The Venture Company: Everyone is entitled to my opinion.

Dumb Capital please exit here

The Venture Company | venturecompany.com — 2010-08-25T05:58:18-04:00

by Georges van Hoegaerden

I was reminded again by how dumb capital has destroyed innovation by listening to Paul Kedrosky's interview with TechCrunch, in which he concludes that The Kauffman Foundation (which Paul represents as a Senior Fellow) may get out of Venture Capital altogether and deploy some of its monetary assets elsewhere.

Not an unexpected move, as I predicted a while ago many Limited Partners (LPs) as investors in Venture Capital (firms) would make, but a somewhat presumptuous conclusion from a respectable foundation that is supposed to be at the foreground and chartered to support the proliferation of innovation. Foolishly, I expected more intelligence from an entrepreneurial foundation than the intelligence displayed by a run of the mill pension fund stuck in a product of their own making.

Nevertheless I applaud the move based on how Paul described the foundation reached that impending conclusion. For we need to rid Venture Capital (VC) of Limited Partners who do not understand the foundational principles of innovation the sector depends on, and who do not understand the deployment of its unique risks. Probably for the same reasons why Michael Moritz of Sequoia Capital twenty years ago did not want to see pension funds enter the Venture Capital fray.

Take responsibility for you own actions (and in-actions)

First off, the reason why Venture has not and unchanged will not perform (at scale) is because of the financial system Limited Partners in Venture Capital have deployed, one that allows Venture Capital firms to take it for an all too comfortable ride.

With multi-tier bottom-level diversification (as described in 2010: The State of Venture Capital), a grab bag of other alternative investment options and ten additional levels of diversification once a VC firm is ready to invest, it should be no surprise that Venture Capital overloaded with derivatives and diversification has lost the merit it was once founded on.

We can now all easily blame 95% of the VC firms who do not produce any consistent returns for their Limited Partners, or Limited Partners can ask themselves the question why they created and participated in a financial system that enables such systemic underperformance.

We, as financiers of innovation need to take the responsibility of how we enabled a flawed governance of innovation.

Mired in "downstream thinking"

But our observations about Kauffman are based on the activities deployed by them over the recent years. The interview with Paul, the types of programs they support and a recent interview of Carl Schramm, Kauffman's current CEO with Charlie Rose all confirm who they have become. The beachhead for downstream thinking.

The entrepreneurial foundation, driven by the principles and money from a magnificent entrepreneur, seems to have made the mistake of confusing deep consensus driven hindsight with the proper definition of innovation; groundbreaking yet unrecognized foresight.

Perhaps not surprisingly since many of the key figures in Kauffman are economists who could not predict the demise of venture capital until it hit them in the face, and consequently have no idea as to how to fix it - as deep hindsight rarely translates into meaningful foresight. Hindsight and foresight are polar opposites.

Rather than to accept the outcome in Venture as a fait accompli, only a real entrepreneurial foundation would start to wonder what needs to be done to tap into the incredible entrepreneurial capacity in this country and model its financial constructs accordingly. Apparently not the Kauffman foundation.

Financial incompetence chokes our country

Now in the grand schema of things Kauffman is a drop in the Venture bucket, with a potentially side effect of dragging down other Limited Partners in Venture who are similarly clueless about how to reinvigorate the arbitrage of innovation. Such an atrophy of Limited Partners is actually a good thing (as it washes out those without proper investment discipline) as long as it is promptly replaced with new Limited Partners who have a more astute and disciplined interest in Venture aligned with the massive greenfield that lies ahead in technology innovation.

Problem is that beyond the danger that Venture as a scalable asset class could unjustly disappear, the malaise of the financial system in Venture may leave a large stain on the potential of the underlying asset, innovation. Already innovation in the U.S. has suffered from twenty years of subprime VC investing that by design can never scale innovative outlier capacity. The damage we already incur is a significant lack of faith, interest and distrust of technology companies by the public.

Because of the underperformance of the vast majority of Venture Capital firms many financiers now begin to think that the potential for innovation has decreased similarly. And that stain causes further mistrust in the sector, increases fear and catapults whatever is left in Venture even faster down the subprime spiral and our country into the lost leader of innovation.

Subsequently, the demise of VC creates some opportunities for alternative venture strategies, new Angel and micro-VC oxymorons that further perpetuate and fragment subprime investments and on average perform even worse than VC firms. Subprime at its best.

My recommendation to Limited Partners:

We are at the beginning of the technology evolution. Keep in mind that less than 20% of the world's population has access to meaningful technology innovation to enhance their daily life and improve productivity. A fantastic investment horizon lies ahead and as the youngest asset class in your portfolio, technology Venture has the most attractive economics and if deployed correctly, phenomenal potential for massive returns short term.
Venture Capital, the way deployed as a financial instrument today cannot support groundbreaking innovation at scale. Not because of a purported "Voodoo" of technology, but because of the systemic improper deployment of risk. Unchanged Venture Capital will continue to create self-induced risk, and therefor consistently produce deplorable returns for Limited Partners.
You can't teach an old dog new tricks, so don't expect better LP returns from the existing crop of VC General Partners. For twenty years Venture Capital has been given virtually unlimited freedom to deploy their optimal investment thesis, with massive market pull and the ability to control all the strings with regard to the governance of innovation. Tightening financial incentives does not magically turn subprime GPs prime and does nothing but dissuade new prime GPs who want to clear the air (the subprime ones will hang on for dear life as long as possible, even if you tinker with their management fees).
The deployment of the financial system that drives the deployment of risk in Venture Capital needs to be re-invented (we have). Investing in Venture unchanged is the definition of insanity. The solution is not a deeper understanding of Venture Capital's complexity, but a dramatic simplification and accountability of its foundational principles.
Stick to your knitting. Get out of Venture if all of this is too much hassle for you. You may miss out on the incredible opportunity that lies ahead in technology Venture but your passive presence in the sector does nothing but perpetuate subprime and hurts the performance of our economy in the long run.

Idiot entrepreneurs

The Venture Company | venturecompany.com — 2010-08-09T12:03:40-04:00

By Georges van Hoegaerden

To complete my affectionate series of "idiot" articles (idiot CEOs and idiot Limited Partners) I am adding idiot entrepreneurs to the list.

Idiots

Idiots are those people who continue to participate in a marketplace that was designed to marry the two most important assets in Venture, Limited Partners with money and entrepreneurs with ideas, governed by Venture Capitalists (VCs) to the dissatisfaction and under-performance of them both. Not even the public is interested (and certainly not for the right reasons, short sellers are not too picky and may artificially boost its initial IPO value).

We know that the real problems in Venture stem from how risk is applied to the creation of early stage companies, and that more discipline deployed by Limited Partners (the investors in Venture Capital) to a new Venture model will fundamentally improve the governance of innovation in the Venture marketplace.

Until then the only constituent in the Venture marketplace who cannot be called an idiot is the Venture Capitalist who without any personal downside can continue to apply the power of someone else's money to define what innovation is and continues to get away with feeble attempts to convince the public of their value for more than ten years.

Perhaps now you understand how the adjective "idiot" is a compliment of sorts. Rest assured, the behavior of and attraction to idiots can easily be fixed.

Life is hard when you follow

Life is tough for entrepreneurs, especially for those who continue to listen to the compass of Venture Capitalists, ignoring the miserable performance of that compass for the sake getting a little bit of money. With a continued dysfunctional deployment of Venture Capital many entrepreneurs continue to succumb to an arbitrage of innovation that, by default, will never lead to achieving groundbreaking upside. Even when the idea holds merit, the flawed deployment of risk by VCs is sure to suck the life out of it.

So, here is a list of attributes by which you do not want to be recognized as an entrepreneur. An idiot entrepreneur is someone:

Who believes that technology creates markets, rather than facilitates an electronic distribution mechanism to serve existing macro-economic marketplaces and behavior.
Who believes and accepts money to build a gating technology proposition in search of a marketplace or without a clearly defined attachment to macro-economic behavior and upside.
Who believes that they or VCs can actually derive foresight from studying statistics and hindsight intensively, forgetting that unique foresight is the only differential and investible attribute to successful companies.
Who believes that capital efficiency is a unique business or investment strategy available only to them or the VC and therefor delivers any differential business or investment value.
Who believes that market execution makes up for a dysfunctional "driving experience" and takes little streams of money to keep trying.
Who blindly believes that raising money is the first step to acceptance of his idea. Not realizing that the compass of most VCs (95%) does not lead to the creation of value to their investors nor the public, and therefor their willingness to provide money is likely to mean absolutely nothing (or quite the opposite).
Who calls himself an entrepreneur simply because he follows VC governance of what a hot innovation wave is.
Who thinks that raising money makes him an entrepreneur, not realizing that raising money is not a vote of confidence from the public.
Who thinks that raising money is an asset, yet with defunct investor performance across the board and in no less than 95% of cases turns out to yield a significant deficit.
Who takes money from a VC, without getting to know the investment partner (General Partner at the VC firm) personally.
Who takes money from a VC, without knowing the vintage and performance of their current or stacked funds. Ignoring blissfully any irrational behavior and panic that is about to come their way soon.
Who engages with an investor who communicates through the valuation and cap table that majority ownership by the investor is ever a good thing in an early stage company.
Who engages in fundraising efforts without a good understanding of the product conversion rates and operating credentials, offering many opportunities to VC of shooting holes in the proposition, to say no to the deal or drop the valuation just so you lose control of the company the moment one of your predictions do not pan out.
Who partners with a first venture investor who cannot lead the complete funding runway, setting himself up for excessive segmentation of rounds, fragmentation of ownership and increased dilution.
Who believes that authentic IPO value can be built for less than $25M, and dicks around with micro-VCs and well meaning Angels.
Who does not know the difference between micro private equity and Venture, praying to beat the simple economics of input and output.
Who takes money to drive Venture growth, but has no $1B upside strategy defined.
Who attempts to raise money from a VC without a real CEO, leaving the inmates to run the asylum and turning the company over to the VCs at the quickest pace possible.
Who prefers to take $250K of subprime VC money in return for 30% of the company, instead of getting a line of credit on your $1.4M house in Palo Alto (with a median house price $750K in the bay area). By the way, neither one is a good idea.
Who creates an iPhone application using Venture money, not realizing iPhone apps do not create venture returns and the top 1,000 applications on the AppleStore make no more than $350K average per year. You and your Venture investor deserve each other, including the idiot adjective.
Who raises money from a (government) small business fund, not realizing that a venture trajectory is incompatible with small business funding.

What to do?

Truly groundbreaking innovation is no longer recognized by the majority of Silicon Valley investors. The Venture business has turned subprime more than 20 years ago and only the delayed response by Limited Partners makes it seem like it has some of its former gusto left.

Entrepreneurs are relegated to the investment thesis emitted by overwhelmingly subprime VCs (some refer to using the oxymoron: micro-VC, which in actuality is not Venture but micro Private Equity) and Angels who, each with their own performance issues, have turned innovation into a commodities business.

Groundbreaking innovation that taps into attachment of existing macro-economic behavior does not evaporate easily and has plenty of time to wait until a new Venture model capable of attracting prime risk (and rewards) is up and running again. That type of innovation can simply not be discovered by subprime VC (let alone Angels), plenty of examples in the past have proven that out. So, unless you know how to get to the 35 out of 790 VC firms that do know how to deploy risk and produce returns, of which we estimate 3/4 do so by deploying diversification, alternative investment strategies or similarly subprime gating tactics, you should keep your job until this subprime VC maelstrom has lost its strength -- or until our systemic fix to Venture is in place.

For those people who aim to follow the investment waves of the current investors, by all means keep trying. Maybe, just maybe your pot of gold will be at the end of a rainbow.

Saving Silicon Valley

The Venture Company | venturecompany.com — 2010-07-28T07:51:11-04:00

By Georges van Hoegaerden

Some people do not understand why I do what I do and why I bother, and underestimate my determination to fix Venture Capital. Certainly there are much easier ways to make money than to pursue the obliteration of an investment cartel, in which seemingly everyone belongs to the club. And some people's actions are distorted by my critical views of what goes on in Silicon Valley, and the increasing popularity of my views may slow down the chase for money that is dished out often so irresponsibly.

My story

Let me tell you who you are talking to when you ask me to give up. My story may also answer the irritable question "who is this guy" I overheard recently. I do want you to know who I am, and how I care about this country. My story is more than just a bunch of business titles slapped together. Ready?

I was born in The Netherlands, the youngest of three boys in a family with a lifelong teacher as a dad, and a gentler mother working to place elderly people in geriatric facilities built by the government. With our parents coming home late from work us three boys literally fought it out everyday. To get to or from school first after a one hour bike ride every day (rain or shine, in Holland that meant rain more often than shine), playing in tennis (while co-founding our new club) and basketball leagues, finishing our dinners first every evening or claiming the window seat in the back of the family car. Everything back then was a competition, and as the youngest I got the brunt of the attempted suppression. Silly stuff, but it honed our skills to compete and I became very good at it.

My Dad was an educated man without much empathy, as most men born his age were (see the Mad Men TV series on AMC). I got my interest in science from him, but not much else. His vast knowledge never seemed to extrapolate to reality and he made his frustrations trickle down to everyone around him. At age seven I realized my life with him was going to be short lived. I never wanted to become him or be around him. I learned from him an important lesson I am sure he did not intend to instill; how to ignore negative pressure. I left the house at around eighteen, the first of the three boys and never looked back. After a shaky start I blossomed.

My Mom was quite the opposite. Friendly, outgoing and always ready to support her children in whatever way she could. I remember vividly the many conversations we had as she put me to bed and we covered the important topics of the day. My love and respect for women grew out of that experience. My Mom's weakness was to let my Dad get away with too much, and nurtured her "blind" devotion often to the detriment of herself.

The most positive influence in my life was the patriarch of the family, my grandfather (my Mom's Dad). A self-made man he became a majestic business figure as one of the co-founders of "van Melle", the company that made the ever so popular Mentos candy (sold a couple of years ago to an italian confectionary) and the generous man who gave us, what we as children then thought of as worthless pieces of paper, real shares in "van Melle" and "Royal Dutch Shell" for our milestone birthdays. He had clear opinions and voiced them when provoked, but he was humble at the same time, always asking the factory workers for permission to test the candy from one of "their" machines. He could laugh at himself, remained a rebel and kept everyone in the family in check. Nobody knew how much money he had until he died. The merit of his actions stayed with us much longer than his few words.

I came to the U.S. on my own with some hard earned chunk of change in my pocket, invited by Marc Benioff (now Salesforce.com CEO, then Oracle VP) and Larry Ellison (Oracle's CEO) who wondered why I was able to sell their (then) emerging products while they couldn't. The difference between my approach and theirs was the business model, to which the new managers I was asked to report to had no clue, let alone respect. I left Oracle with fond memories as soon as my green-card was approved and jumped in Silicon Valley hoping to find more intelligence there. My first startup was a group of consultants with a horrible business plan, and I told them about my opinions in a way only I can. Instead of fleeing, they came back and asked for guidance (management incubation). We turned the company into a product company and raised a double digit series-A post 9/11. The company was sold in 2006 for triple digits. As a board member my encounters with Venture Capitalists quickly made me question their catalytic value. I went on to build a few other successful companies and had a brief part-time stint on the "dark side". A clear pattern of defunct VC governance and execution started to emerge.

To sum it up, I was brought up with an understanding of how to compete, how to separate rhetoric from reality, how to ignore distortion fields, how to be devoted to a cause, how to be clear in your convictions, how to do what you say, how to relentlessly pursue your goals, and how to do what is right even in the face of opposing popularity and extreme controversy. But most of all, I never bought into nonsense, not even when that nonsense is supported by the masses.

I put in my time to get to know every business I was in, and earned my way into becoming a systems manager, computer programmer, IT director, pre-sales engineer, marketeer, entrepreneur, serial CEO, Venture Catalyst and Venture Capitalist along the way. Nothing was handed to me (my parents decided to use my shares to pay for the private education they felt I needed), and my real world experience continues to be a priceless "bull shit" detector in every new endeavor I engaged in. After thirty years in technology (ignited by my addiction for the HP-41C) of which fifteen years in Venture, I have witnessed the workings of the Venture business like no other.

The importance of this story is not to emphasize a purported "micro celebrity status" but to highlight my convictions, as convictions drive consistent and persistent behavior. Everyone has a story like this and staying true to the convictions that are shaped by the past makes for more authentic human beings, and a more natural fit to our contributions in society.

Perhaps my story will help you understand why the odds of building great performance in Venture that will save entrepreneurialism are in my favor. My background including fifteen years of first hand Venture experience in Silicon Valley begs me to unleash the financial choke-chain around the innovator's neck.

Silicon Valley needs help from above

The startling revelation, as proven out by the empirical evidence I have delivered for quite some time now is that according to a renowned money manager 95% of Venture Capital (VC) firms are not making any consistent money for their investors (Limited Partners). And that means Silicon Valley is at the brink of a serious implosion. Imagine what would happen if only about 35 of 790 VC firms were to survive in ten years from now.

Alarm bells should be going off by now, but few appear to be paying attention. Why not, you say?

Well, much of the money pumped into VC firms comes from Institutional Investors (pension funds, endowments, insurance companies etc.) with bulk loads of cash reserves they want to put to work. They dedicate a predetermined amount (usually by board consent), between 10% and 15% of those reserves to alternative investments of which a portion is then allocated to Venture Capital. To make a long story short, a tiny portion of assets from Limited Partners (even the non-institutional ones) is devoted specifically to Venture and a loss or break-even of less than 5% of total assets does not evoke a lot of emotion. Hence optimization discussions with Limited Partners about Venture turn with the agility of a big freight ship.

The alarm bells are getting muffled even more. Institutional Investors have built majestic constructs supporting the deployment of their Venture Capital assets. Many invest in Venture Capital through fund-of-funds with a "specialization" in alternative assets, a fuzzy term for anything that is not mainstream. And thus the actual performance of Venture is hidden behind the performance of the grab-bag of other financial instruments that resides in those fund-of-funds.

And it gets worse, VC firms themselves have been allowed to diversify their risk by embedding alternative investment strategies within the firm, and in worst cases even within the same fund. In short, Institutional Investors have stacked derivative, upon derivative, upon derivative (with of course zero marketplace transparency) and appear surprised performance of Venture Capital has lost the fantastic upside that made them all want to get in some 20 years ago.

And the mess does not end there. The mushy multi-tier asset allocation constructs allowed many General Partners entry to the Venture Capital business who have no credentials of being there. Their lack of experience and foresight has turned into fear and with it the implementation of Venture Capital risk has turned predominantly subprime. As a result Venture Capital risk has produced over the last ten years no more than micro Private Equity returns (less than 10% IRR), squandered about $1.7 Trillion in funds and eroded public trust in companies that never had any social economic value to begin with.

That fear from inexperienced General Partners in VC firms further exhibits itself by the deployment of 10 levels of diversification of risk when a VC firm makes an investment into a startup. Extreme fragmentation of assets and risk protects VC downside (making good money off management fees for 12 years) more than it protects upside, and thus Limited Partners are poised to lose out again, regardless of the economic circumstances. Improper deployment of risk cannot be mitigated by economic recovery.

Venture needs a reinvention from the top. But who cares?

Who cares?

Everyone in or around Venture should. The worst thing that can happen to a sector is that investors stop caring, and many have. Many Limited Partners will not renew their commitments and simply get out, and allocate their 5% of Venture Capital elsewhere. A speaker at a recent conference claimed the demise in VC firms to be as large as 30% over the last 10 years, with as much as 50% of venture folks already affected. New Limited Partners to the sector I speak with simply see no reason for getting in, given its deplorable performance.

And Venture Capitalists don't seem to care too much because ten years of a cushy management fee from a sizable fund with no way for the public to establish their merit gets them setup for life quite comfortably. Under the cloud of economic insecurity and with micro private equity returns in hand, it is still easier to raise another fund (and thus another ten years of fees) than to admit that not the economy is at fault, but their deployment of risk in it. Many idiot Limited Partners have fallen for their arguments again and Venture continues to spiral further down the slippery subprime slope it has been on for a while. To VC, survival of the fittest has turned into survival of the shrewdest. Or as a General Partner from Sequoia Capital allegedly stated: "We used to have a club, now we just club each other".

But the real impact of all this ignorance has already affected entrepreneurialism. Defunct VC governance has led to a dumbed down investment thesis that will only attract entrepreneurs that submit to that thesis. Hence the quality of innovation that surfaces is limited by the quality of the thesis that is projected. Subprime entrepreneurs, willing to be enslaved by subprime VC governance continue to tear down the potential of social economic value groundbreaking innovation is supposed to ignite.

Today, glorified programmers and VCs are the inexperienced partners in a dance that only a small audience (not the public) wants to attend.

Opportunity cares

With 80% of the world's population still not having access to meaningful technology applications, the opportunity to spawn new groundbreaking innovations remains enormous. Technology adoption keeps growing, even when Venture Capital declines in its ability to govern worthy innovation. So, the opportunity dictates that there is much more room for Venture Capital firms to grow, just not for ones that cannot establish a proper investment thesis of innovation.

Governance of innovation is improperly aligned with the opportunity of innovation, and thus any calculation of the size or number of VC firms based on its current workings is witchcraft, irrelevant and inaccurate (up or down) by default.

There is no valid reason why 100 VC firms with a single $100M fund cannot generate a six times return each, except for the improper deployment of risk. Certainly the gaping opportunity in technology dictates that there is also no reason why the total number of Venture firms in the U.S. could not reach 1,000.

The grim impact of doing nothing

The most powerful assets in the Venture ecosystem (see our Venture Primer) are the many entrepreneurs with groundbreaking ideas we have bred in this country. Yet, those outliers of innovation have systemically been ignored by a dumb financial system that favors those willing to be enslaved by subprime risk. Groundbreaking entrepreneurs have already left the party and quickly become extinct. Lured by lucrative offers they chose to find solace with better custodians of innovation, larger yet agile companies that simply took better care. Many returned home to their country of origin with an Ivy League diploma in their pockets. Silicon Valley, for what it once represented, has begun to implode.

With more than 50% of moneys spent in certain areas of Silicon Valley dedicated to startups, a 90% erosion of that money (from cutting down the systemic underperformance of 95% of VC firms and retrenching of disappointed Limited Parters) leads to an estimated 45% decline in overall jobs. That in turn creates massive economic deflation to the region and exemplifies why governmental intervention without fundamental reform (the current band-aids will be circumvented quickly) of financial systems in Venture does nothing to prevent the slide it is on. Our local and federal governments should be all over this case, to prevent a further systemic slide that could turn California into a grave-yard for what has been, and our country from becoming the lost leader of innovation.

Our government has simply not connected the dots between systemic failure in Venture and systemic failures in the economy, just yet. The pain and destruction probably need to become more obvious first.

U.S. Commerce Secretary Gary Locke did the usual politically correct thing by inviting members to his National Advisory Council on Innovation and Entrepreneurship with large statures in the old system, yet none in the new. The outcome of that exercise will be as expected, more of the same (yet no one will be able to politically accuse him). More importantly, Locke's agenda is flawed. The problems in Venture are not with the method of innovation, but with those who govern it.

Venture is the poster child for financial reform

As a reader of my blog, you may not be surprised to learn that the problems in Venture have nothing to do with some deep rooted and mysterious "Voodoo" of technology or innovation. We have an outdated financial system that does not need more regulations of its complexity, but a dramatic simplification and flattening of its marketplace behavior. The Venture business is the poster child for creating such a new financial system, as its current performance can nothing but improved on.

Innovation can only be saved by a financial system that is truly a free-market system, away from the existing cartel that offers no marketplace (transactional) transparency and is void of real competition that lies at the capitalistic fundamentals this country was founded on. Merit attached to money changes the bold lie capitalism is without.

So, my self-imposed journey to save America from itself continues, for I have seen its potential.

We can save the fantastic innovative capacity in this country and elsewhere when we apply the same intelligence of the way entrepreneurs build innovation to the way we fund it. Without a new free-market financial system in Venture be sure to strap in for a massive implosion in Venture that will take ten years for many to discover had been predicted by this annoying whistle blower all along.

At least now you know who he is.

A grand new opportunity in Venture

The Venture Company | venturecompany.com — 2010-07-15T14:09:25-04:00

By Georges van Hoegaerden

I could not leave my previous two "depressing" blog articles out there on a limb for too long without offering a solution. Even though I know that those articles are only depressing to those who cannot see the new opportunities created by the systemic Venture malaise.

Let me be clear, I see a grand new opportunity for Venture investing.

The current VC model can never attract disruptive ideas

Venture is on fire and not in a good way. So agreed with me one of the top money-managers who I met with last week in Palo Alto, and manages over $40B in Private Equity, including Venture. Especially since the Venture asset class is so young and has such a bright future ahead, the deplorable performance of its financial instrument Venture Capital (VC) with minus 10% returns across the board has failed, and proves its governance is fundamentally flawed as its recognition of entrepreneurial ideas has not (even) outgrown the technology adoption baseline it rides on.

The financial system atop of innovation has failed, not our capacity as a country to innovate. The primary reason for the systemic malfunction (described in 2010: The State of Venture Capital) is the incompatible market model created by VCs (and bought into by Limited Partners) that allows for and continues to stimulate the creation of an investment cartel, a single investment thesis that by definition can never find the outlier of innovation.

According to the aforementioned money-manager only 35 of 790 venture firms in the US consistently produce some positive returns (not necessarily venture returns as a return of the deployment of venture risk). That means less than 5% of all venture firms, consistently produce a return. And we can only wonder at this time how many of those 35 actually produce a viable Venture return, as opposed to a micro-Private Equity return, especially since out of fear Venture has turned subprime more than 10 years ago.

That result makes for a pretty depressing outlook for Limited Partners for Venture, with many avoiding or fleeing the asset class altogether. I too would worry about the future of cash infusions in innovation if as an innovator I did not know market fundamentals better.

It takes an entrepreneur to see financial opportunity where none exists today

Regardless of what business you are in, entering a market that relies on a hungry 80% greenfield, that continues to consume rapidly despite the worst of economic fear is an interesting endeavor.

Technology adoption continues to grow rapidly, yet much of it is coming from more effective curators of innovation, including from corporations such as Apple.

The rhetoric from the current intermediary Venture Capital, whilst supported over the last twenty years by truck loads of money from LPs (demand) and in which entrepreneurial capacity is larger than in the last 14 years (supply), and still cannot perform despite optimal circumstances should simply be tossed aside.

Governance of innovation (between the assets of LPs and assets of entrepreneurs, see our Venture primer) is broken, not innovation itself. Deflation of risk has turned the Venture business subprime and all metrics (with numbers that cannot be counted on by Dow Jones, Thomson Reuters, PWC MoneyTree, the NVCA and the likes) of that micro Private Equity deployment is therefor not representative of the opportunities nor the projected demise of Venture Capital.

I agree wholeheartedly with Michael Moritz of Sequioa that we have not deployed the Venture Capital risk profile in the last twenty years, and we rely on a handful of success stories (like Google, Facebook) who in one way or the other have managed to escape the defunct Venture Capital governance (and still got their money) to become successful. Those success stories are the ones that fell through the cracks of the Silicon Valley cartel, they were not the positive outcome of the stifling governance of the cartel, albeit success attempts to claim many fathers.

The opportunity in Venture is to replace governance

Lets try an analogy to cooking to clarify the opportunity in Technology Venture.

It does not take much to imagine that technology is like water. And water is the substrate to which many dishes are produced. But if the only recipe a Venture Capitalist can recognize and cook up is a soup (and based on the results, very few of them are good cooks at that), the measurement of success and the taste of the soup only matters to those who care about consuming soup.

Technology is at the beginning of its discovery that it can be used for much more than just the monolithic production of soup, and that it is a vital ingredient to make bread, cookies, rice dishes and almost everything else we consume. Hence the reason why the number of soup lovers or their enthusiasm is no indication - up or down - to the scale of the potential use of water.

The point being that a close look at the performance of subprime Venture will not lead to a viable conclusion whether or not Technology Venture has room for growth. For that we need to look at the absolute opportunity in technology and wonder why, with all this money spent, 80% of the worlds population does not currently have access to a meaningful technology application.

So the trick in Venture is how we define innovation and what risk we apply to it that reaches a broader audience with meaningful social economic value. That we build an economic model in Venture that stimulates the creation of a variety of innovations (dishes in the cooking analogy), and that can only happen once we break up the cartel that has turned Silicon Valley into a monolithic and therefor extreme risk to Limited Partners.

Time to re-invent Venture investing

The best way to innovate is to ignore everything that has happened in the past (especially when performance dictates so) and imagine how Venture should work if you could design it from scratch today. No right minded individual would design it the way it works currently.

With the Limited Partners' interest in mind we would not design Venture with ten levels deep bottom-heavy diversification, a single investment thesis deployed across most VC firms, extreme fragmentation of assets and risk, and lack of verifiable merit. To support groundbreaking entrepreneurs the financial system needs to reward the outliers in Venture Capital that have the unique capacity to find outlier ideas, and take the prudent risk that reaches massive upside, rather than to engage in risk aversion that secures (often personal) downside.

The grand opportunity in Venture is that such a system is relatively easy to build (I have), with minimal burden to Limited Partners. But even if we do not have a chance to rebuild Venture completely, a single Limited Partner (or a syndicate) can turn this new system in a competitive advantage and reap the benefit of harvesting the enormous greenfield opportunity that is currently ignored. A single VC can turn the deployment of the new model into a unique investment thesis that competes with the complacent investment thesis of the cartel.

Take no prisoners

It is however unlikely that the new VCs will come from the same stables as the current ones. The aforementioned money-manager also expressed his frustration with how many VCs have completely avoided risk and continue to hobble after the me-too deals, a subject we have written about often with regard to subprime VC.

But that should come as no surprise given the limited relevant experience many General Partners have in entrepreneurship (you cannot learn this stuff in school), many have never been an early stage CEO, have never taken companies from the left-side of the chasm to the right-side, and lack the foresight and vision (attitude) that would separate them from pure financiers. Venture may be part of the Private Equity asset class but its demands on General Partners are completely different, given the unique qualities it takes to build successful early stage companies. And insufficient relevant experience of General Partners leads to fear and improper assessment and deployment of risk, a logical outcome of Limited Partners' commitment to the wrong people.

The impending cannibalization of the new model is what gets the National Venture Capital Association (NVCA) protecting the interests of its members, all in a tizzy. It feverishly deploys every asset it has to blame deplorable Venture performance on anything but its own responsibility, steadfastly ignoring its own responsibility. It uses Limited Partner money to protect and defend their stance to politicians, who seem to accept the rhetoric from exactly those people who created the Venture malaise in the first place. Insufficiently informed, those politicians appear willing to cut them even more slack. Yet subprime VCs will never have enough resources (governmental or otherwise) to produce healthy Venture returns, and their clock keeps ticking.

The simple solution to better performance in Venture is to build a financial system that stimulates the creation of new investment recipes, so its deployment can reach the popularity similar to the consumption of rice and bread, and the world will be our oyster.

Venture extinction is upon us

The Venture Company | venturecompany.com — 2010-06-29T05:52:51-04:00

By Georges van Hoegaerden

Some days I look at people and feel pity, with as much pity as Captain Paul Watson from the Sea Shepherd felt when many years ago he looked straight into the eye of one of the whales he was trying to rescue, while a harpoon flew over head. He felt pity for humanity. The same pity I feel for people who take the innovations business for an easy ride and kill it by sucking it dry.

Ways to work Silicon Valley

In my thirty years of the emerging business of technology I have seen product marketing managers at one of the fastest growing software companies pick products that sell themselves, and turn them into "geniuses". I have seen sales people at the same company make tons of easy money for the same reason, only for them later in their career be faced with a more sober reality. I have seen people in another Silicon Valley bellwether hop from one division to another, never to be confronted with the outcome of their guidance in each. I have seen people hop from one Silicon Valley company to another, only to pick up valuable equity in each along the way. I have seen people make friends with pivotal "gatekeepers", only to become employed for long enough to get a piece of equity their merit would have never earned them. I have seen those gatekeepers provide endless references to each other, securing them cushy positions through those who get in first.

Too many times have I seen investors loan-shark companies and dilute unsuspecting entrepreneurs into powerless share holders. I found out too late that an angel investor employed, travelled with and otherwise befriended the wife of the company founder, who I was going to straighten out because of his consistent underperformance, false promises and blatant lies. I should have known when I heard the angel was previously dating a friend's best friend, and allegedly forcing her to break up their relationship. I have seen entrepreneurs pitch to "living-dead" VC firms, crushing their dreams. I have seen Venture Capitalists straight out of business school force CEOs to adopt their misguided agendas or otherwise be sandwiched and squeezed out between investor and founding ownerships. I have seen VC artificially segment the industry, putting off outliers of innovation. I have seen VCs lie about the value I, not they created. I have seen VCs work the books so their investment thesis can never be held to account. I have seen Limited Partners play nice with Venture Capitalists knowing that someday they too will join the club that slides them into a much more lucrative salary.

I have seen it all. The foundation of the venture business is a bigger mess than I could ever attempt to describe here, and much more systemic than temporal.

Proud to be difficult and different

For many of the people described above I am difficult work with. Because I simply refuse to erode what I stand for by playing games (that sadly have become so popular). My passion is to build social economic value that touches real people and as a results builds attractive monetization (in that order). I care a lot about money, but only when I feel my participation deserves it. I do what I say and I say what I do. And every product strategy or company I built became an outlier as a result.

To do so one must challenge everything, including oneself.

The hard part is to walk away from investors and entrepreneurs. I have halted an investment at the last hour from a very wealthy family I have know for more than ten years, after I just discovered a string of misconduct and violations of fiduciary obligations of previous board members. The company would have been a blowout success under my leadership. I also declined an investment from another angel and a friend of the lead investor, after I found out that his reasons for investing where not in line with the business strategy I had laid out and executed on with great success as the CEO. In both cases the original founding board could not see beyond some quick money, and are now suffering from significant dilution in ownership and performance, if they are to survive. I challenged my own position from the decisions I made, a clearly different strategy from the self serving and pleasing route most in our business would have taken.

Technology innovation has become the Wild West who's easy days have past and where gold no longer simply washes ashore. We are now stuck with an overhang of gold diggers whose verifiable merit to locate gold hidden a little deeper has become inadequate. The actions of many in our industry have been too self serving, and therefor by default unsustainable.

Doing the right thing is more important than doing what is most popular. Yet doing what is right conserves a unique species we all rely on.

Conservation of a unique species

Whaling has been banned by most governments, but the Japanese keep hunting whales under the "research" exemption and continue to threaten the important role of an endangered species in the ecosystem. The wrong thing to do that will impact us all.

The endangered species in the technology industry are the real entrepreneurs who with great ideas and with diligence and persistence, together with experienced business managers and visionary investors have the integrity to produce groundbreaking social economic value and thus fantastic investment returns. Many VC investors, too busy protecting their own interests and busy concocting elaborate diversification strategies, have lost their ability to recognize and attract those entrepreneurs. And a reduction of VC investors will not fix its dysfunctional investment thesis, and will not cure its systemic disease in which the improper deployment of risk of micro Private Equity has displaced and dislodged venture capital. And don't be fooled again, VC spinning their wheels just like the last ten years with the improper risk deployed will not lead to the recovery of public trust the sector needs.

Circumvention of government regulation proves in whaling and venture capital that government regulation is not the panacea. The only way to prevent the extinction of a unique species is to provide incentive (or de-incentive) for supply and demand, which in technology innovation can be driven directly by the investment discipline of knowledgable Limited Partners.

So, the conservation of groundbreaking innovation is solely in the hands of Limited Partners, who if they open their eyes and get to know their ecosystem still have time to correct course and can continue to reap generous rewards from the massive opportunity in technology innovation that lies ahead.

On most days I still believe I can help Limited Partners fix venture (although some people have discouraged me), just like Paul Watson believes he can still save the whales. I remain optimistic we can save ourselves, but we are running out of precious time.

Venture is no longer the best performing asset class

The Venture Company | venturecompany.com — 2010-06-14T14:56:02-04:00

By Georges van Hoegaerden

Is the little "fun fact" that occurred at the beginning of this year which Dick Kramlich, General Partner and co-founder at New Enterprise Associates inconspicuously threw into his acceptance speech of the special achievement award from IBF's Venture Capital Investment Conference last week. I told you so...

VC governance is broken

That is a serious message which rebuts all the relativity theories from Venture Capitalists (VCs) and highlights how broken Venture as a financial instrument really is. Especially in light of the fact that entrepreneurial activity according to the Kauffman Foundation is now higher than in any of the last 14 years and VC funds have been fully loaded with commitments from supportive LPs over the last ten years. Short term, even NASDAQ performance beats 2009 performance in Venture.

What it means is that in the marketplace of innovation in which supply and demand are performing well, the governor of innovation (the VC) failed to make financial sense and its arbitration fails to produce merit.

The Limited Partners (LPs) who unchanged keep pumping money in a decaying financial instrument truly deserve to be called Idiot LPs. But we do not want LPs to flee as technology venture remains a highly rewarding investment sector for LPs, just not with the current market model and the current financial derivative. Just because governance is broken does not mean the marketplace is.

