine started with his three million. Founders Fund, I believe, started with 40 to 50 million their first fund. Peter was already super well-known by then and he was already doing a variety of other things beyond well past PayPal, so things grow. They start, they grow, and then with your track record, you can grow them more. That’s how fund management really changes in venture capital.

Conclusion (19:54)

Bertrand Schmitt

Thank you for listening Tech DECIPHERED, Episode 41. As a conclusion, this was our first episode in a series of two episodes about the evolution of venture capital. We just concluded Episode 41 talking about the history of venture capital as well as the business of venture capital. In the next episode, Episode 42, we are going to talk about the process of VC. We are going to share some stats around venture capital, and we will also share our perspective about the future of venture capital. See you next time. Thank you, Nuno.

Nuno Goncalves Pedro

Thank you, Bertrand.