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A grand new opportunity in Venture
July 15, 2010.
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 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.
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.
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.
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.
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.
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.
Comments
Don't bite the public hand that feeds you
May 25, 2010.
By Georges van Hoegaerden
As I explained in "2010: The State of Venture Capital", our Venture primer and "How to fix VC once and for all", Venture Capitalists are the derivative between the assets of the Limited Partner (money) and the assets of the entrepreneurs (ideas).
Venture Capitalists, because they are equipped with the keys to the kingdom by Limited Partners (LPs) therefor claim they must know what is best for the marketplace to function properly, and deploy their best practices (read regulations) to identify investable innovation. And money hungry entrepreneurs bow down to learn from VCs how to build companies, approach investors, time the market, build scale etc.
LPs are getting more frustrated by an exploding technology sector with imploding Venture returns and one recently communicated on PEHub what I have heard many times now in private:
Crucial for entrepreneurs is to realize that in building a product (product in the economic sense, so could be service) for the public, "capital efficiency" is not only a blatant lie, it is the opposite of what creates public trust.
The public needs technology that offers significant attachment to large macroeconomic value, a complete offering (spanning multiple technology silos) and a robust product experience. All the ingredients that are not dished up by the strategies deployed by so many of the subprime VCs who proudly plaster the blogosphere and technology "flea-markets" (you know which technology trade-shows I am talking about) with their spoon fed investment tactics and meaningless advice.
Pension funds, endowment, insurance companies etc. put their reserves from public cash to work to deal with fluctuations in their businesses. So, a Venture business that does not perform well, will not only put pressure on the output of Venture, but will have devastating impact on its input. LPs as the guardians of that money now increasingly are instructed (by their often public boards) to lay off on venture capital.
Entrepreneurs should partner only with Venture investors who understand that Venture Capital is designed to protect upside, not downside. That corners cannot be cut in addressing the needs of those people who are expected to buy your public (or indirectly private) stock later on.
Treat the public how you want to be treated. After all, we are the public.
As I explained in "2010: The State of Venture Capital", our Venture primer and "How to fix VC once and for all", Venture Capitalists are the derivative between the assets of the Limited Partner (money) and the assets of the entrepreneurs (ideas).
Venture Capitalists, because they are equipped with the keys to the kingdom by Limited Partners (LPs) therefor claim they must know what is best for the marketplace to function properly, and deploy their best practices (read regulations) to identify investable innovation. And money hungry entrepreneurs bow down to learn from VCs how to build companies, approach investors, time the market, build scale etc.
In absolute terms Venture underperforms
The only problem is, very little of that has paid off. With fully loaded commitments from LPs, more highly skilled entrepreneurs than ever, an 80% technology greenfield with 7% growth in even the worst of economic developments, Venture Capitalists managed to perform below the technology sector it rides on. None of the financial relativity theories (such as IRRs, financial sector comparisons etc.) can debunk that Venture should have out performed the organic growth in technology and they should have tapped deeper into its virtually unlimited greenfield.LPs are getting more frustrated by an exploding technology sector with imploding Venture returns and one recently communicated on PEHub what I have heard many times now in private:
Clearly the Venture Capital arbitrage, deployed as a demi-cartel in Silicon Valley and feverishly and foolishly copied around the globe, can no longer be trusted. It is time to renew the marketplace and reset the compass of innovation.The correlation between “well-regarded firm” and actually profitable (for its investors) firm is close to zero. I’ve spent the last five years meeting with “well-regarded” firms and it's the rare exception that has actually delivered returns.
The public buys stock
As depicted on the included chart, the role of the public is crucial in establishing a healthy Venture ecosystem. If for nothing else, the most explosive Venture returns are realized in the process from turning a private company public (IPO = Initial Public Offering), and the threat of that investor independence can boost the company's merger and acquisition value. So, a solid understanding of the value of an early stage venture by the public (which we describe as Social Economic Value) is crucial in establishing authentic public stock value.The public buys product
The best way to have the public understand the value of innovation is to have them use it. Without many people understanding the intricacies of social networking, it does not take a lot of imagination that Facebook would be a valuable public investment solely based on its user growth. Facebook tapped into an existing macro-economic need to reconnect with people who were too busy or too remote to stay in touch with otherwise, and now reaps the reward of deploying new monetization schemes to a large installed based with no lead generation cost.Crucial for entrepreneurs is to realize that in building a product (product in the economic sense, so could be service) for the public, "capital efficiency" is not only a blatant lie, it is the opposite of what creates public trust.
The public needs technology that offers significant attachment to large macroeconomic value, a complete offering (spanning multiple technology silos) and a robust product experience. All the ingredients that are not dished up by the strategies deployed by so many of the subprime VCs who proudly plaster the blogosphere and technology "flea-markets" (you know which technology trade-shows I am talking about) with their spoon fed investment tactics and meaningless advice.
The public buys into Venture
Not only does the public purchase stock from companies that turn public, it also feeds the funds of Limited Partners who deploy a portion of those funds to Venture.Pension funds, endowment, insurance companies etc. put their reserves from public cash to work to deal with fluctuations in their businesses. So, a Venture business that does not perform well, will not only put pressure on the output of Venture, but will have devastating impact on its input. LPs as the guardians of that money now increasingly are instructed (by their often public boards) to lay off on venture capital.
The highly inefficient financial instrument in Venture severely erodes the potential and trust in the future of innovation.
Treat the public well
The Venture business does not and will not perform significantly better if it, or our government, does not change the market model it deploys (we have an answer for that). As an LP, investing in Venture unchanged is the definition of insanity. Marketplace transparency (to all marketplace participants), that opens up private companies for public review (not investment) is paramount to establish public trust before the company is put on the public auction block by investment bankers.Entrepreneurs should partner only with Venture investors who understand that Venture Capital is designed to protect upside, not downside. That corners cannot be cut in addressing the needs of those people who are expected to buy your public (or indirectly private) stock later on.
Treat the public how you want to be treated. After all, we are the public.
How Venture Capitalists dig their own political grave
May 17, 2010.
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.
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.
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.
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.
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.
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 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.
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.
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.
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.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).
VC is the financial derivative, not the producer of innovation
Thankfully Barack Obama is smarter than most politicians and demonstrates his ability to separate financial derivatives from producers of value with a single statement: “We understand that start-ups and entrepreneurs are the key to leading the US out of the recession.”Notice the subtle distinction in his statement to emphasize the value of innovation versus the value of its financial derivative. The distinction Barack alludes to is that for too long this country has valued the power of financiers higher than the power of the producers of product.
With our financial system eleven times the size of production, our financial system is simply too large, and our economy is too dependent on the fragile promise of gamblers. And while Barney Frank appears committed to protecting the financial derivative without really understanding the merit of that financial instrument, Barack Obama is vowing to protect the producers of value.
Related to Venture, the NVCA attempts to protect the power of VCs (as the financial derivatives), while I aim to protect the future of entrepreneurs. A crucial distinction.