Checks and balances

According to the panels at the event, the contraction of VCs has started and venture firms are down some 33% with practitioners down 30-50%. Funding rates are currently at about 900 companies per year, leaving about 3,000 companies with previous investments without extended funding runways. The risk profiles tumble further down the subprime slope with early rounds fetching about $1.5M and $70-90M exits on average. Heavy reliance on syndication is the model going forward and VCs are hoarding liquidity.

Even though net returns for investors (LPs) are missing some panel members predict (or wish) no fundamental change will occur. Many LPs unjustifiably appear afraid that if they turn the screws on VC too much, those VC will not let them participate in their next fund. With a new market model we are more than happy to find them more competent replacement for each. Many LPs just stay away from VC, 2x returns on $20M investments is not a great way to deploy Venture risk for many. No v-shape recovery in venture fundraising is expected anytime soon.

Better understanding of underlying assets

Many LPs appear more open to a "forensic analysis" of the Venture ecosystem (get it here), to better understand the asset class and be able to "touch" the companies to which assets are being deployed. Transparency issues are being discussed. Early stage investing requires a unique thesis and LPs are (eagerly) looking for them, with placement agencies sending many VC firms back to the drawing boards. Venture overhang is getting smaller, turnover in LPs is increasing. Empirical evidence of a recent $3B VC fund distributing only $100M back to the LPs makes the IRR's (Internal Rate of Return) calculations quickly lose their value in determining the health of the LP commitments. A stronger emphasis on money-in versus money-out is what now drives LP agendas moving forward.

Making sense

My observation from discussions with pension funds, private equity firms and treasuries is that many Limited Partners are confused. On one hand they want to get out because of unsatisfactory returns and on the other hand they do not want to miss out on the massive opportunity in Venture they know still lies ahead.

A conversation with an LP at the event brought home what that confusion looks like (forgive the brevity on either side, we both sat through the last panel session of a packed two day event - me lingering for a cocktail appointment with another LP).

...before the panel session...
LP: What do you do Georges?
Georges: I am a Venture Economist.
LP: Huh, what is that?
Georges: I help LPs make sense out of their venture strategies.
LP: We should talk.

...after the panel session...
LP (before we can leave the room): So tell me.
Georges: Venture cannot and will not perform using the current model.
LP: Well I know Venture is broken
Georges: Yes, but it is important to know the difference between a cancer and a fever.
LP: Fair enough, but I don't have a problem.
Georges: Really? So, why are we talking?
LP: Uh, I think it is broken too. But my returns were okay.
Georges: Really? You deployed Venture risk and you've gotten micro-Private Equity returns, why is that okay?
LP: Uh (blushing), you are right.

Finance is easy

It amazes me how common sense has prevented to enter the minds of LPs who (in some cases) continue to be swayed by convoluted fairytale stories of a better future. A solution to the Venture malaise needs to include not just a market-model that deploys Venture risk more appropriately, but should also include the canvassing of new general partners with the confidence and capabilities to produce merit in that new system. Both are included in my systemic fix to Venture, a prelude of which (the detection of the disease) can be found in 2010: The State of Venture Capital.

Obviously I will not paraphrase every discussion I have with LPs, and continue to treat them as the other asset holder (like entrepreneurs) in the Venture marketplace with the utmost respect. But LPs should not just listen to VC rhetoric and expect them to come up with fundamental improvements (or perhaps required cannibalization) in the Venture business that jeopardizes their cushy, no downside, protectionist stance. For LPs, I am the resource and the voice-of-reason for those who want to challenge "best-practices" of VCs that have not and will continue to fail to produce proper returns.

But, dear LP, if you aim your frustration with Venture at me instead of the VC, I will kick you out off my process for a much better future in Venture. After all, Venture performance is really your problem, not mine.

Idiot Limited Partners

The Venture Company | venturecompany.com — 2010-06-02T10:21:42-04:00

By Georges van Hoegaerden

Almost one year ago I wrote a wildly popular Idiot CEOs article that highlighted my affection for the crucial role of visionary CEOs at early stage companies, and how instead they are foolishly made/forced to believe that the directives from the company's board (mostly VCs) will guide them to success.

That article was meant to protect CEOs from making mistakes and set things right from the start. So it is now a year later in which my understanding and affection for the role of Limited Partners (LPs, the investors in Venture Capital firms) is voiced in contrast to those LPs who continue to support the dysfunctional VC arbitrage in the Venture ecosystem (see our primer).

This article is meant for those LPs who do not want to earn the adjective "idiot".

Invest at "your own" risk

More important than the easy harping on "the money-men" is the serious realization that investing in venture by LPs, knowing how the VC arbitrage works today, is truly the definition of insanity. Simply put, the way VC works today cannot and will not lead to scalable performance the LPs are betting on and worse, implodes our ability as an economy to create sustainable innovation that can improve our lives, and will erode the dominant role of the United States in it.

Limited Partners (and their boards) and the Public markets are lulled into a false sense of security by Venture Capitalists (VCs) who primarily blame deplorable venture performance on the malaise in the macro-economy, which we have debunked many times. And so Limited Partners should heed the warnings in this article, and if they do not take deliberate action to investigate their actual deployment of risk are going to lose much more than they already have.

Change you must believe in

As many aspects of the technology sector have changed and having met as many VCs as I have over the years, you will realize they have not changed along with it.

- Market access has changed
About 30 years ago, Venture relied on a small and proprietary market model to drive insular innovations that each relied on nothing but itself to carve out a market. A lot of critical success factors have changed since then, and the Internet has all but evaporated the luxury of monolithic access to markets and a straightforward and private way of addressing it. Today's buyers of technology have many more (often jarring) options, which has dramatically increased competition and forces VCs to understand and support the complexity of hybrid market models, unique product experiences, social economic value and a clear understanding of what drives value beyond simply being there first.

- The technology stack has evolved
Technology has become more pervasive in our lives, albeit more than 80% of the worlds population still does not use the internet for meaningful applications. Usage has evolved from the office to everyday lifestyle, with more demanding user experiences as the impetus to buy. No longer is the value of Intellectual Property (IP) simply defined by the ferocity of the many lines of proprietary software code, but by how the proposed user experience uniquely crosses (and hides) the complex boundaries of code, content, distribution, relationships, marketplaces and hardware. Simply put: no longer is the value of the spark plug more important than the value of the car. Producing code is no longer the sole testament of the ability to deliver groundbreaking value.

- Risk and returns have systemically deflated
As Paul Kedrosky (author of "Infectious Greed") alluded to at the Milken Conference panel, "old VC brands are dead". But not for the reason most people think. Counter to what VCs make their own investors believe, investing in Venture has become even more of a specialty and harder, not easier and certainly not cheaper. Fear and the inability of incumbent VCs to change, have forced many VCs to continue to invest using the old Venture model in a market and with technology that has fundamentally changed. Twenty years of VC resistance to change has already turned Venture investing into a subprime sector in which micro-PE (micro-Private Equity) risk deploys no more than micro-PE returns, regardless of the state of the macro economy. And worse, it has attracted developers who think of themselves as entrepreneurs when they feed the VC's micro-PE hunger.

- The VC demi-cartel has no way to detect innovation
As technology is getting more competitive, global and evolves faster than ever before, the current demi-cartel consisting of VCs with a single (outdated) investment thesis that heavily relies on syndication (i.e. consensus) with fragmentation of dollars and deflation of risk to support innovation is counter productive to the economic indicators that are pointing the other way. With ten levels of risk diversification and deliberate price-setting, Venture has become the systemic rollover of the car business, and in need of a overhaul of standards and requirements. Real innovators do not engage with venture anymore, and leave VCs alone with their self-induced and spiraling down subprime investment malaise, patiently waiting for it to break and reset itself completely.

- The grass is not greener
When life gets harder only mediocrity walks away in search for greener pastures. I too believe in a more responsible and greener world, just not with Venture Capital as the financial instrument to drive it. Mediocre VCs are exactly those VCs who successfully sell that the Venture model founded on the fluent economics of technology, blindly applies to every other "feel-good" growth sector, which subsequently lands more LP support and therefor a longer stay in the derivatives investment business. No other asset class than technology venture provides more immediate and effective economies of scale for creation, distribution and adoption of value, that is if as a VC you can define the compass of real value.

Super Pimps

To continue the corollary from Idiot CEOs and based on the fascinating HBO documentary Pimps Up, Hoes Down referenced in the article, idiot LPs are the Super Pimps who believe that the premise of investing in venture, knowing how VCs treat and detect entrepreneurs will continue to deliver outlier returns.

For intelligent LPs, who like many smart rich people continue to write their own checks and get involved in how the rubber meets the road, a wonderful future of returns still lies ahead in technology venture. LPs need to invest in understanding the whole venture ecosystem, and be able to challenge the risk models VC deploy in order to make the smart choices that come with great returns. And today's smart choices are not yesterday's.

But those LPs who by virtue of the deployment of a defunct venture market model, stale VC experience, and a venture cartel treat entrepreneurs like Hoes, will get and deserve nothing more than they have for the last ten years.

Don't bite the public hand that feeds you

The Venture Company | venturecompany.com — 2010-05-25T13:53:34-04:00

By Georges van Hoegaerden

As I explained in "2010: The State of Venture Capital", our Venture primer and "How to fix VC once and for all", Venture Capitalists are the derivative between the assets of the Limited Partner (money) and the assets of the entrepreneurs (ideas).

Venture Capitalists, because they are equipped with the keys to the kingdom by Limited Partners (LPs) therefor claim they must know what is best for the marketplace to function properly, and deploy their best practices (read regulations) to identify investable innovation. And money hungry entrepreneurs bow down to learn from VCs how to build companies, approach investors, time the market, build scale etc.

In absolute terms Venture underperforms

The only problem is, very little of that has paid off. With fully loaded commitments from LPs, more highly skilled entrepreneurs than ever, an 80% technology greenfield with 7% growth in even the worst of economic developments, Venture Capitalists managed to perform below the technology sector it rides on. None of the financial relativity theories (such as IRRs, financial sector comparisons etc.) can debunk that Venture should have out performed the organic growth in technology and they should have tapped deeper into its virtually unlimited greenfield.

LPs are getting more frustrated by an exploding technology sector with imploding Venture returns and one recently communicated on PEHub what I have heard many times now in private:

The correlation between “well-regarded firm” and actually profitable (for its investors) firm is close to zero. I’ve spent the last five years meeting with “well-regarded” firms and it's the rare exception that has actually delivered returns.

Clearly the Venture Capital arbitrage, deployed as a demi-cartel in Silicon Valley and feverishly and foolishly copied around the globe, can no longer be trusted. It is time to renew the marketplace and reset the compass of innovation.

The public buys stock

As depicted on the included chart, the role of the public is crucial in establishing a healthy Venture ecosystem. If for nothing else, the most explosive Venture returns are realized in the process from turning a private company public (IPO = Initial Public Offering), and the threat of that investor independence can boost the company's merger and acquisition value. So, a solid understanding of the value of an early stage venture by the public (which we describe as Social Economic Value) is crucial in establishing authentic public stock value.

The public buys product

The best way to have the public understand the value of innovation is to have them use it. Without many people understanding the intricacies of social networking, it does not take a lot of imagination that Facebook would be a valuable public investment solely based on its user growth. Facebook tapped into an existing macro-economic need to reconnect with people who were too busy or too remote to stay in touch with otherwise, and now reaps the reward of deploying new monetization schemes to a large installed based with no lead generation cost.

Crucial for entrepreneurs is to realize that in building a product (product in the economic sense, so could be service) for the public, "capital efficiency" is not only a blatant lie, it is the opposite of what creates public trust.

The public needs technology that offers significant attachment to large macroeconomic value, a complete offering (spanning multiple technology silos) and a robust product experience. All the ingredients that are not dished up by the strategies deployed by so many of the subprime VCs who proudly plaster the blogosphere and technology "flea-markets" (you know which technology trade-shows I am talking about) with their spoon fed investment tactics and meaningless advice.

The public buys into Venture

Not only does the public purchase stock from companies that turn public, it also feeds the funds of Limited Partners who deploy a portion of those funds to Venture.

Pension funds, endowment, insurance companies etc. put their reserves from public cash to work to deal with fluctuations in their businesses. So, a Venture business that does not perform well, will not only put pressure on the output of Venture, but will have devastating impact on its input. LPs as the guardians of that money now increasingly are instructed (by their often public boards) to lay off on venture capital.

The highly inefficient financial instrument in Venture severely erodes the potential and trust in the future of innovation.

Treat the public well

The Venture business does not and will not perform significantly better if it, or our government, does not change the market model it deploys (we have an answer for that). As an LP, investing in Venture unchanged is the definition of insanity. Marketplace transparency (to all marketplace participants), that opens up private companies for public review (not investment) is paramount to establish public trust before the company is put on the public auction block by investment bankers.

Entrepreneurs should partner only with Venture investors who understand that Venture Capital is designed to protect upside, not downside. That corners cannot be cut in addressing the needs of those people who are expected to buy your public (or indirectly private) stock later on.

Treat the public how you want to be treated. After all, we are the public.

How Venture Capitalists dig their own political grave

The Venture Company | venturecompany.com — 2010-05-17T10:54:33-04:00

By Georges van Hoegaerden

There have been many debates (to which I contributed some of my viewpoints, see for example: peHub's coverage of Barney Frank's statements) as to the systemic risk of Venture Capital that is now dutifully looked into by our government to establish the amount of risk Venture Capital (as a sub sector of Private Equity) poses to our economy, and to embed impending regulations in the Financial Reform bill.

Venture Capitalists have dug their own political grave. Their disingenuous stance is formed by how on one hand they claim to be crucial to the economy (and falsely pat themselves on the back how they create thousands of jobs), and proclaim on the other hand that Venture Capital does not pose a systemic risk (because of its limited size, compared to other asset classes).

Neither of the aforementioned argument is valid, as you can gleam from my previous articles. Yet they deployed their lobbying organization, the NVCA as the ultimate protector of VC downside, into action and collected 1,700 General Partner signatures in an attempt to persuade the senate not to impose on Venture Capital the impending regulations put on big daddy Private Equity. A feeble attempt.

VC is the financial derivative, not the producer of innovation

Thankfully Barack Obama is smarter than most politicians and demonstrates his ability to separate financial derivatives from producers of value with a single statement: “We understand that start-ups and entrepreneurs are the key to leading the US out of the recession.”

Notice the subtle distinction in his statement to emphasize the value of innovation versus the value of its financial derivative. The distinction Barack alludes to is that for too long this country has valued the power of financiers higher than the power of the producers of product.

With our financial system eleven times the size of production, our financial system is simply too large, and our economy is too dependent on the fragile promise of gamblers. And while Barney Frank appears committed to protecting the financial derivative without really understanding the merit of that financial instrument, Barack Obama is vowing to protect the producers of value.

Related to Venture, the NVCA attempts to protect the power of VCs (as the financial derivatives), while I aim to protect the future of entrepreneurs. A crucial distinction.

VC has not made the point it deserves special treatment

The biggest problem with Venture today is that it has no political leg to stand on to demand an exemption from the rules imposed on Private Equity. Contrary to the self-serving rhetoric of NVCA members, Venture - fully loaded by commitments from Limited Partners the last twenty years - should have produced absolute returns that outpaced technology adoption (7% growth in the worst of our economy) and emptied out a greenfield of 80% of the worlds population that still does not use technology to its advantage.

Venture managed to produce returns below the carriage it rides on. Even by their own statistics, Venture produced less than 10% IRR, lost around $1.7 Trillion in opportunity cost, yielded fleeing numbers of Limited Partners, and embodies an in-transparent market mechanism (in-transparent to all marketplace participants) to which we can only fantasize what financial improprieties will surface when that pandora box is forced to open up.

Nothing ventured, nothing gained

Yet Venture Capital was created some forty years ago as a special sector. A sector that deployed significantly greater risk and rewards than Private Equity. Unlike Private Equity, Venture Capital was meant to take the early risk of a company before it has been proven to deliver market value, on the left-side of Geoffrey Moore's chasm and managed to move it miraculously to a massive deployment on the right side (see the chart at "Redefining Capital Efficiency"). That required a unique foresight only beholden to a specialized investor with relevant experience. A lot has changed since then.

On the whole, Venture Capital as the financial instrument to support groundbreaking innovation is dead. Today it can best be described as micro-PE or as we describe here often, as subprime VC (explained in last year's article in support of Vinod Khosla's assessment of the sector). Unfazed, General Partners still rake in cushy management fees (plus micro-PE carry, if at all) defined using rules from the early incarnation of the sector, and blame the lack of results on anything else but themselves. Meanwhile the key stakeholders in the Venture ecosystem, entrepreneurs with groundbreaking ideas and Limited Partners with a large commitment suffer from diminished deployment and return of risk.

So with Venture Capital predominantly operating in micro-PE mode, it is only natural for it to be painted with the same regulatory brush as Private Equity by politicians who do not see a significant difference in role, performance and economic relevance.

Venture born again

But to assume that innovation is dead because of an underperforming financial instrument that controls it is foolish. And to suggest that innovation will suffer from regulations put on VCs is even more ridiculous, where else would their GPs go where downside is more staunchly protected than upside? And it would be easy to replace most of them with better performers.

We have incredible entrepreneurial resources that once supported by a proper financial instrument will prove their value in gold again. Venture needs to prove its merit as a valuable financial instrument to support the outliers of innovation and the creation of real social economic value.

The way to escape impending regulations is to offer to the President a new market model in which the merit of the sector is appropriately and authentically represented. A market model that promotes taking Venture risk and promotes upside and punishes downside. A marketplace in which the merit of investors, as individuals can be openly challenged and their rewards appropriately and dynamically adjusted.

Manage our own "back yard"

The approach the NVCA takes is once again that of protecting downside, but doing literally nothing to promote upside. It makes nothing more than empty promises (based on futile arguments about extrapolation or cyclicality of a glorious past) for a better future based on the changing tide of our economy that is supposed to float all boats again.

Sure, IPOs will increase a little bit, but little Social Economic Value will be created which will yield disappointing post-IPO performance and a further erosion of public trust, let alone significant LP returns. The NVCA's protectionist stance therefor is actually hurtful to the investors, as the preponderance of evidence shows that Venture cannot operate in the same way it operated yesterday.

We need to step in and fix our own ecosystem, unless we want our government to step in and do it for us. The NVCA needs to change its agenda if it wants to preempt government intervention.

I disagree with the President's approach to financial reform

Most reading the above would therefor assume I agree with the President on financial reform, and I do with a twist.

I believe financial reform cannot be established by attempting to curtail all improprieties that occur in our current system that is not a free-market system.

Our financial systems (including Venture) are not free-market systems as they are not transparent to all marketplace participants, are artificially arbitrated, favor the deeply entrenched and do therefor not support a meritocracy. And that means no matter how many great products we invent, even under the "watchful eye" of regulations, the economic value of those products will be severely dampened by the complacency of incumbent investors.

So, the top priority of the President as the head of government (and supported by Larry Summers) is to construct the meritocracy of our financial system, so that all of its future participants can act as watchdogs (or better yet roman geese), establish investor merit and flag improprieties that need escalating and further refinement of law. Venture would be great sector to implement that new market system first.

Regulating the current market system is just a waste of precious time and money.

Until we see the development of such a system, I side with many VCs and even the NVCA, albeit for less altruistic reasons. Without a real free-market system implementing regulations, the industry will quickly establish workarounds and no significant improvement in the support for groundbreaking innovation can be expected.

Subprime Venture Capital will not change to prime by simply adjusting the incentives or applying a plethora of regulations, it requires a market model that allows new investors with an authentic ability to spot groundbreaking innovation to join the marketplace and refresh those that have become stale. Even private markets should be transparent (just not publicly investable yet) so the merit of its inherent social economic value is established before the company transitions to a publicly investable entity (IPO).

With the proper free-market construct (as defined in 2010: The State of Venture Capital for our customers), no longer can over-inflated valuations, ramped up by VCs and settled on under the cover of darkness by investment bankers, erode the trust of the public.

So, dear President, stop tinkering with useless regulations and lets fix the systemic risk of our financial systems first.

Redefining Capital Efficiency

The Venture Company | venturecompany.com — 2010-05-07T11:26:36-04:00

By Georges van Hoegaerden

[This article is a further expansion on the subject of Capital Efficiency of our article from one year ago, named "The trap of Capital Efficiency"]

I cannot tell you how many times I still hear Venture Capitalists (VCs) mention how they look for and "create" capital efficient companies, and how masterfully they continue to sell that "strategy" to their Limited Partners (LPs) as a viable investment thesis.

Those LPs subsequently must believe that they are now investing in a unique class of companies only they have access to (otherwise why is the mention of the specific denomination relevant), and instead of clambering to the old world of capital-inefficient companies, now have the opportunity to prance around in the formation of new, and sexy capital-efficient companies.

Sounds good, doesn't it? Perhaps for those not seeing through the tactics of the spin-doctors.

Let's dissect "capital efficiency" as deployed by most VCs:

First, putting less money into companies, or selecting innovation that supposedly needs less money is a strategy deployed in the last 10 years that has proven not to work. 790 VC firm investors who make - say - two investments per year on average (low ball), produced no more than a handful of IPOs and no more than 10% IRR over the last ten years, is no testament that an attachment to the "capital efficiency" category carries any special value. With our economy now also in dire straits, the chances of capital efficiency bearing fruit has diminished even further.

Second, with a fully loaded commitment from LPs the last ten years, VCs who look for capital efficient deals are dramatically fragmenting investment commitments by having to invest in more companies (to put the full capacity of the fund to work), and conversely increase the investment risk at a time when performance of the sector is already shaky. So the supposed capital efficiency of a startup, with uncalibrated VC fund sizing is actually capital inefficient to LPs.

Third, the cost of acquiring a customer on the Internet has not dramatically changed over the years (if not increased), and so to lower the input into early stage technology companies disproportionate to the dynamics of their output does not only make no economical sense, it again increases the risk of success, opposite of what capital efficiency attempts to promise.

Fourth, Internet technology companies deploy the same rudimentary economics to their customers as old-school companies, they are just using a low threshold (often immature) and a more immediate distribution channel (the Internet). But that immediacy combined with a little bit of money needed to enter into distribution significantly increases competition that in the end favors only those companies that provide relevant social economic value to its customers. And so not the lowest cost-to-entry defines the value of the company, but the quality of service it delivers to its customers. And quality of service is adversely affected by the improper implementation of capital efficiency and thus the reason why the current implementation of capital efficiency in venture capital is incompatible with building real value and public market trust (and therefor reliable IPOs).

Fifth, capital efficiency as deployed by many VCs today, forces startup companies to build technology first. Yet the gating technology proposition offers no indication that the company will ever achieve macro-economic value that has the potential to outshine competition for the next seven years or more. For example, building winner-takes-all marketplaces (such as iTunes, eBay etc.) requires a minimal investment incompatible with the capital efficient VC model, and as such we have not seen any since the popularity of the flawed implementation of that model.

Sixth, technology development is not the risk of a technology company, the application of the appropriate technology to a marketplace is. So, while it may have become slightly cheaper to develop a single line of code these days (I would argue that too), the amount of code needed to make a difference in a highly competitive market, forces companies to make more meaningful and robust products, which requires the deployment of a larger workforce with a cost that hasn't seen any significant reduction. So, just like in any production business, the people-cost is the most predominant factor of the success of the company, not the expense of technology it deploys.

So, yes, capital efficiency the way it is deployed by the demi-cartel of VCs is a big fat lie, that has not and will not deliver.

The ultimate subprime VC lie

Don't get me wrong, capital efficiency is a prudent way to build any company. But the way most VCs confuse capital efficiency lies in the difference between inexpensive and cheap. The way most VCs implement capital efficiency is cheap and lowers a company's ability to grow up, and makes it more difficult for the company to move from the left side of the chasm (Geoffrey Moore) to the right side, where massive user adoption awaits.

The currently popular deployment of capital efficiency spoon-feeds money to startups, which in most cases means the company cannot hire the much needed specialized expertise to turn it from a technology play into a real company early. Many startups can simply not hire a visionary CEO who protects their macro-economic agenda (and returns), and ensures the company remains owner-run (also favored by Warren Buffet) rather than investor-run. That means technology developers without sufficient business experience now run the asylum as inmates of the "investor prison", doomed to make the early mistakes that dilutes founding ownership and therefor - again - increases risk.

So, capital efficiency deployed by subprime VCs is a foolish prophecy. Any VC who uses the phrase capital efficiency as a sector differentiation has no clue what he is talking about. For me, having seen all sides of the venture equation, capital efficiency is the ultimate VC bullshit detector; it communicates they understand nothing about economics, investment risk, innovation, the workings of the technology sector, and business in general.

Capital efficiency today is implemented as downside protection by subprime VCs who look at venture investing as a commodity, and signals how they themselves therefor have become a commodity (and do not belong to operate in Venture Capital).

Capital efficiency should drive upside

Real capital efficiency in venture capital is defined by the cost to produce upside, as opposed to the cost to protect downside. Most companies become extremely capital efficient once they establish beforehand what the operating plan of the business looks like in detail, and as such plausibly define how they need to be "lubed up" to run as efficiently as possible to achieve upside early.

Contrary to popular Silicon Valley belief, technology does not create markets but has - at best - proven to support macro-economic and marketplace behavior that existed for many years. And real capital efficiency is easily achieved by identifying the behaviors that can be more efficiently supported or displaced with the help of technology as content and the internet as distribution. The selection of which marketplace (that is in timely need of efficiency) you pick as an investor determines how capital efficient an individual investment can be.

Capital efficiency, therefor is not a sector strategy, but a way of picking individual companies that have the potential to create extreme and timely upside.

So, from now on dear LP and entrepreneur, when you hear a VC mention capital efficiency, run the other way.

The first 48 hours, my iPad review

The Venture Company | venturecompany.com — 2010-05-03T15:53:51-04:00

By Georges van Hoegaerden

I read a lot of iPad reviews before I found myself waiting in line to get a shiny new 3G iPad from the Apple Store last friday. Because WiFi is simply not pervasive (albeit more pervasive where I roam on the east coast than on the west coast, surprisingly I found even gas stations in North Carolina having free WiFi), the iPad without 3G is perhaps best suited for children who need a somewhat controlled access to the internet and for many of us who use their mobile device connected to the Internet primarily from home (according to a pre-iPad market study I recall).

From the many other reviews (including Walt Mossberg's valuable assessment) you can read about the early experiences with this great new device. I agree with most of Walt's assessment but wanted to offer some complimentary considerations (from a demanding early stage entrepreneur, Venture Catalyst, Venture Capitalist and Venture Economist) I did not see.
The iPad is a beautiful, easy to use computer that will serve the lifestyle, internet and computing needs of most people. You should get one at your earliest opportunity.
If you travel frequently, the iPad 3G is so well equipped and easy to use, you can actually peacefully leave your main computer at home. Even novice users will suddenly have the world at their fingertips.

Here are my remarks to make the iPad even better:

Strategically

The requirement to tether the iPad for the first time to a regular computer and activate it through iTunes is beyond a lawsuit waiting to happen (it does not state such requirement on the box), not the right strategy for consumer adoption of the iPad.

The iPad is a device that is likely to appeal to 5/6th of greenfield of the world's population that is not using a computer capable of running iTunes, and bound to find itself limited in market penetration by the tethered activation requirement. Apple should aggressively offer in-store and cloud based activation to combat this issue.

Positioning

Now, Apple is often referred to as a great marketing company, in my view because they don't do any positioning at all. Most of Apple's products are described by virtue of their beauty and their capabilities and just like with finding a woman with those attributes; you know instinctively when you want to be with her.

Most other technology vendors still foolishly deploy expensive marketing departments to preempt who its buyers may be, and Apple merely states what the device does (in terms of benefits), the number one thing I find myself explaining to interested onlookers is that the iPad is a (lifestyle) computer, not just an iPhone Touch with a bigger screen.

The iPad, also by virtue of which software capabilities are included (see below) suffers from a bit of public confusion and identity crisis, as witnessed by the complete lack of built-in printing capabilities.

Hardware

The shape of the iPad is perfect for a handheld device, yet the 3G is big enough to make you want to rest it on your lap or elsewhere and tap around with both hands. My 5-year old daughter with smaller hands juggles with the weight and requirement to move the iPad around while playing games, yet not enough to keep her hands off my iPad.

- The volume button
The volume button on the iPhone and iPad irritates me to no end, not where it is placed but which part of the rocker is volume up or down. Given that the iPad can be used in many orientations I would make the volume up and down switch sensitive to the context of the orientation. Meaning, no matter how you hold the iPad, the volume up and down coincides in direction with the visual clues on the display.

- The home button
The home button is visually undetectable in the dark, and can be left, right, up or down depending on the orientation of use. This button needs a slight backlit to identify itself under low-lit and dark conditions.

- Back curvature
On a completely flat surface such as a desk or kitchen counter the iPad has a tendency to spin around easily, especially when typing hands-free. A slightly less curved back, with more surface area touching the underlying surface would improve resistance and offer more stable usage.

- Speakers
The current speaker position, (on one side only) leads to frequent muffling and diminished volume and clarity of sound when holding the iPad in landscape orientation when hands are prone to cover up the speaker slots. This needs a different implementation, perhaps dual mono sound asymmetric to the orientation of the device.

- Display
The display, even though made from a special material smudges easily which when viewed from an angle and will make the owner look like a dirty animal. I am not an expert in display technologies to offer a solution, and these fingerprints are hardly noticeable to the user with a straight-on view of the device.

- The Base
The docking base for the iPad (sold separately) only supports a portrait display of the iPad while docked, not the most natural way to view widescreen videos nor the default orientation of the majority of photographs while charging.

- Touch
It is probably a software modification, but I found the iPad sometimes responding to fingers not fully out of the way of the touchpad causing some unexpected behavior. Some of those fingers do not need to touch the iPad, I found out, to cause an in-adverted detection and operation.

Software

Apple is clearly ahead of the pack in delivering a compelling lifestyle computing device we can all use and therefor will catch most of the wind in addressing the imperfections of the software provided. That does not mean I suggest you should not buy the device, but it does mean Apple has room to improve with software updates that make the iPad better.

I can tell (and know) that Apple is developing the software in corporate divisions with their own disparate decision making. As the first vendor to provide truly integrated desktop, mobile and cloud computing services Apple needs to reorganize itself amongst the development of IP (Intellectual Property) that spans those boundaries. No longer is the power of one capability on one platform important, but the lowest common denominator now defines the overall experience.

- Portable capabilities
With much of development efforts at Apple focused on newer devices such as the iPhone and iPad, the lack of development efforts on its OS X companions are affecting the (synchronized) reliability of data on the new devices. With the release of Snow Leopard (OS X 10.6) Apple has really dropped the ball on the stability of the address book, iCal, e-mail and others that affect the use of all devices in concert. With the latest release Apple changed the way it deals with address book imports, how it deals with duplicate contacts, how it syncs address book images etc, to the extent that you need to verify and make frequent backups of every part of the process to prevent unexpected behavior.

- MobileMe
MobileMe is a necessity to synchronize over-the-air many of the e-mail interaction, contact, calendar and notes to keep your information up-to-date at all times, and you should therefor subscribe to it (a $99 / year charge). But it took me two months to figure out how to use MobileMe for my business without showing that the e-mails I sent were coming from MobileMe (a long story). Every business owner who wants to take maximum advantage of the iPad and iPhone capabilities is in the same predicament. The cloud services provided by Google's gmail finally came to the rescue.

But it does worry me that to get and send e-mail using MobileMe a la BlackBerry demands the proper workings of no less than four e-mail servers. The same with calendar sharing where Google cloud services trump those of MobileMe, and for the first time my wife and I can now share a social calendar (using CalDAV) to which we both can add, edit and delete from the same calendar whenever we wish. These everyday capabilities should be supported by MobileMe monolithically by now, but are not.

Also, MobileMe's iDisk and Gallery applications are not (yet) natively available on the iPad and users need to use the iPhone derivatives to continue to use those features. I am expecting a beautiful new Remote application from Apple soon, that allows me to control the Apple TV in wonderful glory.

- AppStore
The Application Store (for the iPad) is supposed to support The Long Tail of applications plus the Torso yet it provides no intelligence (yet) to figure out what based on your interest is the best selection of apps available. That means you need to scroll tediously through thousands of apps icons only to have to start over once you installed one of them from that list (as the store does not remember your last position prior to install). That means you give up exploring the Long Tail of applications pretty fast, and the meritocracy the marketplace (and thus opportunity for app vendors) the AppStore intended to provide is severely diminished.

And while iTunes bravely installs all previously installed compatible iPhone apps on the iPad, the AppStore makes no attempt to then upgrade the Apps (read upsell opportunity) to its iPad native companion. So, it takes hours perusing the AppStore to figure out which of your favorite App has a more capable iPad cousin. I found myself abandoning iPhone apps and instead bookmarking their respective webpages with an icon on the home-screen.

It is also a bit of an embarrassment for AT&T not to have a iPad native iPhone account management app that also incorporates managing the 3G iPad subscription service.

- Dictionary
When entering text the iPad prefers to use capitalization in some weird places, insert spaces at other times (without "suggesting" it first) and in e-mail actually changed the from-address descriptor from "The Venture Company" to "The Company". It appears the dictionary used in the iPhone is more robust than the one used in the iPad.

- iWork
As a long-time iWork user (for most of my work) iWork on the iPad is a big disappointment. I was hoping to use my iPad as the device I could take to Limited Partners and present my now famous "2010: The State of Venture Capital", but I quickly found out that iWork on the iPad is not compatible (in many ways, it imports rather than opens OS X documents) with the version that runs on OS X. As stated before, parity of software capabilities between platforms should be of new importance to Apple as that will prevent people from re-evaluating other options. iWork (KeyNote, Pages and Numbers) are fantastically powerful apps on OS X, and in its infancy on the iPad. Novice users can still have fun with iWork on the iPad.

- Mail
E-mail on the iPad looks and behaves stellar, yet with a few quirks. It appears impossible to change the reply-to address, notes are not synced over-the-air by default, regular IMAP e-mail is pull only and you cannot set a polling frequency. Some e-mails (such as private equity online) previewed incorrectly, the rendering engine must be different from on OS X, where it showed up correctly. Some Word documents could not be opened in Mail, not even with the version of Pages (and part of iWork on the iPad). I hate the horizontal scrolling while you reply to an e-mail, making it impossible to review what you wrote in place.

- Calendar
The Calendar views are visually stunning and well laid out. But some of its functionality bothered me. One cannot change the calendar of an appointment after it has been created. I could not find an option to display the time in the week view (as on OS X), nor could I find a way to accept a Microsoft Outlook invite which it entered correctly in the Calendar.

- Browser
A version of Safari runs well on the iPad, but I miss a few capabilities including a pinning of favorite pages (as available on OS X). Some documents, including v-cards (address book information from LinkedIn for example) do not load into the appropriate application (address book in this case). Some of the new social call-backs designed to integrate social capabilities by Facebook and Twitter do not work well on the iPad browser, thankfully a onetime process that can be handled on the desktop as well.

- Long list navigation
Long list navigation needs a new indexing approach, plowing through 4,500 contacts on the iPhone or iPad is not fun, nor is scrolling through 2,500 photos (a hobby) really practical. Some of the new indexing capabilities of iPhoto on OS X (face, date, folder, theme) would be welcome on the iPad.

- Multi-user login
Even before purchase my daughter "claimed" certain usage rights to my iPad, which to keep things safe, really requires a multi-user login with separate menus. I am hoping that becomes part of the unannounced features pending for the iPhone4.0 release for the iPad slated for the fall.

A new dawn

I may discover more things that are not perfect on the iPad, but so far I have been inseparable from this nifty lifestyle device that manages to take on a much larger part of my business requirements as well.

The continued development of the iPad will change the face of computing forever, and as a result people are no longer beholden to the lazy innovation and complacent attitude of Microsoft, joined by the mediocrity of cheap and ever commoditizing hardware partners.

Apple has singlehandedly changed the computing agenda from business to lifestyle, and managed to serve its fast growing customer base with an experience that truly meets their every day needs.

The iPad has become the third "woman" in my life (in the aforementioned analogy), who is bound to become more capable and more beautiful every day.

VC roast; how to take Venture for a ride

The Venture Company | venturecompany.com — 2010-04-20T12:08:39-04:00

By Georges van Hoegaerden

It is time for a Venture Capital (VC) roast, as I continue to see so many of its General Partners spread the rhetoric that Venture hasn’t performed all that miserably and that it will all rebound, ignoring that the opportunity-cost incurred by a systemic slide from Venture into micro-PE (or what we prefer to call subprime VC) is larger than not investing in Venture at all.

The VC roast

So, let's have some fun and show you what to do when you are a Venture Capitalist and do not want anyone to get suspicious:

- You graduated cum laude from one of the top Ivy League business schools in the U.S. that also invested in your firm as an LP, and discover that none of them have been able to make their endowments in Venture produce a decent return for the last ten years. Oh well, at least your parents loved you enough to give you a great start.

- You copy the Private Placement Memorandum (the business plan of a VC) from a brand-name VC, enter new General Partners in the about section and voila, another VC star is born that Limited Partners (LPs) cannot possibly say no to.

