Is the Benchmark Capital Model the Antidote for Chinese VCs?

Credit: Visual China

BEIJING, August 28 (TiPost) – On July 31, Jack, a partner of X venture capital, stood by the window in the conference room, overlooking the traffic flowing through the district.

This was where he and his team had fought day and night, discussing projects and making investment decisions. It was also the place where they reviewed the first half of the year. After the review, he made an important decision, which was to keep only the necessary administrative positions and lay off all investment managers and analysts.

"This is a decision we made after discussing it with several partners. We want to be a Benchmark Capital-style VC (venture capital), where partners directly participate in project evaluation. At the same time, we will recruit a few capable partners who may not have a VC background but possess specialized skills. The team members complement each other's abilities. Perhaps everyone can live more comfortably in that case," said Jack.

Benchmark Capital, established in 1995, has about five partners with equal voting rights, but without investment managers or analysts. In 2015, the 8 funds managed by Benchmark Capital returned a total of $22.6 billion.

Wang Genwang, the founder of Family Office Insight, a family office-focused information platform based in Beijing, shares a similar view. After exchanging ideas with several GP (general partner) and LP (limited partner) friends, he recently posted his insights on his social media, which include the following: 1. In an uncertain environment, people should aim at small businesses with certainty; 2. Streamline the team, unify thinking, avoid internal conflicts, take small steps and learn from mistakes, persevere; 3. No matter how bad the overall environment is, there are always people who make money, so people should communicate with those who are making money.

The Chinese venture capital industry is undergoing profound changes, impacting everyone in the industry. Many investors in the industry have stated that their institutions are streamlining personnel, reducing travel costs, cutting back on PR spending, and adjusting investment pace and strategies.

Is the Benchmark Capital model the antidote for Chinese VCs?

Be Small Yet Profitable

In the face of difficulties in fundraising, exits, and investments, venture capital firms have become more practical. They are focusing more on profitability.

In the first half of 2023, both the number of investment transactions and investment amount in the VC/PE industry in China continued to decline compared to the first half of 2022. There were 3,638 investment events, a 13% decrease compared to the same period last year, with a total investment amount of 292.97 billion yuan, a 7% decrease year-on-year.

The pace of global venture capital investment is also declining. According to data from Crunchbase, global venture capital investment amount in the second quarter of 2023 fell by 18% compared to the previous quarter to $65 billion. Compared to the $127 billion in the second quarter of 2022, it decreased by 49%.

"The venture capital market is undergoing structural changes, which is expected to last for about three years. It is uncertain whether the situation will improve in the future. Investment institutions need to be mentally prepared, control costs reasonably, manage exit returns, and try to satisfy LPs. Otherwise, in a bad situation, they will be trapped into a vicious cycle and eventually 'kill' themselves," said Jessica, a partner at a venture capital firm.

Let's omit US dollar funds for now and only focus on the development path of RMB funds.

Due to changes in funding sources, RMB funds are moving in two directions. The first group is state-owned funds with backgrounds such as various strategic funds led by state-owned enterprises with billions of yuan, funds established by large central state-owned enterprises, funds of funds established by local governments at all levels, and funds led by local state-owned enterprises. The other is small and medium-sized special funds. TiPost’s analysis of the data on China's VC/PE industry in the first half of 2023 shows that funds with a total fundraising amount of less than 100 million yuan accounted for about 65.7% in quantity, but only 9.7% in fundraising scale. These funds with less than 100 million yuan are most likely special funds.

When choosing GPs, many LPs consider the fund's management scale and brand influence as important reference criteria, which excludes many small and medium-sized institutions.

It is a consensus in the industry that 90% of the money flows to the top 10% of venture capital firms. Small and medium-sized venture capital firms naturally need to develop their own survival mode.

"Last year, we planned to expand, but after reviewing in the middle of this year, we decided to transform into a Benchmark model, becoming a small yet profitable investment institution, accumulating resources and waiting for the opportunity to expand," said Jack.

In his opinion, it is not difficult to establish a profitable investment institution. Firstly, it is easy for small institutions to raise funds. The partners always have several wealthy LP friends around them, so it is easy to raise 100-200 million yuan, whether it is to bring them into the private equity circle or help them with asset allocation planning. Secondly, it is easy for small institutions to invest. With the investment experience and network accumulated in the primary market, it is not difficult for partners to invest in 4-5 projects a year. Thirdly, the return cycle is short for small institutions. From the data performance, the probability of achieving a DPI of 1 in a special fund within 3-5 years is higher than the probability of achieving a DPI of 1 in a blind pool fund within 7 years.

"More and more GPs are taking this path, trying to raise funds while focusing on special projects, especially for small-scale and less well-known VCs," Eric said.

The small-scale and less well-known VCs that Jessica is in contact with are mostly led by industry "veterans" who have been in the industry for at least 6-7 years, and some even more than 10 years. The team size is usually small, ranging from 2-5 people. Each person has their own channels to handle projects and financing, focusing on making a fortune in secrecy.

This model is similar to Benchmark Capital.

Benchmark Capital was established in 1995. Each fund is maintained at a scale of $500 million, with about 5 partners whose voting rights are equal. 30% of the carry and 2.5% of the management fees are evenly distributed among the partners.

In 2015, Forbes published an article titled "The Benchmark Way: Five Partners Who Make Other VC Firms Look Outgunned And Overstaffed," which showed that at that time, the 8 funds managed by Benchmark had returned a total of $22.6 billion to LPs after deducting management fees and carry, with LPs' return rate exceeding 10 times.