VC has not made the point it deserves special treatment
The biggest problem with Venture today is that it has no political leg to stand on to demand an exemption from the rules imposed on Private Equity. Contrary to the self-serving rhetoric of NVCA members, Venture - fully loaded by commitments from Limited Partners the last twenty years - should have produced absolute returns that outpaced technology adoption (7% growth in the worst of our economy) and emptied out a greenfield of 80% of the worlds population that still does not use technology to its advantage.Venture managed to produce returns below the carriage it rides on. Even by their own statistics, Venture produced less than 10% IRR, lost around $1.7 Trillion in opportunity cost, yielded fleeing numbers of Limited Partners, and embodies an in-transparent market mechanism (in-transparent to all marketplace participants) to which we can only fantasize what financial improprieties will surface when that pandora box is forced to open up.
Nothing ventured, nothing gained
Yet Venture Capital was created some forty years ago as a special sector. A sector that deployed significantly greater risk and rewards than Private Equity. Unlike Private Equity, Venture Capital was meant to take the early risk of a company before it has been proven to deliver market value, on the left-side of Geoffrey Moore's chasm and managed to move it miraculously to a massive deployment on the right side (see the chart at "Redefining Capital Efficiency"). That required a unique foresight only beholden to a specialized investor with relevant experience. A lot has changed since then.On the whole, Venture Capital as the financial instrument to support groundbreaking innovation is dead. Today it can best be described as micro-PE or as we describe here often, as subprime VC (explained in last year's article in support of Vinod Khosla's assessment of the sector). Unfazed, General Partners still rake in cushy management fees (plus micro-PE carry, if at all) defined using rules from the early incarnation of the sector, and blame the lack of results on anything else but themselves. Meanwhile the key stakeholders in the Venture ecosystem, entrepreneurs with groundbreaking ideas and Limited Partners with a large commitment suffer from diminished deployment and return of risk.
So with Venture Capital predominantly operating in micro-PE mode, it is only natural for it to be painted with the same regulatory brush as Private Equity by politicians who do not see a significant difference in role, performance and economic relevance.
Venture born again
But to assume that innovation is dead because of an underperforming financial instrument that controls it is foolish. And to suggest that innovation will suffer from regulations put on VCs is even more ridiculous, where else would their GPs go where downside is more staunchly protected than upside? And it would be easy to replace most of them with better performers.We have incredible entrepreneurial resources that once supported by a proper financial instrument will prove their value in gold again. Venture needs to prove its merit as a valuable financial instrument to support the outliers of innovation and the creation of real social economic value.
The way to escape impending regulations is to offer to the President a new market model in which the merit of the sector is appropriately and authentically represented. A market model that promotes taking Venture risk and promotes upside and punishes downside. A marketplace in which the merit of investors, as individuals can be openly challenged and their rewards appropriately and dynamically adjusted.
Manage our own "back yard"
The approach the NVCA takes is once again that of protecting downside, but doing literally nothing to promote upside. It makes nothing more than empty promises (based on futile arguments about extrapolation or cyclicality of a glorious past) for a better future based on the changing tide of our economy that is supposed to float all boats again.Sure, IPOs will increase a little bit, but little Social Economic Value will be created which will yield disappointing post-IPO performance and a further erosion of public trust, let alone significant LP returns. The NVCA's protectionist stance therefor is actually hurtful to the investors, as the preponderance of evidence shows that Venture cannot operate in the same way it operated yesterday.
We need to step in and fix our own ecosystem, unless we want our government to step in and do it for us. The NVCA needs to change its agenda if it wants to preempt government intervention.
I disagree with the President's approach to financial reform
Most reading the above would therefor assume I agree with the President on financial reform, and I do with a twist.I believe financial reform cannot be established by attempting to curtail all improprieties that occur in our current system that is not a free-market system.
Our financial systems (including Venture) are not free-market systems as they are not transparent to all marketplace participants, are artificially arbitrated, favor the deeply entrenched and do therefor not support a meritocracy. And that means no matter how many great products we invent, even under the "watchful eye" of regulations, the economic value of those products will be severely dampened by the complacency of incumbent investors.
So, the top priority of the President as the head of government (and supported by Larry Summers) is to construct the meritocracy of our financial system, so that all of its future participants can act as watchdogs (or better yet roman geese), establish investor merit and flag improprieties that need escalating and further refinement of law. Venture would be great sector to implement that new market system first.
Regulating the current market system is just a waste of precious time and money.
Until we see the development of such a system, I side with many VCs and even the NVCA, albeit for less altruistic reasons. Without a real free-market system implementing regulations, the industry will quickly establish workarounds and no significant improvement in the support for groundbreaking innovation can be expected.Subprime Venture Capital will not change to prime by simply adjusting the incentives or applying a plethora of regulations, it requires a market model that allows new investors with an authentic ability to spot groundbreaking innovation to join the marketplace and refresh those that have become stale. Even private markets should be transparent (just not publicly investable yet) so the merit of its inherent social economic value is established before the company transitions to a publicly investable entity (IPO).
With the proper free-market construct (as defined in 2010: The State of Venture Capital for our customers), no longer can over-inflated valuations, ramped up by VCs and settled on under the cover of darkness by investment bankers, erode the trust of the public.
So, dear President, stop tinkering with useless regulations and lets fix the systemic risk of our financial systems first.
Redefining Capital Efficiency
May 07, 2010.
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.
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.
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).
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.
So, from now on dear LP and entrepreneur, when you hear a VC mention capital efficiency, run the other way.
[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.
VC roast; how to take Venture for a ride
April 20, 2010.
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.
- 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.
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.
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.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."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
Financial systems are a systemic threat to our economy
The behavior in Venture is very similar to the many improprieties of other financial markets, and simply less overt because of its complete lack of transparency to most marketplace participants. But improper behavior in Venture is like "child abuse" of our growing economy; it cuts off the spirit, zest, fortitude, and vision of young groundbreaking entrepreneurs who have the opportunity to become the new business leaders of our world. We will never be able to recover from the Venture malaise if it persists for too long, other nations are not sitting still.The real optimist in the face of the malaise in Venture is not the one who continues to milk the dysfunction or walks away in search of greener pastures, but the one who builds a systemic fix for the failure in Venture and helps groundbreaking entrepreneurs define a new compass of innovation.
I have done both.
Setting a new goal in Venture
April 14, 2010.
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.
But Venture is looking at the wrong metric of success.
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.
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.
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.
And that would be the kiss of death to Venture and to the wide-open opportunities in innovation that still lie ahead.
The Venture business has got the world upside-down, is what I wrote in a recent comment to a VC and I meant it.
Just as upside-down as many people who buy a house and get a mortgage confuse a liability with an asset. A great example I heard Robert Kiyosaki (from Rich Dad, Poor Dad) refer to in an infomercial in the background while I was doing work on a quiet sunday.
Venture should perform much better
From many discussions, publications, public statements and strategies discussed in new Venture videos it is clear how a large part of the Venture community struggles and puts up relative performance metrics (such as meaningless top-quartile definitions), and pad themselves on the back that Venture is still outperforming public markets. All while technology Venture performance should have blown other asset classes and public markets away, by virtue of its massive greenfield (5/6 of the worlds consumers) and continued growth in technology adoption (even through the worst of our recent economic downturn).But Venture is looking at the wrong metric of success.