- You start raising new money, four years after your first, making it impossible for your LPs to establish the real merit of your initial investment thesis. You’ve just added another 12 years to your already comfortable existence and enjoy the stability of a more secure job than anyone else in government.

- You are vague in the actual deployment of your investment strategy so you can balance early and later stage investments based on how the vintage of your fund should look on paper and what the marketability of your second fund is four years into your first.

- You tell the world about how holistic your job really is, and how you as a member of the Venture sector are responsible for generating all these jobs, forgetting of course that you are mainly the matchmaker in the process (between the assets from LPs and Entrepreneurs) and it is not your money you put to work but the public’s money (dispersed through LPs to VCs).

- You tell the world that you really need to exist because innovation is crucial to this country. Forgetting that anyone with real entrepreneurial experience and verifiable merit will gladly take your place the minute you get out of the communal hot-tub you refer to as a unique fund.

- You become a member of the NVCA, whose protectionist agenda and lobbyist resources will provide you with plenty of ammunition to LPs and the government as to why your investments thesis, that is so similar to your peers in the industry should be protected at all cost for the sake of innovation.

- You decline to discuss publicly any rounds of funding into portfolio companies and its valuations, because at some point that may actually lead to the discovery of your real knowledge, vision and merit of decision making in Venture, or what a fool you really are.

- You build out your investment firm to a wide global network, so you can have the unique ability to smooth out investment returns and strike up generous stacked management fees in all.

- You tell the LPs that you are investing in “Capital Efficient” companies, omitting that capital efficiency is defined not by how much downside you protect, but how you enable upside.

- You make the world believe that the best companies to invest in start with the discoveries from white males, under thirty, only a technology proposition, twenty miles from Sand Hill Road and built in a garage where you spoon-feed them $250K tranches, minimizing investor downside risk. Ignoring comfortably that the long-tail of viable ideas should just no longer be explored.

- You tell on your blogs how entrepreneurs need to get better in building companies or how to navigate venture constructs, as opposed to spending all your time on finding groundbreaking innovation with enough upside that helps them hire the best.

- You tell entrepreneurs nothing about your knowledge, performance and merit (and ability to invest or not) but expect to the entrepreneur to be fully transparent.

- You demand from entrepreneurs that they realize you will bring more than money, while you will not talk to them directly and provide no substantial differentiation of your investment thesis on your website. It is maybe because you are not that special to begin with?

- You sit in your office searching through piles of business plans, waiting until technology walks in the door that strikes your fancy. How come the visionary in you cannot proactively induce groundbreaking innovation?

- You preach at the many technology “flea-markets” about what constitutes innovation and how to find the outliers, making no one wonder what you are doing at this “flea-market” to begin with.

- For ten years you pushed valuations through the IPO funnel with little value and now, after you’ve squandered public trust, and struck by the impending retribution, you now defer all early risk to entrepreneurs and wait as long as you can to see if something miraculously pops up.

- You add different investment vehicles to your firm, such as PIPEs, annex funds, buyouts so as to further hide your real merit in the demanding venture sector.

- You give speeches to the world about free-markets from atop a comfortable perch of the most closed, dark, unregulated, in-transparent and proprietary market mechanism in the financial industry.

- You write on your blog that Venture is all about relative performance and then compare Venture indices with those of 100-year old asset classes (with nominal greenfield and growth), so Venture still looks like a “star”.

- You act confident that when the economy recovers all boats in Venture will rise again, delivering the evidence that you do not understand that groundbreaking innovation is resistant to economic aberrations, and your boats should be sailing the skies by now (as other custodians of innovation have proven).

- You cry on stage (like a real man) about the nobel cause of improving our climate, after you realize technology investing does not make turkeys fly anymore and you are looking for greener pastures. Giving you the out to turn your venture firm even faster into a private equity firm (compatible with making greentech investments), a perfect slow paced Venture retirement strategy that makes everyone feel warm inside.

- You tell the world that the Venture business is still "the envy of this world", forgetting that the financial system does not create the value, but the unwavering drive of the groundbreaking entrepreneurs you are choking.

- You tell the government that regulation will kill innovation, forgetting that - at most - regulation will kill venture capitalists who cannot stand to have their merit exposed publicly.

- You convince the senate that innovation is not at risk in our country, based purely on the size of its financial system being larger than that of all other economies combined, forgetting that a financial system eleven times the size of production is a very unstable foundation to begin with and how we’ve become a nation of gamblers rather than producers. Act surprised when other nations slowly start to eat our lunch.

- You tell congress that there is no systemic risk in Venture, convincing congressmen that the sum of all investments in Venture (about $2 Trillion the last ten years) should really not have yielded more than 3% ($66B) in IPO value.

- You tell the world that the malaise in Venture has everything to do with the economy, while venture funds have been fully loaded and startups (at best) produce discretionary revenue that is a minute portion of the overall market and thrives on the pressures of change in economies.

- You tell your LPs how you invested responsibly by chopping up available funds into ten levels of bottom-level diversification and get them to nod favorably about the elimination of risk, rather to embrace the risk that separates Venture returns from Private Equity.

- You tell your LPs afterwards that investing is cyclical and that they should have factored that in their equation, especially now that venture capital has turned into micro private equity. You do not need to tell them that Venture has become more risky because the risk you created as a member of the VC demi-cartel.

- You tell others, shhhh..., how LPs are really not the brightest people on the planet and that they should take part responsibility for the demise of Venture. Because you are simply executing on the same “proven” strategy as your peers in the VC business.

- You tell your LPs that your performance is top-quartile, allowing you to specify who you want to be compared with. What better job than to get away with with writing your own report card.

- You say goodbye to Venture based on the lack of liquidity opportunities in Venture, dumping a sector from which you have extracted a “glorious reputation” and income but do not want to be bothered with the hard work of fixing it.

Causal connection

As with all roasts, the underlying message is a serious one. I can write and speak for days about the empirical improprieties in Venture I discovered as an entrepreneur, venture catalyst, CEO and venture capitalist in Silicon Valley. But rather than to debate each one it is more important to realize that they occur because of an incompatible financial system that allows so many people to take it for a ride.

"Mistrust of every kind of authority grew out of this experience, a skeptical attitude toward the convictions that were alive in any specific social environment — an attitude that has never again left me, even though, later on, it has been tempered by a better insight into the causal connections" -- Albert Einstein

We need to fix, simplify and make our financial systems more accountable, in order to erase the behavior that stifles it. Our government needs to play a role in establishing marketplace transparency and instead of trying to curtail the symptoms, fix the disease that produced it in the first place. Limited Partners need to deploy more discipline with people who know the Venture Ecosystem inside-out and better yet, how it should work.

Financial systems are a systemic threat to our economy

The behavior in Venture is very similar to the many improprieties of other financial markets, and simply less overt because of its complete lack of transparency to most marketplace participants. But improper behavior in Venture is like "child abuse" of our growing economy; it cuts off the spirit, zest, fortitude, and vision of young groundbreaking entrepreneurs who have the opportunity to become the new business leaders of our world. We will never be able to recover from the Venture malaise if it persists for too long, other nations are not sitting still.

The real optimist in the face of the malaise in Venture is not the one who continues to milk the dysfunction or walks away in search of greener pastures, but the one who builds a systemic fix for the failure in Venture and helps groundbreaking entrepreneurs define a new compass of innovation.

I have done both.

Setting a new goal in Venture

The Venture Company | venturecompany.com — 2010-04-14T12:19:50-04:00

By Georges van Hoegaerden

The Venture business has got the world upside-down, is what I wrote in a recent comment to a VC and I meant it.

Just as upside-down as many people who buy a house and get a mortgage confuse a liability with an asset. A great example I heard Robert Kiyosaki (from Rich Dad, Poor Dad) refer to in an infomercial in the background while I was doing work on a quiet sunday.

Venture should perform much better

From many discussions, publications, public statements and strategies discussed in new Venture videos it is clear how a large part of the Venture community struggles and puts up relative performance metrics (such as meaningless top-quartile definitions), and pad themselves on the back that Venture is still outperforming public markets. All while technology Venture performance should have blown other asset classes and public markets away, by virtue of its massive greenfield (5/6 of the worlds consumers) and continued growth in technology adoption (even through the worst of our recent economic downturn).

But Venture is looking at the wrong metric of success.

Focus on upside

The real issue in Venture is that the innovations Venture Capitalists select, barely have any Social Economic Value (SEV) and therefor by definition have severely limited upside potential. On a scale from Technology to Market, to Execution, to M&A, to IPO, to SEV (as depicted in the enclosed chart), most venture investors today look for technologies and apply their risk thesis to the lefthand-side, or downside of the scale, hoping and praying to ever reach the righthand-side.

Frankly, most investors have upside and downside confused, which is the source of their deplorable performance. Technology development is not a testament to ever reaching Social Economic Value. And to demand from entrepreneurs that they build technology is a sign of how they further defer the majority of even downside investment risk to entrepreneurs ("show me what you have built") as a prerequisite to investing (as we explained in the reference to Vinod Khosla's perspective in 2010: The State of Venture Capital).

What we have lost over many years of irrational exuberance in Venture is our ability to spot and target large Social Economic Value. Social Economic Value defined by the trust of the public as a customer, not to be confused with an IPO, which is defined by trust of the public as an investor (preempted by an investment bank).

In the 90s venture investors pushed valuations without value through the IPO funnel, which led to a loss of faith and a retraction of IPOs post 9/11. The way to regain trust with the public is not to sell them another lie, that is based on nothing but the hope and rise of the economy that is supposed to float all boats again, but to have the public use the product as a customer, and let them make up their own mind about its value as an investor. Hence the definition of upside in Venture defined as the creation of Social Economic Value as opposed to an IPO. IPOs will flourish once that public trust from consumers is achieved.

Reverse engineering upside

A fundamental difference in the investment thesis is that as a Venture Investor, instead of looking at the gating technology proposition, you assess an innovation based on the merit of its ability to change the world (where it is likely that no prior implementation exists). But you as the investor can align with the entrepreneur based on a shared vision, compass and the likelihood that the support of that Social Economic Value will feasibly occur within the next five years.

And that means that both the entrepreneur and investor share the predictions of the trajectory that builds Social Economic Value, a much better equilibrium between entrepreneur and investor. One in which according to Warren Buffet, the “owner oriented attitude far outweighs the periodic downside". No longer are entrepreneurs pestered with demotivating rounds of ownership dilution based on unpredictable microeconomic aberrations and, no longer do investors waste time worrying about the minutiae that do not affect the Social Economic outcome.

Rather than forward planning from a technology starting point, Social Economic Value is created by back-planning or reverse engineering upside. Meaning, in order to create large SEV a certain IPO range needs to be achieved, which can be swayed by M&A interest, which is created by great execution, which stems from understanding the behavior of marketplaces, which can be served by technology. Technology is the derivative, not the goal.

The distinction between prime and subprime innovation is simple. Prime innovation is attached to existing macro-economic behavior (and usually the absence of technology previously) and relatively easy to predict (I would be happy to share examples), while subprime innovation is attached to a technology wave with a short expiration date and little macro-economic value (a main reason why many acquisitions perform so poorly) that has a minute chance of ever producing viable returns.

Investing different leads to different entrepreneurs

Upside investing applies the proper risk to an early stage Venture, it applies it to the assessment of anything else but technology. Because, as technologists the creation of technology is the least of our risks. But it requires a VC fund that can carry most of the $25M runway needed to create the success of any disruptive Venture today (yes, "capital efficiency" is a lie). The small funds can continue to deploy their subprime risks, while the larger funds have the opportunity to separate themselves macro-economically, by spawning real innovation.

The minute you as an investor set a different compass and focus on the creation of Social Economic Value, different entrepreneurs come out of the woodworks that subscribe to that investment thesis. Suddenly you will meet the entrepreneurs that through years of experiencing macro-economic deficiencies, have a vision of how to change the world for the better and as a result generate the large outlier fund returns Limited Partners need to see to stay confident.

Change is inevitable

We may see a slight upswing in IPOs this year, as the economy recovers, micro-PE deals are the best game in town, and those with money to play regain some confidence. But if we as investors do not change our investor tactics and produce real Social Economic Value, it is inevitable that Venture will descent even further to micro-PE than it already has, and continues to suck the risk and returns out of performance.

And that would be the kiss of death to Venture and to the wide-open opportunities in innovation that still lie ahead.

My advice to VCs

The Venture Company | venturecompany.com — 2010-04-11T11:57:09-04:00

By Georges van Hoegaerden

I am perhaps the most well known (so they say), open and prolific contrarian of the complacent attitude, role and performance of Silicon Valley's most notorious Venture Capitalists (VCs), and frequently I get the question from entrepreneurs suggesting that those VCs must just hate me with a vengeance.

My consistent answer to that question is;

Very short: "I don't care, the truth needs to be told",
Longer: "I don't care what the many subprime VCs who underperform think of me",
Even longer: "I would not raise, nor suggest other entrepreneurs to raise money from VCs who cannot be challenged on their merit, methods and madness",
Longest: "If they hate me so much, why are many then in conversation with me - my arguments are apparently crisp and tantalizing enough to engage in the debate for a better future"

Tough and fair, yet balanced

The reason why many VCs continue to talk with me is that I've known many for a long time (as a former part-time Venture Partner trolling, eating and networking with them on Sandhill Road) and that my observations are tough but fair and stem from an authentic desire and urge to fix Venture.

Honestly, I like many General Partners personally, I just despise the institution they have created - in the same way many of us like their congressmen but hate congress. But smart people can be wrong (and use their smarts to protect their self interests), and many VCs are seriously wrong.

The Venture ecosystem (the way it works top-down) is structurally flawed to which blame could and should be directed to Limited Partners who do not deploy sufficient investment discipline to such a specialized sector, to VCs who have taken the liberty to take the system for a personally prosperous ride, and also to massive volumes of would-be-entrepreneurs, who attracted by the predominantly subprime investment thesis made it significantly harder for VCs to separate subprime from prime innovation.

My observations are also balanced in the sense that I do not subscribe to new mechanisms that treat entrepreneurs unfairly (we just launched a new way to rise groundbreaking innovation above the noise), treat VCs unfairly (which I think The Funded does), and treat LPs unfairly (for whom we built a permanent fix by virtue of a new market model). However, all participants should be held accountable to turn this sector around and produce outlier results consistently.

Why VC needs help

And while I have provided much rationale to clearing up the mysteries for the primary asset holders in Venture; LPs with money and Entrepreneurs with Ideas, my public support for VCs has been waning. Most probable because many VCs come across as arrogant, mislead entrepreneurs (sometimes without realizing it) and are the ultimate protectionists in the Venture ecosystem that leaves every participant unhappy except themselves, living a lush life and raking in astronomical management fees (from largely our public money) that at least secures their life for the next ten years to come.

But new General Partners in VC firms like some of my friends who are raising new funds, new GPs like Mark Suster from GRP Partners (a former entrepreneur who appears to agree with many of my observations, see the accolade) and even some we would classify as the older garde of the Venture ecosystem seem interested in a debate as to how their performance and the Venture business can become prime again.

The really "old" goats of the industry who survived the self-induced Venture malaise because of their early foray in the Venture business and hide behind their brand, PIPEs, annex, buyouts, secondaries and massive investment networks that allows them to smooth out (read: level fund returns so they all look optimal) performance, want nothing to do with any anything that could potentially cannibalize their cushy position. But who needs help if they can retreat to their own island and live happily ever after? I still spar with them at times.

So, let's give VCs who have not yet raised their crucial third fund and still need to demonstrate consistent returns to LPs, the benefit of the doubt. Without further ado.

Be aware of the sector's legacy

Limited Partners, as I explained in one of my previous blogs, have become extremely reserved when it comes to treating Venture as a viable asset class (or better, sector). The malaise in Venture is apparent and can no longer be simply explained away by the state of the economy (as Venture is resistant and out-of-cadence with it). Instead Venture by virtue of the growth in technology adoption (7%) should have simply grown rather than declined in performance as better custodians of innovation are able to prove.

Hence GPs raising funds need to come up with a much better story than the old tactic of copying the private placement memorandum from a "top-tier" VC that makes the resumes of the GP its biggest differentiation. Me-too funds are no longer funded and a whole new investment thesis must lie at the foundation of those who want to succeed.

Be aware of the pool you dive into

It is crucial to realize that while you may march to the beat of your own drum and with a unique investment thesis, the marketplace consisting of LPs with their asset - money -, and entrepreneurs with their asset - ideas - still has not yet substantially changed. Massive amounts of ideas without substantial Social Economic Value float around, and thus GPs need to be extra savvy to communicate their thesis clearly to prospective entrepreneurs.

Moreover the marketplace in which you act as the arbiter of Venture transactions (see our primer) is highly suboptimal. We repeat for clarity from a previous blog why even your stellar performance may do little for your LP. So, an LP that is diversified in many other VC funds may not recognize you as the outlier, because you participate in a marketplace that by definition mutes outlier results:

A marketplace that marries the assets of supply and demand, with many arbiters not having - or earning - verifiable merit
A marketplace that marries the assets of supply and demand, using a single commoditized investment thesis
A marketplace that hides behind the performance of hybrid asset classes, sectors, segments and stages
A marketplace that hides behind ten levels of diversification of risk
A marketplace in which the arbiters do not compete (but syndicate)
A marketplace which openly engages in price-setting and operates as an innovation demi-cartel
An in-transparent marketplace that functions like a black-box to most marketplace participants
A marketplace that appears extremely sensitive to economic aberrations
A marketplace that has not produced healthy returns in twenty years

And that means that with a new fund you are probably better off raising money from a new LP, local or sovereign that understands how to distinguish between the scorn reputation of Venture and the massive greenfield opportunity that unwaveringly lies ahead and you become one of the few commitments in that fund.

Own and prove the validity of your unique thesis

But let's assume you as the GP realize all the above and have your ducks in a row and funds secured, how now do you build solid returns for your $100M plus fund.

Minimize syndication

If your investment thesis is indeed unique, you and only you are qualified to carry the risk for your favorite investment. Syndication is fragmentation of LP dollars and thus fragmentation of risk, which turns Venture Capital quickly into micro-PE. As long as the investment has large Social Economic Value, the right amount of focused risk will get it to fruition. Fewer deals at the right intersection of your unique investment thesis, with the appropriate support for upside will produce by definition much higher success rates than the sector average (otherwise your thesis is invalid). So don't be afraid to stand alone.

Invest in Social Economic Value

Many VCs have turned subprime, even some of the well know brands. Subprime is not defined solely by how much money is put in a startup but more importantly at which point. Most VCs defer risk to the entrepreneur and therefor create a highly fragile company from the start. The creation of Social Economic Value that can build trust for an IPO has a radically different planning and funding model associated with it.

Invest in market principles

For twenty years GPs have used technology as the starting point of making investment decisions. Yet, more crucial is the macro-economic impact of innovation in which technology is the enabler but not the deciding factor. Macro-economic impact can be achieved through multiple technology strategies and is likely to see a few different iterations in its lifetime. The starting incarnation of technology is the least of the investment risks and hardly ever proof that it subscribes to any macro-economic benefit.

Become an active investor

Most VCs wait somewhat passively until innovation walks into their door, the appropriate response for many GPs who do not have the experience, credentials and foresight of an entrepreneur. But many innovations, especially those founded upon macro-economic behavior can easily be predicted and thus also ignited by the investor. If you truly know your domain, you should be able to predict and reach out to great entrepreneurs and have them run with some of your vision at times.

Communicate your differentiated investment thesis clearly to entrepreneurs

I have heard the complaints from VCs overwhelmed with business plans which forces them to default to their old buddies network. Yet, if you communicate leadership as an investor those entrepreneurs that do not fit your thesis will stop knocking on your door. We experienced that ourselves as we were hesitant to turn commenting in our blog on, for fear of having to respond to the same messages all day, but a few clear answers made entrepreneurs understand what we stand for and diminished the interaction with subprime entrepreneurs significantly. A not so clearly differentiated investment thesis is the source of many wondering would-be-entrepreneurs knocking on every door they can find.

Be real and let your authentic merit define you

With the bottom falling out of VC performance, it is important for VCs to be as open and transparent as possible in setting a new tone. A tone that is not embedded in arrogance and ignorance nor a marketing tool to lure in unsuspecting entrepreneurs, but reflects a realization that you understand what the deplorable past of VC has done to innovation and how you intend to chart a much improved course.

Getting Venture un-stuck from its subprime maelstrom

The Venture Company | venturecompany.com — 2010-04-08T08:37:43-04:00

By Georges van Hoegaerden

I keep hammering on the systemic dysfunction of our financial system in Venture that sits atop the massive entrepreneurial capacity of this country, that is crushing it slowly to death (having done so for some 20 years already).

And frankly, I start getting a little tired of having to repeat myself, over and over again, spawned by misleading articles from VC bloggers and their cohorts and being surrounded by a halo of negativity (albeit deserved). I prefer to spend my time on fixing and building things.

"Be the change you want to see in the world..." Gandhi

Fix 1 of 3: a top-down fix for Limited Partners. Check!

To combat that dysfunction I took action, analyzed the Venture ecosystem from the outside-in and covered in my presentation "2010: The State of Venture Capital" how Limited Partners (LPs) with $1B in assets under management dedicated to Venture can instantly correct its malaise from here-on out.

Intrigued, many of the LPs in Venture I spoke with now need to go back to their management and essentially confess how inadvertently they allowed Venture Capitalists so much slack in "playing" with the money they committed, that caused the descent to a predominantly subprime sector in the first place. Some big-boat LPs will find it hard to make the turn and simply leave the sector. In light of the massive opportunity in technology venture that will prove to be a very foolish choice, because unlike in any other committed asset class or sector, ahead in technology venture lies a massive greenfield ready for the taking.

Many entrepreneurs will keep pressing forward no matter what financial system they encounter and their need to make lemonade out of lemons will force them to submit to subprime terms and conditions that are so prevalent in Silicon Valley today.

Fix 2 of 3: a fix for groundbreaking entrepreneurs. Check!

Yet I run into entrepreneurs all the time (or rather, they run into my philosophies on my website), who have laid the foundation of some groundbreaking innovation that does not fit the mold of subprime investors and are poised to die a sudden death if not helped along. After all, not the false positives are the biggest source of failure in Venture, but the inability to attract real outliers who refuse to be the pimp's ho.

If I only had the time to dedicate more time to them:

One of those companies was a company with great technology, a much better immersive gaming experience than the Nintendo Wii (available before the Wii), that would dramatically broaden the bell curve of adoption of gaming and, because of the subprime nature of Venture, is now relegated to a less optimal strategy of becoming a technology services company and a PE deal at best.

Another company tapped into a lack of free-market principles in digital photography in which supply and demand transact in artificially arbitrated manners, much like music before iTunes where the Internet could provide instant disruptive value to assets sold today. That is if investors would understand that macro-economic value supersedes pure technology plays.

Another company had developed a small part of a new way to find things on the internet that had the ability, with some significant elevation of its macro-economic benefit, to become a much more intelligent operating system than what is currently available on the iPhone or the iPad. Again and again, the stale investment thesis of many investors in Silicon Valley fails to recognize the potential of big ideas that has proven to yield big returns.

Examples abound. But investors with a dumbed down investment thesis and limited scope will never get to see or hear from these innovations:

"Whether you can observe a thing or not depends on the theory which you use. It is the theory which decides what can be observed". - Albert Einstein

So, what I decided on is to take action again and capture, nurture and proliferate the creation of groundbreaking innovation by having entrepreneurs not foolishly follow the investor compass, but follow their own - with a little help from us - in identifying large social economic value, and help deliver that proposition to prime investors all while making Limited Partners aware of the vast opportunities that still lie ahead.

It is time we treat Venture like the real marketplace we defined it in our Venture primer.

Welcome to The Venture Company Network.

The Venture Company Network ("The Network") will operate not under the structure we proposed in a fix for LPs just yet, but will follow the free-market principles that ignite the natural evolution of competition and meritocracy of all participants in the Venture ecosystem. That means that entrepreneurs (and subsequently investors) regardless of their descent, location or brand, and only defined by their unique and verifiable merit will be given premium attention into making investment marriages happen.

We focus only on ideas that can lead to sizable returns for LPs by producing social economic value that can generate the public trust needed to re-ignite IPOs and therefor big ideas need to gravitate towards the following:

• $1B single-trigger revenue opportunity
• Macro-economic relevance and impact
• ~$25M venture risk
• $300M+ venture exit in 7 years

Remember, capital efficiency is a loanshark's trap, especially when you consider what that popular phrase has produced in the last 10 years.

The Venture Company network is like TED for technology innovation, but for Ideas worth Building. Its current incarnation is just a start where we begin to "separate the boys from the men". We completely ignore the way subprime VC works today and focus solely on the creation of large social economic value, regardless of cost (as cost is somewhat irrelevant to the size of upside).

Entrepreneurs can get more information about The Network here, where they can review its terms and conditions and join. Your involvement and contribution as a groundbreaking entrepreneur will help get the best innovation in front of prime investors, improve your chances of succeeding and get the sector back on its feet. I am committed to making that happen if you are.

Let's raise the bar together and provide proof to show that under a heavy (and incompatible) financial system remains a vibrant entrepreneurial capacity and inventory.

Why entrepreneurs should not follow an investor compass

The Venture Company | venturecompany.com — 2010-04-08T08:37:39-04:00

By Georges van Hoegaerden

I think it is quite hilarious to see so many Venture Capitalists (VCs) tell entrepreneurs everyday how to build a successful business, given that they have no political leg to stand on to offer such advice. The advice offered ranges from how-to-build a company (many have never) to how-to-talk to an investor (to submit to subprime?), to how-to-deal with their downside protection.

The merit of the VC compass

The reality is that in the marriage between the assets of the Limited Partner (money) and the assets of the entrepreneur (idea), VC has proven to be a miserable match-maker by virtue of its empirical and statistical performance (see here).

So in essence it is the VC who needs help in finding more disruptive innovation, not the entrepreneur providing it.

We covered at length how few VCs actually have had the relevant personal experience of guiding an early stage company as CEO from the left side of the chasm to the right side (where massive adoption awaits) and why few of them actually have the merit to judge innovation to begin with. But even if some GPs did have the personal experience, the model by which many deployed risk is simply incompatible with finding the outliers of innovation to which none of their innovation "scripts" applies. With an overall success rate in the last 10 years by VCs of less than 3%, simply raising a first round from any investor has statistically become the entrepreneur's highway to hell.

And VCs openly and proudly admit to their demi-cartel (confusing a strength with a weakness). Here is some evidence I picked up from the Twitter hemisphere recently that describes that abuse of power, the lack of investor competition and the dysfunction of the Venture market model so well:

If U (that is "you" in text-speak) say to investor A that investor B wants to invest, expect A to immediately ping B. And if B says no, kiss goodbye to A.

Now I have spoken with the investor in the past who said this, and know some of the portfolio companies from his first-time lower-teens "play" fund, and can imagine how he depends on the consensus from his peers to make investment decisions. He cannot invest using a truly unique thesis, as he simply cannot support the runway of any of his companies monolithically with such a tiny fund and I feel sorry for the stance he has to take. But the commoditized investment thesis (alluded to in the Tweet), stuffed with syndication makes for a cess pool of subprime deals that is so indicative and prevalent in Silicon Valley.

So entrepreneurs should not get derailed by the general VC compass, as it:

Generated no more than 3% public value over the last 10 years (below 1% if you take the Google IPO out of the mix)
Lost about $1.7 Trillion in funds
Eroded public market trust with short term gains

For twenty years real entrepreneurs have been abused by a financial system that first threw money at anything moving and ten years later retrenched and still imposes the fear stemming from the minute social economic value those opportunities created.

The entrepreneur's conundrum

But that leaves entrepreneurs with an interesting conundrum, of who to listen to. If the compass of the VC that may give the entrepreneurs their first money to start building their company cannot be trusted, where else do they go to get their idea funded? VCs exploit this problem by basking in the glory of no real deal competition (they prefer to syndicate) and no other financial instrument that can compete in providing full runway support for early stage innovation. Meanwhile entrepreneurs get more desperate and bow down to the will-power of the VC cartel, and submit to its terms.

That deadlock caused the smart entrepreneurs to leave the "dating scene" altogether (and find better custodians for their intellectual brainpower) and leaves a maelstrom of subprime VCs actively telling hopeless entrepreneurs how to build greater returns using subprime deployment of risk and terms. And we still have 10-years of past subprime deals clogging up the pipes of venture firms to look out for and ready to pop soon.

The answer, my friends

Instead of listening to the opinion from many VCs (whose merit is impossible to assess, but based on average sector performance generally deplorable) drawn out in the blogosphere, entrepreneurs should simply follow the compass of success.

So I hear: define success.

Success in early stage technology innovation is highly dependent on the creation of authentic social economic value and public trust (and attachment to existing macro-economic behavior), that creates valuable IPOs, that can be courted by M&A, that is supported by high-growth venture investments, that is spawned by the proper deployment of investment risk.

Venture investors need to step up to combat the lack of trust our public market has in technology companies. Since many venture investors pissed away public trust in the 90s with their choices of new public companies that suggested massive valuations but proved to contain only nominal value, investors now need to be extra diligent in producing authentic value the public market can trust again.

But entrepreneurs need to learn that the real value of the idea is not described by populist investor buy-in, but is defined by how unique and how well the company can build that social economic value. And that means instead of forward planning from a first round of funding, entrepreneurs need to set their compass to point to a social economic endpoint, get agreement with investors on the objective and then back-plan to what steps and investments are needed to achieve that public trust.

Social economic value is not proven by first building technology (the least of our venture risks) and will not evaporate anytime soon, so entrepreneurs should not leave their jobs just yet, before they are adequately able to sell the viability of reaching the end-point to a prime investor.

Groundbreaking entrepreneurs follow their own compass

The definition of the compass, the pin-pointing of social economic value can best be established by the entrepreneur (not investor) with the unique vision for a better world. By the groundbreaking entrepreneur who by definition does not subscribe to the populist view, who has the vision and ability to enable change, and an unwavering passion to improve the way the world works (as Craig Furgeson says "reminds you of anyone?").

All Venture investors need to do is assess whether the vision and ability to execute of the company, started by the entrepreneur is plausible in generating the large social economic value that was promised. Cost is highly relevant only to those investors who have nothing to hang on to but downside protection. The opportunity for creating large social economic upside in technology remains priceless.

When life gives you lemons

Raising money is just like dating, those who pretend to be someone they are not will find themselves inevitably failing, and unhappy with what they submitted to. So, they key to raising money is to keep looking for an investor who has the merit and money, and can subscribe to what the entrepreneur is selling (by virtue of its goal). If none do, and one has clearly defined the path to large social economic value, stay firm and keep at it.

Only groundbreaking entrepreneurs make orange juice when life gave them lemons.

Investing in Venture unchanged, is the definition of insanity

The Venture Company | venturecompany.com — 2010-03-23T13:48:38-04:00

By Georges van Hoegaerden

I have the utmost respect for groundbreaking entrepreneurs, or better yet all the people who produce great products (or unique services). I love technology and believe we have not even scratched the surface of its macro-economic impact.

And it is those entrepreneurs, with the simple power of their dreams and perseverance, who collectively and unwaveringly hold up the massive weight of an outdated and incompatible financial system eleven times the size of production that keeps this country afloat.

It is for them that I fight to make our financial system more modern and nimble to withstand the test of time.

The writing is on the wall

Unless you have been living under a rock, you should by now be aware that the performance in Venture for the last twenty years has been deplorable. After a fantastic start by people like Bill Draper, and point successes from next generation icons like Vinod Khosla in the nineties, Venture quickly became the stomping ground for anybody with money, not necessarily combined with merit.

Growing numbers of Venture Capital (VC) firms arguably over-invested in their interpretation of innovation that had the majority of even the 90s funds (with vintages in the 2000s) generating no more than 10% IRR on average. Just the last 10 years VCs have generated no more than 3% public value out of all investments made, or specifically lost about $1.7 Trillion in, mostly public, money from their Limited Partners (LPs). And the performance of the current funds does not look much brighter as witnessed by incoming reports from early 2000 funds and the discontent of many LPs I speak with.

And on the mirror

But even if you are not a fan of numbers, which often become the subject of endless debate and can be excused away since they are lagging, not leading indicators, Venture has produced only a handful of viable companies that ultimately created some sustainable value public markets have faith in. Seven-hundred-and-ninety (790) VC firms in the U.S. chomping at the bit producing no more than a handful successes is the billowing smoke that indicates a raging fire. More specifically it indicates "the system" or "the compass" by which Venture is deployed does not work, its systemic approach is broken and only a few outliers in Venture produce the returns that make the headlines for all.

When doing your best just isn't good enough

VCs now hold on for dear life, blaming their lack of performance on esoteric macro "windows" of opportunity (irrelevant to startups), and they feverishly add up portfolio revenues to claim they are still producing value and are doing "their best", all while big corporations frequently beat them to the punch with real innovation that outpaces the market.

VCs attempt to hang on to comparing Venture to 100-year old asset-classes, sectors or segment indices, patting themselves on the back with a relativity theory that is as flawed as comparing apples and oranges. Unlike these old indices that have become somewhat stale because of their age, Venture continues to ride on the information technology platform that continues to grow aggressively (despite the economy) and still leaves a massive greenfield (5/6 of the world's population) underserved. VCs have not succeeded in tapping into that upswing and their best is clearly not good enough to make us proud.

Venture Capital morphed into Micro-PE

Venture Capital, after the irrational exuberance of the early 90s, has quickly and predominantly turned subprime - or - into micro-Private Equity, with most risks deflated and/or deferred to the entrepreneurs. LPs who thought they invested in Venture Capital, by virtue of how they deployed money, instead invested in a more risk averse Private Equity segment, a different thesis with different risk/rewards associated with it. But we ended up getting what we invested in; micro-PE returns. Nothing Ventured, nothing gained.

Looking good spending money

Now, I see some LPs "blindly" renewing their commitment to Venture, which for LPs that have access to prime VC firms that have still produced healthy returns in the last two decenniums makes only nominal sense. If an LP does not have the wherewithal to understand the dysfunction in Venture, it may as well bet on the best horse in the race, even if the race ends up being a Private Equity race instead. Those LPs may make a buck (with a minor part, 10-15% of their total allocation), maybe even outpace other asset classes and care less.

But the wide-open greenfield in technology and the culmination of a fantastic real-time distribution mechanism (the Internet) of technology should have made technology Venture the best performing asset-class, bar none. That is of-course, if one understand the requirements of the sector and deploys the appropriate risk, discipline and market model.

Social Economic Value

Most of the money invested in Venture is (indirectly) public money, such as the endowments and pension funds (CalPERS, ~$17B) which beyond a sheer money making objective also has a strong social economic value attached to it. CalPERS needs the money, but also needs Silicon Valley to be at the top of its game to produce healthy economic spin-out (driving other asset classes as well). The new funds just deployed by the North Carolina and Florida (coming) treasurers also promise to carry the good karma spawned to aid the most important driver of the economy; innovation.

Yet most meaningful innovation, that has the potential to scale big fast, does not start with or in Private Equity, it starts with the unique risks deployed by Venture Capital. And so the importance of what you as an LP are betting on, with the specific knowledge of what is Venture and what is not, is crucial in establishing a healthy conversion from technology to large social economic value, and subsequently public support and trust.

The Insanity in Venture

The systemic failure in Venture to produce returns in line with the wide-open opportunities in technology is the result of the composition of its incompatible financial system. Venture today is an artificially restricted marketplace to which not the outliers of innovation are attracted, but those who are attracted to the commoditized investment thesis of the predominantly subprime VCs.

But even if one knows nothing about Venture, insanity is the descriptor that belongs to the person who believes in a marketplace where the following attributes can consistently produce outlier returns:

A marketplace that marries the assets of supply and demand, with the arbiter not having - or earning - verifiable merit
A marketplace that marries the assets of supply and demand, using a single commoditized investment thesis
A marketplace that hides behind the performance of hybrid asset classes, sectors, segments and stages
A marketplace that hides behind ten levels of diversification of risk
A marketplace in which the arbiters do not compete (but syndicate)
A marketplace which openly engages in price-setting and operates as an innovation demi-cartel
An in-transparent marketplace that functions like a black-box to most marketplace participants
A marketplace that appears extremely sensitive to economic aberrations
A marketplace that has not produced healthy returns in twenty years

No tinkering with micro-economics in the marketplace such as management fees, carries or other micro-incentives can turn a subprime VC, prime. Just like entrepreneurs are born, not created, so are venture investors with their unique intuition for taking risk born, not created.

The marketplace needs to be rebuilt from scratch and embed free-market principles that allows for healthy competition between all participants in the marketplace. Any LP with $1 Billion committed to Venture can do so independently today, and reap the rewards that lies at the untapped and phenomenal foundation of the growth in technology.

We owe change in Venture to those that produce

We owe it to the producers of groundbreaking products and value, to support them with a financial system that is lean and mean, nimble and modern, competitive and transparent, that dynamically establishes, monitors and corrects the merit associated with all marketplace participants. We will dramatically flatten and simplify the marketplace, remove excessive diversification and fragmentation of risk. We, the marketplace, will establish and expose the authentic merit of every participant.

