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.

Tags: Kauffman, Limited Partners, Innovation, Angels, Sequoia

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.

Tags: Subprime, Limited Partners, Entrepreneurs, VC, Innovation, Integrity, Investment, Government, Growth, Arbitration, Capitalism, Cartel, Diversification, Economy, Experience, Free-market, Funds, HP, LP, Organic growth, Private Equity, Risk, SalesForce.com, Silicon Valley, SocialEconomicValue, Transparency, Venture, Oracle

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.

Tags: Limited Partners, VC, Entrepreneurs, Innovation, Apple, Private Equity, Monolithic, Performance, NVCA, SocialEconomicValue, Experience

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.

Tags: Limited Partners, VC, Venture, Marketplace, Funds, Fundraising, Arbitration

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.

Tags: Limited Partners, Innovation, Investment, Marketplace, Private Equity, Subprime, VC, Cartel

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.

Tags: Limited Partners, VC, NVCA, Innovation, Meritocracy, Free-market

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):


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.

Tags: Limited Partners, Funds, Venture, Meritocracy, Marketplace, VC

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.

Tags: Subprime, Private Equity, Venture, Limited Partners, Entrepreneurs, VC, Fundraising, Funds

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.

Tags: Free-market, Limited Partners, Growth, Government, Economy, Einstein, Marketplace, VC, Entrepreneurs, Innovation, Investment, Macro-economics

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.

Tags: Innovation, Fundraising, SocialEconomicValue, Macro-economics, VC, Entrepreneurs, Limited Partners, Marketplace

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.

Tags: VC, Fundraising, Funds

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.

Tags: Macro-economics, Meritocracy, Marketplace, Limited Partners

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.

Tags: Macro-economics, Experience, Demi-cartel, VC, Entrepreneurs, Marketplace

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.

Tags: Subprime, Limited Partners, VC, Venture, CalPERS, Macro-economics, Marketplace, Meritocracy, Transparency

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.

Tags: Venture, VC, Entrepreneurs, Private Equity, PPM

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.

Tags: Macro-economics, Valuation

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.

Tags: Venture, Limited Partners, VC, Marketplace, Meritocracy, Subprime, Apple

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.

Tags: Limited Partners, Venture, Entrepreneurs, Subprime, VC, Economy

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.

1. 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.
2. 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.
3. 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.
4. 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.
5. 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:

1. 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.
2. A (loosely coupled) commoditized investment thesis can never outgrow its peers, and thus is incapable of generate meaningful alpha.
3. 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:

1. Our Venture model removes the diversification at the bottom of the Venture equation, exposing VC matchmaker merit and accountability.
2. Our Venture model employes dynamic marketplace merit, not static institutional merit.
3. 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.

Tags: Limited Partners, VC, Subprime, Meritocracy, NVCA, Marketplace, CalPERS

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.

Tags: Limited Partners, VC, Venture, Funds, PPM

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:

1. 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.
2. 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.
3. 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.
4. 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:

1. 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.
2. 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.
3. 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.
4. 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.

Tags: Limited Partners, VC, FoF, Risk

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.

Tags: Macro-economics, Limited Partners, NewYork, Investment, Private Equity

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:

1. 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.
2. Technology taps into a massive greenfield consisting of 5/6th of the world population, and is only at the beginning of its exploration.
3. The internet provides a zero cost distribution channel that feeds relevant new technology directly and instantly to massive market pull.
4. The fluidity of technology implementations allows disruptive technology to quickly respond and become resistant to economic aberrations.
5. 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.

Tags: Limited Partners, VC, Macro-economics, Experience, Eco-systems, Economy

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!

Tags: Marketplace, Meritocracy, Einstein, Capitalism, Long Tail, Democracy

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.

Tags: VC, Innovation, Marketing, Marketplace, Business Model, Investment

By Georges van Hoegaerden

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

Tags: Limited Partners, VC

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.

Tags: Limited Partners, VC, Transparency, Disruption, Assets, Diversification

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.

Tags: Limited Partners, VC, Assets, Transparency, Subprime, Marketplace, Meritocracy

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?

1. 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. $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.
3. 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.
4. 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.
5. 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.
6. 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.

Tags: GDP, NVCA, Congress, Limited Partners, VC, Innovation, Government, Marketplace, Meritocracy

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.

Tags: PPM, Limited Partners, VC, Entrepreneurs, Eco-systems

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.

Tags: Macro-economics, VC, Private Equity, Congress, Marketplace, Innovation, Limited Partners

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 transpa