Bigger Isn’t Better: Why Madrona Capped its New Fund at $300M

Madrona Venture Group could have gone bigger than $300 million for its already oversubscribed fifth venture fund. Much bigger, managing director Matt McIlwain says.

So why stop raising money? Well, the few-hundred-million range has worked out pretty well for the Seattle venture firm, which focuses mostly on early stage deals for local technology entrepreneurs.

Every one of Madrona’s four previous funds has delivered returns that rank in the top 25 percent of VC firms nationally, according to the Cambridge Associates benchmarks, McIlwain says. At the same time, staying in the few-hundred-million range also gives the firms’ partners more room to be hands-on with their portfolios.

“For an early stage venture firm, that’s a real sweet spot to be in,” McIlwain says.

It also may keep a firm’s performance better aligned with the interests of institutional investors, according to some prominent critiques of the venture business. In a detailed study of venture performance released in May, the Kauffman Foundation criticized a lack of information for institutional investors, underwhelming returns, and out of whack pay structures that it said encourages larger funds, rather than better performance.

So it was notable that Kauffman, which said it planned to narrow its venture portfolio to a smaller number of better-performing funds, was featured prominently in Madrona’s own announcement about its new fifth fund. “We are enthusiastic in our support of Madrona’s fifth fund,” Kauffman investment chief Harold Bradley said.

McIlwain agreed that the fund size keeps Madrona’s interest better aligned with its limited partners like Kauffman. And he noted something else that fits with the foundation’s guidelines: Rather than a 1 percent personal stake in investments, Madrona’s managing directors put their own money behind 5 percent of the deals they strike.

“We’ve always done that,” McIlwain says. “I want my CEOs knowing that all of us are personally writing significant checks every time we make an investment decision.”

Those investments will, by and large, be close to home. Madrona plans to continue its practice of focusing on Northwest companies—all but one of its investments in 2011 were based in the Seattle area, Portland, OR, or Vancouver, BC.

McIlwain says the firm believes that, despite advancements in travel and communications technology, early stage venture investing is still done best in your own back yard.

“The reason for that is not really about capital, but is much more about company building,” McIlwain says. “You do that best by the face-to-face conversations about strategy, about team needs, about key customers and partners, and then going out there and introducing your companies to talented people that might become part of their team or leveraging your network to make customer and partner introductions.”

But at the same time, McIlwain says, Madrona isn’t just trying to play small ball. “To be clear, we’re trying to build the best companies in the world and we’re trying to continue our track record,” he says.

The Seattle region is in a period of important growth right now, with Amazon’s breathtaking growth and ambitions to play in several new sectors, including mobile, advertising, digital content, and more. Microsoft, for all of its missteps, remains a behemoth in corporate IT, entertainment technology, and general software. Mobile has a rich tradition here, and is one of the areas ripest for innovation.

Add to that the continued march of Silicon Valley companies establishing engineering outposts in the area, and you’ve got a recipe that could pay off with startup success over the longer term.

Yes, it’s hard to recruit as a startup now, with regional offices for Google, Facebook, Zynga, and Twitter grabbing engineers. But McIlwain says that over the next decade or so, those companies will start spinning out more entrepreneurs and continue bringing talent to the region.

“Some of that talent will stay with big companies for a long time. But some of that talent will find a problem they think they can solve better than anybody in the world, and they will want to start a company,” McIlwain says. “And they’ll do it here.”

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