Venture investors with merit and foresight will thrive by ignoring subprime propositions that cannot re-establish their individual supremacy, and instead focus on those innovations that match their authentic competency and skills. Groundbreaking entrepreneurs will come out of the woodworks again once they see the development of a better custodian than their corporate overlords flourish. Limited Partners will be happy because they reap rewards that outperforms their ancient asset classes by a long shot.

Groundbreaking entrepreneurs are the life-blood of this country and we better start treating them with the care and attention they deserve. We need to lift the weight of this incompatible financial system off their shoulders if we want to remain on the leading edge of innovation.

We still can.

My message to LPs in Venture; more discipline please

The Venture Company | venturecompany.com — 2010-03-15T15:18:12-04:00

By Georges van Hoegaerden

The more I look into the complete value-chain that makes up Venture (from Limited Partner all the way to Entrepreneur), the more I see the origination of its gaping dysfunction. My conversations with a $3 Trillion, a $20 Billion and a $1 Billion Limited Partner (LP) with some of its asset-under-management (generally between 10-15%) committed to Venture, yields the same fundamental conclusion.

Lack of general investment discipline

It appears that many of these LPs in Venture deployed money frankly too lazily and too hastily to a sector that was once booming, as they rushed to get in to reap similarly projected upside. Without any specific Venture expertise, they quickly deployed a me-too investment model to Venture (copied from its elderly Private Equity PE brother) that was supposed to significantly outperform its other asset classes, but it didn't. And those LPs now wonder in disappointment whether Venture scales, to which of course my answer is:

No investment strategy without discipline scales.

Most surprising in my conversations with LPs who are eager to improve Venture performance is that almost all of them seem to expect me to roll out a more dark and deep "Voodoo plan of Venture investing", with more complex detail and nuance combined with alternative exit structures.

I do quite the opposite, as I prefer to simplify things dramatically. As an "outsider"-looking-in, my role is not just to absorb the way investing works today but more importantly, identify the way a better financial system for Venture should work. As if today is the first day of Venture investing.

So rather than with a submissive attitude akin to the usual money-hungry cast of characters that approach LPs, I challenge them on the basic fundamentals of the assessment of investment risk to benefit us all, and to come up with the proper investment structure to curtail superfluous risk. Because the only risk LPs should incur is the market risk of the startup companies that are invested in, not incur incremental risk because of the sizable financial system that sits on top.

Au contraire, LPs have deployed superfluous risk in Venture that "by design" underperforms:

- Deflation and fragmentation of risk

As one can gleam from our 2010: The State of Venture Capital presentation, LPs have allowed the deployment of no less than ten levels of diversification (and fragmentation), before the money reaches the startup it invests in. And that means the underlying instruments are deploying excessive risk aversion and downside protection, a source of comfort (perhaps) but not indicative of a great understanding of risk nor a consistent process of great performance by the supposed investment professionals.

- Lack of focus and accountability

LPs should have deployed an upside-down pyramid in the deployment of risk, meaning they get to deploy diversification of assets and below its diversification should be dramatically reduced or (ideally) zero. So, while top-heavy diversification may be meaningful, bottom-heavy diversification is destructive and leads to lack of accountability to the investment thesis. Many Fund-of-funds that deploy Venture money for LPs, themselves have their own diversification strategy, as they also invest in PE, buyouts, pipes. So do some Venture Capital firms (VCs) who also diversify in different instruments, sectors, stages, industries sometimes aided by investment networks that can "uniquely smooth out investment commitments", clouding the performance of a specific investment thesis and the merit of the people attached to them even more.

- Mediocre Private Placement Memorandums

The composition and content of many of the Private Placement Memorandums (PPM) from VC firms I have seen is an absolute joke, and many of them are a straight copy of the plan from one of the early brand-name VCs on Sand Hill Road. No business plan from an entrepreneur with such a vague description of the ability to execute would make it past a first meeting with a VC. Yet LPs even go as far as defending why no PPM commits to a target return; "the lawyers will not allow it". But without a baseline performance index, LPs who invest in multiple VC firms have no simple way of holding VC firms to their promise, except to try and assess whether the VC firm "did their best". No startup gets sued over not making its target revenue numbers, and I am sure we can find a legally acceptable way to hold VC firms accountable for their bottom-line.

Lack of Venture specific discipline

But Venture requires a few crucially different disciplines than its elderly "brother" PE. The major difference is in the nature and the risk associated with the asset LPs (indirectly) invest in. Simply put, PE relies on more hindsight (ability-to-execute) than foresight to become successful, while Venture requires more foresight than hindsight to cross a chasm (Geoffrey Moore) that is so unique to that disruptive innovation.

- Lack of relevant GP experience

We have hit on the general lack of relevant entrepreneurial experience of GPs (that passed LP scrutiny), which is important in helping plot the risk associated with an early stage investment and with the identification of how much money an investment requires to create disruptive market value and subsequent public value. Many GPs came from PE, Wallstreet or other finance positions, or came out of a late stage technology company that made money in the hay-days, and have now slid into the aforementioned unaccountable GP role with a comfortable income, plus no downside but upside for the next ten years. Very few of them actually have proven that they have what it takes to take a company from the left side of the chasm to the right side of the chasm successfully, and therefor lack the necessary foresight that is so pertinent to Venture.

- Lack of expectations

Many LPs in Venture allow GPs to hide behind the notion that startup success is impossible to predict. It is indeed when GPs have only hindsight as the instrument to project foresight. But as an experienced entrepreneur who wants to change the world, and being born with such characteristics and subsequently honed and monetized those skills for 30 to 40 years, your odds as that entrepreneur are much better than you can often articulate, and certainly much better than many of the current GPs can evaluate. Every company or product line I ran became successful beyond its expectations, and I would not even engage when my next venture (which is to rebuild venture) would not have a higher success rate than 50%. So, GPs who are comfortable with two successes out of a portfolio of ten demonstrate what they are made of, they gamble instead of have their relevant experience and foresight play the crucial role of setting a higher (disruptive) bar. LPs should simply demand more than a 50% success rate from their GPs.

You get what you put in: put in $x, get $x. In Venture, put in $x + foresight, get $x times foresight.

Lack of discipline turned VC subprime

Smart entrepreneurs, who do not let themselves be "abused" by unfavorable terms or partnerships that do not match the authentic experience and merit of the entrepreneur, are not engaging with the predominantly subprime VCs, waiting instead patiently until conditions improve.

For the last 10 (I believe 20) years VC have treated entrepreneurs like a cheap commodity, that subsequently has overwhelmingly answered subprime VC mating calls. Subprime VC now attracts hordes of subprime entrepreneurs, convening in flashy technology flea-markets where each apply their ill-advised risk analysis in a quick dating scheme to make a buck. They deserve each others company.

But the lack of relevant public value (through IPO) has deflated trust not just with the public - and thus output, but now also with those LPs managing public money to fund venture - and thus input.

To fix Venture

So, to fix Venture we need to implement a mechanism that marries the needs of those with money, the LPs, with the needs of those with disruptive ideas, entrepreneurs, in a more effective fashion. We need to treat Venture as a marketplace, in which not syndication perpetuates common mediocrity but real competition amongst GPs emphasizes their merit and demonstrates their unique ability to find outliers of disruptive innovation.

We are blessed in this country with very smart entrepreneurs who have found refuge from the Venture malaise in as many ways as entrepreneurs can. They will come out of the woodworks again when the appropriate marketplace for disruptive innovation presents itself.

All LPs need to do is treat Venture as a special sector that can create, with the right market model and incentive structure, better returns than any other asset class. Because technology and its immediate impact on the world is at the beginning of its evolution.

But Venture requires a discipline and devotion many LPs do not have today. So, dear LP: stock up on experience, knowledge and discipline and let's rock-and-roll again soon.

Silly Venture, surfing the waves

The Venture Company | venturecompany.com — 2010-03-09T20:31:27-05:00

By Georges van Hoegaerden

Without being brutally honest I believe it is difficult to build a great company or a sector (that creates sustainable jobs and value), and now with artificial borders collapsing everywhere around us, only a high degree of authenticity can prevail. No longer can people, tucked in institutions continue to make false promises or hide behind the skills of others. The merit of the individual will soon start to prevail over the bravado of institutions.

Sex, lies and videotape

The lies are everywhere in an industry as young and as quickly emerging as technology. Just like the infamous rush for gold during the Wild West, technology has become the breeding ground for more pandemonium than value. On the buy-side and sell-side of technology.

Honesty is a hard nut to crack in California, where the authenticity of silicone boobs is as vigorously defended as the authenticity of silicon valuations. Years of people making good money on riding "the system" yields a formidable defense for its impending change.

Yet the result of the lies in Venture are starting to surface, directly by virtue of its performance and indirectly by smart people leaving the "marketplace" and turning the remainder sub-prime. And just like in any eroding segment a surge of bottom-feeders takes care of the many scraps, making money off of anything that has the hope and desperation to stay alive. With the overhang of a wonderful past, those still in it keep holding on to what once was.

Fuel to the fire

I have been in Venture for more than 15 years (and technology for 30) and personally witnessed from my backyard in Palo Alto how it has destroyed itself, by not being honest, greedy, a lack of discipline or simply by not demanding the best. A mediocrity we aim to fix, systemically.

Here is a small collection of what I perceived, based on multiple observations described in one example, as adding fuel to the fire of an already troublesome Venture sector that is in need of a major overhaul:

Valuations without value

I witnessed a large company acquire a startup for more than $500M and after doing a post-close deep dive into its financials (ignoring strong political discourse) its actual acquisition value should have been around $100M (at best, using the same multiple). What is disturbing about this is that the mis-formed exit valuation creates the perception that the initial VC investment in the startup had merit. Its shareholders profited handsomely, have gotten themselves positioned for life, and Venture Capitalists tout their horn - all because the corporate development overlords have not been paying really close attention. A good reason why private companies should not be private in terms of how they report earnings. Private should refer only to what type of investors can participate, not its lack of transparency. Examples abound.

Desperation

I heard from a very reliable source in a company I know well that an acquisition of a $100M-plus startup occurred because the VCs in the deal got nervous, one of the executives at the company described it as "if our last two quarterly numbers were simply flipped, we would not have been forced to sell". With heavy dilution for the entrepreneurs (not smart enough to protect their own turf) and the external board members (with some "top brand" VCs) owning the company, sub-optimal exits are common to save already fragile VC portfolio returns. Even if it means selling for less than 2x. This is clear indication of how even the "best" VCs have become subprime.

Price-setting

I also heard from a very reliable source how two large Silicon Valley acquirers called each other and discussed that they did not want to compete with each other on the proposed acquisition price, and one really wanted it more than the other. So, they settled on a price (without the appropriate auction battle) together, informing the entrepreneurs at which price and by who the company was going to get acquired. Not only does this process not provide the best value for entrepreneurs, it produces a deflated return for Limited Partners (LPs) who rely on great returns to re-commit to Venture.

Spinning wheels with no traction

Many entrepreneurs confuse the pulse of Silicon Valley with what creates value. While it is noteworthy for publications like VentureBeat to record all the innovation and deals that are being done, we need to remember more than 97% of all investments in the last 10 years have not led to producing any lasting public value. That in turn means that more than 97% of what is described as "hot" is really not. And thus new entrepreneurs should not base and bias their ideas on what is described in such publications. They are much better off in following their own compass and experience. Statistically entrepreneurs are better off doing the opposite of what is in those publications.

Group-think

Hundreds of Technology trade-shows like DEMO and the AlwaysOn series (I have been to both once) amplify the problem of institutional VC and "entrepreneurial" group thinking even more. They harvest so-called innovation by technology segment, mimicking the intake criteria of many sub-prime investors. It is exactly for the reason Chris Anderson of TED describes in his introduction video why filling a magazine like Business 2.0 to the size of a telephone book is in no indication of the prosperity or capacity of the industry. TED is so different from the previous conferences because it highlights the outliers of innovation, without categorization, and amplifies its macro-economic impact and value.

False hope

As can be surmised from my blog I am a steadfast critic of the role of Venture Capital, having turned predominantly subprime. So, it would be easy for me to align with The Funded in its attempts to rate VCs. And while The Funded is an interesting attempt to start making VCs a little bit more accountable and it has succeeded in erasing the worst of blatant VC misconduct, The Funded is really like a photography site where the ratings of who likes a photograph is in no way in correlation to how well a photograph sells. So, the portrayed VC transparency (to unsuspecting onlookers and participants) and rating is not just a little more transparent; it is wrong. Even more wrong because deal performance is no indication of the viability of producing real success down the road (see how dating doesn't produce a healthy child) or the health of the sector, especially not when the majority of VCs have become sub-prime and so have the entrepreneurs who glowingly fall into their trap.

Venture Capitalists that are not

I have written about the lack of relevant entrepreneurial experience of VCs, many of whom have never crossed any chasm in their own lives to be in a position to help their portfolio companies calculate the risk of doing the same. While the previous is debilitating in its own right, many VCs are also poor economists who cannot even articulate the basic fundamentals of free-market principles. That matters because it means VCs cannot see and evaluate macro-economics adequately (which supplies most of its disruptive value), nor establish the proper funding requirements of a company that depends on it, as the funding requirements of a startup company driving a free-market model is so fundamentally different from those pursuing a proprietary market strategy. So, again, to quote Einstein, "the quality of your theorem defines what you observe", and what VCs have observed and produced the last 10 years is therefor challenging their theorem.

Angels that are not

I have done angel deals (as well as VC) and applaud them for taking the extraordinary risk of not only being an active investor but being their own LP at the same time. It gives them more credence but not necessarily more merit. Many of them made their money when turkeys could fly or side winds blew in their favor. Very few earned their money the way a startup intends to, by having an outlandish vision and doing all the hard work yourself to turn it into success. Groups of angels are springing up every quarter now, nobly compensating for the lack-luster investment pace of VC, yet turning technology Venture even faster in a more fragmented sub-prime business than it already has become. Because of the lack of seamless runway support and deflation and fragmentation of risk, more technologies will be built that yield even fewer companies with even less macro-economic relevance.

The experts that are not

Better hindsight does not translate to better foresight. Especially not in disruptive innovation, where hindsight is considered toxic waste. Time and time again do I see the people with a crafty description of how the world works today, quickly become the heralded experts of how it should work. Forgetting that a better understanding of the way the world works today, especially in Venture, is no indication how it should and actually eroding the opportunity for groundbreaking innovation. That valuations are no indication of the health of our sector, and that the number of deals done are not, nor the number of VCs, nor the number of startups. The only thing that matters is a fruitful alpha (portfolio return) for LPs, who supply their asset (money) to the VC. A journalist who takes the reports from Thomson and dissects it earlier than others, is not an expert in Venture because of it. A General Partner who is part of a brand name VC firm, and created the problem in VC to begin with, hanging on to a rambling attachment of external factors should not be crowned the expert in fixing it. With the sector in the dump, it is time to look for solutions elsewhere.

The need for alpha to produce alpha

Now all these aspects seem as impossible to overcome as a dog biting and barking at everyone and everything, but it is not. A dog needs an alpha-model to submit to, in the same way Venture needs the discipline of a new financial system to keep sane. For the last 20 years LPs have let VCs run around like wild dogs, and their performance now dictates that they need to be reigned in.

The existing improprieties in Venture only exist because we have deployed a piecemeal market model, reminiscent of the aforementioned Wild West. Most problems in Venture will be resolved by curing its systemic disease, and by implementing a new free-market system that does not exist in Venture today.

The financial system we propose implements free-market principles that facilitates the removal of bottom-level diversification, the deployment of responsible risk and the reliance on marketplace transparency to all marketplace participants to (re)define merit of innovation (as defined in our primer).

Only alpha-model discipline can produce the alphas LPs are looking to generate. Venture is not too big to fail, and without that new discipline it will, to the detriment of us all.

A new, modern financial system to fix Venture is coming

The Venture Company | venturecompany.com — 2010-03-06T10:46:06-05:00

By Georges van Hoegaerden

I have disclosed in "How to fix VC once and for all" one important aspect of how to fundamentally change the financial system in Venture, and that is to change it into a real marketplace. A free-market in which marketplace transparency to all participants will establish the true merit of all participants; Limited Partners (LPs), Venture Capitalists (VCs) and Entrepreneurs alike.

Without that marketplace transparency, Venture Capital will continue to slide down the sub-prime investment slope it has been on the last 10, if not 20 years, leaving a growing opportunity of disruptive innovation under-financed and starving. Unchanged, the deployment of LP dollars will continue to fragment and yield even lower public value and trust than it has produced over the last 10 years.

Top-level Venture reform

The systemic failure of the financial system in Venture is why its output does not generate enough value (M&A, IPO etc). Venture Capital needs to become more agile, risk-taking, transparent and accountable (turn prime) in order to consistently attract entrepreneurs with a value that can change the world.

Its financial system is what turned Venture Capital sub-prime, not the lack of entrepreneurs, developers, visas, too many regulations, sarbox, FAS157 etc.. Once we change Venture into an efficient free-market marketplace I can assure you many of the current restrictions, born out of an artificially regulated market, will simply dissipate or become irrelevant.

Today, Venture performance is severely hindered by its black-box, under-the-table, institutionalized, monolithic operations. Lack of marketplace transparency (amongst many other deficiencies):

allows walking dead VC firms to crush the dreams of (unknowing) entrepreneurs
prevents competition between VCs, leading to a demi-cartel and a commoditized investment thesis
allows GPs to hide behind the (often outdated) brand of their aging VC institutions
clouds the difference between money and merit

Take me serious

Building a new financial system for the sake of re-empowering innovation through Venture is "my new startup", and as is typical to innovation, many first ignored me, then they ridiculed me, then they fought me, and then I win (Ghandi quote).

I win because Venture reform is the right thing to do for our country (not because I have an axe to grind). I win because the sector has lost serious money. I win because the opportunities in Venture have never been better. I win because the systemic failure of VC proves they are wrong. I win because there are no more bubbles for VCs to ride. I win because VCs are running out of excuses and time. I win because VCs (by virtue of their selections) have abused the trust of public markets. I win because entrepreneurs are unhappy with whom they partner and how they are being treated. I win because both asset holders in Venture are unhappy with the derivative. I win because I have identified the systemic failure in Venture and have a solution to fix it all in one fell swoop. We all win because that solution gets us all to a better place, including VCs with merit.

LPs own the problem

LPs are becoming aware of VC dysfunction and have started calling their Fund-of-funds and VCs based on my individual conversations with them and my blog, some VCs have confessed to me. LPs are at the top of the food-chain and can no longer deploy money without verifying the merit of the underlying financial system, top-to-bottom. The behavior of the dog is the responsibility of its owner, and so is the performance of VC the discipline of the LP.

LPs now start to realize that great performance in Venture comes from establishing discipline. Not just to who, but how they deploy money matters, and what the impact is on the rest of their value chain and the sector. How it affects VCs and how its finds the outliers of innovation that can produce substantial value. Only that discipline can fundamentally and consistently lead to great performance.

Smart LPs in Venture understand how to rely on a real marketplace in which merit and real competition (not the artificial one Tim Draper defines as "I have respect for all my competitors. We co-invest together.") thrives to find the outliers of innovation.

Inappropriate measures

It still baffles me how some LPs continue to recommit to Venture without a change to the underlying financial system and marketplace characteristics. But perhaps I shouldn't be surprised: a sector that has previously managed to sell the delusion of cyclical performance, measured against irrelevant market indices, and attracted the improper influence of the macro-economy, is very capable of producing new promises to maintain its position.

LPs should just not expect those promises to come true, not again. That would be the definition of insanity.

What is not a solution to Venture is cutting management fees. Changes in fees and carry structures are not going to change a sub-prime VC to prime. You cannot train or coax sub-prime VCs to become prime, in the same way you cannot train or coax people to become entrepreneurs. You are or you are not (by virtue of your DNA and life experiences). And just like VCs need to focus on the creation of upside, not the protection of downside - so do LPs need to focus on the upside with VC, established by merit, rather than protecting downside.

Lift the veil off my plan

But marketplace transparency is just one aspect of my plan. The Venture reform described in the (for customers only version of the) acclaimed presentation "2010: The State of Venture Capital" resolves all of the aforementioned issues in Venture, including:

reduces ten levels of diversification by more than half
eliminates bottom-heavy diversification
employs far less fragmentation of risk
establishes a meritocracy of GPs
creates natural competition between GPs
de-commoditizes the investment thesis
allows for the discovery of the outliers of innovation
provides better support for entrepreneurs
deploys real venture capital
builds more stable companies
builds more disruptive value

First movers advantage

Prior to Apple entering the music arena, many VCs invested in music without producing any lasting public value. Now in Venture I am about to deploy a winner-takes-all Venture platform that leaves the LP laggers with artificial Venture marketplaces behind. Venture, the way it works today can never function nor scale, because the market model is simply incompatible with the discovery of the outliers innovation.

I invite the LPs who see the wide-open greenfield opportunity in Venture, to hop on board and use a brand new mower that is indeed capable of harvesting the hay that is ready for the taking. Innovation is by no means dead, and neither is the fantastic new opportunity to monetize it.

Why VC is such a bad date

The Venture Company | venturecompany.com — 2010-02-25T08:48:07-05:00

By Georges van Hoegaerden

Today's Venture Capitalists (VCs) have often qualified innovation as a buyer's or a seller's market (in publicly discussing valuation trends) and that communicates so well how they view innovation; as a commodity.

No wonder they fail miserably in generating meaningful alpha (portfolio returns for Limited Partners, or LPs). It is impossible to find and attract outliers of innovation by comparing and compressing valuations. And commodities never outgrow their peers.

Disruptive innovation is never a commodity and is always a seller's market (with the company selling its stock to investors). So, the minute innovation becomes a buyer's market, that innovation has just been "crowned" a sub-prime entity and so have both buyer and seller.

Finding the perfect date

As a VC, finding the right type of innovation to monetize is like finding the perfect date, they are few and far between. And to a founder of a startup finding the right General Partner (at a VC firm) is similarly daunting.

A unique match between two people (the General Partner and the CEO) is something that takes more than glowing at the prospect of having a baby together (i.e. build a new prosperous company) and discussing the financial projections and terms of the deal.

Most of us can dream, but can we make it happen together is the real question.

Higher standards

The reason why many people are such bad daters is because they do not hold on to their own standards, those that make them happy and those that make them strong. They confuse money, power and perks with merit and hope sheer proximity will someday rub some off to them. But it never does, you need to do the hard work yourself to reap its precious reward. You get what you put in.

I do not consider myself a pretty boy, yet never had a problem dating because I know what I want and especially stand firm on what I do not. Standing firm allows you to stay true to yourself and often has the additional benefit of weeding out sub-prime parties quickly and thus avoid unmanageable disaster further down the road. (That is my happy date-turned-wife in the picture.)

Stay authentic

I cannot tell you how many times I have spoken to entrepreneurs that have banged their heads against the doors of VCs, and selectively served as their dutiful psychologist to help them not to bow down to sub-prime standards.

Most entrepreneurs become nervous and afraid to negotiate, because this VC may just be the only interested party they have, and if you are a tough negotiator those investors may frighten others that you are "hard to work with". But a choice of one investor is not a choice.

Even before any commitment to invest is reached, entrepreneurs frequently let VC change their business model, use-of-proceeds, valuation and everything else, in the hopes of landing a round of funding. Not realizing that this VC can have whatever opinions it wants, but as an entrepreneur you are the only one responsible for making it happen. Do not accept an infinite monkey theorem, that you then need to turn into a work of Shakespeare in your startup.

So, don't be afraid to lose. Because losing from a sub-prime VC really is a win.

Marriage does not make a person

Getting laid is not a recipe to produce a happy child, a healthy marriage is. So, even if an entrepreneur lands an investment, raising Venture Capital alone does not make a successful company. With so many sub-prime VCs, statistically and empirically the odds are still not in your favor.

Success, in the latter case, is defined by the company's ability to produce public value, either by serving the public directly or indirectly by getting them to invest by way of IPO (or acquisition).

So, both parties need to demonstrate that they are experienced, skilled, agree and contribute to achieving that (early) public value for the company. In other words, a marriage needs to be consummated in which the assets, principles and goals of raising a happy child (the company) is shared. And that means that while both parties supply different assets, one cannot overpower the other (like Pimps and Hoes) and force its agenda.

A priori, an equilibrium needs to be established that is healthy and promises minimal friction down the road.

Bad starts make for bad endings

Without an organic fit and chemistry, a venture deal that starts off wrong usually ends wrong. For the VC that damage is diversified, for the entrepreneur it is often crushing. So, the dating process is not just a way for the VC to check the entrepreneur out, but for the entrepreneur to gauge if the proposed equilibrium (mentality, experience, skills, term-sheet, vision) is authentic, attainable and healthy.

Here is how many VCs set themselves up wrong for the dating game and why entrepreneurs deserve better (in this context "the date" is the VC, and "you" is the entrepreneur):

The date wants to know everything about you but won't tell much about himself.

VCs demand to know a lot about the entrepreneur, but what does an entrepreneur really know about the VC's merit? GP merit hides behind ten levels of diversification and a fuzzy Private Placement Memorandum (PPM, the business plan for LPs) that leaves plenty of room for "creative" post close re-interpretation. Whether the GP is a great gambler or skillful is impossible to assert. What we do know is that many GPs have never themselves crossed the chasm, a trait that makes them almost certain a bad dating partner.

The date wants to date other people at the same time.

VCs diversify their risk by investing in other (hopefully not competitive) companies at the same time and hedge their bets, they do not often hedge their often ill-informed opinions upon the entrepreneur. Expect many to do a John Edwards on you when your future suddenly looks like cancer.

The date does not want you to date someone else too.

VCs diversify their risk, but watch their reaction when you do the same. They'll get mad, because you have just told them that VC money is a commodity (and disruptive innovation is not) and now they need to step it up and prove their value-add. Right where you want them.

The date wants to have a threesome, and takes his pick.

VCs are more worried about downside risk than upside risk and try to find an accomplice, and syndicate early to avoid risk. They often finagle a sweet syndication deal with a partner under the table that is unlikely to be in your advantage. VC is a demi-cartel.

The date thinks that his money compensates for lack of empathy.

Many VCs lack entrepreneurial experience, which according to a Dutch saying means "they've heard the church bell ring, but they don't know where the sound came from". Money does not make up for in-experience and lack of skills, especially not in the boardroom of an early stage company.

The date wants you to tell him exactly what you are bringing to the table, without him doing the same.

Entrepreneurs are asked to make elaborate predictions about growth trajectories, and stick to them. But have you asked the VC to provide full runway support in return?

The date discusses divorce before you even start dating.

You want to change the world, the VC wants to target exits. Foolishly the sub-prime VC does not realize that changing the world creates a much more reliable exit than an early "delivery" could ever promise.

The date wants to know whether you want children, but withholds his wishes.

Real entrepreneurs want to change the world, not just to exit. VCs however will change their mind depending on how the rest of their portfolio is doing and whether at that time they can get themselves in the top-quartile. I know many companies that have been pushed to early "delivery", to the chagrin of their founders.

The date never really commits and keep all options open.

Entrepreneurs are forced to submit to funding rounds that are designed purely to minimize downside risk for VCs. While you commit to the marriage all the way, a VC can decide to bail out at any time, leaving you hanging (with a strategy that may not be yours, a cap-table that is destroyed and a runway that may no longer be viable).

The date needs the approval of all his cousins before he can get married.

Seldom can the opinion of one GP secure the deal. He has to push an outlier proposition through an elaborate socialist process with other GPs in the firm to close. Simply an incompatible process that should be banned.

The date requires a prenuptial to engage.

VCs structure elaborate ownership agreements, by way of voting rights, valuations, bylaws - you name it. Forgetting that rudimentary control plus the ability for the company to develop itself gives it the highest probability of succeeding. If as a VC you don't believe that, you should not engage in the deal to begin with. Elaborate downside protection means you simply do not believe in the upside.

The date wants full control over your purse.

Excessive controls on money means there is no trust between VC and entrepreneur. It is necessary to verify trust, but not giving it in advance means the entrepreneur is not giving the VC his trust either. A CEO needs to be able to run the company and not be bogged down by distracting and bureaucratic spending rules as long as he stays within the use-of-proceeds.

The VC institution needs to be fixed first

Now, I can make a similar list about people that chase sub-prime investments. More than 10 years of sub-prime investments has attracted a lot of people to that sub-prime thesis, the majority without the attributes needed to become a successful entrepreneur. With a still growing number of sub-prime VCs at play, certain corporations have become better custodians of disruptive innovation, able to stimulate entrepreneurs more effectively.

The only way, in my view, we can fix Venture is to change the model by which we deploy the matchmaking services between the assets of the LPs (money) and the assets of the entrepreneurs (ideas). With a more discretionary VC intermediary we will automatically attract more disruptive ideas (by stimulating entrepreneurs to look at Venture as a prime venue for innovation again) and create more meaningful value.

By the way, I do not dislike many VCs personally, I just despise the institution they represent - because it performs so poorly. That hurts LPs and their dissatisfaction will have a devastating effect to the innovation in this country.

I am working feverishly on getting VC fixed by changing the economic model that allows LPs to be taken for a ride. Disruptive innovation can wait until they start implementing my economic system. And in the meantime, dear entrepreneur, if you think you have what it takes now, keep your foot down and your head up and keep looking for that discretionary VC in the haystack.

Happy dating! Je maintiendrai!

There never was a Tech bubble

The Venture Company | venturecompany.com — 2010-02-23T12:13:43-05:00

By Georges van Hoegaerden

Part of the discovery of coming up with a permanent fix to Venture came not from an endless debate about what happened to Venture (although I am more than willing to do so on occasion) but to envision what should happen to Venture if one were to erect the sector now (something emerging economies are actively pondering).

That is perhaps the reason why the only one who could come up with a permanent fix to Venture is an entrepreneur. Because as an entrepreneur you are born with the gift not to analyze existing market deficiencies (with loads of statistics) until you are blue in the face, but to reconstruct and imagine a new and much bigger opportunity from your (perhaps idealistic) view of how the world should work. And then to develop such a robust new system so the bad things from the past find automatic resistance (not manual labor or government regulation).

And boy, do I believe in a big opportunity in Technology Venture. I even believe it scales.

Is this working for you?

I use the previous phrase from Oprah a lot as it communicates so well that regardless of anyone's rational for the prospects of innovation, the current system under which we deploy it simply does not work. And I pity the LPs who with blinders on, continue down this road expecting a different result. Good luck!

To reiterate again, over the last 10 years (some technology celebrities say longer) we, as participants in the sector have generated less than 10% IRR to Limited Partners (LPs, who disseminate their money through VC), wasted about $1.9 Trillion in funds that never produced any public value and have left LPs and entrepreneurs severely disillusioned about the value, viability and path of innovation.

All the while, many Venture Capitalists, as the derivatives (without assets) in this marketplace pride themselves being in the top quartile (a meaningless definition in its own right), or the survivor of "the fittest" of an underperforming sector with little value. They continue to stuff their pockets with a fat-and-happy management fee that allows them to retire for life (sometimes after just one 10-year try and vintage), publicly comforting themselves that the world has changed so much that it is now time for new investors to step in. Thanks a lot, after having taken Venture for a very comfortable ride without producing real returns, and worse, soiling the pool for the rest of us.

The real asset holders in Venture, LPs with money and entrepreneurs with ideas have been fooled (many times over). But by who really?

Who's bubble is it?

As you can tell from the last paragraph I am often irritated by the lack of integrity of many human beings, especially of those who do anything to make a buck. Because VCs with integrity could solve their own issues in Venture without the need for a complete Venture overhaul. But that would require their ability to be self critical (they have done nothing but blame external factors) and people who are confident enough to cannibalize their own position for the greater good. Too idealistic perhaps. And so a new system in Venture needs to include not just measures to provide better upside but a concerted and immediate eradication of those intermediaries that do not perform.

But we need to fix the disease not merely fix the symptoms and the following quote from Einstein comes to mind:

"Mistrust of every kind of authority grew out of this experience, a skeptical attitude toward the convictions that were alive in any specific social environment — an attitude that has never again left me, even though, later on, it has been tempered by a better insight into the causal connections." - Albert Einstein

Which I parlay in Venture to:

"I mistrust many venture capitalists for good reason (their lack of merit), but have learned that the casual connection is the dysfunctional financial system that allows them to take it for a ride." - Georges van Hoegaerden

Just like the behavior of a dog is the responsibility of its owner, so is the performance of the VC the responsibility of the Limited Partner. And VC does not perform (and unchanged will not) because it selects companies that are sub-prime innovations that do not have a strong potential to yield public value. And that is because many VCs themselves are sub-prime and therefor unable to spot disruptive innovation to begin with. On top of that we have an in-transparent financial system that allows for bottom-heavy diversification of more than ten layers deep (see "2010: The State of Venture Capital"), that is far removed from an efficient marketplace in which LPs and entrepreneurs can verify the merit of the ideal VC matchmakers.

Blame where blame is due

And so the real owner of the bubble is (again) our financial system that allows sub-prime operators (VCs without entrepreneurial merit) to slip in and mess up the initial success of the venture sector that was so beautifully crafted by Bill Draper and the likes.

So, the 2001 implosion was not a tech bubble, but a finance bubble and a clear warning of what is to come to other sectors that deploy the same economic model to their respective domains (I have spotted the pattern).

We need entrepreneurs to think bigger (not more restricted) and unabashed to find the next innovation that can change the world. But only an economic system that deploys prime matchmakers will be able to cherry-pick those prospects. So, in the end we cannot really blame the current crop of sub-prime VCs for getting picked, and they will continue to sit on their throne (a ten year vintage) until time runs out anyway, but we need to change our economic system so we prevent them from entering in the first place. And changing management fees (that some focus on) alone does not turn a sub-prime VC into prime.

With our financial system eleven times the size of production, it is time for the foundation of our economic system to get an overhaul. And Venture would be a great place to start.

Does Venture Scale?

The Venture Company | venturecompany.com — 2010-02-22T13:43:15-05:00

By Georges van Hoegaerden

Last week, through a long string of conversations with a CalPERS board member and some trusted peers, I ended up speaking with Joe Dear (Chief Investment Officer) and other members of his Venture team at CalPERS in Sacramento, the largest pension fund in the United States with $200 Billion in total Assets Under Management and single largest investor in the Venture sector (as a Limited Partner, or LP), with an allocation of around $20 Billion in direct and indirect (fund-of-funds) alternative investments (which includes venture).

Joe expressed specific concern about the ailing Venture sector, a message we as participants in the Venture ecosystem should all take very seriously. I do, because I hear it all the time, and it worries me how devastating a withdrawal of CalPERS (10% or so of all U.S. Venture and the consequent ripple) from Venture would be to Silicon Valley and to our country.

Such withdrawal would be devastating to our entrepreneurial capacity and drive to which we owe our statue in the world. We still have many parasites (some quite well known, and not too anxious to be found out) who are too busy deploying ingenious methods to suck this ecosystem dry while it lasts, unable and unwilling to see the dark clouds forming above their heads.

Yet, we all need to pay attention to the discomfort of LPs, and resolve those - not with a new set of lies and promises - but with a breakthrough systemic solution to improve the performance of Venture Capital.

Late to the table in 1988 as portfolio manager Jesús Argüelles explains, CalPERS made up for it in the 90s followed by disappointing performance today. Joe questioned the sector's viability as a whole, by rhetorically asking me (amongst other topics):

Does Venture Scale?

Before I answer that question it is important to note how ignorant the many players in Venture are to the impending threat this question poses.

At this public event, I recognized only two Venture Capital (VC) firms that where present. If as a VC I really wanted to make money for my LP in these turbulent times, I would show up to offer whatever support I can muster. I did: to represent the unwavering value of disruptive innovation.
No-one of note from the National Venture Capital Association (NVCA) was present according to the attendee listing handed out at the event. Rather than to focus on helping CalPERS generate upside, I guess it prefers to spend its time protecting its members' downside to lawmakers. The VC lobbyist needs to rethink its leadership focus.
The dismay of LPs in the Venture sector is in sharp contrast to the incessant, blind, self-serving and false optimism of many Venture participants, journalists and investors who continue to suck entrepreneurs dry and leave a subprime Venture pool behind that clouds the opportunity for serious investors and serious entrepreneurs.
No-one (except we) in the Venture community is truly acknowledging, with a plan of change, how the performance in Venture can systemically be improved. Better times, with more of the same is what many wait for, but hope is not a plan.
If we do not take the subtle message from CalPERS serious, more than 10% of Venture investments in the United States could suddenly disappear, with many other LPs quickly following suit. And that means that (once again) the deployment of an incompatible financial system destroys the innovative capacity of those that deserve better.

My answer

So, my short answer to Joe's loaded question was:

"Sub-prime Venture does not scale, but Prime Venture does".

The currently deployed economic model of Venture will never scale, and here is why:

Ten levels of diversification with multiple (hybrid) relationships from LP to startup investment makes it impossible to identify the real merit and performance of VCs and the validity of their investment thesis.
A (loosely coupled) commoditized investment thesis can never outgrow its peers, and thus is incapable of generate meaningful alpha.
Sub-prime VC systemically destroys the trust of Public Markets by pushing so-called innovations through the funnel, soiling the opportunity for more discretionary value.