Focus on upside
The real issue in Venture is that the innovations Venture Capitalists select, barely have any Social Economic Value (SEV) and therefor by definition have severely limited upside potential. On a scale from Technology to Market, to Execution, to M&A, to IPO, to SEV (as depicted in the enclosed chart), most venture investors today look for technologies and apply their risk thesis to the lefthand-side, or downside of the scale, hoping and praying to ever reach the righthand-side.Frankly, most investors have upside and downside confused, which is the source of their deplorable performance. Technology development is not a testament to ever reaching Social Economic Value. And to demand from entrepreneurs that they build technology is a sign of how they further defer the majority of even downside investment risk to entrepreneurs ("show me what you have built") as a prerequisite to investing (as we explained in the reference to Vinod Khosla's perspective in 2010: The State of Venture Capital).
What we have lost over many years of irrational exuberance in Venture is our ability to spot and target large Social Economic Value. Social Economic Value defined by the trust of the public as a customer, not to be confused with an IPO, which is defined by trust of the public as an investor (preempted by an investment bank).
In the 90s venture investors pushed valuations without value through the IPO funnel, which led to a loss of faith and a retraction of IPOs post 9/11. The way to regain trust with the public is not to sell them another lie, that is based on nothing but the hope and rise of the economy that is supposed to float all boats again, but to have the public use the product as a customer, and let them make up their own mind about its value as an investor. Hence the definition of upside in Venture defined as the creation of Social Economic Value as opposed to an IPO. IPOs will flourish once that public trust from consumers is achieved.
Reverse engineering upside
A fundamental difference in the investment thesis is that as a Venture Investor, instead of looking at the gating technology proposition, you assess an innovation based on the merit of its ability to change the world (where it is likely that no prior implementation exists). But you as the investor can align with the entrepreneur based on a shared vision, compass and the likelihood that the support of that Social Economic Value will feasibly occur within the next five years.And that means that both the entrepreneur and investor share the predictions of the trajectory that builds Social Economic Value, a much better equilibrium between entrepreneur and investor. One in which according to Warren Buffet, the “owner oriented attitude far outweighs the periodic downside". No longer are entrepreneurs pestered with demotivating rounds of ownership dilution based on unpredictable microeconomic aberrations and, no longer do investors waste time worrying about the minutiae that do not affect the Social Economic outcome.
Rather than forward planning from a technology starting point, Social Economic Value is created by back-planning or reverse engineering upside. Meaning, in order to create large SEV a certain IPO range needs to be achieved, which can be swayed by M&A interest, which is created by great execution, which stems from understanding the behavior of marketplaces, which can be served by technology. Technology is the derivative, not the goal.
The distinction between prime and subprime innovation is simple. Prime innovation is attached to existing macro-economic behavior (and usually the absence of technology previously) and relatively easy to predict (I would be happy to share examples), while subprime innovation is attached to a technology wave with a short expiration date and little macro-economic value (a main reason why many acquisitions perform so poorly) that has a minute chance of ever producing viable returns.
Investing different leads to different entrepreneurs
Upside investing applies the proper risk to an early stage Venture, it applies it to the assessment of anything else but technology. Because, as technologists the creation of technology is the least of our risks. But it requires a VC fund that can carry most of the $25M runway needed to create the success of any disruptive Venture today (yes, "capital efficiency" is a lie). The small funds can continue to deploy their subprime risks, while the larger funds have the opportunity to separate themselves macro-economically, by spawning real innovation.The minute you as an investor set a different compass and focus on the creation of Social Economic Value, different entrepreneurs come out of the woodworks that subscribe to that investment thesis. Suddenly you will meet the entrepreneurs that through years of experiencing macro-economic deficiencies, have a vision of how to change the world for the better and as a result generate the large outlier fund returns Limited Partners need to see to stay confident.
Change is inevitable
We may see a slight upswing in IPOs this year, as the economy recovers, micro-PE deals are the best game in town, and those with money to play regain some confidence. But if we as investors do not change our investor tactics and produce real Social Economic Value, it is inevitable that Venture will descent even further to micro-PE than it already has, and continues to suck the risk and returns out of performance.And that would be the kiss of death to Venture and to the wide-open opportunities in innovation that still lie ahead.
My advice to VCs
April 11, 2010.
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;
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.
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.
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.
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:
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.
I am perhaps the most well known (so they say), open and prolific contrarian of the complacent attitude, role and performance of Silicon Valley's most notorious Venture Capitalists (VCs), and frequently I get the question from entrepreneurs suggesting that those VCs must just hate me with a vengeance.
My consistent answer to that question is;
- Very short: "I don't care, the truth needs to be told",
- Longer: "I don't care what the many subprime VCs who underperform think of me",
- Even longer: "I would not raise, nor suggest other entrepreneurs to raise money from VCs who cannot be challenged on their merit, methods and madness",
- Longest: "If they hate me so much, why are many then in conversation with me - my arguments are apparently crisp and tantalizing enough to engage in the debate for a better future"
Tough and fair, yet balanced
The reason why many VCs continue to talk with me is that I've known many for a long time (as a former part-time Venture Partner trolling, eating and networking with them on Sandhill Road) and that my observations are tough but fair and stem from an authentic desire and urge to fix Venture.Honestly, I like many General Partners personally, I just despise the institution they have created - in the same way many of us like their congressmen but hate congress. But smart people can be wrong (and use their smarts to protect their self interests), and many VCs are seriously wrong.
The Venture ecosystem (the way it works top-down) is structurally flawed to which blame could and should be directed to Limited Partners who do not deploy sufficient investment discipline to such a specialized sector, to VCs who have taken the liberty to take the system for a personally prosperous ride, and also to massive volumes of would-be-entrepreneurs, who attracted by the predominantly subprime investment thesis made it significantly harder for VCs to separate subprime from prime innovation.
My observations are also balanced in the sense that I do not subscribe to new mechanisms that treat entrepreneurs unfairly (we just launched a new way to rise groundbreaking innovation above the noise), treat VCs unfairly (which I think The Funded does), and treat LPs unfairly (for whom we built a permanent fix by virtue of a new market model). However, all participants should be held accountable to turn this sector around and produce outlier results consistently.
Why VC needs help
And while I have provided much rationale to clearing up the mysteries for the primary asset holders in Venture; LPs with money and Entrepreneurs with Ideas, my public support for VCs has been waning. Most probable because many VCs come across as arrogant, mislead entrepreneurs (sometimes without realizing it) and are the ultimate protectionists in the Venture ecosystem that leaves every participant unhappy except themselves, living a lush life and raking in astronomical management fees (from largely our public money) that at least secures their life for the next ten years to come.But new General Partners in VC firms like some of my friends who are raising new funds, new GPs like Mark Suster from GRP Partners (a former entrepreneur who appears to agree with many of my observations, see the accolade) and even some we would classify as the older garde of the Venture ecosystem seem interested in a debate as to how their performance and the Venture business can become prime again.
The really "old" goats of the industry who survived the self-induced Venture malaise because of their early foray in the Venture business and hide behind their brand, PIPEs, annex, buyouts, secondaries and massive investment networks that allows them to smooth out (read: level fund returns so they all look optimal) performance, want nothing to do with any anything that could potentially cannibalize their cushy position. But who needs help if they can retreat to their own island and live happily ever after? I still spar with them at times.
