What Facebook IPO says about venture capital

May 12, 2012, 12:16 AM UTC

FORTUNE — When Facebook goes public next week, it will mean a massive payday for Accel Partners — the venture capital firm that originally backed Mark Zuckerberg in 2005 and remains the company’s largest outside investor. It also could help support an argument that the most successful VC funds are small VC funds.

In a recent report on the sad stage of venture capital, the Ewing Marion Kauffman Foundation wrote: “We have no funds in our portfolio that raised more than $500 million and returned more than two times our invested capital after fees.” More broadly speaking a venture capitalist recently sent me an unpublished white paper (dated March 2011) that uses Thomson Reuters data to claim that “no venture fund larger than $750 million has ever returned more than 2.0x to its limited partner investors.”

This brings us to Accel: Back in 2002, the firm was in trouble. It was investing out of a $1.6 billion fund (Accel Partners VIII) that had been raised at the height of the dotcom bubble, but the resulting bust meant that Accel had more money than it could reasonably invest. It was a common problem in VC-land, with many firms simply telling investors that they wouldn’t call down 40% or 50% of committed capital.

Accel, however, tried a different strategy — split. From a story I wrote at the time:

Accel, on the other hand, wants to maintain the $1.6 billion already committed by spreading it over the life of both Fund VIII and a brand new Fund IX. By doing so, Accel would be able to lock in its 30% carried interest structure and significantly lengthen its investment runway.

Accel’s investors, however, thought they smelled a shell game. They rejected the proposal, and Accel ultimately agreed to slash the fund size down to around $770 million (via a pair of cuts).

When Accel went back out for money two years later, it learned that the episode — plus poor returns — had burned bridges with a number of limited partners. Longtime investors like Harvard, MIT and Princeton decided not to come back for Accel Partners IX, which closed on just $440 million.

It has proven to be a costly mistake for the Ivys, because Accel Partners IX currently holds around 149.5 million shares of Facebook stock. If the social network prices its IPO in the middle of its proposed $28-$35 range, the position would be worth more than $4.7 billion. And that doesn’t even include the Facebook shares Accel already has sold on the secondary market, which some say may have already returned the entire fund.

Now it’s entirely possible that Accel would have funded Facebook in 2005 through its “split” $1.6 billion fund. But that’s not what happened. At $1.6 billion, Accel’s fund was a loser. At $440 million, it likely will become the best-performing venture capital fund of all time — particularly once other portfolio companies like Glam Media get factored in.

Consider it just the latest, and largest, data point to support the “smaller VC funds are better” argument.

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