The necessity to produce public value

It is a bad idea to ignore the public's perception of Venture Capital. With a large sum of Venture money (roughly $1.9 Trillion) over the last 10 years producing no substantial public value by way of IPO, sub-prime VC has lost the confidence of the public that does not only supply the money to VC (indirectly through the public pension funds, endowments etc.) but is also expected to buy post-IPO stock on the public stock market.

So, rather than to continue with "the models for success that have worked for our industry in past decades" as many of the NVCA cohorts continue to preach, we need to rely on a new economic model that fundamentally changes Venture Capital to its core.

Our proposal in the presentation "2010: The State of Venture Capital" will do so and it scales because:

Our Venture model removes the diversification at the bottom of the Venture equation, exposing VC matchmaker merit and accountability.
Our Venture model employes dynamic marketplace merit, not static institutional merit.
Our Venture model attracts unique investment theses that have the ability to find the outliers of innovation.

Incompatible financial systems

The problem with Venture is that traditional financial systems (stemming from more conservative asset classes and times) are incompatible with the risk and returns that early stage Venture has to offer. Over time the old financial system has steadily suffocated, and worse alienated disruptive innovation, by forcing sub-prime innovation through an exit funnel that as a result left a trail of eroded trust.

Venture has lost trust with public markets, but even more so with the outlier entrepreneur. Truly disruptive ideas do not even show up at the doorsteps of many VCs any more, because certain corporations have become better custodians of innovation than venture capital (remember those ludicrous buyers/sellers-market arguments of VCs).

Change the dating service

But just because VC is broken does not mean innovation is. We need to re-establish the merit and definition of disruptive innovation and stimulate the creative and intelligent minds that can spawn it. The Internet provides a massive opportunity to tap into the buying power of 5/6th of the world population that is still technologically disenfranchised.

But if we leave the Venture Marketplace functioning the way it does today, less money-in will not change the alpha (portfolio returns) for Limited Partners. Survival of the fittest in a dysfunctional market is a worthless asset.

Superior Economics

Smart Limited Partners stay committed and realize that Technology Venture has superior economics, that with the right economic construct has the ability to outperform any other asset class.

Technology feeds the brain in the same way water feeds the body. Technology can be served up in many ways to produce, share and monetize knowledge, just like water can be used to produce soup, coffee, tea or anything else you can think of. We have all the ingredients in this country to make lovely dishes, all we need is a better economic system to attract the right chefs with scrumptious recipes.

The new size of Venture Capital

So, stop making statements about whether Venture Capital should be smaller or larger. It's a futile discussion. The size of an inefficient marketplace is irrelevant and thus by definition wrong. First we need to deploy an efficient marketplace (that is designed to find the real merit of innovation), before we can make educated guesses about how to best support it with a proper financial system and size. Lowering the commitment to Venture Capital does not create more efficiency, changing the marketplace does.

So, LPs need to deploy a new economic system that systemically roots out sub-prime. The solution that scales to its authentic potential is here today.

How LPs in Venture have been fooled, many times over

The Venture Company | venturecompany.com — 2010-02-05T10:45:28-05:00

By Georges van Hoegaerden

A fantastic television ad by Ally Bank, in my view best describes how Limited Partners (LPs) as the investors committed to Venture have been fooled.

In the event you have not seen the video, it shows a slick man in a business suit sitting cosily around a kids table with two little girls.

The suit then asks one girl if she would want a pony. When she replies yes, he hands her a toy pony. He then moves on to the second girl and asks her if she wants a pony, and then calls in a real pony. Clearly the first girl is upset that she did not get a real pony and complains, upon which the man replies, "well, you didn't ask."

What pony did you ask for, by virtue of your actions?

That is exactly what has happened to LPs in Venture who did not ask the specific questions that could have led to their success in Venture. In many cases those LPs failed to generate impressive returns in Venture because they did not know they had to ask specific questions and should have taken control of the situation in order to get the results that the sector is able to generate.

Many LPs, glowing at the early return profiles of Bill Draper, Vinod Khosla and other early illuminaries, simply said "yes" to General Partners (GPs) who asked LPs if they wanted Venture returns, without even asking how much (see the many PPM's that do not even have clear return targets).

And of course now, many LPs are utterly disappointed and mistrust the GPs (and worse the sector), similar to how the little girl in the video now mistrusts the man.

Ask the right questions

To help make clear to LPs what questions to ask I have added a new section to the wildly popular presentation 2010: The State of Venture Capital, the Prelude (posted on Slideshare) describing how an LP thought his commitment would be applied, and how it was in reality. See for yourself:

We pride ourselves on a solid and no-nonsense understanding of the Venture ecosystem, top-to-bottom, which is crucial in leading to a permanent fix in Venture and to improve its performance. So, we back up our rational on the right side of the previous slide with the observations of how the Venture business really operates today. And here is how the rubber meets the road:

The bottom line is simple. It is okay to deploy your money as an LP through GPs as the arbiter, but just like many Hollywood stars have found out, if you are not signing your own checks, know what they are being spent on and how - don't be surprised your money will be taken for a ride. It is the nature of letting go of financial control (and really, you should not be surprised).

Today's Venture pipes are still being pumped full with subprime deals, which means the ten-year outlook for Venture will not look much different from its miserable ten-year past. So, the time to act is now if you expect a different outcome in ten years.

Take control

The Venture business needs to be reigned in, with controls put in place so it can no longer be taken for a ride.

The sector has a bright future ahead, with massive market-pull from the majority of people in this world who still crave technology solutions to improve their lives. The only way we, as the most innovative nation in the world can screw it up is to deploy a piece-meal financial system that misses its intended target.

That has to stop, right now.

Dear LP, a permanent fix to Venture, by way of a new economic system you can deploy, is waiting for you. Act now or forever hold your peace.

2010: The State of Venture Capital, updated

The Venture Company | venturecompany.com — 2010-05-10T16:50:52-04:00

By Georges van Hoegaerden

New slides added May 10th
The changed Venture Capital risk profile

Other slides added April 19th and Feb 22nd, 2010. Originally released to the public January 31, 2010.
Targeting Social Economic Value as the impetus of behavioral change for VCs
Confusing upside with downside is the reason why Venture does not perform
Unchanged, reinvesting in Venture is the definition of insanity
Who can solve the systemic issue in Venture today

More than 150 money managers (including some VCs) have received a controlled prerelease of the previously announced 2010: The State of Venture Capital on January 1st, 2010. Since then more than 5,000 others have reviewed the presentation online and has been generously lauded. Clearly the content is striking a chord.

What this presentation is not:

• This is not another numbers deck: clearly not everything that can be counted, can be counted on...
• This is not yet another self-written report card from venture capital lobbyists
• This is not a blind prayer for hope of a better future

What this presentation contains:

• This is a reflection of the effectiveness of Venture Capital from the point of view of a successful entrepreneur; first hand observations
• This is a top-down analysis of the Venture ecosystem for Limited Partners
• This is a permanent fix to Venture and a methodology for LPs and Fund-of-funds of how to re-commit (TVC customers only)

The Prelude to the permanent fix of Venture Capital is available right here (click Full for a full-screen version):

2010: The State of Venture Capital, Prelude (Updated)

View more presentations from Georges van Hoegaerden.

Feel free to make comments, ask questions by using the online form, e-mail us or contacting us by telephone.

The top-down fix to Venture Capital is reserved to Venture Company customers, embodies a new market system and provides fundamental differentiation to Limited Partners and Fund-of-funds managers and a permanent solution to the malaise in venture. Change is easy, we will implement it for you.

The world of monetizable innovation has changed, and we need to change with it. Venture should be and can again be, with a restructuring, the best performing asset class (sector) to money managers.

This presentation has received top presentation of the day recognition on Slideshare based on its content and perceived value by Slideshare staff and has been a top viewed presentation for many weeks.

The problem with Venture: no true Alpha and no true North

The Venture Company | venturecompany.com — 2010-01-29T10:48:38-05:00

By Georges van Hoegaerden

I am talking to a lot of Limited Partners and Fund-of-funds managers these days and the reputation of venture as a viable asset class (sector) is really bad (even though the opportunity dictates it shouldn't be).

Few people at the top of the investment food-chain seem to have a good sense of what it going on down below (with General Partners at VC firms), and even fewer believe a further commitment to venture makes sense. Our government adds to that mistrust by not even acknowledging venture as a viable instrument to resurrect innovation.

No True Alpha

But can we blame them? The returns (of the portfolio of investments, some money managers represent by a formula that yields "alpha") in the venture business have been deplorable from many angles:

From a Limited Partner (or Fund-of-funds) perspective; with less than 10% IRR over the last 10 years and less than 3% of $2 Trillion invested yielding public value.
From an economic perspective; more than $1.9 Trillion of (mostly) public money has been wasted in the last 10 years on so-called innovations by venture that never generated any public value.
From an entrepreneurial perspective; the definition of innovation has severely eroded by the subprime nature of the investment thesis that makes it unattractive for meaningful innovation and real entrepreneurs to be discovered.
From a consumer perspective; we have created no more than a handful meaningful innovations with an army of 800 Venture Capital firms chomping at the bit. We have eroded the trust of the people we aim to serve and those we rely on to spawn a high-flying public offering.

No True North

No True Alpha is the result of a defective compass of the Venture Capitalists (VCs) - arbitrating the money-flows - that is no longer pointing towards True North, but rather Magnetic North. In this context Magnetic North defined as a gamble with someone else's money, a very lofty salary and no downside for the next 10 years. Should we really be surprised that without transparency and accountability Magnetic North is much easier to achieve than True North?

Other temptations of Magnetic North are misleading VCs even further:

Target acquisitions: many startups are funded and built with improper expectations. While exciting in nature for many, the past bull-market flurry of acquisitions misleads VCs to believe that they can target one. Yet most acquisitions of early stage technology companies are completely erratic (I can tell you many buy-side tales), because they are primarily based on internal corporate struggles rather than somewhat predictable, external market indicators.
Exit at underperformance: we are soiling the acquisition pool. Acquisitions, in the majority of cases do not work out for the acquirer and are very often overpriced, overhyped and under-deliver (I can talk about many experiences here too). Usually not by design, but simply because they lack macro-economic value to begin with. And while money is money, every acquisition that does not deliver deflates the valuation of the next innovation that deserves better and therefor negatively impacts portfolio returns.
Stay away from IPOs, the window has closed. I always smile at that popular phrase by VCs and reply: if I want fresh air I will open a window. The public mistrust we have created by pushing subprime innovations through the IPO funnel for the last 20 years, has quickly developed an innate scrutiny to invest only in what the public understands and what matters to their life. Macro-economic impact of innovation is the only value that can pass these days and VCs have restricted their thesis to the extent that they just do not know how to find and fund those. Our focus should be on building real companies, not technology gimmickry.
Inappropriate deployment of risk: their lack of relevant market experience forces VCs to focus on the only thing tangible to them, the technology implementation. And that while the creation of technology is the least of the risks in a technology venture. What matters, again, is the application of technology to a viable marketplace. And so the risk is in identifying and fully addressing the needs of the marketplace, with whatever modern technology does the trick.

There are many other magnetic distractions that keep VCs from reaching or ever pursuing True North, some of which I have covered in other places in my blog, but that laundry list would go beyond the patience of my readers.

From isolate to insulate

The point I am making here is that no-one should be surprised that venture is not performing. The LPs were there to allocate the money, the entrepreneurs were there to dream up innovation, and the public is still yearning for technology innovation to substantially improve their lives.

The problem in Venture is the derivative, the Venture Capitalist who without economic viability has no political leg to stand on to stay in business. We have isolated the problem: the "referee" is in trouble, not the players nor the game. Now we just need to insulate the problem, and the controls are solely in the hands of discerning LPs and Fund-of-funds that need venture to perform.

A simple fix

The solution to a healthy Venture climate is simple (in the same way e=mc2 is simple, its discovery took me and Einstein a while); change the construct of venture investing so it mimics the meritocracy of innovation that can produce uniquely disruptive value.

The impetus of that new model can be found here, the actual fix by contacting us here.

New York, an empire state of mind

The Venture Company | venturecompany.com — 2010-01-21T10:30:59-05:00

By Georges van Hoegaerden

I always love being in New York and last tuesday I attended the AAAIM 2010 Investment Themes event in New York (a fairly closely held affair, thank you Brenda Chai) with a keynote from John Liu, newly appointed New York City comptroller (closely guarded by his security detail) and other luminaries from the New York investment world, including Kelly Williams from Credit Suisse Customized Fund Investment Group, Marcos Rodriguez from Palladium Equity Partners, Jimmy Yan from New York City Employees' Retirement System and Peter Marber from HSBC.

All speakers (and attendees) manage multibillion (double and triple digit) dollar funds and what struck me was how little these top managers know about venture, except to frown or stay away from the sector given its miserable performance and reputation for the last 10 years (we describe in my blog often).

There is clearly more work needed and opportunity to be gained to resurrect the face of venture and to establish new faith and trust. That trust of-course can only come from being honest and critical about past venture performance and offering a clear rational and remedy to resurrect it. Exactly what our focus has been for the last few years.

Now, I am not a journalist and I am not going to go into the many personal conversations I have had with regard to venture investing, yet I do want my readers (specifically those interested in venture) to understand how some of the financial pressures will impact venture directly, indirectly or potentially, as could be surmised from the speeches of the public speakers.

And, the more every venture marketplace participant knows about its dependencies (especially from the Limited Partners at the top of the venture food-chain), the more we can each respond to and secure a better future for a sector that, in my view and with my venture model, deserves much more commitment than 10-15% of overall LP commitments.

The State of the City

Both New York City and New York State have raked up sizable budget deficits. New York Sate has a $7B deficit and New York City as the nations 4th largest government with a budget of $60B has incurred a $4B deficit. If comptroller John Liu has his way the deficit will not be hidden under the rug by borrowing money, but lowered by cutting expenses and/or raising taxes to erase the deficit of about 1/5th of the flexible $25B part of the total budget. The City is looking for creative ways to achieve those savings objectives.

A question from the audience raised about increasing taxation on $25B of newly issued Wallstreet bonuses was quickly and politically sidestepped by forecasting its prospective value to only yield $0.5B, assuming those bonuses were all distributed in liquid form. In addition the comptroller stated he prefers to find more long-term solutions to erase the deficit, essentially leaving the contentious issue of dealing with Wallstreet up to the President.

Limited Partners

John Liu is also custodian/board member of 4 of the New York pension funds (including NYCERS with $35B under management), comprising of $100B in assets. No mention of fund performance (we know from other sources more or less what is going on) but he expressed specific interest in widening the network and making it easier for small new asset managers, with unique industry experience and merit to participate in the deployment of diversified assets.

As you can imagine, after having written for years about the lack of verifiable investor merit at the bottom of the food-chain, I was enthused to hear the comptroller usher rudimentary free-market principles as its new goals in deploying monetary assets. The proof of-course is in the pudding and I hope to meet with his people soon to exchange my macro-economic views on how financial systems aught to work.

Globalization

Another highlight of the evening was a great overview on emerging markets by Peter Marber who runs emerging market investments for HSBC. Peter stressed the need for a renewed focus on emerging markets, supported by some interesting statistics and the use of "The Mac Theory" (I've heard before), not a macintosh this time but a MacDonalds Big Mac. He simplified the value of a currency by comparing the price of a Big Mac in a country with the price of a Big Mac in the US. The difference yields a fairly accurate view of the expense of doing business in the juxtaposed country.

According to Peter, emerging markets cover 6 Billion people who cover 77% of the global landmass. He sees new opportunities in what he calls shifting democracies, with Japan's economy growing at a 4% rate versus a growth rate of 2.5% for the US. Emerging market debt has grown by 171% and global equity growing by 82%, while US equity has declined 24%. BTW: Just yesterday it was reported China's GDP grew a stunning 10.7% in the 4th quarter of 2009.

Peter comes across as savvy asset manager with his feet still firmly planted in the ground, a practicality we can never have too much of. Peter's global viewpoints are well put and he expects that venture will remain (for now) a US dominated opportunity as long as the products we build have (immediate) global market impact. I concur, as long as we free innovation from the choke hold of our current venture system.

New York, your lights continue to inspire me.

A new way in is the way out of Venture

The Venture Company | venturecompany.com — 2010-01-11T08:21:43-05:00

By Georges van Hoegaerden

Many Limited Partners are contemplating getting out of the venture sector altogether and end their commitments to Venture Capitalists (VCs), no surprise given the sector's miserable performance of less than 10% IRR the last ten years and no more than 3% of moneys invested producing real public value.

Flight is a natural, but inappropriate response

The technology sector has a long way to go in supplying 5/6th of the world with meaningful technology applications. And with more (global) entrepreneurs at the ready to tap into that wide open greenfield the pain in the venture business is not with supply and demand, but with the arbiter in the venture business - the venture capitalist.

I often use a simple analogy to make this clear: just because the performance of eHarmony (a leading dating site) is down, does not mean we necessarily have fewer potential marriages. It just means the marketplace (see our new Venture Primer) where those connections are being made is inefficient. Smart participants will seek to explore new marketplaces where the arbitrage fits their requirements and so should Limited Partners.

Expect absolute, not relative Venture performance

Many VCs who smell the impending cannibalization of their cushy, no downside position throw anything at Limited Partners to make them recommit for another ten years at the expense of public money.

VCs continue to use any tactic in the book to persuade Limited Partners that none of the malaise in venture was their fault. Aided by the conglomerate resources of their lobbying organization, the NVCA (the National Venture Capital Association) they drum up every statistic and external market factor known to man to hold on to their position in this ailing sector.

The mere existence of a lobbying organization (with international branches and replicas) alludes to the deployment of artificial market forces and should be a wakeup call to those depending on it.

But great performance in the venture business should not be measured relative to other VC funds (using meaningless self-serving top quartile accolades), or worse be measured against public market indices, but should be measured against the opportunity to monetize the penetration of technology in its global greenfield.

To use another analogy:

The best athlete is not one that wins the race, but the one that becomes the fastest man on earth.

The best of the worst

Now, I know the job of Limited Partners is to deploy assets (surplus cash) and get the best possible yield for a given time period on that commitment and lockup, without a loss and better, a significant yield. To the Limited Partner it is a game of responsible diversification to a spread of asset classes in which not the individual performance matters, but the yield of all assets under management.

Venture, as one of the avenues with an average allocation of between 10 and 15% of total assets under management has been for many Limited Partners just the "icing on the cake", a nice to have but not a necessity. Until the other asset classes started imploding. Hence the reason why many Limited Partners first were reluctant to criticize VC and now suddenly debate to leave the sector altogether.

Some VCs have gone out on a limb and publicly cheered that on, forgetting that - using our previous analogy - a select few may have won the last ten year's race but that their absolute performance still does not make for a great spectator sport. Especially not since their reason for winning is comparable to a winning streak in Vegas, sheer luck and unsustainable.

Technology Venture should outpace any other asset class

In any economy, Technology Venture should outpace any other sector or asset class for Limited Partners with a ten year horizon, simply because of the following reasons:

Technology is a low cost production business (not a derivative) that capitalizes on the unwavering intellectual brainpower of global entrepreneurs to tap into existing macro-economic needs.
Technology taps into a massive greenfield consisting of 5/6th of the world population, and is only at the beginning of its exploration.
The internet provides a zero cost distribution channel that feeds relevant new technology directly and instantly to massive market pull.
The fluidity of technology implementations allows disruptive technology to quickly respond and become resistant to economic aberrations.
Technology relies on nothing but itself to create and maintain instantaneous value, the only volatility in venture is venture itself.

A new way in

What is broken in venture is the VC as the arbiter, who claims to have the ability to spot disruptive innovation but has not delivered, some say for the last twenty years. The commitments from Limited Partners are still flowing and so are the unwavering ideas from entrepreneurs. All that is needed is a different arbitrage that has proven to spawn highly monetizable innovation against the (absolute) spectrum of a massive technology greenfield.

The existing crop of VCs may not get there, as cannibalization of a complacent position will be painful. But I am sure that if we replace every VC today with an experienced former startup entrepreneur (with successful company growth under his belt) we will quickly produce results far better than the last ten years. The past is the past, so let's not dwell - but get rid of it.

I can't think of any asset class with a better risk profile that within a ten year vintage has the propensity to deliver stellar results. But only with a few new rules of the game and referees that have the wherewithal and experience to make it happen. The instruments of change in its tremendous rewards are in the hands of Limited Partners who remain committed to technology venture.

So, we should treat Venture for what it is: the fastest athlete in the world. And recruit trainers who can get it there.

Why Einstein would be a better VC

The Venture Company | venturecompany.com — 2010-01-06T12:06:05-05:00

By Georges van Hoegaerden

I think about the future of Venture Capital a lot (day and night, can you tell?) and how we can continue to drive and fund innovation. And I have said many times that "the quality of the deal intake is only as good as the quality of the investor", which specifically in venture means that an investor needs to have the experience and foresight of an entrepreneur to support others.

Raise the (public) value of innovation

Clearly with truckloads of money from Limited Partners over the last ten years, more highly skilled global entrepreneurs than ever, and 5/6th of the world population still void of essential technology applications, VC has done a deplorable job in the matchmaking process between the assets of the Limited Partner (money) and the assets of entrepreneurs (ideas), which should have tapped into that massive greenfield more aggressively.

Less than 10% IRR for more than 10 years, or to use another worrisome statistic: less than 3% of dollars invested in VC over the last ten years leads to the production of any public value by way of IPO (Initial Public Offering), as 10 years of VC investing at $200B/year (give or take) x 10 generated $66B in IPOs (per Dan Primack, PEHub). No wonder the Limited Partners who fund VCs scratch their heads at what just happened to their money.

It's all about the Benjamins (and the quality of people behind the money)

I referred to Albert Einstein before (way back in 2006) and an amuzing article from Dave B Lerner turning Sherlock Holmes into a VC reminded me how the principles of Einstein should be held against the selection process for General Partners (GPs) at a VC fund.

Quotes from the Genius

So, with Einstein's Wikipedia encyclopedia at hand let's roll out some of his famous quotes and see how the current state of venture stacks up:

"Imagination is more important than knowledge. Knowledge is limited. Imagination encircles the world".

So why do GPs demand to see a product demo before they can decide to invest, is it because they have no imagination? Perhaps we should encircle a world of innovation that is bigger than Silicon Valley?

"For knowledge is limited, whereas imagination embraces the entire world, stimulating progress, giving birth to evolution. It is, strictly speaking, a real factor in scientific research".

Why a SuperBowl ring is so much more valuable than an Ivy League ring, in any job in the venture business.

"A new idea comes suddenly and in a rather intuitive way. But intuition is nothing but the outcome of earlier intellectual experience".

Why relevant entrepreneurial experience is such an important attribute to a VC investor, intuition not analysis drives the selection of rewarding investment decisions.

"Whether you can observe a thing or not depends on the theory which you use. It is the theory which decides what can be observed".

Silicon Valley has commoditized the investment thesis (or what we refer to as the-same-difference investment thesis), no surprise that it cannot detect disruptive innovation even if it would show up at their doorstep.

"Falling in love is not at all the most stupid thing that people do — but gravitation cannot be held responsible for it".

GP should not be afraid to feel passionate about their companies and make independent investment decisions (that may not find other syndicates), but the gravity of investment commoditization can not be held responsible if they do not.

"It can scarcely be denied that the supreme goal of all theory is to make the irreducible basic elements as simple and as few as possible without having to surrender the adequate representation of a single datum of experience".

Customers need simpler technology solutions, not more complex. As investors that means we should not invest in technology, but the application of technology to meet customer needs. But not so simple that it has no macro-economic and public relevance (IPO).

"Humanity has every reason to place the proclaimers of high moral standards and values above the discoverers of objective truth".

A higher moral standard in the venture business would ensure that we deploy free-market principles to the support for innovation. We are far removed from deploying transparency to the venture business that would expose the true merit of investors with the true merit of entrepreneurs. Only then will the truth reveal itself.

"A happy man is too satisfied with the present to dwell too much on the future".

GPs locked up into 10-year fund vintages are fat and happy, too happy to dwell to much on the malaise in venture.

"The state of mind which enables a man to do work of this kind is akin to that of the religious worshiper or the lover; the daily effort comes from no deliberate intention or program, but straight from the heart".

Great convictions from the heart lead to great investments and financial returns in venture. The investor who is content with the current investment program will soon meet his maker.

"I am by heritage a Jew, by citizenship a Swiss, and by makeup a human being, and only a human being, without any special attachment to any state or national entity whatsoever".

We are citizens of our world, so perhaps we should start investing that way. We need to get away from Sand Hill Road more often and tap into global resources, not just to fund entrepreneurs but also to experience and understand what drives global marketplaces.

"Concepts that have proven useful in ordering things easily achieve such authority over us that we forget their earthly origins and accept them as unalterable givens. Their excessive authority will be broken".

Just because we have constructed the relationships between Limited Partners and VCs in a certain organized fashion does not mean we should accept them. Especially not when performance proves the vast majority of those relationships do not work out to satisfaction.

"Great spirits have always encountered violent opposition from mediocre minds. The mediocre mind is incapable of understanding the man who refuses to bow blindly to conventional prejudices and chooses instead to express his opinions courageously and honestly".

Entrepreneurs should expect to receive violent opposition from mediocre VCs (who focus on technology builds), but entrepreneurs should remain courageous and honest. Courageous in their entrepreneurial ideas and honest about their ability to build them.

"The important thing is not to stop questioning; curiosity has its own reason for existing".

Many people take for granted what has been imprinted in their brains from childhood, but you would be surprised to learn how many of those things are actually false. Not by design, but by interpretation. Drill deep in what you have been told as the truth and you will find new opportunities for innovation.

"Nature shows us only the tail of the lion. But I do not doubt that the lion belongs to it even though he cannot at once reveal himself because of his enormous size".

A Long Tail without a Torso is meaningless.

"What is thought to be a "system" is after all, just conventional, and I do not see how one is supposed to divide up the world objectively so that one can make statements about parts".

Markets do not exist, as I have stated many times before. Only marketplaces do, in which the choices of individual participants with unique ideas are married.

"Few people are capable of expressing with equanimity opinions which differ from the prejudices of their social environment. Most people are even incapable of forming such opinions".

The social environment on Sand Hill Road that has perpetuated the mediocrity in venture is preventing GPs from expressing opinions about how it should change. In fact, none of the Limited Partners I spoke to have received a viable plan from VC as to how to combat the venture malaise we are in.

"My political ideal is democracy. Let every man be respected as an individual and no man idolized".

When you do not belong to the (subprime) "venture club" or play their game, you are not let in and respected. So why should we repay that homage back with idolization?

"The really valuable thing in the pageant of human life seems to me not the State but the creative, sentient individual, the personality; it alone creates the noble and the sublime, while the herd as such remains dull in thought and dull in feeling".

Meritocracies are created by transparency, and we have none in venture. No surprise it is dull in thought and dull in feeling.

"My passion for social justice has often brought me into conflict with people, as did my aversion to any obligation and dependence I do not regard as absolutely necessary".

Free-markets are created by meritocracies that rely on transparency. The social justice of a meritocracy is hard to grasp for those who hide behind walled gardens to protect their own insecurities.

"Mistrust of every kind of authority grew out of this experience, a skeptical attitude toward the convictions that were alive in any specific social environment — an attitude that has never again left me, even though, later on, it has been tempered by a better insight into the causal connections".

I mistrust many venture investors for good reason (their lack of merit), but have learned that the casual connection is the dysfunctional financial system that allows VCs to take it for a ride.

"Everyone is aware of the difficult and menacing situation in which human society -- shrunk into one community with a common fate — now finds itself, but only a few act accordingly".

Waiting, talking and reporting about the malaise in venture is one thing, offering solutions to it is another.

"The economic anarchy of capitalist society as it exists today is, in my opinion, the real source of the evil".

That is of course because the only form of capitalism we practice today is far from a meritocracy. Capitalism spawned by meritocracy is a wonderful thing and builds opportunity for all people with merit (within the Long Tail and the Torso).

No need to be Einstein to become a VC

Einstein himself did not think he was special and neither should a VC. All you need to become one is solid early stage experience and a vivid imagination of how the world should work.

Yet to make venture work, Limited Partners need to start by deploying money to GPs who themselves have proven how those crucial attributes helped them cross the chasm, before those GPs are allowed to tell other entrepreneurs how to do the same.

My investment and drive is for democracy, meritocracy and capitalism to work hand-in-hand to produce the powerful innovation that enhances the lives of people around the world. Until that happens, I leave you with a last quote from the Genius himself: "To punish me for my contempt of authority, Fate has made me an authority myself".

Happy New Year!

Predicting the future is why macro matters

The Venture Company | venturecompany.com — 2010-01-05T02:54:59-05:00

By Georges van Hoegaerden

As an investor, and especially a venture capital investor you need to have the ability to predict the future within an acceptable degree of accuracy. And that is exactly a skill many venture capitalists (VCs) so miss out on and generate such mediocre returns. The value of their innovation is simply not meaningful enough.

Venture Capital differs fundamentally from (other forms of) Private Equity in that it requires an extraordinary level of foresight and prescience. After all, one needs to believe in something that does not already exist and little proof exist it ever will - or is there?

It is impossible to predict what technology will prevail

VCs today are still too focused on technology, even though many proclaim to understand markets (more on that later). The reality is that rarely any business without a technology demo gets funded these days. Yet popular technology flavors change frequently (every three years or so) and betting on technology is a foolish game. We should know by now.

Driven by the urge to produce results within ten year vintages and complicated by the (we claim, self induced) lack of IPOs and M&A, the majority of VCs have retracted to a short term investment focus, massive diversification and fragmentation of investment dollars. Quite the opposite of what should have happened to the venture business.

But how do you tell someone to step into the circus ring to tame a tiger, without having had the confidence and prior experience to do so. It is just not going to happen. Change in the venture business needs to come from the top.

Limited Partners who do not refresh their VC commitments and requirements now, are bound to lose big-time on venture pipelines stuffed with sub-prime investments with no place to go.

It is easy to predict what macro-economics will prevail

Warren Buffett said it right in a recent interview with Charlie Rose in that the future long term is a lot easier to predict than the short term. Or the way I tell my wife; I don't know where I'll be during the day, but you can count on me coming home for dinner.

In business, long term value does not discount the need for short term planning, but short term without long term (or macro) is a loosing gambit. Here are some examples of the lack of macro-economics and its failures :

- The venture ecosystem

The venture capital ecosystem consists of ten(!) layers of diversification before the dollars from a Limited Partner lands into the bank account of the company of an entrepreneur. No matter what your views on the venture business, but anyone who has attended business school should know that this kind of over-diversification leads to a morass of accountability and in-transparency of results. Without fundamental change to the way venture works today, venture is poised to become more mediocre than its today. Venture is macro-economically broken. The reason why we provide a solution for Limited Partners here.

- The VC intake model

Most venture capitalists sit impatiently through an entrepreneur pitch, checking their blackberry's until the product demo. Not only does this communicate the VC has no empathy for the macro-economics, it also communicates that technology risk is the only risk they think they can assess. Per previous analogy, those VCs are the wives who call their husbands twenty times per day, just to know where you are. They demonstrate a lack of understanding and lack of faith in macro-economics and an improper assessment of investment risk.

- Entrepreneur pitches

Perhaps dumbed down by the only pitch process that leads to getting money from (sub-prime) VCs, many entrepreneurs pitch technology without understanding the macro-economic forces at work that prevent a pure technology play (albeit perhaps better) from having access to paying customers. When a large incumbent owns the access to the majority of customers through perception, a proprietary business model or otherwise, technology innovation without a fundamental disruption of the business model is worth very little. Entrepreneurs need to think business and include macro-economics.

- Marketing experts

Markets do not exist. Yep, I said it (and yes, I have worked in "marketing" too). Market definitions are stale and artificially extrapolate people that once exhibited a common purchasing decision into individuals that from then on behave the same way going forward. They don't.

We all know instinctively that every individual is different (even when that individual represents a company), that none of us like to be put in a box and that our reason for purchasing is unique and more than simply price/performance ratios. In addition we participate in multiple competitive and complimentary marketplaces in whatever order we deem appropriate. And any attempt to put marketplace participants in a fixed market bracket is therefor hopelessly self-serving.

Markets do not exist, but marketplaces do. The impetus to participate is extremely complex, complex to quantify yet not complex to qualify. A simple need for improved relevance and better value - based on individual needs and objectives. Marketplaces are no longer one-to-many, but have become many-to-many, with social networks emphasizing and echoing those individual requirements. The long tail of supply is met with a long tail of demand.

So, macro-economically the basis of marketing is flawed. Product success is not driven by marketing, but rather by how true the product is to its promise. And that means marketers who make product decisions based on market numbers are wrong and so are the investment decisions derived from market analyses.

Be ready for the swing test

Macro-economics really matter as it defines whether you have a chance of making it big, but not without careful micro-economic fulfillment. As an entrepreneur "dating" the right investor you need to be prepared for the swing test that goes roughly as follows:

Explain the vision, explain the product experience, explain the business model, explain the technology, explain the scalability, explain the product requirements, etc. etc. going back and forth between macro and micro until the swing comes to a halt with no questions left unanswered. Now, investor and entrepreneur have a common understanding of the risks involved for the road ahead.

A new investment focus

As experienced technologists we know we have many technology options to support a macro-economic need, and technology development is the least of our risks. The real question is whether the application of technology makes acute macro-economic sense. And surprisingly enough and again in agreement with Buffett, macro-economically we are not much different from a hundred years ago.

We like to play music, iTunes anyone? We like to stay connected, Facebook anyone? We enjoy free-trade, eBay anyone? Many other macro-economic desires remain unfulfilled with technology. Opportunity abound.

Fulfilling support for that macro-economic need is what Venture Capital should be all about. And it will again when we as Limited Partners tell the referees (the VCs) that the rules for investing have changed. That our expectations for VC are to chase macro-economic impact, rather than to allow the mindless technology herding to continue.

Endless opportunity for great returns

Supporting existing macro-economics with a more meaningful technology experience that meets the needs of 5/6th of the worlds population, that still does not use a meaningful internet application, makes for a fantastic and highly scalable investment thesis. One that we should allocate more-not-less money to as Limited Partners.

But we need to change our tune, now, before it all comes crashing down on us.

Introducing The State of Venture Capital

The Venture Company | venturecompany.com — 2009-12-17T10:37:57-05:00

By Georges van Hoegaerden

The Prelude to 2010: The State of Venture Capital is now available for public viewing here.

Capitalism Without Merit Is a Bold Lie

The Venture Company | venturecompany.com — 2009-12-15T14:40:55-05:00

By Georges van Hoegaerden

And socialism without merit is a lie too, a hollow lie. So do not even try to juxtapose capitalism and socialism here, not the point. Neither is the "rich" man's black-or-white argument that the mere thought of criticizing capitalism defaults into sudden socialism.

Putting our economies in a box is the last thing we should be doing, it separates us further in an increasingly global marketplace that requires the opposite. The real issue here is how to revive our economy, knowing we have powerful capitalistic assets and an unending innovative drive in our back pocket.

We need to be ready to challenge the status quo, let go (yet not discard) of the past and endure the rigor of change if we want to prevent the bottom from falling out from under our economy or face worse in ten years from now. Hope is not a strategy, change is. So, hang in there with me to redefine economic change.

The Lies We Tell Ourselves

We cannot change our economy for the better if we keep lying. And as a former leader of this country has proven, reiterating lies do not make them come true. The biggest lie is that we claim that we are more free than any other country in the world. As a polyglot immigrant I can refute that argument flat out, that is if we use the same definition of "free".

Freedom is the foundation of free-markets that ensures that every willing-and-able participant can become an integral building block of our economy. While there will never be total freedom, the lies we tell ourselves prevent even rudimentary freedom from taking hold.

Our Freedom Is a Lie

Freedom is not your compliance to your boss's expectation to dress-up to go to work every day, nor your inability to challenge his leadership for fear of losing your job, health insurance, pension contribution and other financial perks.

Freedom is also not a financial system eleven times the size of production that turns running a company into a Las Vegas gamble, demanding a focus on investors that precedes and overshadows the needs of customers. Freedom is also not an aging stock exchange (copied around the world) that promotes the financial agenda of short sellers and forces companies to adopt a short term agenda, rather than to build long term sustainability (or however the company prefers to be measured).

Freedom is not the inability to really say or write what you want, for fear of retribution from a bulging legal system that makes it so easy to file bogus claims, such as defamation of character. Freedom is also not our cunning ability to segregate the rich from the poor, the native americans (in today's indian reservations) from the rest, or blacks from whites (I should know, I am part of an interracial family).

I can go on for a while, but I think you are getting my point. We are lying.

The Freedom To Abuse Freedom

Just because all 400 million of us live in the same country, does not mean we enjoy the same freedom. Many of us are disenfranchised by freedom; the freedom to abuse freedom and to create whatever walled gardens are needed to keep others out. And that is the freedom I am so against.