So, let's give VCs who have not yet raised their crucial third fund and still need to demonstrate consistent returns to LPs, the benefit of the doubt. Without further ado.
Be aware of the sector's legacy
Limited Partners, as I explained in one of my previous blogs, have become extremely reserved when it comes to treating Venture as a viable asset class (or better, sector). The malaise in Venture is apparent and can no longer be simply explained away by the state of the economy (as Venture is resistant and out-of-cadence with it). Instead Venture by virtue of the growth in technology adoption (7%) should have simply grown rather than declined in performance as better custodians of innovation are able to prove.Hence GPs raising funds need to come up with a much better story than the old tactic of copying the private placement memorandum from a "top-tier" VC that makes the resumes of the GP its biggest differentiation. Me-too funds are no longer funded and a whole new investment thesis must lie at the foundation of those who want to succeed.
Be aware of the pool you dive into
It is crucial to realize that while you may march to the beat of your own drum and with a unique investment thesis, the marketplace consisting of LPs with their asset - money -, and entrepreneurs with their asset - ideas - still has not yet substantially changed. Massive amounts of ideas without substantial Social Economic Value float around, and thus GPs need to be extra savvy to communicate their thesis clearly to prospective entrepreneurs.Moreover the marketplace in which you act as the arbiter of Venture transactions (see our primer) is highly suboptimal. We repeat for clarity from a previous blog why even your stellar performance may do little for your LP. So, an LP that is diversified in many other VC funds may not recognize you as the outlier, because you participate in a marketplace that by definition mutes outlier results:
- A marketplace that marries the assets of supply and demand, with many arbiters not having - or earning - verifiable merit
- A marketplace that marries the assets of supply and demand, using a single commoditized investment thesis
- A marketplace that hides behind the performance of hybrid asset classes, sectors, segments and stages
- A marketplace that hides behind ten levels of diversification of risk
- A marketplace in which the arbiters do not compete (but syndicate)
- A marketplace which openly engages in price-setting and operates as an innovation demi-cartel
- An in-transparent marketplace that functions like a black-box to most marketplace participants
- A marketplace that appears extremely sensitive to economic aberrations
- A marketplace that has not produced healthy returns in twenty years
And that means that with a new fund you are probably better off raising money from a new LP, local or sovereign that understands how to distinguish between the scorn reputation of Venture and the massive greenfield opportunity that unwaveringly lies ahead and you become one of the few commitments in that fund.
Own and prove the validity of your unique thesis
But let's assume you as the GP realize all the above and have your ducks in a row and funds secured, how now do you build solid returns for your $100M plus fund.Minimize syndication
If your investment thesis is indeed unique, you and only you are qualified to carry the risk for your favorite investment. Syndication is fragmentation of LP dollars and thus fragmentation of risk, which turns Venture Capital quickly into micro-PE. As long as the investment has large Social Economic Value, the right amount of focused risk will get it to fruition. Fewer deals at the right intersection of your unique investment thesis, with the appropriate support for upside will produce by definition much higher success rates than the sector average (otherwise your thesis is invalid). So don't be afraid to stand alone.Invest in Social Economic Value
Many VCs have turned subprime, even some of the well know brands. Subprime is not defined solely by how much money is put in a startup but more importantly at which point. Most VCs defer risk to the entrepreneur and therefor create a highly fragile company from the start. The creation of Social Economic Value that can build trust for an IPO has a radically different planning and funding model associated with it.Invest in market principles
For twenty years GPs have used technology as the starting point of making investment decisions. Yet, more crucial is the macro-economic impact of innovation in which technology is the enabler but not the deciding factor. Macro-economic impact can be achieved through multiple technology strategies and is likely to see a few different iterations in its lifetime. The starting incarnation of technology is the least of the investment risks and hardly ever proof that it subscribes to any macro-economic benefit.Become an active investor
Most VCs wait somewhat passively until innovation walks into their door, the appropriate response for many GPs who do not have the experience, credentials and foresight of an entrepreneur. But many innovations, especially those founded upon macro-economic behavior can easily be predicted and thus also ignited by the investor. If you truly know your domain, you should be able to predict and reach out to great entrepreneurs and have them run with some of your vision at times.Communicate your differentiated investment thesis clearly to entrepreneurs
I have heard the complaints from VCs overwhelmed with business plans which forces them to default to their old buddies network. Yet, if you communicate leadership as an investor those entrepreneurs that do not fit your thesis will stop knocking on your door. We experienced that ourselves as we were hesitant to turn commenting in our blog on, for fear of having to respond to the same messages all day, but a few clear answers made entrepreneurs understand what we stand for and diminished the interaction with subprime entrepreneurs significantly. A not so clearly differentiated investment thesis is the source of many wondering would-be-entrepreneurs knocking on every door they can find.Be real and let your authentic merit define you
With the bottom falling out of VC performance, it is important for VCs to be as open and transparent as possible in setting a new tone. A tone that is not embedded in arrogance and ignorance nor a marketing tool to lure in unsuspecting entrepreneurs, but reflects a realization that you understand what the deplorable past of VC has done to innovation and how you intend to chart a much improved course.Getting Venture un-stuck from its subprime maelstrom
April 08, 2010.
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.
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.
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:
It is time we treat Venture like the real marketplace we defined it in our Venture primer.
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.
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:
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."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
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.
Silly Venture, surfing the waves
March 09, 2010.
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.
There never was a Tech bubble
February 23, 2010.
Part of the discovery of coming up with a permanent fix to Venture came not from an endless debate about what happened to Venture (although I am more than willing to do so on occasion) but to envision what should happen to Venture if one were to erect the sector now (something emerging economies are actively pondering).
That is perhaps the reason why the only one who could come up with a permanent fix to Venture is an entrepreneur. Because as an entrepreneur you are born with the gift not to analyze existing market deficiencies (with loads of statistics) until you are blue in the face, but to reconstruct and imagine a new and much bigger opportunity from your (perhaps idealistic) view of how the world should work. And then to develop such a robust new system so the bad things from the past find automatic resistance (not manual labor or government regulation).
And boy, do I believe in a big opportunity in Technology Venture. I even believe it scales.
Is this working for you?
I use the previous phrase from Oprah a lot as it communicates so well that regardless of anyone's rational for the prospects of innovation, the current system under which we deploy it simply does not work. And I pity the LPs who with blinders on, continue down this road expecting a different result. Good luck!To reiterate again, over the last 10 years (some technology celebrities say longer) we, as participants in the sector have generated less than 10% IRR to Limited Partners (LPs, who disseminate their money through VC), wasted about $1.9 Trillion in funds that never produced any public value and have left LPs and entrepreneurs severely disillusioned about the value, viability and path of innovation.
All the while, many Venture Capitalists, as the derivatives (without assets) in this marketplace pride themselves being in the top quartile (a meaningless definition in its own right), or the survivor of "the fittest" of an underperforming sector with little value. They continue to stuff their pockets with a fat-and-happy management fee that allows them to retire for life (sometimes after just one 10-year try and vintage), publicly comforting themselves that the world has changed so much that it is now time for new investors to step in. Thanks a lot, after having taken Venture for a very comfortable ride without producing real returns, and worse, soiling the pool for the rest of us.
