Those accustomed to reading sheet music may find the term ‘Accelerando’ familiar. Its origin is Italian and means ‘pick up the pace’. Wanting to be in lockstep, Arthur Patterson and Jim Swartz named their venture capital firm Accel — a play on accelerate and excellence. Accel Partners was primarily founded to invest in hardware companies and to capitalise on the founders’ experience at Citicorp Venture Capital. Ever since, the growth of the firm has been true to its name despite the occasional stumble along the way. Not only did it miss out backing Google, the lacklustre performance post the 2000 dotcom bust resulted in investors exiting the fund. But Patterson and gang did bounce back and in style. Since inception, Accel has delivered a 30% return, net of partner fees. While it has quite a few blockbusters to its credit, it is most famous for being the first major investor in social media phenomenon Facebook. Cottoning on early to what Mark Zuckerberg was up to helped convert the firm’s $12 million investment into a peak valuation of $10 billion. If this fact ever gets mentioned on Facebook, it surely will get its share of likes. Since then his firm has been a part investor in almost every major social media start-up. Patterson though likes to keep it low-key. He has hardly been interviewed before and the Apple store on University Avenue is a better known landmark than the office of Accel Partners. That’s despite having an entire stone grey building to itself in downtown Palo Alto. Patterson would rather let Accel’s investments do the talking.
The philosophy at Accel Partners is to be the first institutional investor in a start-up. Tell us about the firm’s approach and thought process.
You have to put it in context. We spend a lot of time thinking where we want to be first before we decide to be first. There is intense discussion about which areas are evolving, which ones are passé and which ones will be the most fruitful for us to focus and be really up-to-speed on. Our philosophy is to think about business areas deeply so that when an entrepreneur comes in to present a plan, the partners gauging him know 90% of what he is going to talk about and can focus on figuring if he is the right entrepreneur who can put all the macro factors together. So you are just looking at the entrepreneur to bridge that last 10%. Unless you have prepared yourself well, you are not going to recognise either the opportunity or why this is the team for that opportunity. Being first, the marketshare leader in any market is going to make the most money. But you have to choose the right spots: being first does not mean things will necessarily fall into place.
Facebook was an investment that went to the moon. What were the driving factors at that point?
We had an internal project where we were monitoring the consumer usage of software. We looked at some of the newer companies in this area and made ourselves very knowledgeable and available to people in the business. Then we met Mark Zuckerberg and recognised that it was the 10% that we were looking for. So we moved very quickly despite the company having no revenue at that point. We paid a very good price going in and it made sense to us as the company had already made brilliant progress.
Many of your exits have been through a trade sale. Is the question, “Who can I sell this to after scaling up?” consciously asked whenever you fund a start-up?
While ‘logical potential buyers’ can always be conjectured, we do not get into any start-up thinking that we are going to sell at the first chance possible. We are keener on figuring out if there is a big enough opportunity both in terms of the company being funded and the segment it is going to play in. Now, if it scales up attractively, it will naturally attract buyer attention. However, selling a stake to a bigger company depends a lot on the politics within those companies. Those are very unpredictable. Besides, in our experience, it takes anywhere from three to 10 years for a fledgling to scale up. We can’t predict what or who in those ‘logical buyers’ would be interested in something in those time frames from now.
What is your plan B in case events don’t play out the way you thought they would? How do you decide if you should pump in more resources or push for a change in direction?
There is no question that you learn much more in companies that you struggle with because there is a lot more work and involvement and harder problems to solve. In the portfolio perhaps only 10% of them are going to work just like you thought they are going to work and be straight up just like the spreadsheet said they were going to be. In over 80% there will be setbacks. One of the fundamental reasons Silicon Valley throws up successful companies is because they have to raise money once every year, approximately, in their early years. Since it involves third parties, it is a very competitive and objective process. So when a start-up can’t raise new money, you know that it is off course in some way to be a leader in its marketplace. You can see there is no new direction, the progress made isn’t enough and there is no realistic alternative because you have miscalculated the market development speed. Then it is a question of how long you work to get it back on trajectory and how patient you want to be. That depends on how good the team is, how big the area is. Our investment approach has very high quality control at the front end and that is why we are a lot more patient on getting things back on track.
Where is most of the venture activity happening now? Which areas look most promising?
In the technology cycle, digital media consumer-oriented projects always seem to succeed the first. The heavy duty projects that tend to lag are SaaS, Big Data, storage and infrastructure. But to some extent they are pulled forward by the demands of the digital media companies, the Googles and the Facebooks whose dependence on back-end infrastructure is high. The first wave was more the consumer digital media companies; that is now shifting and infrastructure companies are receiving more funding and beginning to go public. If you look at today’s companies many of those ideas were talked about in the 1999 period. But the enabling infrastructure in terms of broadband availability, computing power and social capabilities, just didn’t exist then. We are very sensitive and well informed about the changes that are happening in the technology space. Successful companies always capitalise on and ride these external forces. Some things start as just an application, like Facebook. Today Google and Facebook have become a big external factor to many start-ups as they have become a standard. Getting the timing of these external forces right is half luck and half skill — perhaps 80% luck. For the really big winners, it is 90% luck.