Our Government's Delicate Role

We cannot really blame Apple that it signed an exclusive arrangement for the iPhone on AT&T's network to yield focus and produce higher margins, but it is the Federal Communications Commissions' (FCC) fault, asleep at the wheel that allowed device-to-network locking before the iPhone was even conceived (device locking was contrary to what the GSM standard was designed to do; I was free to use and roam my european GSM phone on any european network more than 20 years ago).

We cannot blame public companies to drive a short term strategy, as the Security and Exchange Commission (SEC) has implicitly dictated that a string of positive quarterly earnings reports are the predominant way to measure company performance and respectively its CEO. And we should not be surprised that a temporal decline in revenues is then quickly followed by staff reductions to make those quarterly numbers still look good on paper. Are quarterly earnings really an accurate reflection of company performance for a company that has been in business for twenty years or more?

We also cannot really blame Venture Capitalists (VCs) for taking advantage of the blind faith (and now delayed response) from Limited Partners if the SEC continues to treat participants and investments in private companies as under-the-table transactions, hiding important transparency from marketplace participants.

Cure the Disease, Not the Symptoms

But the delicate role of our government is not to regulate the symptoms but to prevent the disease. It is impossible for government to keep tabs on the impurities of symptoms in all marketplaces, but rather it should aggressively work towards enforcing the definition of free-market principles to each domain that poses what it deems a direct or indirect systemic risk to our economy (I can think of about ten depending on granularity, possibly all boiling down to a single driver: our financial systems).

I do not want our government to tell banks how to describe their interest rates to customers, but I do want our government to require banks to file and freeze (for a certain period) their lending terms in a central database, so its customers can query a single website to get the rates from the bank that meet their needs.

The role of government is to establish the marketplace principles, not to establish what is merit. The marketplace participants will sort the latter out quickly.

Relevant Transparency Builds Merit

Transparency is becoming a buzz-word and similar to the buzz-word "experience" means nothing without the preceding adjective relevant. What is relevant is that all participants have immediate access to the transparency of marketplace transactions (between supply and demand) in order for that marketplace to be driven by merit. And that means that the performance of marketplace participants is measured solely by the nature of their unique offering in the marketplace, not a complex myriad of stifling walled gardens and derivatives.

The beauty of relevant transparency is that all marketplace participants become watchdogs. That the signals of impropriety are detected instantaneously by many rather than by a few who choose to pay attention. That must be the reason why the Romans preferred a flock of geese over a single dog to protect their property.

Economic Growth is Defined by the Merit of Marketplace Transactions

No longer will merit be built by the posturing and decibel marketing of the supply side of a marketplace, that without transparency can make virtually any claims it wants. Merit will also not be built by the endless expression of desires from the demand side. What creates economic growth is the merit of the completed transactions between unrestricted supply and unrestricted demand.

So, to come full circle on our financial systems; our stock exchange needs to evolve into a free-market. Where the supply of stock will reflect the strategy by-and-of the company (not by the bourse), and the purchasing of stock is based on investors buying into that strategy. Venture Capital needs to change from a closed market to a free-market in which the transparency allows Limited Partners and entrepreneurs to find VCs who have the merit to pick, build and monetize truly groundbreaking innovation.

Free Ourselves and The Rest Will Follow

Relevant transparency builds free-market principles that leads to merit, in every economic circumstance.

Relevant transparency of our education system will improve the much needed individual merit of teachers and the individual opportunities for children. Relevant transparency of our financial system will improve the merit of investors and the innovative companies they spawn.

Relevant transparency of our economy will improve the opportunity for all people with merit. And all people do have merit. Many people, stifled by the constriction of artificial marketplaces have simply not discovered it yet. Opening up our marketplaces to become more free will allow each participant to discover and hone their own merit and produce better customer value.

The world will be a much better place when every person can participate and validate their own intrinsic merit in a thriving marketplace. So, let's stop lying and demonstrate to the world what real freedom looks like.

Why Venture Capital will not simply recover when the economy does

The Venture Company | venturecompany.com — 2009-12-04T11:24:13-05:00

By Georges van Hoegaerden

I saw an article a few days ago from an enthusiastic young General Partner (GP) declaring that "Venture is Back" and it reminded me how frighteningly naive some people in the venture business are.

A naiveté that gives entrepreneurs (and Limited Partners) false hope. And we do not need more false promises in the venture business.

Believe me, I want nothing more than to leave this horrible decennium of venture behind and start a new one afresh, but I cannot get excited about the mere sound of a spinning engine that gets the car rocking back and forth. Frankly, the car is still stuck in the sand with spring breakers drinking the kool-aid and cheering it on.

Spinning the wrong wheels

I too see the statistics on the venture pace going up and down and depending on whose reporting of an in-transparent venture business you believe, you can pick your pill of the day.

But how fast Venture Capitalists spin their wheels is irrelevant to the performance of the venture business. And even how many deals are done and how many exits are produced is irrelevant. Short of any transparency in the venture business those metrics are poor derivatives to report on its ups and downs.

What matters is fund returns

But what really matters to Limited Partners is how much money goes into the VC fund and how much comes out at vintage (after the 7-10 year life-cycle of the fund). Only a fund return that outscores any other asset class a Limited Partner (LP) invests in, can count on receiving continued commitments that add to the growth of the venture sector. And the venture sector is far from growing.

Why venture remains broken

There are much more fundamental reasons as to why in the years between 9/11 and the economic crisis of 2009 venture funds have not shown dramatically better performance while the wind was blowing in the sails of VC who had their LP commitments lined up (see how we counter the hope-and-pray philosophy).

Here is my top 3:

- Flawed deployment of risk

The majority of VCs today rely solely on what I call "technology grazing" as the method to extract greater business value. While that not only reduces potential upside it also deploys a flawed risk profile to the creation of early stage companies.

Venture Capital has died and resurfaced as micro-PE (Private Equity) that deploys an inappropriate risk model to innovations that are supposed to set the world on fire. To the many VC funds larger than $100M, chasing companies that have access to less than $1B in monolithic revenue opportunity and less than a $300M exit opportunity is simply a waste of time.

But the GPs have done so in droves anyway, because God forbid if they would have to give money back to LPs unable to find truly disruptive innovation and forego some of their management fees.

- Too many cooks who can't cook

The vast majority of VCs in the venture business today have never themselves crossed the chasm that would allow them to find the outliers and arbitrate innovation accurately. While GPs in Private Equity may get away with rudimentary skills to accelerate growth, the venture sector relies on specialist GP skills to turn early ideas into highly relevant innovations.

And even then, outliers are usually detected by outliers themselves, not by people who merely followed an educational trajectory cum laude. From a dissection of their bios on their websites you will find the evidence that most General Partners have no merit in judging how and when an early stage company should make the transition from an early adopter to a mass market and with what kind of an investment.

Experienced entrepreneurs are like discerning food lovers, they have a choice and stay away from bad restaurants.

- Endless diversification without accountability

Excessive multi-level diversification does not work and leads to more fog than clarity of purpose. Everyone and everything becomes a derivative, with no line-of-sight to accountability.

First the LPs diversify their risk by deploying a mere 10-15% to alternative assets (which includes venture, relying on other assets to produce the majority of LP returns), then they diversify to commitments in a multitude of venture firms, who then diversify into multiple funds, that then diversify to multiple GPs, who then diversify in multiple startups, who then diversify investments in multiple rounds, and then syndicate with multiple VC peers.

Hence my reference to a venture soup. And the asset holders, LPs and entrepreneurs are not liking the way it tastes.

The real fix

The underperformance in venture is similar to the car driving in the sand with the wrong tires and without locking differentials. The size of the engine (VC fund) does not matter, nor does it matter how fast you sped away on other roads. Only the way you apply the power to the current surface does. And so what matters is to what risk the moneys of a VC fund are applied.

So, unless the VC funds are setup and mandated to chase different risk, I do not expect to see any positive sustainable change in venture performance.

Yes, macro-economic confidence will increase investment pace and even improve the pace of mergers and acquisitions, but as long as we keep filling the pipe with sub-prime investments, we will not see more than sub-prime returns. We simply keep producing insufficient innovative disruption to significantly outpace other prime LP asset classes.

Over the next couple of months our government should instill free-market principles to the financial industry that through transparency can expose the real merit of investors in the venture business. But before that each individual LP can make immediate changes to their VC commitments now, to stave off the lingering curse of subprime VC.

The good news is that the future of the venture business is solely in the hands of the LPs, who by virtue of more discretionary VC selection are able to enthuse the outliers of innovation who, because they have more options, are currently patiently lying in wait.

Venture Capital needs a reset, my message to LPs

The Venture Company | venturecompany.com — 2009-11-19T13:20:11-05:00

By Georges van Hoegaerden

I covered the systemic risk of Venture Capital (VC) many times (see in my previous article "Less is more") and emphasized how the passion to create disruptive innovation is the driving force of our great nation, an asset the rest of the world looks up to and I aim to protect with everything I have.

I came to this country some 15 years ago to pursue my entrepreneurial endeavors and despite my successes have seen the effects of a debilitating venture business restrict the dreams and bright future of others.

Even some of my entrepreneurial work could have yielded better financial returns, were it not for the subprime nature of some VCs (and their entourage) of whom, in an in-transparent business (read "How to fix VC once and for all"), it is often impossible to establish their real merit (and character) ahead of time.

The Venture Dilemma

Limited Partners (Pension funds, Endowments, Family trusts etc.) who supply their money to VC in capital-calls are faced with the harsh reality that venture (the venture capital sector) has produced less than 10% IRR for the last ten years and are now asked again to buy into the rhetoric from General Partners (GPs) at the VC firm that none of this was their fault, and renew 10-year multimillion and sometimes billion dollar commitments. The question for the Limited Partner (LP) arises; should I stay or should I go?

Many Prime VC Firms have Turned Subprime Too

Top quartile performance (a meaningless definition in its own right) by one VC fund is unlikely to rescue the plethora of under-performers nor yield much higher than 10% IRR in total LP sector returns. And even the performance of classic top-tier VC funds leaves a lot to be desired.

Mayfield Fund appears to have no regret admitting “classic bubble” mistakes and “bringing in big company management”, non-market risk mistakes that do not belong to a seasoned investor. Sequoia Capital issued a dramatic cutback message at first dawn of the economic crisis to its portfolio companies, in essence communicating that their companies are not disruptive enough to withstand economic aberrations. From public reporting by a public pension fund, Draper Fischer Jurvetson does not appear to be knocking it out of the ball-park either. Rumor has it that another top-tier firm, Benchmark Capital is the only firm in Silicon Valley to produce more than a 1x return on all of its funds. This is totally unacceptable performance and behavior of venture firms we collectively tend to think of as top quartile. Are they?

Many of the top-tier funds that flourished in strong winds and made even turkeys fly, have diluted their teams with general partners who simply lack the relevant operational experience (read "Why VCs really need relevant operating experience, now") needed to prevent them too from sliding into the overwhelmingly subprime venture ecosystem.

The Threat to Innovation

Clearly LPs have alternative options of deploying money into other asset classes (liquid or illiquid) and not buying into the feeble VC (and their lobbying organization) arguments will by default yield to a significant reduction of funding for innovation if not cause the industry to spiral further down to inappropriately applied risk and deal commoditization (we refer to as subprime VC).

At least ten years of subprime VC continues to attract subprime entrepreneurs which in turn creates more subprime performance and turns venture capital into micro private equity (PE). The erosion of the venture sector is well on its way and LP assets meant to be deployed to high-risk/high-yield innovation have instead slid down to high-risk/low-yield scale. LPs who meant to invest in venture, have instead invested in micro-PE.

Technology is Not the Risk

Fragmentation and further diversification at the VC level is not the answer to an ailing venture business. While it is exciting for the unknowing entrepreneur to see new angels attempt to fulfill the role VCs are not; such as Jason Calacanis, Adeo Ressi from The Funded, and other new angel groups, the early stage technology trials (as I prefer to call them) continue to deploy the wrong risk and continue to pull the venture business further into the swamp of subprime innovation. As I described before (also read my reference to Vinod Khosla's model of investing), technology development is not the investment risk of the venture business.

Smart LPs Look for a New Breed of GPs

Those LPs who do not want to flee the venture sector and realize that technology still has a bright future ahead better not make the same mistakes twice. The dating service of innovation (VC) may not be working correctly, but the real asset holders in the marketplace of innovation (see my article on the innovation marketplace) are eager and aplenty to monetize a new world of change.

New VC fund requirements need to be established to reintroduce risk-taking Venture Capital to the technology sector which subsequently attracts entrepreneurs that have the capacity and drive to change the world.

LPs need to:

Establish new GP qualification criteria. Money without merit is not likely to yield outlier results.
Re-evaluate Private Placement Memorandums to focus on market risk rather than technology risk
Drive defragmentation and accountability of the investment thesis
Implement merit based GP remuneration, including downside

Financial marketplace imperfections aside, the miserable performance of the venture sector has nothing to do with the economy and has everything to do with the risk we as early stage investors deploy to attract truly groundbraking innovation.

I have been called taking cheap shots at VC when they are down - by one VC titan I reached out to. But for some reason I do not feel bad demanding excellence from people driving their Maseratis and Porsches from the mostly public money that feeds them. It is not personal, but we owe it to our economy to return merit-to-money.

Limited Partners are in full control of their own destiny in venture, by virtue of how they commit. And now is the time to commit to venture with more discretion and expertise and hit the VC reset button.

Why VCs really need relevant operating experience, now

The Venture Company | venturecompany.com — 2009-11-05T10:27:39-05:00

By Georges van Hoegaerden

I keep getting questions from Limited Partners (LPs) and Journalists all over the world as to why and what relevant operating experience is needed to become a successful early stage investor or Venture Capitalists (VCs).

The easy answer is: well, if you are building a house you better know something about architecture, design and construction.

But the reason for the return of those questions is probably because I covered this topic before (see: "Why VCs need relevant operating experience") and left the door open to less operationally savvy investors in a new world of investing. After all in a new free-market of innovation (see: "How to fix VC once and for all") the merit of the investor, whatever that merit is composed of, defines the reputation of an effective marketplace participant.

If only we had arrived at that glorious point already.

Since we do not have a free-market of innovation today and Limited Partners are asking me for new fund selection criteria now, I give them the following reason as to why technology Venture Capital's General Partners need relevant operational experience:

1) Venture investing requires different skills than Private Equity

Investing in early stage companies requires a solid understanding of how to turn a vision into a thriving business. As Geoffrey Moore pointed out in his book Crossing the Chasm, successful innovation requires from entrepreneurs an understanding of how to cross the chasm and I demand from VC an understanding of when and how to help entrepreneurs make them do so.

VC should make the appropriate assessments alongside the entrepreneur and support the transitions with appropriate funding levels in which selling to early adopters and visionaries turns into selling to much larger demographic on the other side.

That means Venture Capitalists who claim value-add in their Private Placement Memorandum (PPM: the business-plan from VC to LP), better demonstrate that they know how to cross that chasm and better yet, can prove to Limited Partners that they themselves have done so successfully. Not at a time when turkeys could fly, but when the wind was blowing in the wrong direction.

VCs with only impressive corporate backgrounds very often fail to be aware and understand what it takes to cross the chasm. It is easier to have earned stripes on the right side of the chasm, than it is to have earned them from the left-to-right.

Private Equity investors spend their time on the right, successful Venture investing requires an understanding and experience from the left-to-right of the chasm.

2) Ecosystem performance defines company success

In a perfect world a startup would build a perfect product with support from the perfect investor that relies on the enthusiasm from satisfied users and their word-to-mouth to become successful.

The reality is that tip-toe funding combined with downside investment strategies the success of a company is dependent on many more attributes than merely product development, especially in subprime VC.

Limited funding forces companies to push out product early (many times too early) and relies on "decibel" marketing, business development, and customer support to compensate for product deficiencies in-market.

A great CEO is the ultimate orchestrator of the unique ecosystem of his company, one that requires continuous tuning to run like a well-oiled money-making machine. A Venture investor who drills deep into the performance of a company and make judgements on ecosystem parameters, should have knowledge of and experience in each of those ecosystem parameters and better, have been a CEO at an early stage companies having made such an ecosystem work against-all-odds.

Separate relevant from irrelevant experience

Thanks to the Internet, anyone can do the following exercise: go to a VC website and look at the relevant experience of the General Partners and hold them against the two criteria described above. The outcome will not surprise their performance.

A product manager at the GAP, a financial analyst in Hong Kong, a VP of Marketing in a large hardware company, a CEO at an IT consulting company, a large-cap consultant at Bain - all combined with impressive ivy league education makes for nice resumes in a PPM, but delivers no relevant credentials to lead the early stage innovation that our country depends on.

My advice

Limited Partners should stop doing business with people who have never crossed the chasm and never operated as the CEO of an early stage companies having successfully managed its ecosystem. And entrepreneurs should thoroughly review the relevant operating experience of its prospective board member, before they take their money.

If we do not pay attention to these things, the technology sector is poised to become the next auto-industry: a business we invented but lose in the end. The time for change is now, if we want the technology sector to be in a better position in five years from now.

Why do we keep listening to VC as the barometer of innovation?

The Venture Company | venturecompany.com — 2009-11-03T09:41:20-05:00

By Georges van Hoegaerden

It baffles me how the representatives in Congress keep listening to, and some media stay enthralled with the self-serving circumstantial excuses of Venture Capitalists (VCs) that also still manages to keep some Limited Partners (LPs, their bosses) tuned in. I predicted five years ago, with my declaration of sub-prime VC that Venture Capital was at the brink of disaster, so what is the hot news now?

VCs continue to demonstrate their lack of foresight as they only now, when the statistics of their performance are rolling in, seem able to "predict" their demise with remarkable accuracy. And that while foresight should be one of the most important traits of early stage investors. They still do not understand that an underperforming artificial market leads to one of two outcomes: cannibalization or replacement.

The VC benchmark

News to me is that one of Silicon Valley's most renowned VC funds; Benchmark Capital is rumored to be the first and only VC firm scrambling to produce at least a 1x return on all of its funds. Is such best-of-the-worst really a crowning achievement to be proud of and listened to? Such top-quartile performance is not going to save the reputation of venture sector (even if it does Benchmark's), which relies on the deployment high risk to promise high rewards.

Let me juxtapose why VC should have performed much better than any other time in history:

Technology has moved from hardware, to software, to software services with immediate market recognition and impact, allowing for simple business models and reduced risk with regard to customer adoption.
The Internet with its ever increasing penetration provides a boundless addressable market for technology that a successful proposition can tap into at almost no additional expense.
Until this year (thankfully LPs are now waking up) there have been truckloads of support from Limited Partners to the Venture sector, allowing VCs to pick their preferred fund size and implement their ideal diversification strategy.
We produce more highly skilled local students and have access to a much larger petri-dish of (global) entrepreneurs than every before, that should account for a much larger supply of disruptive ideas and development resources.
The penetration of applications to vertical markets (healthcare, oil and gas, real estate, etc.) remains pretty much untapped, leaving low hanging fruit investment opportunities unserved.
The deployment of macro-economic principles with the application of technology to drive more efficient marketplaces remains untapped, leaving winner-takes-all investment opportunities unserved.

So no, I do not buy into the excuses from the current VCs who point to irrelevant market indices or anything else they can hang their hat on to justify why they should be allowed to deploy a fundamentally flawed risk profile for another 10 years.

The Venture business should continue to outperform other asset classes by a long shot, by virtue of

its long-term commitments from LPs, and
its never ending (long-tail) supply of entrepreneurs, and
its resistance to economic aberrations (as monetization of disruptive monetization happens typically at the end of the funding runway)

And VCs who do not, should be ashamed of themselves and be pushed out of the business. LPs should no longer accept anything but bottom-line results, regardless of the state of the economy. Playing with someone else's money requires merit, just as much merit as we demand from entrepreneurs to help their companies grow. It is time we hold VC to higher standards and make them accountable.

Free this marketplace

VCs spin their rhetoric and mask that for too long they have deployed not Venture Capital but micro-PE (Private Equity) to innovation, a fundamentally flawed risk/reward investment thesis applied to the early stage sector. And they continue to do so under the cover of darkness (to the marketplace participants).

No improvement in the economy, except for the implementation of free-market principles (see "How to fix VC once and for all") will change the outcome of the Venture Capital sector.

Congress and government should worry less about the symptoms of its considerable systemic risk and stop applying useless post-mortem regulatory checks to the Security and Exchange Commission (SEC), but instead deploy macro-economic principles so the "disease" will not continue to percolate and the marketplace of innovation will self-regulate based on transparency and merit.

It is time to demand from VC not relative, but absolute performance. And stop listening to those who are going to be cannibalized or replaced. All the ingredients for an efficient marketplace for innovation are here, and with newly established free-market principles at its foundation we can finally let the real cooks emerge.

Less is more; moving regulations from government to the marketplace

The Venture Company | venturecompany.com — 2009-11-18T15:10:51-05:00

By Georges van Hoegaerden

For the first time I listened in on a live interview by members of Congress with members of the Private Equity and Venture Capital community recently. I was surprised and-then-not that Congress, who closed its eyes and ears to the malaise of our financial systems for so long, is now also buying into the arguments from the participants of that malfunctioning marketplace that there is no systemic risk in Private Equity's Venture sub-sector. Duh!

Massive systemic risk, financial and spiritual

Congress and the majority of VCs are (again) so wrong. Do we really need more evidence to justify change?

Less than 10% IRR produced by VC for the last 10 years makes many Limited Partners wonder why they should put their money in Venture Capital, and rightfully so. The result of some of the LP's withdrawal results in a lack of support for the sector, even if miraculously VC would get its act together. The cultural advantage we have to produce an endless stream of innovation is (and has been, some argue) suppressed by an underperforming financial system that sits on top and squeezes the air out of it. Our competitive advantage as a nation is at stake.
$2.9 trillion in spin-out revenues (as reported by Polaris Ventures in its public address to Congress) produced by VC over the last thirty years is about to significantly deflate as a result of lack of exits over the last ten years. The Venture business has produced very few real companies in the last 10 years or so, resulting in a massive erosion of spin-out revenues.
Roughly $297B in yearly venture commitments is hoping on "external factors" to recover, ignoring that sub-prime (or micro-PE) VC tactics are preventing the intake of truly disruptive innovation that would have had the potential to create significant returns. And that while early stage innovation is very resistant to economic aberrations and in many cases thrives because of it.
We agree with some of the titans in the VC business (Mike Moritz, Vinod Khosla, etc.) that Venture Capital has been broken for 20-years, meaning we are steadily amassing a deficit of 40 years of investing in the wrong innovation, further deflating our competitive advantage as an innovative economy.
The participants in the venture business (see "How to fix VC once and for all") with real assets, the Limited Partner (money) and the disruptive entrepreneur (idea) are unhappy with the artificial arbitration of Venture Capital, yielding a departure and declining entry of both. So, despite great spin-stories and self congratulatory statistics from VC lobbying organizations (such as the NVCA) we are witnessing the net outcome of a severe decline in venture job creation and value.
It is dangerous for Congress to rate our systemic risk low because of the sheer size of our financial system, proudly described by one member of Congress to be larger than that of China, India and Europe combined. I surmise that is because our financial system is bloated with derivatives, currently eleven times the size of production. We have become a nation of gamblers in derivatives rather than direct investors in the creation of disruptive innovation. The size of our in-transparent and mostly derivative financial system is an unstable and unsustainable foundation to our economy.

If I had the resources of The White House at my disposal I could come up with a much larger laundry list of negative spinout from the underperforming venture business for those who still need it.

Does Congress matter?

Clearly Congress does not understand the venture business, as it interviewed in that recent session only the derivatives of the venture business, the VCs who hold no assets. If congress had read my blog "How to fix VC once and for all" as some of its peers in Washington have, it would have invited the real asset holders, Limited Partners (money) and Entrepreneurs (innovation) to verify the actual effectiveness (see "Why do we keep listening to VC as the barometer of innovation?") of the matchmaking service we call venture capital.

Congress has again allowed protectionists to write their own report cards, just like it allowed the auto companies to make false new promises. Maybe we should just not expect real leadership from Congress.

Healthcare reform has been on the books for a long, long time until a new and smarter president (Barack Obama) decided to pull it through the bureaucratic system and deploy free-market principles that expose merit and long-term save us all a ton of money. The (often hidden and recurring) cost of an ineffective artificially arbitrated market is much higher than the cost of transforming it into a free-market once and for all. But there is a cost nonetheless, the cost of change.

I count on the President

It is the same leadership that finally allows us to transform the healthcare system to a free-market and expose the merit of its participants that is needed to expose the merit of the venture business and our financial system as a whole. Our dependency on a bloated financial system, riddled with derivatives and artificial arbitration is what blurs the creation of real value.

I do not believe Venture Capitalists are bad people. But the venture business has simply adopted a financial system, with all its impurities, that overarched it and allowed it to get away with unverifiable merit for too long.

Less regulation is more

As we can learn from Cesar Milan (The Dog Whisperer on National Geographic) that the behavior of a dog is the responsibility of its owner, so is the behavior of our financial system the responsibility of our government. Just like any dog can be rescued, so do I believe our financial system can be. That is, if we have a pack leader.

Our government needs to institute free-market principles (a few simple filing regulations maintained in a central database) as described in my blog "How to fix VC once and for all" so we can ensure that transparency exposes merit. The merit of which VC (by General Partner denomination) is truly the expert in spawning and monetizing disruptive innovation he claims to be and at what expense. The transparency of the investments to all marketplace participants (including Limited Partners and Entrepreneurs), will quickly and continuously separate the weed from the chaff. And like free-markets are known to do, they create unique marriages between the outliers of innovation and the outliers of investors.

When the free-market of innovation is in place, and only then, should we evaluate getting rid of costly regulatory compliance such as Sarbanes-Oxley, FAS and others that were created to curtail the bad behavior of the old artificially arbitrated market. With the erection of free-markets, less regulation can then indeed be more.

A free country is built on free-markets

Capitalism without verifiable merit simply means we are fooling each other, and the bottom is falling out of our economy because of it. I believe we can rejuvenate and re-authenticate capitalism by deploying free-market principles in our financial system, starting with the venture business. In a free-market those who have merit will become the capitalists, who will then be able to discover and support others with merit. The engine of innovation is revving up again.

I am at your service, Mister President.

What Silicon Valley can learn from the Shark Tank

The Venture Company | venturecompany.com — 2009-10-23T05:31:44-04:00

By Georges van Hoegaerden

The currently running TV show The Shark Tank on ABC produced by Mark Burnett is an amuzing, dare I say reality show in which five investors confront entrepreneurs with direct investment decisions into fledgling startup companies.

What the investors on the Shark Tank have in common with Silicon Valley is that their seed funding rounds range from $50,000 to $1M, yet often in more than pure technology plays.

While the title of the show sounds harsh, and some of its investors are, its actual workings is much better and more sincere than that of Silicon Valley:

Investors with relevant operating experience

Kevin O'Leary, Barbara Corcoran, Robert Herjavec, Daymond John and least impressive Kevin Harrington have earned their stripes in running very successful businesses with exits to boot. They demonstrate their knowledge and experience in making impromptu investment decisions and their ability to deliver their value-add to entrepreneur. So unlike Silicon Valley.

Transparency of decision making

Not only is the investment decision occurring almost immediately (or declined at the same pace), the reasoning of such decisions is happening right in front of the entrepreneur. The entrepreneur is able to respond, interject and argue a refusal to invest if he believes the arguments are invalid, and worth rebutting. Transparancy of decision making allows for a better alignment between entrepreneur and investor. So unlike Silicon Valley.

Open competition between investors

Once the interest in a startup has been established, the key investors Kevin, Barbara and Robert publicly fight over the deal like lions devouring a kill. Kevin cannot help but expose his unruly personality and because of it never gets his way, which reminds me of many Sand Hill Road investors. Robert is the more level headed investor who keeps his cool and his smarts at every turn, and Barbara perhaps the shrewdest of them all, waits silently until the boys have finished argueing and often walks away with the grand prize. All while the entrepreneur enjoys a steady increase in valuations and moneys invested. So unlike Silicon Valley.

There are many aspects of the show that are compelling and an interesting watch for entrepreneurs. The Shark Tank demonstrates why Silicon Valley needs the transparancy, that leads to a meritocracy that leads to the discovery of truly disruptive innovation (as described in "How to fix VC once and for all"). The show also points out how badly Venture Capital treats entrepreneurs and how it has stooped below the tactics of the Sharks in Nature's pyramid of investing.

Bottom feeding comes to mind.

The importance of being free-and-earnest

The Venture Company | venturecompany.com — 2009-10-20T13:47:02-04:00

By Georges van Hoegaerden

I have had several discussions and e-mail conversations with entrepreneurs, journalists and venture capitalists (VC) about the free-market principles described in my blog "How to fix VC once and for all". In that blog I propose to apply free-market principles to the marketplace of innovation, in connecting the assets of the Limited Partner (LPs): money, with the assets of the entrepreneur: ideas.

What struck me most is how few people are familiar with those macro-economic principles that beyond consumer benefits have a significant impact on how an entrepreneur goes to market and how VCs fund them.

VC feedback

Especially eerie, short and dismissive was the interaction with one of the most well-known VC czars of Silicon Valley, who publicly proclaims to be a proponent of free-markets (that is exactly why I contacted him) yet does not seem to understand their basic premise. He brushed off my marketplace-for-innovation plan as just more creeping Socialism.

I am of course the fool, for telling the old-boys club to now support a meritocracy, and dump the walled gardens that made it fat-and-happy in the first place.

I knew that switching to free-markets will unleash the protectionist stance in many VCs. But what worries me more is that the opinions and decisions made by this General Partner (GP) impact startups whose successes are predicated on a firm understanding of macro-economics. His responses mean that this GP would simply brush off platform investments that embody free-market principles (eBay and the Apple AppStore for example) as socialistic movements. History proves that is not a good idea.

And that dear reader, is what the rest of the world (and the majority of Silicon Valley) looks up to. We blindly copy methodologies that no longer work in the hopes that 20-years of underperforming past behavior is not indicative of future behavior. It is all someone else's fault.

Start praying.

Debunking free-market myths

But where there is smoke there is fire (aptly considering the many other fires in California) and it is important for the marketplace participants, LPs (money) and entrepreneurs (ideas) who bring real assets to the table, to get a good understanding of free-market benefits. So, let me debunk some free-market myths:

Myth #1: free-markets are socialistic movements

A free-market is a self-regulatory instrument that ensures that a true meritocracy prevails, destroying artificial walled gardens such as geography, demography, old-boy status, first-mover advantage etc. A free-market ensures that the quality of the authentic value-add by each participant is evaluated based on its independent merit. A free-market therefor is the ultimate in capitalism, those who build earnest value will prevail.

Myth #2: free-markets require a lot of governance

More and different regulation than none, for sure. But the regulation will not come from government but from the marketplace participants (see my blog "Why innovation needs regulation"). When transparancy to all participants (a requirement of free-markets) is implemented, all participants benefit from the exposure and individual merit becomes the governor.

Myth #3: free-market transparency is unwanted

Transparency promotes competition, and competition based on merit is good for LPs, VCs and entrepreneurs. Merit yields better value to the detection of outlyers who lay at the foundation of disruptive innovation. LPs will benefit because in the formation of new funds, they can proactively bid to get in on a VC fund they previously only had access to when approached. New LPs can enter the fray and compete at an equal level. Small LPs can bid alongside large LPs. Entrepreneurs gain precious time in dealing with VC that have proven merit, and achieve more attractive valuations and secure better runway support - reducing the infant death syndrome as a result of investor lock-ins. VCs who are comfortable that money is not the only value they offer should feel confident their role is secured by the merit of their value-add.

But even if you are not convinced that the current VC performance is a systemic risk, a move to a free-market mechanism that (if nothing else) offers the transparency to all participants, is the fastest way to prove the other side of the argument wrong.

My hope is that we, in the venture business, establish these free-market principles voluntarily and without intervention from the government. But the feedback to my query as witnessed by the protectionist answers from VCs does not hold a lot of promise.

With a systemic risk of $2.9 trillion of innovation-spin-out revenues quickly deflating, we face a similar overruling by the government as healthcare, where rather than a voluntary free-market, a free-market with arbitrage from the government will be forced upon us.

Take your pick.

How to fix VC once and for all

The Venture Company | venturecompany.com — 2009-10-11T06:40:34-04:00

By Georges van Hoegaerden

The venture business needs an overhaul, and below is my low-burden / high-impact plan for change.

Problem

Venture Capital (VC) is a systemic risk to our innovative culture, to $200B in direct asset allocations and to $2.9 trillion in spawned revenues (since 1970, per IHS Global Insight report). Yet VC has produced less than 10% IRR for the last ten years promoting a fear/flight response by Limited Partners (LPs), on the verge of pulling their money out of the sector and investing it elsewhere.

Top technology and investment experts, like Larry Ellison, Vinod Khosla, Greg Lamond and many other illuminaries now subscribe to the mediocrity of the current state of venture, with Mike Moritz (GP Sequioa) stating venture has been underperforming for 20 years. I agree.

Direct and circumstantial evidence suggests that the venture business needs a major overhaul, to ensure that the assets of the Limited Partners (money) are effectively lined up with the unwavering assets of the entrepreneur (innovation). Just because the intermediary "dating" service (VC) is broken does not mean we should lead to conclude supply (LP) and demand (entrepreneur) side participants are.

LPs are still looking to deploy high-risk/high-yield commitments and entrepreneurs are still coming up with highly disruptive ideas. The economic marketplace where those transactions occur is simply structurally ineffective.

Opportunity

Technology venture should be producing premium returns because of:

Its infancy, 5/6 of the worlds population is not connected via broadband, exposing a massive greenfield of new unexplored market opportunities.
Relatively (compared to other sectors) low cost of production, software applications and services require no physical manufacturing.
Low cost of distribution, the internet distribution is effective and low cost (as long as the product is good enough).
Immediacy of customer fulfillment, the impact of internet applications is instant.
Independent ownership of the complete value-chain from idea-to-customer means the risk to success is highly predictable.

I cannot think of a better asset class or sector where the development of an idea can lead so quickly to immediate and widespread customer impact. Unlike biotech or greentech, the attributes of technology venture are such that they will produce returns compatible with the 5-10 year lifecycle of those funds. That is if the market intermediary makes the right choices, guided by relevant experience.

Solution

We can all argue until we are blue in the face as to what is a great venture investment strategy, and I certainly have my opinions. But none of that matters. What matters is to create success for those that put assets to work, financial success to the LP and entrepreneurial success to the inventor. What matters is merit not rethoric.

Venture investing needs to move from an artificially restricted market to a free-market in which the transparency of, and to all participants identifies and perpetuates the ever changing meritocracy of innovation.

That means all participants need to adopt free-market principles so that the merit of their work, not an artificially privileged status distinquishes them from others. Such is the necessary, sustainable and thriving foundation for innovation and capitalism.

No one will be able to hide, and the marketplace as a whole will automatically give preference to those participants and their transactions that build real success. Only capitalism based on merit is sustainable long-term.

Above is a simplified chart that depicts the venture marketplace. For those unfamiliar: LPs invest in VC funds who, by virtue of a lead GP invests in the startup of an entrepreneur. LPs set aside a predetermined commitment to the VC fund and GPs make capital calls when required by their investments into startups. GPs allocate a certain runway for startups and at funding time stage their investment in investment rounds to mitigate risk. At M&A or IPO cash is returned to the VC in exchange for the equity position and VC returns a part of those funds (minus management fees and other reserves) back to the LPs.

Transparency leads to meritocracy

To enable a meritocracy the marketplace needs to enforce full transparency to all of its participants. At the transaction level by GP, not by VC firm. More important than to feed the Security and Exchange Commission (SEC), the marketplace itself (not a government agency) will then govern its own success:

LPs need to disclose their commitments, how much is drawn, when, running returns and include the fund maturation date
GPs need to disclose which companies they invest in, how much and at what valuation
Entrepreneurs need to disclose what exit returns they produce

I realize that type of transparency will get VCs all riled up, they recently testified to congress as such. As protectionists of their current walled-gardens they fear that such disclosure would challenge their competitive stance. Exactly, and that is what we want.

Because today the cartel VCs have formed around their collective wisdom, outdated execution and dismal returns prevent really smart entrepreneurs from participating in venture transactions to begin with. If VCs believe so firmly in the proprietary value-add of their services to the investment process, why would they be afraid to disclose everything but their secret sauce. Investment dollars into a company can be derived from other sources, but is very cumbersome if not impossible to retrofit to the exact origination and source in the marketplace model.

LPs would have less of a problem disclosing such information and many, like pension funds, already do. But they will need to firm up that reporting to the standards of the marketplace, not an incomplete disclosure that does not match up with that of its peers.

Not public is not private

Economically and to minimize abuse, all companies should be transparent to some extent, including private companies at least to meet the above described marketplace requirements.

Not all transparency is created equal, in a marketplace the transparency needs to be provided to all participants; LPs, VCs and entrepreneurs in the same fashion. Not just in case of suspected abuse and post-mortem to the SEC, since that kind of transparency does little to promote marketplace merit.

In the same way banks are supposed to report certain transactions above $5,000 should we disclose the investments in private companies above a certain threshold. In other places outside the U.S. (such as Europe) private companies already need to abide to certain disclosures, paving the way for meritocracy.