The real asset holders in Venture, LPs with money and entrepreneurs with ideas have been fooled (many times over). But by who really?
Who's bubble is it?
As you can tell from the last paragraph I am often irritated by the lack of integrity of many human beings, especially of those who do anything to make a buck. Because VCs with integrity could solve their own issues in Venture without the need for a complete Venture overhaul. But that would require their ability to be self critical (they have done nothing but blame external factors) and people who are confident enough to cannibalize their own position for the greater good. Too idealistic perhaps. And so a new system in Venture needs to include not just measures to provide better upside but a concerted and immediate eradication of those intermediaries that do not perform.But we need to fix the disease not merely fix the symptoms and the following quote from Einstein comes to mind:
"Mistrust of every kind of authority grew out of this experience, a skeptical attitude toward the convictions that were alive in any specific social environment — an attitude that has never again left me, even though, later on, it has been tempered by a better insight into the causal connections." - Albert Einstein
Which I parlay in Venture to:
"I mistrust many venture capitalists for good reason (their lack of merit), but have learned that the casual connection is the dysfunctional financial system that allows them to take it for a ride." - Georges van Hoegaerden
Just like the behavior of a dog is the responsibility of its owner, so is the performance of the VC the responsibility of the Limited Partner. And VC does not perform (and unchanged will not) because it selects companies that are sub-prime innovations that do not have a strong potential to yield public value. And that is because many VCs themselves are sub-prime and therefor unable to spot disruptive innovation to begin with. On top of that we have an in-transparent financial system that allows for bottom-heavy diversification of more than ten layers deep (see "2010: The State of Venture Capital"), that is far removed from an efficient marketplace in which LPs and entrepreneurs can verify the merit of the ideal VC matchmakers.
Blame where blame is due
And so the real owner of the bubble is (again) our financial system that allows sub-prime operators (VCs without entrepreneurial merit) to slip in and mess up the initial success of the venture sector that was so beautifully crafted by Bill Draper and the likes.So, the 2001 implosion was not a tech bubble, but a finance bubble and a clear warning of what is to come to other sectors that deploy the same economic model to their respective domains (I have spotted the pattern).
We need entrepreneurs to think bigger (not more restricted) and unabashed to find the next innovation that can change the world. But only an economic system that deploys prime matchmakers will be able to cherry-pick those prospects. So, in the end we cannot really blame the current crop of sub-prime VCs for getting picked, and they will continue to sit on their throne (a ten year vintage) until time runs out anyway, but we need to change our economic system so we prevent them from entering in the first place. And changing management fees (that some focus on) alone does not turn a sub-prime VC into prime.
With our financial system eleven times the size of production, it is time for the foundation of our economic system to get an overhaul. And Venture would be a great place to start.
Does Venture Scale?
February 22, 2010.
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):
The currently deployed economic model of Venture will never scale, and here is why:
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:
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).
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.
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.
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.
Last week, through a long string of conversations with a CalPERS board member and some trusted peers, I ended up speaking with Joe Dear (Chief Investment Officer) and other members of his Venture team at CalPERS in Sacramento, the largest pension fund in the United States with $200 Billion in total Assets Under Management and single largest investor in the Venture sector (as a Limited Partner, or LP), with an allocation of around $20 Billion in direct and indirect (fund-of-funds) alternative investments (which includes venture).
Joe expressed specific concern about the ailing Venture sector, a message we as participants in the Venture ecosystem should all take very seriously. I do, because I hear it all the time, and it worries me how devastating a withdrawal of CalPERS (10% or so of all U.S. Venture and the consequent ripple) from Venture would be to Silicon Valley and to our country.
Such withdrawal would be devastating to our entrepreneurial capacity and drive to which we owe our statue in the world. We still have many parasites (some quite well known, and not too anxious to be found out) who are too busy deploying ingenious methods to suck this ecosystem dry while it lasts, unable and unwilling to see the dark clouds forming above their heads.
Yet, we all need to pay attention to the discomfort of LPs, and resolve those - not with a new set of lies and promises - but with a breakthrough systemic solution to improve the performance of Venture Capital.
Late to the table in 1988 as portfolio manager Jesús Argüelles explains, CalPERS made up for it in the 90s followed by disappointing performance today. Joe questioned the sector's viability as a whole, by rhetorically asking me (amongst other topics):
Does Venture Scale?
Before I answer that question it is important to note how ignorant the many players in Venture are to the impending threat this question poses.- At this public event, I recognized only two Venture Capital (VC) firms that where present. If as a VC I really wanted to make money for my LP in these turbulent times, I would show up to offer whatever support I can muster. I did: to represent the unwavering value of disruptive innovation.
- No-one of note from the National Venture Capital Association (NVCA) was present according to the attendee listing handed out at the event. Rather than to focus on helping CalPERS generate upside, I guess it prefers to spend its time protecting its members' downside to lawmakers. The VC lobbyist needs to rethink its leadership focus.
- The dismay of LPs in the Venture sector is in sharp contrast to the incessant, blind, self-serving and false optimism of many Venture participants, journalists and investors who continue to suck entrepreneurs dry and leave a subprime Venture pool behind that clouds the opportunity for serious investors and serious entrepreneurs.
- No-one (except we) in the Venture community is truly acknowledging, with a plan of change, how the performance in Venture can systemically be improved. Better times, with more of the same is what many wait for, but hope is not a plan.
- If we do not take the subtle message from CalPERS serious, more than 10% of Venture investments in the United States could suddenly disappear, with many other LPs quickly following suit. And that means that (once again) the deployment of an incompatible financial system destroys the innovative capacity of those that deserve better.
My answer
So, my short answer to Joe's loaded question was:"Sub-prime Venture does not scale, but Prime Venture does".
The currently deployed economic model of Venture will never scale, and here is why:
- Ten levels of diversification with multiple (hybrid) relationships from LP to startup investment makes it impossible to identify the real merit and performance of VCs and the validity of their investment thesis.
- A (loosely coupled) commoditized investment thesis can never outgrow its peers, and thus is incapable of generate meaningful alpha.
- Sub-prime VC systemically destroys the trust of Public Markets by pushing so-called innovations through the funnel, soiling the opportunity for more discretionary value.
The necessity to produce public value
It is a bad idea to ignore the public's perception of Venture Capital. With a large sum of Venture money (roughly $1.9 Trillion) over the last 10 years producing no substantial public value by way of IPO, sub-prime VC has lost the confidence of the public that does not only supply the money to VC (indirectly through the public pension funds, endowments etc.) but is also expected to buy post-IPO stock on the public stock market.So, rather than to continue with "the models for success that have worked for our industry in past decades" as many of the NVCA cohorts continue to preach, we need to rely on a new economic model that fundamentally changes Venture Capital to its core.
Our proposal in the presentation "2010: The State of Venture Capital" will do so and it scales because:
- Our Venture model removes the diversification at the bottom of the Venture equation, exposing VC matchmaker merit and accountability.
- Our Venture model employes dynamic marketplace merit, not static institutional merit.
- Our Venture model attracts unique investment theses that have the ability to find the outliers of innovation.