Compared to Sequoia and A16z, which pursue rapid expansion and aggressive growth, Benchmark Capital is indeed unique, but its extremely high returns make it a model in the industry.

Efficiency Is the Key

Efficiency is the key to high returns.

Benchmark Capital does not have a CEO or a distinction between junior and senior partners. All the 5 partners act independently and take their own responsibilities. Over the past 28 years, they have invested in "big-name" projects such as Dropbox, eBay, Instagram, Twitter, Uber, and Snapchat.

The team’s small scale forces them to be full of enthusiasm and act quickly every day. In 2014, Forbes published an article, which told the story of Domo's CEO Josh James describing his new startup idea to Benchmark Capital partner Matt Cohler in 2010. Cohler invited him to give a presentation to the entire partner team the next morning. Without looking at any data, Cohler decided to invest $30 million in James’ startup on the spot. The contract terms were printed within 30 minutes, and the money was in James' account 17 days later. Of course, James is not an ordinary person. He previously sold his company Omniture to Adobe for $1.8 billion.

"Fast" is one of the impressions Silicon Valley entrepreneurs have of Benchmark Capital.

In contrast, in China, venture capital firms operate like a company, despite having a partnership structure. To secure funding for a project generally involves the following steps: investment manager contacts the project - team review - meeting with the entrepreneurs arranged by the partners after approval - issuance of term sheet - due diligence - investment decision meeting - entering the payment process. The entire process takes 3-6 months.

Clear hierarchy, layered decision-making. "It's like seeing a doctor. Everyone hopes to see the attending physician rather than being questioned repeatedly by the receptionist to determine whether an attending physician is needed. It's a waste of time for both parties," an entrepreneur said.

For Benchmark Capital, partners are the only ones that an entrepreneur can meet at the firm. Partners are the soul of a venture capital firm and the final investment decision makers. In the operating model of a company, front-end and middle-end personnel are basically "supporting roles", responsible for sourcing and post-investment services, supplementing the partner's understanding of the industry. The expenses for these personnel are not small, but the income they generate is quite limited.

"LPs care about how much money GPs can make for them, not how big a team GPs have. Venture capital is a business based on close personal relationships, not an industry that can be easily expanded," Jack said.

Zhe is an expert in industrial robots. Having started related projects, he is now operating an industrial robot community, regularly organizing relevant activities. He is also the founder of a small fund. With his deep understanding of the industrial robot industry and media connections, he can accurately identify and lead LPs to invest in early-stage projects related to industrial robots.

"A good paper does not necessarily mean a good investment. Papers cover trends, directions, tracks, and projects that are already apparent. Venture capital invests in projects that are underwater, capturing the 1% and generating a hundredfold return," said Jack.

Benchmark Capital, which used to expand everywhere, firmly believes that venture capital cannot be scaled up, and talents are the core of creating value for venture capital institutions. "With unified goals, no internal conflicts and overstaffing, everyone is a beneficiary and a 'sniper.' We are also exploring and finding our own pace," said Jack.

Intuition and Connections

"In early-stage investments, intuition, connections, and a bit of luck are often important," said Jack.

"From the essence of investment, venture capital is a job that deals with the difference between actual risks and perceived risks," said Cao Darong, founding partner of Cloud Nine Capital. "Many crazy and great projects cannot be invested in based on rational analysis,” he added.

Investors need rationality, but they also need sensibility and need to be inspired by great entrepreneurs. For many projects, rational people would not invest in them at all. Most investments are made when investors are moved at that moment, even though the risks seem high, which is called perceived risk. Afterward, some investors may regret it. Several years later, time may prove that they invested in a great project, and the actual risks were not as big as they thought. Therefore, when investing, they need to accept this sensibility. Investors need to see the aspiration of the CEO and see the future world in their perspective.

Based on rational judgment, Don Valentine from Sequoia Capital and Tom Perkins from Kleiner Perkins Caufield & Byers initially rejected Steve Jobs, who had messy facial hair, a thin build, and was wearing jeans and a T-shirt. The sentimental 33-year-old retiree Mike Markkula became Jobs' angel investor simply because he believed in the future of computers.

Xu Xiaoping (Bob) is the sentimental representative in China’s venture capital circle. There are many stories circulating about his sentimental nature, such as investing in angel rounds after having a cup of coffee with entrepreneurs or investing in angel rounds because he was moved by the dreams of entrepreneurs.

Emotional investment is seemingly a "foolish" behavior, but behind it is the investor's sensitivity to human nature and the courage to take risks. It also requires imagination, a deep understanding of the industry, models, technological trends, and the CEO's mentality, state, and vision. In Cao’s view, “determining the upside is much more difficult than analyzing the downside.”

The premise of demonstrating soft power is to have contact with the founder. Investors need their own network and channels for project sourcing.

"Investment has always been a game within a small circle, where founders introduce other founders, LPs introduce founders, and acquaintances are the most common way for the investment circle to obtain reliable projects. FA is only a supplement for some projects and relies purely on luck because most FAs involve casting a wide net for project submissions," Jack said.

Based on Jack's experience, it is important to first befriend the founder before investing in a project, understand their character, how they handle things, the team, and their past experiences. People are the premise of all investments because the entrepreneurial journey is not smooth sailing. Different people will yield different results when faced with the same situation. For example, when facing risks, excellent entrepreneurs see opportunities behind the risks, while foolish ones only see insurmountable obstacles. Intuition and experience are indeed important, but not more important than clear understanding.

The structural changes in the venture capital market have segmented the original big market into numerous small ones. While the survival strategies are largely similar, tactics are different. Venture capitalists need to find their own ways out.

(Note: $1 = 7.29 yuan)

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