Entrepreneurs are often proud to disclose how much money their idea generated were it not for acquirers, who afraid of competition often press for non-disclosure. Yet those numbers will now come out of the new marketplace, and competition as a vital ingredient for exits is re-established as well.

Once we have the fundamental transparency of the marketplace in place, the following benefits will surface almost immediately (especially when we apply this transparency retroactively):

We will know which VC actually has money to deploy, and entrepreneurs will not be wasting precious cycles
We will know which VC actually has a reputation of building successful companies
We will know which GP actually has earned the reputation to sit on a board
We will know which GP actually has the foresight and credentials to invest in upside rather than downside
We will know the merit of GP vision, specialties and domain experience
The meritocracy of investments will support the long-tail of ideas rather than regurgitate its commodization

The merit of all participants will be disclosed, by virtue of their investment in success.

Low burden change, immediate impact

The goal of this plan is to serve the risk/reward needs of LPs and connect that with highly disruptive innovation from great entrepreneurs. No drastic changes need to be made to the current investment model. No drastic change in the investment pace needs to take place until the meritocracy demonstrates otherwise.

Transparency to all participants will act as the dynamic referee in an ever changing venture business. Compared to the past, merit will now closely follow and support the change of innovation, rather than remain stale and outdated. And the meritocracy of the marketplace will also determine whether or not the venture business is too large, too small, or just right. But it would be highly inaccurate and irresponsible to make those decisions based on the workings of the venture business today.

How you can help

I am already working with individual LPs to familiarize them with the specific rollout of this plan, and I invite others to participate (contact us here). I also extend a hand to VCs, some of whom have responded, to become be part of the solution. I would like nothing more for us, as participants to the venture business to solve our own problems, without the need for government intervention.

The venture business is too important to our economy (for the reasons mentioned above) and we owe it to the entrepreneurs (across the world) to build a financial system that supports the merits of their intellectual brainpower.

Join me in this effort and feel free to spread the word, syndicate this blog (with proper attribution and link-back) and retweet. Let's make positive change happen.

The telephone-game of derivatives

The Venture Company | venturecompany.com — 2009-10-05T10:28:48-04:00

By Georges van Hoegaerden

One of the most important traits of a great person, great CEO and great investor is the unrelenting pursuit of the truth and a firm ignorance for anything else. The truth in a world that is full of smoke and mirrors, stemming from an unconnected era in which the creation of heaps of walled gardens would go unnoticed to unsuspecting participants.

Even though we don't like to admit it, we as grownups still play the telephone game frequently, in which a chain of derivatives regularly degrades the truth.

But those days are slowly coming to an end, as the internet with the free-market principles it aims to deploy, and social networking as its unforgiving arbitor is steadily eroding misplaced authenticity and trust (see Trust is the currency of success).

Most people reading this blog will think of derivatives as a financial instrument first, but our world is chockfull of others that invade our lives from every corner. The dictionary definition holds a clue:

adjective : imitative of the work of another person, and usually disapproved of for that reason
noun: something that is based on another source, an arrangement or instrument (such as a future, option, or warrant) whose value derives from and is dependent on the value of an underlying asset

Sound decision-making comes from a clear understanding of the difference between fact and derivative. Below are examples of everyday derivatives and the impact they have on their surroundings. Some may be shocking, but I promise will yield incredible new focus and progress if simply ignored.

Markets

Markets don't exist, we covered a whole blog about it. Read it please. Customers do not buy products because they associate or belong to a derivative descriptor of a market. They buy because the marketplace (a mechanism to buy) offers the best opportunity to serve their (often complex) individual needs. So, go ahead and thrown away your industry and market segmentation or market-share leapfrog strategies. They are worthless.

Venture Capitalists

In the investment equation between the assets of a Limited Partner (money) and the assets of the entrepreneur (idea), venture capital is merely a dating service (with no assets to speak of) that establishes the transaction of the marketplace, a financing round. While Venture Capital (VC) behaves as if it is the originator of assets and the creator of value, LPs are actually the ones that deploy the commitments to the creation of value by the entrepreneur. Contrary to their testimony to congress, VCs did not create millions of jobs, LPs did by deploying their monetary assets. While VCs force entrepreneurs to buy into their (steadily commoditizing) investment wisdom, more than 90% of those wisdoms do not pan out. An entrepreneur is better off to ignore VC advice altogether and pursue the creation of real value to its customers. Fundraising is a lot easier that way.

Psychologists

Many people seek solace in the interaction with a psychologist to solve relationship problems or otherwise. While an outside perspective may be liberating at times, a sustainable solution based on a derivative opinion is highly unlikely. Spend more time with the people you have relationship problems with, than your psychologist. Because the stories you tell him are themselves derivatives.

TV Journalists

CNN today is a prime example of a network that has gone from reporting the news (expensive) to regurgitating the news with hordes of consultants (inexpensive), delivering derivatives of the news rather than the news itself. CNN has moved from a real new source to a commodity entertainment channel, eroding and consistently being beaten at its home turf. Ignore the regurgitation by derivatives and you'll save precious time of your day.

The Stock Market

The stock market is an exchange but not a marketplace in the free-market definition of it. As if the performance, long and short, of a company can be derived from something as simple as price-to-earnings ratios. Public CEOs know how to dance the dance, market to those numbers and become short term focused to meet Wall Street expectations. Yet long term and macro-economic differentiation that requires investments (expense) is arguably more important than meeting the quarterly drill of meaningless earnings reports. The performance of stock is a derivative of the short-sellers view of the performance of the company, and by definition inaccurate. And so are the investment decisions derived from them.

Money

The dollar is not worth the paper it is written on. It merely communicates the value of trust attached to that piece of paper. And even though that money can buy you great things, it matters whether it is acquired from a foundation of trust. Cash is not king, trust is. Easy money has a way of punishing its acquirers in un-expecting and fleeting ways, hard earned money amplifies itself consistently. So, money is a derivative of trust, and someone with a lot should not automatically be confused with authenticity and trustworthiness. Earn money the hard way and you'll be rewarded for life. Money can be a derivative of trust, but with financial derivatives eleven times the size of production should not be confused with trust itself.

There are many more derivatives I can talk about. But the purpose of this blog is to make you think. Hopefully the next time you spend time with someone, you will ask yourself the following question: is that person claiming to be the authority of derivatives or the authority of truth. The answer will define your success.

The nitwits on Sand Hill Road

The Venture Company | venturecompany.com — 2009-10-02T03:02:04-04:00

By Georges van Hoegaerden

I could not help but chuckle (again) when Oracle's 30-year-running CEO, Larry Ellison (full disclosure) fiercely yelled out the words from the title of this blog, referring to the artificial arbitration of innovation applied by Venture Capitalists (VCs) we talk about in this blog so often.

Sand Hill Road, for those unfamiliar is the street in Menlo Park, California where the majority of Silicon Valley VC enjoy some of the most expensive office rent in the country and invite their often starving entrepreneurs to "beg" for money. The area is considered the birthplace of Venture Capital.

Larry goes on to say that Venture Capitalists think that innovation is like coming up with a new technology buzzword, expressing his specific dismay with the term cloud computing (watch the Churchill Club interview on YouTube, skip to 47:53 min if you don't like boating).

The reason why I bring that up is four-fold:

Entrepreneurs are subject to this artificial arbitration (that is applied with the seasonality and commonality of fashion) as the primary method to get their high growth company funded. Entrepreneurs think that "wisdom" leads to success, yet deplorable VC returns prove otherwise.
Limited Partners (LPs) seem to respond commensurate with their limited allocation in venture (usually less than 15% of total allocation) and their natural inclination is to rest with the excuses (we debunked) from VCs, who never fail to reiterate that cyclical behavior of the financial markets and the economy are to blame for the deplorable returns in venture.
VCs are downplaying the systemic risk of this artificial arbitration (applied by the venture investor cartel) to our government, stating that $200B of venture investments pose less systemic risk than other asset classes, while completely ignoring that their behavior kills the meritocracy and innovative culture our country was founded upon.
Other VCs in the country (and around the world) copy the tactics of Silicon Valley investors, with similar results awaiting them.

But feel free not take my word for it. Agreeing with Larry Ellison, Mike Moritz, one of Silicon Valley's most lauded VCs was recently heard saying the Venture Capital business has been broken for twenty years. So do similarly successful venture peers Vinod Khosla and Greg Lamond, who believe - like we do - that when the risk is sucked out of investing, one should not expect great returns.

Still not listening? Stanford, Yale, Harvard and Princeton universities all appear to be suffering from significant losses to their endowment as a result of investments in "alternative" assets, which includes venture capital. To combat, according to PE Hub, Stanford has just raised a $1 billion in a bond offering last April in case of a “true emergency".

By the way: with those Ivy League universities having bred the most renowned economists and professors in entrepreneurship does anyone question whether their expertise is worth the tuition? Are the experts really what they claim?

How much exactly of that depressing news can be contributed to the performance of Venture Capital is not clear to me today (Hedge funds and Private Equity are the most common other assets) yet reports from both CalPERS and CalSTRS pension funds suggest a lackluster contribution of VC across the venture spectrum.

Deaf? Many of my peers in executive positions at Apple, Cisco, Oracle, HP, eBay refuse to enter the venture fray in which the equilibrium of entrepreneur and investor is completely out of whack. The cyclical nature of the downward sub-prime spiral continues to rear its ugly head. The only entrepreneurs that submit to sub-prime investments today are as sub-prime as their investors, incapable of building great fund performance.

The alarm bells are ringing. Limited Partners need to wake up, simply because of the loud reverberation of a vast preponderance of circumstantial evidence. It is time for LPs to listen, not to popular opinion from the people who got them in this financial debacle in the first place, but to people who offer ideas that simply serve entrepreneurs better. The time for change is now.

Passively waiting for consensus on data driven views is guaranteed to lead us to what Larry referred to as an L-shape recovery in the venture business.

VC performance, a closer look

The Venture Company | venturecompany.com — 2009-09-21T12:05:53-04:00

By Georges van Hoegaerden

I decided to do a little deep dive after I reviewed the CalPERS alternative assets performance posted by PEHub's Dan Primack, to help entrepreneurs get a better understanding of who they may be talking to when raising their next round of funding. While in the relationship between entrepreneur and VC the utmost transparency of the entrepreneur is demanded, VCs often bask in the glory of darkness.

For those who do not know, CalPERS is one of the largest state pension funds in the United States with a large alternative asset allocation (north of $53B over the last twenty years), the majority of it dedicated to venture investing, both directly into VC funds and indirectly through fund-of-funds.

Why half transparent is in-transparent

The CalPERS performance report may comply to the government's mandate for transparency, but still lacks the full transparency needed to understand whether or not CalPERS is making real money in the venture sector.

Here is why the numbers cannot be used to represent CalPERS performance:

Size of commitments may be larger due to exclusion of terminated relationships (no reason specified)
Actual yield may be inaccurate due to lack of standardized VC performance metrics
Actual yield may be inaccurate due to J-Curve and varying fund vintages
Actual yield may be inaccurate due to difference between commitments, cash-in and cash deployed
Actual yield may be inaccurate due to varying definition and timing of remaining value per fund
Actual yield may be inaccurate due to the exclusion of terminated commitments

What we can surmize is that the total size of commitments to the alternative assets as of March 31st, 2009 is at least the size depicted in the chart, and the yield percentage in my chart is a simple calculation based on the actual amount of cash put into the VC fund (unbiased by the remainder of commitments from CalPERS to the fund). Only the most "meaningful" returns, the returns from pre-2005 vintages have been included in this analysis.

So, while we cannot discern from the report how CalPERS is managing the alternative assets, we can get an overview of how CalPERS evaluates the performance of the commitments it has on the books.

Individual VC performance(*)

The simplest way to evaluate any financial performance is to calculate the difference of money-in versus money-out. We then calculate a yield as the difference between money-out and money-in as a percentage of money-in.

A positive yield means the fund is on track to return all of the money it has drawn, plus that percentage above zero. A negative yield means the fund is losing that percentage of the money drawn (yet depending on vintage it may still have enough capital commitment or return value left to recover from those losses).

The point I am making here is simple, just like VCs want entrepreneurs to explain their ups and downs in their career, it make sense that based on the reporting provided by CalPERS, entrepreneurs start asking questions about the ups and downs of VC as well. Bad money is rampant in the venture business and knowing who sits across the table is pertinent to the chances of success for an entrepreneur.

Furthermore, funds that remain under 10 or even 20% at the end of their vintage are subject to increased scrutinity by Limited Partners (LPs) as they do not outperform the other asset classes LPs can deploy money to. LPs do not need to take risk that is out of sync with the rewards or worse, they do not need to deploy money at all in certain cases. Apart from performance, entrepreneurs should also be aware of the fund vintage a VC General Partner is investing out of, to ensure an exit is not solely driven by the unilateral urge to produce desperate VC returns.

Entrepreneur, consider yourself informed:

(*) Performance numbers listed here are subject to change, depending on fund type, vintage and many other cash-flow reporting factors.

How to set and ask for valuations

The Venture Company | venturecompany.com — 2009-09-15T02:12:51-04:00

By Georges van Hoegaerden

Everytime I see the quarterly reports from Fenwick & West on Silicon Valley valuations I cringe. Not because the report is wrong, but because I know how entrepreneurs and Venture Capitalists (VC) use the valuation medians (that have gone down again) in the report to establish their starting, or worse their ending negotiation positions. And they are both so wrong.

First off, valuations are never to be discussed by entrepreneurs before an alignment of the grand vision with the VC is established. Whether or not the VC is the right partner has everything to do with a shared vision of the upside potential of the company, at the outset excluding the potential of the newfound company's ability to execute on that promise.

No precedent

In many ways VCs discussing their allegiance to Silicon Valley medians is a testament of what a cookie-cutter business early-stage venture investing has become. Great investments (in truly disruptive innovations) have no precedents and neither do their valuations. Compliance to median valuations is an early detection of a sub-prime investor juggling with an equally sub-prime and subordinate entrepreneur.

Don't step up

Years of sub-prime investing (that has yielded equally sub-prime Limited Partner returns), by inexperienced technology investors have dumbed down the investment thesis to incremental rather than disruptive innovations. That is perhaps the biggest problem venture-investing faces today. The "step-up" approach to investing yields insufficient exit values and allows technology prospects (and acquirers) in less attractive economic circumstances (personal, local or global) to wait until the dust settles and delay their buying decisions for the next step of that incremental development.

As Ray Lane, former COO of Oracle and now partner at VC fund KPCB in remarkable honesty once declared: "[Oracle] customers would have been better of skipping client/server altogether" describing posthumously the problem of "step-up" innovations best.

Step-up innovations are highly unlikely to generate the $300M+ exits needed to build a decent VC fund return and leaves the VC after the "honeymoon" with a majority stake in the company, unwilling to wait for further miracles and because of the urge to produce cumulative vintage-fund-returns for LPs, to sell out at any price. Many subprime VCs hope that the sum of all tiny subprime returns still yields something of value, rather than chase the best outcome for each portfolio company independently. With a lack of exits (of their own making) those same VCs now use cumulative portfolio company revenue reporting to demonstrate to LPs that they are building value, and deserve another chance when "exit-markets" miracularly recover. Cumulative portfolio revenues is a poor man's defense of venture capital.

Think big, or go home

So, the first step to setting a great valuation for an entrepreneur is to ensure the idea is truly disruptive. Disruptive not from a relative perspective (compared to existing competitors) but an absolute perspective. Absolute disruption does not care about competitors, because there are none.

Absolute innovation relies on a greenfield of 5/6th of the worlds population that is not (efficiently) served with technology products today, but should. Low hanging fruit is the application of technology where a need is already defined, just not with the implementation of technology. Many ideas come to mind and marketplaces are fundamental, and I would love to hear about your ideas.

The unfortunate aspect of today's early-stage venture investment climate is that investors who recognize disruptive innovation are hard to find, not in the least because few fund structures are designed to chase them.

Glass half-empty valuations

Many venture investors (I should know, I lived in Palo Alto amongst them for 15 years) cannot detect innovation until they spot it in their rearview mirrors. Replicas or step-ups of a handful of sector investment success still creates an ocean of delayed me-too investments with mediocre exits, steadily decreasing the confidence in venture investing as a high yield asset sector for Limited Partners.

Smaller funds, lower valuations and risk averse investments have led to VCs and their syndicates huddling together in what I would classify as an informal investor cartel. An investment cartel that uses (the inappropriate) technology segmentation as an artificial standard for the lowest valution they can get away with. Hence the reason why entrepreneurs should not expect or shop around for higher valuations; you will be snitched on.

I refer to those investments as downside valuations, since they are based on the average choices and (lackluster) performance of past investments by all investors, not the unique marriage between the individual investor and entrepreneur. It is also a downside valuation because it is based on the lowest cost-to-entry, rather than geared towards the highest chance of success.

Downside valuations are easy to spot. Regardless of the problem the entrepreneur aims to solve, his company value is improperly correlated to the underlying technology architecture or technology categorization.

Glass half-full valuations

Truly disruptive innovation however, is priceless. If as an investor I believe an entrepreneurial idea can feasibly claim access to a monolithic $1B+ revenue opportunity, the difference between putting $10M, $20M or $50M in the runway and therefor the valuation is somewhat irrelevant (assuming the fund is big enough). The confidence required from both entrepreneur and VC comes from the words of Albert Einstein: "Imagination is more important than knowledge." Imagination, just like in Einstein's case, ofcourse guided by experience.

So when, and only when, the grand vision of the entrepreneur fits the imagination of the investor should further discussion take place around upside valuations. In our book not many of today's VC investments would fit the profile of disruptive innovation and so upside valuation calculations would not apply. Upside valuations differ in granularity and exact makeup for every investment opportunity but goes roughly like this:

Upside valuation = 30% of total-addressable-market divided by investment risk to get there.

Total-addressable-market is a subject I can write a book about. Most technology companies are embroiled in a short term rat-race (to feed quarterly earnings hunger to Wallstreet) and spend very little time on the wide open greenfield opportunities that take a little longer to plan. Lets take computer security software as an example.

Symantec and McAfee attempt to leapfrog each other in this space, with Symantec for now taking the top spot (primarily due to a plethora of acquisitions) from a revenue perspective. Yet by our latest estimate more than 40 spam and virus vendors exists, and on top of that, the majority of computer users do not use any security software at all. So the pursuit of delivering a truly effective product in a highly inefficient market makes a ton of sense, even though most investors would qualify the security market as saturated. Clearly it is not.

There are many examples of ineffectively served segments, many which current investors are unable to attract, by virtue of their structure, lack of relevant experience and operating credentials. The definition of investment risk in the aformentioned equation is multi faceted. Investment risk consists of the following broad stroke categories, in no particular order:

Inroads
Patents
Management team
Runway required
Business roadmap
Business model
Dependencies
Timing
Flex power
Customer experience
Product evolution

Without going into detail about each category (beyond the scope of this blog), the report card on those issues determines the amount of discount applied to the total-addressable-market. It simply discounts the probability of reaching market leadership (losely defined as 30% ownership), by the proprietary risk assessment of the investor.

Counter to the glass-half-empty valuations, the glass-half-full valuation method does not challenge the absolute value of the idea, it merely discounts the value with the work that needs to be done to build a real business out of it. In many cases, again assuming the idea is truly innovative, even an aggressively applied discount does not lead to a majority stake in the portfolio company, as it shouldn't.

In a modern world a great marriage means you do not own your wife, just like in a great investment you do not own the business. Neither of them work very well when exorbitant pressure is applied.

Upside valuations are applied to take calculated risk, the risk that makes Venture Capital as an asset class segment so different yet so much more rewarding than traditional Private Equity. Disruptive innovation is priceless and nowadays may consist of many other attributes that just a piece of code. Yet to achieve upside valuations entrepreneurs need to prove that the value of their idea is not the technology itself but the application of technology to a marketplace.

Ask, never give a valuation first

When an investor likes an entrepreneurial proposition they will invariably ask for a valuation, unless the pitch did not strike a chord. Under no circumstances should an entrepreneur mention a valuation first, as this is the entrepreneur's most powerful instrument to verify the authentic alignment with the assets, skills and imagination of the investor. Money talks.

Asking the investor for a valuation is like asking a customer to buy, crucial to the closing process. If the investor's valuation is out of sync (most commonly negatively) with the realistic, yet unspoken expectation from the entrepreneur it is time to walk away. The alignment on valuation speaks volumes about the entrepreneur's future and the equilibrium of entrepreneur and investor on a deal moving forward. It means that just like in marriage both parties are in it for the right reasons.

So, an investor who does not want to talk about the value of the upside is an investor from which you should expect nothing but a downside valuation, similar to the many others in his portfolio. Entrepreneurs should avoid getting stung by sub-prime VC at any cost (including shelving the idea for better times), because money from the wrong investor is a dead-end street anyway.

Valuations are fantastic instruments to gauge (from the beginning) if the entrepreneur and investor are meant for each other. The outcome should be like the innovation; priceless or else both parties are just wasting their time.

How to remove the systemic risk of our economy

The Venture Company | venturecompany.com — 2009-09-10T17:14:46-04:00

By Georges van Hoegaerden

I was delighted to hear Barack Obama yesterday describe a marketplace mechanism as the platform for improving the meritocracy of healthcare, something I have talked about with regards to economies, venture investing and technology products for the last two years. I can only muse that the recent vists from Axelrod and Clinton to our blog delivered some inspiration for the change we need to undergo as a country. Perhaps one of my readers was right, I should be running things in Washington. But enough about me.

Our greatest assets

We should be proud to live in a country that has repeatedly earned its stripes as a staunch democratic and a fierce capitalistic nation at the same time. Each individually breaking new ground in creating building blocks for a more effective economy. We are blessed that way. Not all countries in the world have both assets represented in a single economy and their imbalance makes them more vulnerable.

More vulnerable than we are, for we can quickly swing either way and tap into those resources to correct a temporal imbalance that threatens our economy. With the rest of the world watching over our shoulder, learning from our resolve.

Artificial segregation is our biggest problem

Just like how we are still extremely racially divided (I should know) do we remain politically divided. We act as if we live under seperate roofs on a single property, sharing a bathroom through which we regularly flush the disdain for each other, in subtle and not so subtle ways. Whites against blacks, democrats against republicans, opponents of regulations against proponents of regulation, proponents of gun control versus opponents of gun control, etc. Idian reservations with autonomous rulings are a stark reminder of how we allow segregation to perpetuate.

We often take a hard stance by associating ourselves prematurely to an (artificial) association, without re-evaluting our actual stance based on the acute problem that is being presented. I could categorize myself in any of the aforementioned groups depending on the economic problem at hand and may want to change my mind at any time based on timing and perhaps my deeper understanding of the issue. The timing and situation would define my choices, not a party line.

We are all right

Monolithic democratic societies and monolithic capitalistic societies simply don't work, history has proven that out. Pure democracies (I should know given my country of birth) are known for their endless debates where everyone has a voice that eventually yields nothing but burgeoning baggage of complacency. Pure capitalistic societies are driven by classic neanderthal behavior, where the biggest stick gets rid of everything in its way and drives the majority of less fortunate and lucky to dispair.

For years have we benefitted from the surplus of democratic and capitalistic assets while ignoring the deficiencies in both. Now, the state of our economy forces us to illuminate and evaluate all the pluses and minuses.

Meritocracy = democracy + capitalism

We need our economy to be an organic reflection of the current opinions and capacity of our people, not a delayed distortion field of vintage parties, segments or groups. We need to combine the value of our democratic and capitalistic assets and get rid of the deficits of both.

Mathematically put: opinions plus actions minus complacency minus abandonement equals a meritocracy. And a meritocracy is the product of free-market principles (extensively described in my previous blogs). Free in terms of equal access to all participants, supply and demand.

Just like in the Venture business, politicians better prove that they accurately represent the meritocracy of opinions from the people (all people, not just the ones that vote). If not, replacement and removal of politicians will soon be upon them soon. They better stop bickering about party lines and start worrying about why the majority of people in the US still don't vote (36.8% voter turnout).

Perhaps technology can help shape up politicians by building a ballot marketplace in which for certain decisions, the house of representatives, senate and president can directly tap into the opinions from the people they represent.

Our financial system is not a meritocracy

Barack explained why healthcare is not a meritocracy yet needs to be, and if you read my marketplace blogs you would not be surprised to find that our stock-markets are not meritocracies either. Stock-markets, the way they work today, violate fundamental supply and demand rules associated with free-markets. The foundation of our financial system (copied around the world) is based on the same artificial arbitration as healthcare, posing a systemic risk to our economy.

Testament of the misalignment in our financial system is its size; an exorbitant 11-times the size of the businesses it represents (2008 Wikipedia). That means that the size, performance and characteristics of our financial system is far removed from the size, performance and characteristics of the underlying businesses. It also means we have become a nation built on gamblers rather than on value creators, and that too poses a high risk to our economy.

So, to remove the systemic risk of our economy we need to remove most derivatives (similar to parties and associations in politics) and create a marketplace (which is macro-economically not the same as an exchange) in which the meritocracy of ideas meets with as few financial derivatives as possible. That will re-ignite the innovative culture our country was founded upon, as it tears down the artificial arbitration that prevented a meritocracy of ideas from taking shape in the first place.

We need a transparent, trustworthy and flatter economy if we want to protect its vibrant future.

VC is dead, long live VC

The Venture Company | venturecompany.com — 2009-09-02T18:20:00-04:00

By Georges van Hoegaerden

I read Bill Gurley's article on "What is really happening to the Venture Capital Industry" and submited my reply. While his article provides a decent explanation of the mechanics of Venture Capital (VC) today, especially for entrepreneurs who want to get to know the workings of VC better, it (again) offers no clues as to how it should work. Those of us working in the venture sector know how LP allocations work, the important question is (just like with innovation): what should a brighter future look like. And Bill's article falls very short on that.

VC is not an industry

Far from merely an excusable slip of the pen, the self serving pronouncement in the title of Bill's article is indicative of how many Venture Capitalists see themselves; as the center of the universe of innovation. A balsy statement for VCs to make considering that they hold no assets (I'll explain). Some of them go even further by correlating their, should I repeat dismal performance to the capacity of disruptive innovation and even the lack of great entrepreneurs.

It is true that VC should be the most effective way to get early stage innovation out of the gate. The reality is that in many cases VC is not, and has not proven to deliver the promised value. Some describe the VC sector as broken, others blame it on mechanics, or a too large VC pool, or mega funds, or a sudden lack of exits, or the economy, or anything else they can hang their hat on - with the media having a field day delving into the pros and cons of every argument.

And with money to distribute, the articles from VCs - who created the problem in the first place - gain most of the popular momentum. At this point do we really believe their analysis is credible? But that is why you are now reading this blog too, so lets continue...

Innovation is a marketplace (continued)

Venture Capital is the arbitrator in the marketplace of innovation connecting the assets of Limited Partners (money) with the assets of entrepreneurs (ideas), both collectively referred to as marketplace participants (supply and demand). Simplified, the VC makes choices and investments (and yes, regulates) on behalf of the LP in return for equity in the assets of entrepreneurs (ideas and execution), of which at exit VC gets a commision (the carry and then some).

For any marketplace to thrive, the needs of supply and demand participants have to be satisfied. Only then will each participant come back for more (and tell their friends).

LPs expect the venture sector to outpace their other (often less risky) asset allocations and entrepreneurs want to change the world and get rich while doing it (in that order). LPs have not seen more than 10% IRR over the last 10 years from VCs (there are other measurements of VC failures) and smart entrepreneurs shelve their ideas because of unfavorable funding conditions and fundamental misalignment between VC and entrepreneurs (also read my blog Idiot CEOs).

The self-regulatory nature of marketplaces has started; new LPs and entrepreneurs refuse to enter and many currently active LPs and entrepreneurs will take their losses and leave. If the rules of engagement do not change, money hungry entrepreneurs who continue to submit to sub-prime VC will stay, supported by non-discretionary LPs who have the patience to wait for miracles. Unchanged, the future of disruptive innovation is bleak.

Long live the VC

But although the marketplace (in its current incarnation) may and should die, its participants never will. There will always be a need to deploy high-risk/ high-yield assets and there will always be entrepreneurs that can produce disruptive innovation. All it takes is a new marketplace in which the meritocracy of ideas from entrepreneurs is matched with discretionary support from LPs.

The matchmaker in that marketplace better be a VC who understands that simply serving one participant, while depressing the needs of the other will inevitably lead to removal of the arbitrator status in the marketplace. Only a VC with vision who understands free-market principles, and satifies LPs and entrepreneurs simultaneously can generate the meritocracy of ideas that are priceless.

VC is here to stay, but the overinflated personalities with no authentic value-add will be kicked to the curb. For LPs and entrepreneurs it will take some time to recognize which VC is on his way out and which one is on his way in. 7-10 Year VC fund vintages with lack of transparency will do that to you.

But if you read my blogs carefully (or ask my advice) you will learn to spot them from a mile away.

Why innovation needs regulation

The Venture Company | venturecompany.com — 2009-08-21T08:17:17-04:00

By Georges van Hoegaerden

A ban on advertisement of healthcare drugs on national television in The Netherlands. Free public phone calls in Singapore, just a one-time 10 cent connection charge. Mandatory health inspections in restaurants in North Carolina, with regularly updated door-posted scorings. Those are great examples of how government regulations provides better quality of life to its citizens.

But in the United States we generally balk at any form of government regulation as if it is poised to erode the freedom we set out to create. It makes for good press to publicly support a free world and anarchy rather than the opposite. Being a freedom fighter is good karma.

Regulation is not an option, but a requirement

But regardless of government involvement our world is riddled with self imposed regulations. We stop when pedestrians cross the road (regardless of whether they should), and show more respect to elderly than we are often given. We raise kids as best as we know how, and send them to the best schools we can afford. Most of us are decent people who respectfully comply to our individual interpretation of the definition of decency; a set of self-imposed regulations.

Regulations, self-imposed or governed, are the foundation of free-market principles (see our extensive coverage on free-market principles in our blog entry Marketplace Rules). And free-markets only function well when they stimulate or enforce behavior that builds transparency and trust, pulling in new participants and thereby allowing the marketplace to grow itself.

Everything in life is a marketplace (in the macro-economic sense of the word). And we have the option to growth those marketplaces based on a meritocracy, or create excessive walled gardens that, when the impact on our economy becomes too big, risks the enforcement of regulations by our government.

Innovation is a marketplace

In large part early-stage innovation in The United States is fueled by the investment dollars from Limited Partners (LPs), allocating their money to invest in the ideas of the entrepreneurs, using Venture Capitalist (VC) as their conduit and decision maker. In the marketplace of innovation the LP and the entrepreneur represent supply and demand with the VC acting as the arbitrator of the marketplace.

The preponderance of evidence makes for a lousy marketplace in which the VC acts as the Emperor with no clothes:

Less than 10% IRR of the venture sector in the last ten years
Few truly disruptive innovations are born
The number of entrepreneurs are declining (according to Kauffman, see attached chart)
The number of LPs and investment dollars are declining

The VC as the systemic risk to innovation

It is ironic that so many VCs who are vehemently against government regulation (and put their efforts at attempting to stave it off) actually are themselves the ones that aggressively use arbitration to regulate (with their peers) the restrictions that are put upon the entrepreneurs. They collectively set standards on deal intake, technology focus, valuations, syndications, geographical proximity etc., and allow for very little deviation that is inherent to a marketplace meritocracy.

Simply put, VCs are the ones that violate many of the free-marketplace rules (stay tuned for a detailed deep-dive) and prevent the innovation marketplace from prospering, thereby inhibiting the creation of disruptive innovation.

Why we need new regulations

Frankly, we messed up and we should be ashamed of ourselves.

Innovation is a crucial ingredient to our economy, as explained in my previous blog entry The Systemic Risk of Venture Capital. We need to remain at the forefront of innovation for our immediate benefit and how we set an example for (not arbitrate) the rest of the world. Innovation has a big impact on GDP growth and spirit.

We, marketplace participants and government should do our part in fixing the innovation marketplace that is so sorely broken. Our government should force VCs to exhibit transparency (one aspect of marketplace rules). LPs should do a better job of hiring VCs with relevant early-stage operating experience to create more trust. The integrity of the new marketplace we create together will improve the integrity and quality of entrepreneurs it attracts.

We are responsible

The point I am making is that every marketplace requires pretty much the same amount of rules and regulations to instill transparency and trust, no matter where you apply that marketplace. The owners of the marketplace, by virtue of their performance, get to decide how much of those regulations they can deploy themselves. Bad performance with big economic stakes is punished by government intervention.

So, rather than to discourage and blame the government, we as marketplace participants should instead re-install the support for free-market principles in innovation that promotes the meritocracy, spirit and entrepreneurial capacity that this country was founded upon.

Stop blaming someone else and join me in this effort for the sake of our global competitiveness.

The Silicon Valley emperor has no clothes

The Venture Company | venturecompany.com — 2009-08-08T17:24:05-04:00

By Georges van Hoegaerden

In the words of Danish poet and author Hans Christian Andersen, Silicon Valley has become the emperor who wears no clothes. Many Venture Capitalists (VCs) like the emperor will hold their head high and continue their procession for the sake of protecting their management fees.

And even though more than 77% of funds will finagle themselves into the top quartile performance bracket (according to a recent study) and persuade LPs to hang on, the simple fact remains that very little disruptive innovation is born. And without disruptive innovation (and the risks that such innovation incurs) it is just a matter of time before the Limited Partners (LPs) recognize that the emperor's procession is coming to an end.

It continues to amaze me how certain people and organizations (specifically the NVCA, desperately hanging on to the past) continue to protect the failed "dating service" between the assets of the LPs and the assets of the entrepreneurs, and continue to blame external circumstances on the miserable performance (less than 10% IRR) from the last ten years.

A recent conversation with a Mercury News technology journalist confirms again how many VCs still blame their underperformance on anything else but themselves (see how we debunk their excuses). Another reason why the crop of current VCs could never be or align with entrepreneurs, real entrepreneurs would never stop until they get it right. If VCs are so entrepreneurial, why don't they innovate themselves out of this malaise?

How did we get here?

In the early days of VC, originating from Bill Draper's first innovative financing, the sector produced more than 40% IRR. New LPs, attracted by those generous returns, flocked to the sector and deployed massive amounts of money to VC, without properly validating the GPs relevant entrepreneurial credentials. And with VCs improperly calculating risk, the wrong companies are funded - in large numbers. With almost none of them able to fool private or public markets, regardless of the state of our economy. That's where we are today.

Innovation is not the problem

But just because the current VC "dating service" is broken that does not mean the LPs or the entrepreneurs should lose faith in the monetization of disruptive innovation. Both should simply seek to establish a more effective dating service, one that focuses and supports upside, rather than worry about downside risk.

Entrepreneurs should refuse to work with investors that improperly assess business risk, money from the wrong investor is a dead-end street anyway. But most influential will be the immediate action from LPs who should close their underperforming commitments (instead of flee), reset their fund requirements and require more relevant operating credentials from General Partners (Venture Capital requires more relevant early-stage credentials and vision than other Private Equity sectors).

New opportunities abound

With the foundation of technology established (chipsets and the internet) the next wave of innovation comes from platforms and applications (macroeconomic marketplaces), all of which can be developed anywhere. Combine that with the dysfunction of Silicon Valley VCs and you have the perfect storm of starting new entrepreneurial endeavors in other geographies.

Innovation should not and will not just come from Silicon Valley, but it will only thrive in the hands of investors who understand that the cost of disruptive innovation is priceless. So, simply starting technology innovation elsewhere is useless if it is not matched with an investor who has the experience and foresight to see what others don't: a unique innovation he wants to put his all behind.

The procession continues

The sheer size of LP commitments outstanding to the VCs will keep the emperors procession going for a while, and the VCs refusal to criticize themselves is a sign that it is incapable of recovery and self regulation. We need new VCs, with a new mindset and a different DNA to get there.

While there were more important reasons for me to move (with my family) to the East coast, I certainly do not regret not being there when the naked emperor continues his procession through Sand Hill Road. My focus will remain on helping LPs understand how to invest in Venture Capital and how to regenerate the impressive returns the sector is still capable of producing -- or show it to them myself.

We are after all at the beginning, not at the end of technology innovation.

Why VCs need relevant operating experience

The Venture Company | venturecompany.com — 2009-07-18T16:00:19-04:00

By Georges van Hoegaerden

[The article has been supplemented by a more recent "Why VCs really need relevant operational experience, now"]

I frequently get asked by individual Venture Capitalists (VCs) whether I really think General Partners (GPs) need operating experience to be more effective (as if my blog is not clear about that). And just recently HP's Venture Group seems to agree with me.

That topic was also recently challenged by Daniel Primack from Reuters' PEHub (I know he likes a good debate) who decided to make a statistical point that there is no correlation between fund success and GP operating experience.

Yet my short answer is: "yes, but it depends".

What my answer does not depend on is Daniel's statistical analysis of the Forbes Midas List and loosely matching credentials to his sample. With more than 90% of VC not making a real profit (above the asset class expectation of it), the 10% Midas sample can hardly be called statistically representative. And even if it would, a highly inefficient market (created by the ineffective "dating service" VCs currently provide) does not statistically represent the workings of the efficient market we wish for. And the majority of the Midas List GPs have their "success" firmly rooted in a timeframe when "turkeys could fly". Should I go on?