Incompatible financial systems
The problem with Venture is that traditional financial systems (stemming from more conservative asset classes and times) are incompatible with the risk and returns that early stage Venture has to offer. Over time the old financial system has steadily suffocated, and worse alienated disruptive innovation, by forcing sub-prime innovation through an exit funnel that as a result left a trail of eroded trust.Venture has lost trust with public markets, but even more so with the outlier entrepreneur. Truly disruptive ideas do not even show up at the doorsteps of many VCs any more, because certain corporations have become better custodians of innovation than venture capital (remember those ludicrous buyers/sellers-market arguments of VCs).
Change the dating service
But just because VC is broken does not mean innovation is. We need to re-establish the merit and definition of disruptive innovation and stimulate the creative and intelligent minds that can spawn it. The Internet provides a massive opportunity to tap into the buying power of 5/6th of the world population that is still technologically disenfranchised.But if we leave the Venture Marketplace functioning the way it does today, less money-in will not change the alpha (portfolio returns) for Limited Partners. Survival of the fittest in a dysfunctional market is a worthless asset.
Superior Economics
Smart Limited Partners stay committed and realize that Technology Venture has superior economics, that with the right economic construct has the ability to outperform any other asset class.Technology feeds the brain in the same way water feeds the body. Technology can be served up in many ways to produce, share and monetize knowledge, just like water can be used to produce soup, coffee, tea or anything else you can think of. We have all the ingredients in this country to make lovely dishes, all we need is a better economic system to attract the right chefs with scrumptious recipes.
The new size of Venture Capital
So, stop making statements about whether Venture Capital should be smaller or larger. It's a futile discussion. The size of an inefficient marketplace is irrelevant and thus by definition wrong. First we need to deploy an efficient marketplace (that is designed to find the real merit of innovation), before we can make educated guesses about how to best support it with a proper financial system and size. Lowering the commitment to Venture Capital does not create more efficiency, changing the marketplace does.So, LPs need to deploy a new economic system that systemically roots out sub-prime. The solution that scales to its authentic potential is here today.
New York, an empire state of mind
January 21, 2010.
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.
Why Einstein would be a better VC
January 06, 2010.
I think about the future of Venture Capital a lot (day and night, can you tell?) and how we can continue to drive and fund innovation. And I have said many times that "the quality of the deal intake is only as good as the quality of the investor", which specifically in venture means that an investor needs to have the experience and foresight of an entrepreneur to support others.
Raise the (public) value of innovation
Clearly with truckloads of money from Limited Partners over the last ten years, more highly skilled global entrepreneurs than ever, and 5/6th of the world population still void of essential technology applications, VC has done a deplorable job in the matchmaking process between the assets of the Limited Partner (money) and the assets of entrepreneurs (ideas), which should have tapped into that massive greenfield more aggressively.Less than 10% IRR for more than 10 years, or to use another worrisome statistic: less than 3% of dollars invested in VC over the last ten years leads to the production of any public value by way of IPO (Initial Public Offering), as 10 years of VC investing at $200B/year (give or take) x 10 generated $66B in IPOs (per Dan Primack, PEHub). No wonder the Limited Partners who fund VCs scratch their heads at what just happened to their money.
It's all about the Benjamins (and the quality of people behind the money)
I referred to Albert Einstein before (way back in 2006) and an amuzing article from Dave B Lerner turning Sherlock Holmes into a VC reminded me how the principles of Einstein should be held against the selection process for General Partners (GPs) at a VC fund.Quotes from the Genius
So, with Einstein's Wikipedia encyclopedia at hand let's roll out some of his famous quotes and see how the current state of venture stacks up:"Imagination is more important than knowledge. Knowledge is limited. Imagination encircles the world".
So why do GPs demand to see a product demo before they can decide to invest, is it because they have no imagination? Perhaps we should encircle a world of innovation that is bigger than Silicon Valley?"For knowledge is limited, whereas imagination embraces the entire world, stimulating progress, giving birth to evolution. It is, strictly speaking, a real factor in scientific research".
Why a SuperBowl ring is so much more valuable than an Ivy League ring, in any job in the venture business."A new idea comes suddenly and in a rather intuitive way. But intuition is nothing but the outcome of earlier intellectual experience".
Why relevant entrepreneurial experience is such an important attribute to a VC investor, intuition not analysis drives the selection of rewarding investment decisions."Whether you can observe a thing or not depends on the theory which you use. It is the theory which decides what can be observed".
Silicon Valley has commoditized the investment thesis (or what we refer to as the-same-difference investment thesis), no surprise that it cannot detect disruptive innovation even if it would show up at their doorstep."Falling in love is not at all the most stupid thing that people do — but gravitation cannot be held responsible for it".
GP should not be afraid to feel passionate about their companies and make independent investment decisions (that may not find other syndicates), but the gravity of investment commoditization can not be held responsible if they do not."It can scarcely be denied that the supreme goal of all theory is to make the irreducible basic elements as simple and as few as possible without having to surrender the adequate representation of a single datum of experience".
Customers need simpler technology solutions, not more complex. As investors that means we should not invest in technology, but the application of technology to meet customer needs. But not so simple that it has no macro-economic and public relevance (IPO)."Humanity has every reason to place the proclaimers of high moral standards and values above the discoverers of objective truth".
A higher moral standard in the venture business would ensure that we deploy free-market principles to the support for innovation. We are far removed from deploying transparency to the venture business that would expose the true merit of investors with the true merit of entrepreneurs. Only then will the truth reveal itself."A happy man is too satisfied with the present to dwell too much on the future".
GPs locked up into 10-year fund vintages are fat and happy, too happy to dwell to much on the malaise in venture."The state of mind which enables a man to do work of this kind is akin to that of the religious worshiper or the lover; the daily effort comes from no deliberate intention or program, but straight from the heart".
Great convictions from the heart lead to great investments and financial returns in venture. The investor who is content with the current investment program will soon meet his maker."I am by heritage a Jew, by citizenship a Swiss, and by makeup a human being, and only a human being, without any special attachment to any state or national entity whatsoever".
We are citizens of our world, so perhaps we should start investing that way. We need to get away from Sand Hill Road more often and tap into global resources, not just to fund entrepreneurs but also to experience and understand what drives global marketplaces."Concepts that have proven useful in ordering things easily achieve such authority over us that we forget their earthly origins and accept them as unalterable givens. Their excessive authority will be broken".
Just because we have constructed the relationships between Limited Partners and VCs in a certain organized fashion does not mean we should accept them. Especially not when performance proves the vast majority of those relationships do not work out to satisfaction."Great spirits have always encountered violent opposition from mediocre minds. The mediocre mind is incapable of understanding the man who refuses to bow blindly to conventional prejudices and chooses instead to express his opinions courageously and honestly".
Entrepreneurs should expect to receive violent opposition from mediocre VCs (who focus on technology builds), but entrepreneurs should remain courageous and honest. Courageous in their entrepreneurial ideas and honest about their ability to build them."The important thing is not to stop questioning; curiosity has its own reason for existing".
Many people take for granted what has been imprinted in their brains from childhood, but you would be surprised to learn how many of those things are actually false. Not by design, but by interpretation. Drill deep in what you have been told as the truth and you will find new opportunities for innovation."Nature shows us only the tail of the lion. But I do not doubt that the lion belongs to it even though he cannot at once reveal himself because of his enormous size".
