ill Hambrecht discusses how venture capital has changed and how fund size impacts investor returns. WR Hambrecht’s OpenIPO^® auction process is leveling the playing field among investors, issuers and the investment banks and has been called one of the few disruptive innovations in modern finance. In addition to WR Hambrecht+Co, Bill co-manages Hambrecht Ventures I focused on disruptive technologies. If you would like more information on this series of conversations with Bill, contact Peter Morrissey at 415-551-8613.

The increase in venture capital available for entrepreneurs is fantastic: it means more jobs, a stronger U.S. economy, faster innovation, and better products. Venture investment expands the amount of research into life-extending drugs and non-polluting energy and I truly believe that my grandchildren will live in a better world than I do in part because of the venture industry.

My one caveat is that while a larger venture capital industry is good, larger venture funds are probably not.

I have a couple of issues with larger funds. First, the larger the venture fund the less likely it is actually doing venture capital and the more likely it is a private equity fund doing financial engineering rather than funding intellectual property. Most innovative ideas only need a modest investment of capital to prove out. Of course there are exceptions to the rule, but in most cases a few million dollars is all an entrepreneur will need to either create a dramatic increase in value or fail.

A venture capitalist does not provide value by creating scale: that is what some LBO shops do by providing either growth capital or acquisition capital. VC funds add value through guidance for the entrepreneur, building the management team, technical expertise and connections. What a good VC does for a company doesn’t scale. I think many VC fund management groups face a conflict when considering scale. There are some large firms, because of their tremendous track record, that will continue to attract high quality opportunities no matter what their size. However while any larger fund is more profitable to its partners, many of the great performance records of the past were based on small, very early investments and may not be replicable at larger fund sizes.

I was afraid you were going to ask me that! Not to avoid the question, but it really depends on several factors including the types of investments the fund makes and the operating structure and strategy of the fund. First, and most obviously, what stage investments does the fund participate in? Seed and early stage rounds are not more than a few million dollars, sometimes less. While the fund will have to make follow-on investments generally the more successful the company the less additional money is needed from the original investors to maintain their pro rata.

Second, different industries require much different amounts of start up capital. Most intellectual property companies seemingly can get started on a shoestring while hardware companies require more capital. I should note, however, that with more and more companies outsourcing assembly, even hardware “manufacturing” is less capital intensive than in the past.

Third, what is the operating philosophy of the fund? Here at Hambrecht we follow Clay Christensen who is focused on putting the business model to the acid test of profitability as soon as possible. Forcing a company to prove its profitability early reduces the amount of capital a VC needs to commit, whether the idea is a hit or a miss. A young company that successfully creates a disruptive business model has a good chance to create an entirely new industry, the way Google did in online advertising.

Finally, how many partners are in the fund?  I generally believe that a fund should have less than a dozen partners and more than two.  Each partner cannot monitor more than four or five companies at a time.

So an early stage software fund with three or four partners shouldn’t be bigger than $50 million, while a later stage hardware fund with a dozen partners might be $500 million.

Doesn’t it! One problem with the venture industry is that the work (and the value added) of a venture partner is a function of the number and stage of the investments while the income of a venture fund scales with the amount of money in the fund. Venture partners thus always have an incentive to raise more money to invest in fewer later-stage companies.

Many venture partners believe that you start with a small fund to build a track record and then graduate to larger funds to make more money. The problem with that from an investor’s perspective is that a larger fund needs to make different types of investments than a smaller fund and requires a different set of skills. It is no surprise that larger funds often have worse track records than their predecessors.

Of course, a smaller successful fund that was able to invest its capital in only a year or two probably should raise a larger fund, but a fund that takes five years to fully commit its capital probably doesn’t need to increase in size.

For venture funds, it often is.