But most importantly, statistics are derivatives - not drivers - of market behavior, in the same way liabilities and assets are opposites (read "Rich Dad, Poor Dad"). It is unwise to apply a derivative (statistic) as a driver for market decisions. All experienced entrepreneurs know that.

So, my answer depends on whether you reference the actual or supposed workings of VC.

In today's VC

In today's venture capital ecosystem it is very important for every GP to have relevant operating experience, with the emphasis on relevant. Relevant experience as that of an early-stage CEO in tough times, still producing success.

Many GPs can only flaunt past experience from behind the confines of a large brand name conglomerate, rather than the experience of an early-stage CEO, investing his own money, defining a unique company ecosystem, living on borrowed time, raising a few rounds and selling the company. The VCs with that level of operating experience are hard to find and so are their successes.

Why is VC operating experience important:
1/ Many venture funded companies today are built with what I coin as the sub-prime VC model. Amongst many things it means founders need to prove a lot of technological capabilities (see my Khosla reference) before they see an investment dime, and when so, usually receive too little money to hire an experienced CEO. As a result, the board (of investors) runs the startup and thus their relevant operating experience becomes pivotal to the success of the startup.

2/ Relevant operating experience matters, not just any operating experience. Successful startups rely on a clear definition of a unique ecosystem (with divisional expenditures and conversion rates). The last thing an entrepreneur needs is a group of investors who can barely deviate from their business school thesis to meet reality and a world that is in flux.

3/ GPs need to be entrepreneurial to recognize and weigh one. The success of a technology startup is not just dependent on how cool the technology is but requires an operational assessment to figure out whether the business model is sustainable, and whether the application of that technology to a demographic makes economic sense. Operating experience is crucial to validate the combined value of operations and innovation.

I can name probably a hundred other reasons, but that would extend beyond the artificial limit of this blog and your patience.

In new VC

In a new VC structure I would argue for a more balanced makeup of economic managers and operational managers. But that structure can only work when all GPs share responsibility for every deal, rather than today's norm of every GP managing his own subset of companies within the portfolio. Many more things need to change in order for VCs to accurately calculate startup risk, snippets of which I've covered elsewhere in this blog and will cover extensively in my upcoming LP seminar "The Inconvenient Truth of Venture Capital".

Alignment with the entrepreneurs

So, until we change the fundamental workings of VC are we bound to hire GPs with relevant operating experience, those that combine that operating experience with the ability to accurately calculate upside risk and align with the entrepreneur.

But a VC firm without relevant operating experience is a risky investment (for LPs) and a bad strategic partner for the entrepreneur. The great difference between Private Equity and its sub-class Venture Capital is that the latter can create massive returns, albeit with GPs that are capable of recognizing a diamond-in-the-rough and performing a little bit of heavy lifting when needed or desired; by applying experience and influence.

That, as an operator, makes Venture Capital so much fun for me.

Why VC does not line up with innovation

The Venture Company | venturecompany.com — 2009-07-01T15:04:32-04:00

By Georges van Hoegaerden

The biggest complaint I hear and agree with is that Venture Capitalists (VCs) just don't get it and in the words of a VP at Apple, VCs simply don't line up with the needs of entrepreneurs.

Real innovation has no precedent and leaves many VCs, with their platitudes and an army of analytics in the dark in coming up with a reliable reason to invest. I personally had a VC become teary-eyed about the prospect of having to convince the rest of his team about an investment I presented, and I subsequently got it funded elsewhere.

With monetary assets being equal, it takes a visionary or a black swan (whichever classification floats your boat) to separate the good investor from the bad. Great investors have a strong belief that finds solace in an internal compass that is fine-tuned by years of risk-taking. Risk-taking in entrepreneurship or personal life, whichever one shaped that core competency. We have many VCs with strong beliefs, but few of those beliefs are founded on relevant experience.

So, entrepreneurs (and LPs) take note of what is the most important ingredient to look for in the bios of General Partners (GPs). With few exceptions, a GP (General Partner) that has never been a CEO at a startup, responsible for developing and executing its unique ecosystem, is not a great candidate to become a VC. Neither is the GP who has never challenged him/herself personally.

Venture Capital is government

But not only are those investors hard to find, the physical makeup and workings of the current VC construct is diametrically contradicting the decision-making for groundbreaking innovation. As long as the meritocracy at the VC level of the investment pyramid that started Venture Capital is not restored, the artificial arbitration of the current aristocratic model will continue to erode high yield returns.

Here is how VC acts like government:

1/ You (still) need to be in Silicon Valley

Just like you need to be in DC to make an impact on politics, do you need to be within 20 minutes of Sand Hill Road in Menlo Park to be on the radar of investors.

2/ You need an intro to the VC

In DC you need lobbyists to get anywhere, in Silicon Valley you need to find similar lobbyists that can introduce you to the investor you want to talk to. Most GPs simply refuse to talk with entrepreneurs they have not met before. Entrepreneurs who contact VCs directly will find themselves debating the vision with an academic white swan, dramatically improving their chance to get rejected.

3/ Investment decisions require internal consensus

Politics is based on consensus. Likewise, if the entrepreneur is lucky to convince one GP of their proposition, the next monday morning meeting at the VC firm is spent on getting other GPs to agree (except if the first GP is of John Doerr stature). In essence it means a unique invention is shoved through a democratic (government) filter to be validated with chances of a majority vote rapidly approaching zero.

4/ Deal syndication requires external consensus

Many VCs don't have the balls (excusé les mots) to make independent contributions to companies and look for syndication to mitigate the risk. Just like in DC where politicians look for peers to join their charter, before they stick their necks out.

5/ Lack of accountability

VCs can hide behind the size of the portfolio to select one or two successes to brag about. Just like politicians that hide behind a party and associate themselves with many initiatives and get credit for the few that worked. Quite opposite to the devotion of an entrepreneur.

6/ Lack of transparency

To understand politics you need a graduate degree in the subject matter, to understand VC you need to be (or have been) one. Just because the type of businesses VC invests in are private, that doesn't mean VC needs to be.

7/ Far removed from its constituents

Not only physically but spiritually many politicians are far removed from their constituents when they enter into office. So are the VCs who prefer to congregate more with each other than with entrepreneurs to develop unique support for disruptive innovation. VCs are oblivious to the many "false negatives" (as described in my previous blog) they don't even get to see, just as many politicians forget that many americans don't vote at all.

8/ Fewer real innovations are born here

DC (at least before Barack) is not the place to get anything done, and Silicon Valley choking on a vast supply of sub-prime VC is not the place to get anything really disruptive done. The real world is the market, not the current VC interpretation of it.

9/ Long incubation periods

Just like in politics, once the GP secures a fund with the LP the performance of the fund is in limbo for 5-10 years. That is a more secure job than the presidency of the United States. Many GPs stack funds or jump ship before it is about to go under, picking up new management fees under a different fund and LP structure. Another 5-10 years of GP safety lies ahead.

10/ External circumstances

Just like in politics, VCs blame their underperformance on anything else but their own decision making. The state of the economy is their welcome excuse, even though startup economics are quite resilient to macro economic aberrations.

So, the point of this blog is to emphasize that in order to get VC to create high yield returns we not only need to take a close look at the GPs that take the risk but change the mechanics of VC from a "government" based system to a meritocracy at the VC level of the investment pyramid. That is the message I will develop further (and more constructively, I've hammered on VC enough) in helping individual LPs develop new relationships with VC firms.

The systemic risk of Venture Capital

The Venture Company | venturecompany.com — 2009-06-25T10:18:54-04:00

By Georges van Hoegaerden

The debate is heating up about the impending regulations from the government applied to Private Equity (PE) and its sub-class Venture Capital (VC), fought by the National Venture Capital Association (NVCA) and reluctantly supported by the Private Equity Council (PEC). The latter stating that private equity does not represent a systemic risk. Perhaps not, if the council excludes VC from its membership, but VC as Private Equity poses a systemic risk as the gatekeeper to innovation.

Why the government is forced to step in

The government has decided to step in and we, as participants in the ecosystem should present our government with the facts (good and bad) so it can make informed decisions going forward. If we give the government self-serving information, rather than the facts, we will get punished by regulations that miss their intended target. So, now is the time to separate greed from honesty and shape the regulations that will be bestowed upon us.

The most rational explanation as to why the government is tightening our private equity belts came from Bob Grady, Managing Partner at The Carlyle Group (who worked for the government for a while) at the recent IBF conference. He suspects that the government simply wants to reduce the size of the financial services industry as a percentage of GDP (Gross Domestic Product).

Not unreasonable, considering the collapse of our financial system and the discovery of an endless supply of imploding derivatives (and vice-versa). Simply put, the equilibrium between people who create products and those that capitalize on them is out of whack. We need more innovation with fewer derivatives attached to them.

VC is a systemic risk

The creation and growth of the Internet (and all the components around it) could not have existed without the faith and dollars from Limited Partners (LP), deploying their assets through VC firms. Kudos to people like IBF life-time award winner Bill Draper who started Venture Capital by literally knocking on the door of an interesting company, buying his first shares for $20,000. But the last nine years have been dismal for VC performance, almost 900 U.S. VCs producing less than 10% IRR, tarnishing the technology ecosystem and prompting LPs to look around to reallocate money to a different asset class.

Why VC needs to work

While venture-backed companies represent around 0.02% of GDP prior to exit, post exit they represent about 18% of GDP (according to the NVCA) and 9% of jobs in America. So, the decision-making process by a VC of what company to invest in is vital to building a healthy economic conversion rate. And I predict information technology will claim a larger stake of GDP as it continues to mature from its infancy. So while VC is a small percentage of the total Private Equity pie invested, it has proven its ability to produce a healthy stimulus to the economy.

What has changed

We can look at the statistics from the NVCA and debunk those statistics with reality, but common sense tells us that most of us would be hard pressed to name ten ground-breaking technology innovations in the last ten years. So, if 900 VCs produce this few real innovations, the billowing smoke is sufficient indication of a fire. On top of that companies like Apple show us how to invest in categories (like music) VCs had unsuccessfully invested in for the last 10 years, challenging VC fundamentals to its core.

Proper assessment of investment risk

The problem with VC is that it is inherently risky (more than other forms of Private Equity) and with the wrong people running VC firms, the asset - risk - that produces great returns is being sucked out of the investment equation.

Smaller funds, feverish syndications, easy exits are all instruments that create more rather than less derivatives to the creation of disruptive value. VCs now sell to LPs a similarly ill-fated pattern of risk as sub-prime lenders sold to their investors. Hence our frequent use of the sub-prime VC classification throughout this blog.

As a result of a lack of meaningful segmentation and guard rails by many me-too VC funds, LPs have actually invested deep rather than wide in information technology (as the included chart points out). For the last nine years that has created a massive number of false positives and false negatives and a continued downward spiral that attracts only entrepreneurs that comply with this risk-deflated investment mold, rather than attract entrepreneurs with truly disruptive ideas (that hold their value in any economy). So, for the last 9 years LPs have invested deep in a risk-averse technology sector while they expected their 10-15% venture share of total allocations to be applied to the inverse.

Moving forward

Many LPs are ready to cut all but their top quartile VC funds from their portfolio by flushing them through (i.e. letting them run their course without re-upping new commitments). That means over the next 5 years we are going to see many VC firms disappear, some replaced with new VC firms with more relevant entrepreneurial pedigree and investment models that are as unique as the strategies of the entrepreneurs.

New regulations by the government and tougher practices by LPs will make our industry more transparent and aim to create a platform in which the old aristocratic VC model will be replaced by a model that supports a meritocracy at every level of the investment pyramid. That is a fantastic development for entrepreneurs and VCs who are attracted by - and deserve - the merit.

Big stakes, big returns, fewer players, better innovation

LPs expect bigger returns (before larger commitments) from their allocation in venture and the only way to get it is to deploy risk. VC is designed to be the intermediary between the LP and the entrepreneur to mitigate that risk for LPs. Yet because of the aforementioned commoditization of VC investment strategies the VC model has failed to produce.

With LPs retrenching (to perhaps another asset class), the VC firm that wants to survive better articulate a clearly differentiated investment strategy with new GPs that can recognize and attract more disruptive (and sustainable) innovation, knows how to commit and helps make its portfolio companies work.

A new day

To create better returns for LPs, VCs need to rethink how to pick better companies with more disruptive (and sustainable) innovation and invest in upside rather than downside. The smart entrepreneurs are out there (we talk to them), waiting patiently for the right investment climate to light up their flame. Remember, great innovation can afford to be patient.

Venture Capital as the derivative in the investment pyramid between the assets of the LPs (money) and the assets of the entrepreneur (innovation) needs to provide a better service to both parties (or else it will be tossed out as a "dating service").

Until we fix VC, will it remain a systemic risk to our asset class, economy and frankly our reputation as the most innovative country in the world.

How LPs should deal with VC

The Venture Company | venturecompany.com — 2009-06-15T17:17:04-04:00

By Georges van Hoegaerden

Last week's 20th anniversary of IBF Venture Capital Investing Conference (congrats to Alex Scott and Christina Riboldi) in San Francisco was a unique opportunity for me to witness the atmosphere between 487 Limited Partners and General Partners (also referred to as Money Managers by LPs).

My first ringing of the closing bell on Nasdaq followed by a packed premier event of the Asian American Association of Investment Managers (AAAIM) at The Harvard Club in New York, with keynotes from Julian Robertson, CEO of Tiger Management and David Rubenstein, founder of The Carlyle Group gave me some great insights into the world - and thinking - of LPs.

It is clear from these sessions that LPs (and Fund-of-funds) are misled and confused about how to improve the performance of Venture Capital (VC). The VC sector of the Private Equity asset-class has been plagued with dismal performance of less than 10% IRR (Internal Rate of Return) for the last 9-years, leading some LPs to question and reduce allocation (US: 10-15% of total assets per firm, Europe: ~4%) in a sector that deserves quite the opposite.

The emerging opportunity in technology VC

The technology sector which is my passion for the last 30-years is at the beginning, not the end of its emergence. Perhaps the top-level indicator of the innovative runway we have ahead of us is the following: more than 5/6 of the world's population does not yet use a computer connected to high-speed/broadband internet today. And all should and will, given the right technology. That's where technology innovation comes in; not just in connecting people to the internet but in deploying innovation that uses the internet as a distribution mechanism. The way we use the internet today is rudimentary, and many new technology stacks will emerge to improve its impact on everyday citizens.

Given the early days in the life-cycle of the technology sector relative to any other sector or asset-class is; low-cost to produce, low-cost to distribute and because of the internet has immediate customer impact with independently short sales-cycles. That means with relatively little money in, a massive impact can be produced, virtually instantly. A great investment allocation opportunity for LPs still lies ahead.

Why the VC sector is not producing

In the words of Cesar Millan, the popular dog whisperer on National Geographic, who states that the behavior of the dog is the responsibility of its owner, so should LPs demand control of the behavior of the VCs. Like dogs, VCs exhibit primal behavior that can make them great money-managers, but only when they are controlled. An issue even The Carlyle Group recognizes by including a code-of-conduct in its recently published annual report. LPs should let go of the leash after VC performance becomes apparent, not before.

-- Risk deflation
VCs sell well upwards to the LP at fundraising time, but they seem to have forgotten that they need to serve the entrepreneurs just as well. In the investment pyramid between the dollars from the LP and the ideas of the entrepreneur, the VC is simply the derivative that should serve both. Today it does neither. The money-tree report further hides the ugly reality under-the-hood as the funding stages have disrupted the equilibrium between entrepreneurs and VCs and steadily turned VC into loan-sharking.

-- Lack of relevant experience
Most VCs in Silicon Valley simply have no relevant operating experience that allows them to service the needs of entrepreneurs adequately (see sub-prime VC). And that in turn creates a massive amount of false negatives and false positives to which no liquidity mechanism (from the NVCA or Tim Draper) will suffice. Beginning in the early 2000s, the VCs have simply consistently invested in entrepreneurs that submit to sub-prime innovation and terms.

-- Lack of vision
No surprise that, according to a conversation with a chinese private equity investor at the AAAIM conference, recently 12 highly successful chinese immigrant entrepreneurs left the U.S. disappointed to go back to China because the VCs did not allow them to take the helm at their own companies. They will in China. Smart entrepreneurs simply won't submit to sub-prime VC, leaving the VC (and therefor indirectly the LP) alone in their spiraling sub-prime demise.

To echo Jessica Reed Saouaf, Managing Partner of Hall Capital Partners (with $17.5B in assets under management) who describes at IBF that the VC business today is too institutionalized with too few visionaries to create promising returns. LPs need to do a better job in sourcing, segmenting, controlling and demanding transparency so the behavior of VCs remains an extension of the LPs investment brand and integrity.

The myths LPs are being told

But the incumbent VCs are not taking this criticism without a fight, a fight to hold on to their cushy management fees and plush existence. From the focus of their rebuttal (by way of pump-and-dump liquidity plans, annex funds etc) you can gleam their true nature, they worry more about protecting their downside than improving their upside.

A welcome exception to the majority of followers of the auto company's plan to fixing VC are the younger VCs like Jason Green (Emergence Partners) and Paul Holland (Foundation Capital) who on the IBF panel proclaim that, unlike the NVCA they do not lie awake at night about the impending increase in capital gains tax on their carry. Instead, just like great entrepreneurs, they worry first about delivering value and returns, trusting that personal wealth will naturally follow.

Here are the most frequent myths I hear VCs attempt to imprint on the LPs that I want to debunk here quickly to prevent a further slide down the sub-prime spiral:

-- It's the economy; new fund - stack fund - annex fund
Nonsense: even the most successful startups do not achieve revenues or market-share above 10% of their total-addressable-market (TAM) during their private funding cycle. That means that 90% of the total-addressable-market is still not served effectively. With a few exceptions it is hard to imagine that a 10% decrease in market will have any affect on the success of the startup. I would argue that in a down-market the opportunities for new technologies improve considering the fact that an early adopter can more effectively compete with 90% of its competitors. So, conversion rates of companies with macro-economic differentiation should improve and so will their market-share and revenues and consequently the opportunities for great exits.

-- We are in a down-cycle, we will bounce back; new fund - stack fund - annex fund
Nonsense: the barrel of a downward spiral is cyclical too, be sure to recognize the difference. Sub-prime investments have no exits and will not yield valuable fund returns, no matter what the liquidity structure is. VC portfolio choices that cannot withstand the test of time simply have no fundamental differentiation and independent future. And a GP that cannot distinguish between prime and sub-prime will never be successful.

-- Companies are cheaper to build; new fund - less money
Nonsense: I have heard LPs echo the term "Capital Efficiency", and it is a trap. Not just for the entrepreneur but for everyone in the technology ecosystem. Unlike in the past, no product can withstand the scrutiny and the power of social networks unless it is really well built, offers fundamental and disruptive value and delivers authenticity and trust. Only then will users adopt it. And since distribution is virtually immediate, more competitors will spring up to provide the noise that makes life harder. So products are actually more expensive to build and requires a different ecosystem makeup and funding trajectory for the company. VCs that look for smaller funds demonstrate further misalignment with reality and therefor exits.

-- There are not enough great ideas; new fund - less money
Nonsense: but sub-prime VC behavior and terms turns off great entrepreneurs. Only idiot CEOs and unsuspecting entrepreneurs submit to terms that hands control and destiny to underperforming VCs. Other forms of artificial arbitration such as geographic distance of 20 minutes moves the VC even further from the meritocracy it should be looking to embrace. The institution on Sand Hill Road is severely limited by its lack of peripheral vision of technology and the world.

-- New (government) regulation is strangling exits; new fund elsewhere
Nonsense: the bar has been raised for technology companies as it should. No longer can public markets be fooled by valuations that have no value. Real value jumps the hurdles of regulations with ease (as witnessed by OpenTable and Rosetta Stone). The current startup inventory, that was subject to sub-prime investment tactics to begin with, may not be able to get to the finish line. Such is the punishment for lack of independent differentiation and value.

-- The grass is greener in green; new fund - hot market
Nonsense: I have witnessed the rush to these "hot-pockets" before but hot-on-supply does not equate to hot-on-demand. Or as Julian Robertson says; "there is a difference between having a bakery and baking bread". Contrary to technology, greentech is expensive to produce, expensive to distribute, relies on long sales cycles and arbitration (subsidies, politics etc. ) that is beyond the control of the startup (and much more complicated in its regulative risk than, for example, healthcare). A dependency on government is very dangerous in meeting the time-to-money milestones for early stage companies and fund returns. I believe in the value of green-tech and energy-tech to create a greener planet, but I don't believe the current VC funding models with former technology GPs looking for greener pastures can support its early financial success within the current funding vintages. It is ironic to see VCs use the capital-efficiency slogan under the same roof as their capital intensive strategies for energy-tech.

-- The grass is greener global; new fund - new fund elsewhere
Not yet: as we move up the technology stack and specifically the investments in software, the origination becomes less relevant, I will yield to that (although I see still see an entrepreneurial quality difference), but startup investments should reside where the execution is, regardless of origination. While other geographies score well on low-cost manufacturing (and programming), real disruptive ideas and the majority of early adopter markets (driven by the frantic pace of unbridled capitalism) still reside in the U.S. So VC funds should be equipped to handle international deal sourcing (and be the first investor in) and only become truly international once the remote exits prove to justify an independent local operation. For that to happen, creation, execution and exit values need to yield appropriate dynamics. Remote execution and exit values remain sporadic today, but that may change as those markets develop and emerge as prominent technology visionaries and consumers.

How to fix VC

Optimizing VC is probably easier than most LPs think, since the issues plaguing VC have to do with regaining fundamental leadership of the investment ecosystem. Simply put, LPs need to become "VC whisperers" (to use the Cesar Millan analogy), those that can control the performance of VC so the leash can be loosened. The good news is that none of the deficiencies in VC are rooted in the complicated micro-economics of technology, contrary to what some GPs may want you to believe. But it is important that LPs hear more than the repetitive sugar-coating from underperforming VCs and keep a close eye on entrepreneurs who actually represent the monetizable assets.

-- No more "duh" PPMs
No more Private Placement Memorandums (PPM) that look remarkably like a wish-list without substance. Yes, I've seen the memorandums produced from brand-name VCs that get replicated by many other VCs in the valley. No right-minded VC would accept a business plan from an entrepreneur that looks like that, neither should an LP. The quality of the PPM is a direct indication of the quality of the VC fund and should help LPs clearly segment the risk associated with technology investments. LPs have invested deep rather than wide in the technology sector, hence the birth of many false positives.

-- Assess the GP's unique vision
Many of the PPMs talk about rearview mirror analyses, but the only advantage one investor has over any other is his forward looking views on the industry, or vision. So LPs need to assess the risk associated with that vision, much of which again is related to macro-economic impact rather than technology waves. GPs should be able to demonstrate that their unbridled vision in the past came true.

-- Assess the GP's relevant operating experience
To become a valuable partner to the entrepreneur the GP needs to be able to prove relevant operating experience related to the investment thesis and specifically to the segmentation. Information technology is a broad sector and experience in consumer technology differs from the application of technology to healthcare. Being able to help entrepreneurs develop a large vision with tangible baby-steps is a skill that GPs need to master to improve the size of disruption and returns. That experience needs to map directly to the investment thesis in the PPM.

-- Assess the GP's track-record for deal sourcing
Getting your hands on real disruption requires a proactive approach to finding the "diamond-in-the-rough". Many early stage entrepreneurs, hurt by sub-prime VC tactics, need help thinking bigger. The size of the disruption, rather than the cost of entry is crucial. Finding deals that can be turned in game changers is fundamental to the success of great returns.

-- Hire an expert
All this deep-diving may be too much for an LP who has nearly 90% of its assets allocated to other asset-classes, so the smart thing to do is to hire an expert that speaks the language of the entrepreneur and ensures that the needs of LPs and entrepreneurs are effectively met through an intermediate VC vehicle.

Conclusion

Crucial to the success of the technology sector is to do the opposite of what most VC funds are currently setup or guided to do. To follow Warren Buffet's advice: when everybody is investing using sub-prime tactics then now is the time to do just the opposite. Venture Capital is a sector that can produce great returns when it takes great risks, not when it becomes risk averse, and fragments and commoditizes investment dollars. Deflating the risk through sub-prime investment tactics has killed the want to innovate, and may lead to an accelerated intellectual exodus that will hurt our economy as a whole.

Apart from fixing what is broken I think the time is right to fundamentally restructure early stage innovation and make its financial support just as innovative as the inventions themselves. Facebook sets a good example of how it taunts with the institutionalized investment "rules of Silicon Valley".

LPs who cannot see the massive opportunity in technology should simply exit from Venture Capital. But continuing to support sub-prime VC funds is a sure way to continue down the spiral of suboptimal returns we have been stuck with for the last ten years and damage the innovative ecosystem our economy depends on.

So dear LP, go big or go home. And when you plan to go big I will make myself available to put words into action. I cannot wait to turn this page.

The auto company's plan to fixing VC

The Venture Company | venturecompany.com — 2009-05-18T17:22:00-04:00

By Georges van Hoegaerden

The National Venture Capital Association (NVCA) has released its recovery plan (4-pillar plan) to fix Venture Capital that is eerily similar to that of the auto companies. It focuses on the prolongation of (their) life rather than on the quality of its product; the ability to spawn meaningful innovation.

Now I am sure Dixon Doll, from his perch atop a $1.6B Venture firm, means well but his purview is severely limited by his role as chairman as one of the most closely held investment clubs in the nation. Its members, ninety-something percent of the U.S. VCs are simply not incented to present all options for improvement, and certainly not one that would include self-cannibalization.

Nothing in this plan covers the stimulus and meritocracy required to spawn and monetize disruptive innovation. The plan mentions entrepreneurs, as the real value creator in this equation - in passing - only once (slide 11) amongst its thirty slides. The plan seems to forget that the entrepreneur is the real value creator, not the VC.

The plan, like the plan of the auto companies boasts of past accomplishments (count on two hands; poor result coming from 800 VCs, but we all know that) and how it puts a lot of people to work (it better when $28B of LP money is dispersed; what else would you spend it on), yet it offers no clues as to the fundamental resurrection of IPOs and meaningful M&A. Could it be that VCs simply picked the wrong companies to invest in? Could it be that the driver, not the car caused the accident?

Faster and easier liquidity paths, using the suggested liquidity platform, does not make up for ill-defined risk assessment applied by many VCs. I predict, such a platform will then be used by VCs who are stuck with many false positives as the pump-and-dump platform to hide their bad choices. The proposed structure of the NVCA reminds me of an intermediary company/fund that tried very hard to sell me equity in some of Kleiner Perkins (KPCB) later stage companies. I happened to know a little more about those companies and their products and gracefully declined.

We don't need more complexity in the Venture Capital business. We need to flatten, segment and remove derivatives in the same way we are about to remove derivative structures from the banking world. We need Venture Capitalists that can quickly be held accountable for their actions and implement transparency that offers LPs the instruments to do so. After all, the VC is merely a derivative in the process of innovation.

Fixing VC will be remarkably easy when you consider the needs of entrepreneurs and I plan to present my entrepreneur focused plan to the LPs soon. A further descent down the sub-prime spiral (in which all participants are entangled) makes it hard for some to see the forest through the trees and find a solution. But the current situation is bad for Silicon Valley, for our leadership position in an increasingly global technology landscape and detrimental to our economy as a whole. That is why I care. I care about the meritocracy we talk about so often but so poorly deliver on, with capitalism as the excuse.

I don't want to see other countries walk away with an optimized model of our technology innovation, like we seem to lose many other innovations, just because they understand that (at least local) meritocracies require some form of regulation, transparency and other aspects of free-market principles. Capitalism, just like football, requires rules in order to flourish.

The NVCA plan is a bad plan because it does nothing to fix the false negatives and false positives VC produce today, one that is currently shutting out meaningful innovation. And it demonstrates how it continues to treat entrepreneurs with remarkable ignorance.

Idiot CEOs

The Venture Company | venturecompany.com — 2009-05-11T17:36:32-04:00

By Georges van Hoegaerden

That's how one of the many CEOs that contact me recently described his colleagues who submit to Venture Capital (VC).

This alternatively funded CEO describes other CEO’s that seek VC funding as idiots – with a 1 in a 1000 shot at a lousy valuation (52% Round A, 25% Round B and 15% Round C). He continues that many of the serial entrepreneurs trumpeted by VC’s have no money themselves despite “successful” previous exits.

He is not alone about the ineffectiveness of Venture Capital, I frequently hear from other successful entrepreneurs about it. And the situation may get worse before it gets better. The economy is offering VCs even more excuses to turn the screws, and control of companies is gained in more ways than a simple equity stake.

I believe technology investing today is largely a sub-prime asset class as described in a plethora of sub-prime articles in this blog, and find many entrepreneurs discouraged by both the process as well as the outcome of fundraising, even when that yielded a round.

Because of the ineffectiveness of VC and the rampant false positives and false negatives I refuse to believe VCs (and the NVCA collectively), who suggest that the sum of Venture Capital equals the sum of technology innovation. We see great entrepreneurs actively pursuing more creative investment vehicles (high-net-worth individuals, private equity firms, investment bankers, sovereign funds...anyone with money), and rightfully so.

In the meantime, oblivious to recognizing their own flaws, VCs are further descending down the sub-prime spiral by restricting investments to compliant entrepreneurs, evidence that they remain clueless about the fundamental risk management of high yield returns.

Smart CEOs should simply refuse to work with many technology investors for the following reasons:

- Exorbitant loss of upside
Great entrepreneurs are known for their passion to pursue their dreams at virtually any cost, and sub-prime VCs smell their blood and desperation. Those companies become owned by VCs quickly and because of the investors' lack of relevant operating experience yields a further deflation of the valuation of the company. We've seen many companies with end-game founder stock way below 5%, which is unlikely to become life-changing. So, why would you take the scrutiny of the CEO job with that outcome in mind?

- Indirect loss of control
Voting rights as well as other fine print in the termsheet severely impact your ability as a CEO to disrupt a market. While in the beginning the founders may still own the majority of the shares, the dependance on further runway support gives VCs the ammo to press their preferred operational trajectory and leaves operational decisions at the mercy of its first investors.

- Restrictive expenditures
The powers of the CEO are further restricted by clauses on expenditures in either the articles of incorporation, termsheets, voting rights or other legal documents. We've seen restrictions requiring board approval for expenditures as little as $5,000. That means a CEO can't make pressing decisions until a next board meeting or when there is an ability to call an impromptu session. These restrictions are further evidence that a CEO does not have the trust of the board.

- Insufficient ecosystem control
Investors typify investments in technology waves (witnessed by their mindless herding at technology focused events) and blindly allocate certain expenditure expectations to R&D, marketing, business development and sales divisions. But the ecosystem of every company, regardless of segment, is unique to that company. CEOs who let VCs determine or validate the ecosystem expenditures will spend the subsequent board meetings explaining why they deviated from that, a waste of precious time.

- Deal with undeserved authority
Many VCs do not have the credentials and relevant operating experience to lead an experienced CEO. Yet it behooves the CEO to listen to the idiosyncrasies of the VC in order for them to endorse a CEO's leadership. Nothing is worse for a company's future than having to wait for the investor to validate every step along the way.

- Micro-economically sandwiched
Technology founders and VCs are often focused on building technology, very few investors pay close attention to the macro-economic differentiation (and valuation), leaving intelligent CEO left to drive a more sustainable big picture strategy with limited board and back-end support.

- Forced syndicates
Investors with early stakes can essentially force the company to engage with other VCs in subsequent rounds that favor the initial investor, rather than the entrepreneur. Many VCs huddle together in like-minded "vulture" strategies in the hopes of maximizing their often ill-performing portfolio.

- Damaging to reputation
The valley is so small and ignoring the advice from an investor can have detrimental effect on a CEO's future career. The "you will never work in this town again" syndrome is not unique to Hollywood, it is alive and well in Silicon Valley. The word spreads quickly when you challenge VCs and don't accept their terms, a reason why they tell you not to shop valuations around - it will actually hurt you.

- Sticky lawyers
We've inherited bad ones in companies we ran and found some good ones. But in many cases lawyers in Silicon Valley pretend they actually created the companies, simply because they filed their incorporation paperwork or attended board meetings. They mingle with the money sources and make the introduction to VCs that secure their billing runway. They end up getting cosy with the major shareholders and tilting the balance even further away from the CEO who signs their checks. Another entity to keep in check as a CEO.

- Low salary
Opportunity rather than salary is top of mind to entrepreneurs, but that changes quickly when they struggle to support their families and pay mortgages. $175K is not a salary that leaves much on the table, especially not when you live in the expensive area around Sandhill Road. And VCs are challenging those salaries even more while they are raking in astronomical fees associated with their large funds and sitting pretty for the next ten years. The risk/reward equation between VC and entrepreneur is completely out of whack.

- Poor severances
Board-run companies leave CEOs in a vulnerable state once its collective wisdom does not pan out. The blame for that failure is usually generously applied to the CEO, while the decision making power was not. An early stage CEO should consider himself lucky if the company can still honor its pre-negotiated severance obligation.

Pimps and Hoes

The current venture climate reminds me of the fascinating HBO documentary Pimps Up, Hoes Down in which the undeserved authority of Pimps is applied to the Hoes who do all the (dirty) work.

No self respecting CEO should accept the constriction deployed by sub-prime Venture Capital as described above. The outcome of the current entrepreneurial restrictions is not only highly predictable but has thankfully reached the balance sheets of fund-managers and Limited Partners, who fund the VCs and are starting to question the role of the VC as the intermediary.

The downturn in the economy masks the unrelated impending implosion of Venture Capital. No VC should use the economy as the excuse for the restrictions above and as a CEO you should read its deployment for what it is; a diminished faith in you and the company.

So, unless you can reach a great VC independently or with help from others quickly, my suggestion is to wait with testing your CEO skills until Venture Capital, not the economy recovers. If you can.

In the meantime I'll do my best to help fund-managers revive Venture Capital. It is about time the fund-managers hear the entrepreneur's point of view. That has become my new mission.

Your car did not cause the accident

The Venture Company | venturecompany.com — 2009-05-04T18:50:11-04:00

By Georges van Hoegaerden

What does that title have to do with technology innovation and investing? A lot apparently to my brain.

VC spin doctors
The recent flurry of articles by individual Venture Capitalists (with catchy titles such as "VC rightsizing") along with the help from their association (the National Venture Capital Association, NVCA) spin a wonderful story as to how external circumstances have closed IPO windows and reduced M&A valuations. "Helped" by an ailing economy, Sarbanes-Oxly, and other new regulations VCs blame their inability to spot real innovation on anything else but their own choices. Good luck trying to convince the police officer that your car was really to blame for the accident, and the VC malaise we are in.

Didn't your football coach teach you in school that you can't blame the referee for your loss, even if the referee made the wrong call? He would tell you to man up and just play better so there is no room for error. Isn't that what VCs expect from their entrepreneurs when they go to market?

And that is what I am now telling VCs.

No more excuses
I don't believe for a moment that Google, Facebook, Twitter, Rosetta Stone and OpenTable have or will consider their ability to go public on just the pressure of regulations or the process of going public. Those companies have a macro-economic value that is resistant to - perhaps - cumbersome rules. And companies that can't jump the regulatory hurdle should frankly not be allowed to play in the big league of public markets and offered an opportunity to stain the reputation of technology innovation.

A major issue that great new venture funded companies face now is their ability to overcome the erosion of trust (as the currency of success) caused by its many sub-prime predecessors. For the last 10 years sub-prime VCs have collected sub-prime innovations which, without prior resistance propelled meaningless valuations into unsuspecting public markets. The likelihood of the current VCs (gathered at the NVCA) regaining that trust is as likely as a cheating husband regaining the trust of his wife -- it will take more than blaming everyone and everything else.

What matters is the entrepreneur
Moreover, the efforts of the NVCA described in their recent presentation emphasize the wrong point. The conservation of relentless entrepreneurs, not the VCs, is the real issue at hand. A VC, at best is a derivative, not the creator of disruptive innovation. For too long have inexperienced VCs been allowed to attract and perpetuate false positives and false negatives that have now clogged up the entrepreneurial ecosystem. And the only way to attract better entrepreneurs is to attract VCs with a vision as impressive as their personal entrepreneurial experience.

So, yes, I am in total agreement with Barack Obama's stance on imposing regulations to curtail the erosion of trust in the public markets. The importance of a vibrant technology ecosystem is crucial to our economy (that part of the NVCA pitch I agree with), and fund and endowment managers need to do a better job of sourcing, segmenting and keeping their VCs on a tight leash.

All free-markets require rules
No regulation that embraces the spirit of innovation can be more damaging than a continuation of the current sub-prime VC model greased up with efforts to exit out even easier and faster. Thankfully, fund managers have woken up and realize that moneys are best distributed to people who add value rather than simply extract money.

Instead of greasing the skids for VCs we need to find capable risk managers who measure up to capable drivers, likely to avoid accidents altogether. So stop examining the vehicles, but rather take a close look at who is in the driver seat.