A Long Tail without a Torso is meaningless."What is thought to be a "system" is after all, just conventional, and I do not see how one is supposed to divide up the world objectively so that one can make statements about parts".
Markets do not exist, as I have stated many times before. Only marketplaces do, in which the choices of individual participants with unique ideas are married."Few people are capable of expressing with equanimity opinions which differ from the prejudices of their social environment. Most people are even incapable of forming such opinions".
The social environment on Sand Hill Road that has perpetuated the mediocrity in venture is preventing GPs from expressing opinions about how it should change. In fact, none of the Limited Partners I spoke to have received a viable plan from VC as to how to combat the venture malaise we are in."My political ideal is democracy. Let every man be respected as an individual and no man idolized".
When you do not belong to the (subprime) "venture club" or play their game, you are not let in and respected. So why should we repay that homage back with idolization?"The really valuable thing in the pageant of human life seems to me not the State but the creative, sentient individual, the personality; it alone creates the noble and the sublime, while the herd as such remains dull in thought and dull in feeling".
Meritocracies are created by transparency, and we have none in venture. No surprise it is dull in thought and dull in feeling."My passion for social justice has often brought me into conflict with people, as did my aversion to any obligation and dependence I do not regard as absolutely necessary".
Free-markets are created by meritocracies that rely on transparency. The social justice of a meritocracy is hard to grasp for those who hide behind walled gardens to protect their own insecurities."Mistrust of every kind of authority grew out of this experience, a skeptical attitude toward the convictions that were alive in any specific social environment — an attitude that has never again left me, even though, later on, it has been tempered by a better insight into the causal connections".
I mistrust many venture investors for good reason (their lack of merit), but have learned that the casual connection is the dysfunctional financial system that allows VCs to take it for a ride."Everyone is aware of the difficult and menacing situation in which human society -- shrunk into one community with a common fate — now finds itself, but only a few act accordingly".
Waiting, talking and reporting about the malaise in venture is one thing, offering solutions to it is another."The economic anarchy of capitalist society as it exists today is, in my opinion, the real source of the evil".
That is of course because the only form of capitalism we practice today is far from a meritocracy. Capitalism spawned by meritocracy is a wonderful thing and builds opportunity for all people with merit (within the Long Tail and the Torso).No need to be Einstein to become a VC
Einstein himself did not think he was special and neither should a VC. All you need to become one is solid early stage experience and a vivid imagination of how the world should work.Yet to make venture work, Limited Partners need to start by deploying money to GPs who themselves have proven how those crucial attributes helped them cross the chasm, before those GPs are allowed to tell other entrepreneurs how to do the same.
My investment and drive is for democracy, meritocracy and capitalism to work hand-in-hand to produce the powerful innovation that enhances the lives of people around the world. Until that happens, I leave you with a last quote from the Genius himself: "To punish me for my contempt of authority, Fate has made me an authority myself".
Happy New Year!
Predicting the future is why macro matters
January 05, 2010.
As an investor, and especially a venture capital investor you need to have the ability to predict the future within an acceptable degree of accuracy. And that is exactly a skill many venture capitalists (VCs) so miss out on and generate such mediocre returns. The value of their innovation is simply not meaningful enough.
Venture Capital differs fundamentally from (other forms of) Private Equity in that it requires an extraordinary level of foresight and prescience. After all, one needs to believe in something that does not already exist and little proof exist it ever will - or is there?
It is impossible to predict what technology will prevail
VCs today are still too focused on technology, even though many proclaim to understand markets (more on that later). The reality is that rarely any business without a technology demo gets funded these days. Yet popular technology flavors change frequently (every three years or so) and betting on technology is a foolish game. We should know by now.Driven by the urge to produce results within ten year vintages and complicated by the (we claim, self induced) lack of IPOs and M&A, the majority of VCs have retracted to a short term investment focus, massive diversification and fragmentation of investment dollars. Quite the opposite of what should have happened to the venture business.
But how do you tell someone to step into the circus ring to tame a tiger, without having had the confidence and prior experience to do so. It is just not going to happen. Change in the venture business needs to come from the top.
Limited Partners who do not refresh their VC commitments and requirements now, are bound to lose big-time on venture pipelines stuffed with sub-prime investments with no place to go.
It is easy to predict what macro-economics will prevail
Warren Buffett said it right in a recent interview with Charlie Rose in that the future long term is a lot easier to predict than the short term. Or the way I tell my wife; I don't know where I'll be during the day, but you can count on me coming home for dinner.In business, long term value does not discount the need for short term planning, but short term without long term (or macro) is a loosing gambit. Here are some examples of the lack of macro-economics and its failures :
- The venture ecosystem
The venture capital ecosystem consists of ten(!) layers of diversification before the dollars from a Limited Partner lands into the bank account of the company of an entrepreneur. No matter what your views on the venture business, but anyone who has attended business school should know that this kind of over-diversification leads to a morass of accountability and in-transparency of results. Without fundamental change to the way venture works today, venture is poised to become more mediocre than its today. Venture is macro-economically broken. The reason why we provide a solution for Limited Partners here.- The VC intake model
Most venture capitalists sit impatiently through an entrepreneur pitch, checking their blackberry's until the product demo. Not only does this communicate the VC has no empathy for the macro-economics, it also communicates that technology risk is the only risk they think they can assess. Per previous analogy, those VCs are the wives who call their husbands twenty times per day, just to know where you are. They demonstrate a lack of understanding and lack of faith in macro-economics and an improper assessment of investment risk.- Entrepreneur pitches
Perhaps dumbed down by the only pitch process that leads to getting money from (sub-prime) VCs, many entrepreneurs pitch technology without understanding the macro-economic forces at work that prevent a pure technology play (albeit perhaps better) from having access to paying customers. When a large incumbent owns the access to the majority of customers through perception, a proprietary business model or otherwise, technology innovation without a fundamental disruption of the business model is worth very little. Entrepreneurs need to think business and include macro-economics.- Marketing experts
Markets do not exist. Yep, I said it (and yes, I have worked in "marketing" too). Market definitions are stale and artificially extrapolate people that once exhibited a common purchasing decision into individuals that from then on behave the same way going forward. They don't.We all know instinctively that every individual is different (even when that individual represents a company), that none of us like to be put in a box and that our reason for purchasing is unique and more than simply price/performance ratios. In addition we participate in multiple competitive and complimentary marketplaces in whatever order we deem appropriate. And any attempt to put marketplace participants in a fixed market bracket is therefor hopelessly self-serving.
Markets do not exist, but marketplaces do. The impetus to participate is extremely complex, complex to quantify yet not complex to qualify. A simple need for improved relevance and better value - based on individual needs and objectives. Marketplaces are no longer one-to-many, but have become many-to-many, with social networks emphasizing and echoing those individual requirements. The long tail of supply is met with a long tail of demand.
So, macro-economically the basis of marketing is flawed. Product success is not driven by marketing, but rather by how true the product is to its promise. And that means marketers who make product decisions based on market numbers are wrong and so are the investment decisions derived from market analyses.