Can we talk about the Patterson Cycle, which states that a technology upswing runs for eight years and deflates the next six years? Where in the cycle are we now?
I first started writing to investors about it in 1990, but The Wall Street Journal didn’t call it the Patterson Cycle until 2009. I would say that it applies more distinctly to technology, and other sectors like healthcare tend to be pulled along with it more from a fund-raising point of view. You tend to be pulled along because the IT sector is where most of the money has been made in the venture capital field over the past 40 years.
It is one thing to say it is the cycle but quite another to establish the causality. My view is that it is driven by the 30% improvement that happens in the underlying raw materials of the business. It is like oil getting 30% cheaper every year. It won’t make much of a difference in the first year or the second. But by the time it is down by 80-90%, businesses depending on it will have changed dramatically.
You couldn’t do Facebook in 2000. The technology just wasn’t there. But by 2004 with this steady improvement you could. Then you get this jump and then this thing accelerates because companies like Facebook become platforms themselves that others like Groupon or Zynga build on. But when you get past the peak, then everything built on the fundamentals will diminish. If we take 1999 as the peak of the last cycle, I would believe we are closer to another peak. Right now, we still have a large number of investee companies going public. So as long as that is going to continue I think it will keep extending the top of the cycle for another two years.
Can’t too much liquidity distort the Patterson Cycle? Failures might happen but then liquidity could stretch the cycle on the upside?
I don’t think so, as the cycle alternates in intensity. If you look at the 1969 peak, what companies sold for is much more extreme than the 1983 peak and the 1999 peak was more extreme than the 1983 peak. The causality is that people have forgotten the last cycle and they are less cautious. In comparison, in this cycle, the start-ups that are getting funded are much less speculative than was the case in 1999. We are manufacturers of companies. If we can sell what we have got, we will make more of them. That is why I say hundreds of companies will go public before the cycle heads down.
During the 1999 gold rush, listed incubators such as CMGI and ICG fuelled start-ups before flaming out. But largely, liquidity goes into commodities and real estate and can’t flow into venture capital even if it wants to. There is just no place for it to go.
As it is, the best new ideas don’t absorb much cash. The size of our early-stage funds have actually declined. Later-stage funds can absorb more capital, which is happening. There is some expansion with angel investors participating and that always changes the business for a little while.
There is always too much venture capital for the small number of really good ideas. Ever since I got into the business in 1971 it has been too much. It is a supply-driven business, not a demand-driven business. Liquidity constitutes demand.
How do you see the venture capital business evolving from here? Does the risk of market dislocation exist for VC companies?
Every cycle has been larger than the last because technology has touched more people both in the US and in the world. One of the things that you have seen in this cycle that you haven’t seen before is much richer entrepreneurial opportunities in areas like New York or São Paulo or some other international markets. There are quite a few digital media and e-commerce companies that we have invested in, in New York. The primary reason is that the back-end technologies have been taken off their backs by cloud computing. In the international markets you have seen a lot of copycat deals. There are guys set up in Europe to copy anything in the United States and around the world as quickly as possible. But Silicon Valley has the whole stack of technology. There are several things you can’t do anywhere but in Silicon Valley.
But I would say the biggest shift in technology is that New York is an interesting place to make venture investments these days. Will the next cycle have more of a change like that? If these areas have enough to work on during the dry spells and they have a vibrant enough community they may be interesting areas to start companies. Everybody would like to have a Silicon Valley, whether it is Pittsburgh or Moscow. It is just really hard to get the preconditions. It is so hard to develop certain kind of companies anywhere but in Silicon Valley. We have an incredibly optimised, naturally organised machine to take these technology innovations to the marketplace.
What are the challenges for Accel Partners going forward? Do you see China becoming a bigger part of the portfolio and growing in importance?
The actual number of ‘world-class’ new technology companies today in our China funds are a small fraction of what we see in the Valley. But the opportunities are different. They are dealing with very high growth in domestic markets and maybe you are better off in a Flipkart in India than you are in being a cloud company in Silicon Valley with some sort of base technology. It is just different opportunities. We haven’t seen any leadership companies but there is no reason you wouldn’t. When you are dealing with so many fundamental needs, who wants to spend time creating something for which there is no market. Today most of the Chinese projects are copies for the local markets.
Is this going to be a challenge for Accel Partners going forward in emerging markets — maintaining the sector cohesiveness that you have in the US market?
That’s a good question. You can clearly do it if you limit fund size. In India we have a relatively small fund. We think it is sized to stay coherent in IT technology. If we had raised a $500 million fund, then we couldn’t have maintained that cohesiveness. But our teams operate quite autonomously and so, if they are determined to raise a much larger fund, it will become less focused on IT technology.
What differentiates Accel Partners is this tremendous depth of experience that you have across partners. Have you tried to institutionalise that experience into the firm?
We have certain processes. Over time a venture firm will be more or less successful depending upon how professional and how consistent it can be over a long period of time. It sounds very easy but turns out to be very hard. We have been lucky but we also have been consistently professional. Anybody can have a Google or a Facebook and then you look at the portfolio and it looks very good. The lucky venture firms would probably produce 30% return per year. But over extended periods of time better processes, better people and professional commitment make a big difference. These little things, however, are hard to do in a consistent way.