Be ready for the swing test
Macro-economics really matter as it defines whether you have a chance of making it big, but not without careful micro-economic fulfillment. As an entrepreneur "dating" the right investor you need to be prepared for the swing test that goes roughly as follows:Explain the vision, explain the product experience, explain the business model, explain the technology, explain the scalability, explain the product requirements, etc. etc. going back and forth between macro and micro until the swing comes to a halt with no questions left unanswered. Now, investor and entrepreneur have a common understanding of the risks involved for the road ahead.
A new investment focus
As experienced technologists we know we have many technology options to support a macro-economic need, and technology development is the least of our risks. The real question is whether the application of technology makes acute macro-economic sense. And surprisingly enough and again in agreement with Buffett, macro-economically we are not much different from a hundred years ago.We like to play music, iTunes anyone? We like to stay connected, Facebook anyone? We enjoy free-trade, eBay anyone? Many other macro-economic desires remain unfulfilled with technology. Opportunity abound.
Fulfilling support for that macro-economic need is what Venture Capital should be all about. And it will again when we as Limited Partners tell the referees (the VCs) that the rules for investing have changed. That our expectations for VC are to chase macro-economic impact, rather than to allow the mindless technology herding to continue.
Endless opportunity for great returns
Supporting existing macro-economics with a more meaningful technology experience that meets the needs of 5/6th of the worlds population, that still does not use a meaningful internet application, makes for a fantastic and highly scalable investment thesis. One that we should allocate more-not-less money to as Limited Partners.But we need to change our tune, now, before it all comes crashing down on us.
Introducing The State of Venture Capital
December 17, 2009.
By Georges van Hoegaerden
The Prelude to 2010: The State of Venture Capital is now available for public viewing here.
Less is more; moving regulations from government to the marketplace
November 18, 2009.
For the first time I listened in on a live interview by members of Congress with members of the Private Equity and Venture Capital community recently. I was surprised and-then-not that Congress, who closed its eyes and ears to the malaise of our financial systems for so long, is now also buying into the arguments from the participants of that malfunctioning marketplace that there is no systemic risk in Private Equity's Venture sub-sector. Duh!
Massive systemic risk, financial and spiritual
Congress and the majority of VCs are (again) so wrong. Do we really need more evidence to justify change?- Less than 10% IRR produced by VC for the last 10 years makes many Limited Partners wonder why they should put their money in Venture Capital, and rightfully so. The result of some of the LP's withdrawal results in a lack of support for the sector, even if miraculously VC would get its act together. The cultural advantage we have to produce an endless stream of innovation is (and has been, some argue) suppressed by an underperforming financial system that sits on top and squeezes the air out of it. Our competitive advantage as a nation is at stake.
- $2.9 trillion in spin-out revenues (as reported by Polaris Ventures in its public address to Congress) produced by VC over the last thirty years is about to significantly deflate as a result of lack of exits over the last ten years. The Venture business has produced very few real companies in the last 10 years or so, resulting in a massive erosion of spin-out revenues.
- Roughly $297B in yearly venture commitments is hoping on "external factors" to recover, ignoring that sub-prime (or micro-PE) VC tactics are preventing the intake of truly disruptive innovation that would have had the potential to create significant returns. And that while early stage innovation is very resistant to economic aberrations and in many cases thrives because of it.
- We agree with some of the titans in the VC business (Mike Moritz, Vinod Khosla, etc.) that Venture Capital has been broken for 20-years, meaning we are steadily amassing a deficit of 40 years of investing in the wrong innovation, further deflating our competitive advantage as an innovative economy.
- The participants in the venture business (see "How to fix VC once and for all") with real assets, the Limited Partner (money) and the disruptive entrepreneur (idea) are unhappy with the artificial arbitration of Venture Capital, yielding a departure and declining entry of both. So, despite great spin-stories and self congratulatory statistics from VC lobbying organizations (such as the NVCA) we are witnessing the net outcome of a severe decline in venture job creation and value.
- It is dangerous for Congress to rate our systemic risk low because of the sheer size of our financial system, proudly described by one member of Congress to be larger than that of China, India and Europe combined. I surmise that is because our financial system is bloated with derivatives, currently eleven times the size of production. We have become a nation of gamblers in derivatives rather than direct investors in the creation of disruptive innovation. The size of our in-transparent and mostly derivative financial system is an unstable and unsustainable foundation to our economy.
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.
Why VCs really need relevant operating experience, now
November 05, 2009.
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:
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.
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.
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.
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.
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
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.
What Silicon Valley can learn from the Shark Tank
October 23, 2009.
The currently running TV show The Shark Tank on ABC produced by Mark Burnett is an amuzing, dare I say reality show in which five investors confront entrepreneurs with direct investment decisions into fledgling startup companies.
What the investors on the Shark Tank have in common with Silicon Valley is that their seed funding rounds range from $50,000 to $1M, yet often in more than pure technology plays.
While the title of the show sounds harsh, and some of its investors are, its actual workings is much better and more sincere than that of Silicon Valley:
Investors with relevant operating experience
Kevin O'Leary, Barbara Corcoran, Robert Herjavec, Daymond John and least impressive Kevin Harrington have earned their stripes in running very successful businesses with exits to boot. They demonstrate their knowledge and experience in making impromptu investment decisions and their ability to deliver their value-add to entrepreneur. So unlike Silicon Valley.Transparency of decision making
Not only is the investment decision occurring almost immediately (or declined at the same pace), the reasoning of such decisions is happening right in front of the entrepreneur. The entrepreneur is able to respond, interject and argue a refusal to invest if he believes the arguments are invalid, and worth rebutting. Transparancy of decision making allows for a better alignment between entrepreneur and investor. So unlike Silicon Valley.Open competition between investors
Once the interest in a startup has been established, the key investors Kevin, Barbara and Robert publicly fight over the deal like lions devouring a kill. Kevin cannot help but expose his unruly personality and because of it never gets his way, which reminds me of many Sand Hill Road investors. Robert is the more level headed investor who keeps his cool and his smarts at every turn, and Barbara perhaps the shrewdest of them all, waits silently until the boys have finished argueing and often walks away with the grand prize. All while the entrepreneur enjoys a steady increase in valuations and moneys invested. So unlike Silicon Valley.There are many aspects of the show that are compelling and an interesting watch for entrepreneurs. The Shark Tank demonstrates why Silicon Valley needs the transparancy, that leads to a meritocracy that leads to the discovery of truly disruptive innovation (as described in "How to fix VC once and for all"). The show also points out how badly Venture Capital treats entrepreneurs and how it has stooped below the tactics of the Sharks in Nature's pyramid of investing.
Bottom feeding comes to mind.
The importance of being free-and-earnest
October 20, 2009.
I have had several discussions and e-mail conversations with entrepreneurs, journalists and venture capitalists (VC) about the free-market principles described in my blog "How to fix VC once and for all". In that blog I propose to apply free-market principles to the marketplace of innovation, in connecting the assets of the Limited Partner (LPs): money, with the assets of the entrepreneur: ideas.
What struck me most is how few people are familiar with those macro-economic principles that beyond consumer benefits have a significant impact on how an entrepreneur goes to market and how VCs fund them.
VC feedback
Especially eerie, short and dismissive was the interaction with one of the most well-known VC czars of Silicon Valley, who publicly proclaims to be a proponent of free-markets (that is exactly why I contacted him) yet does not seem to understand their basic premise. He brushed off my marketplace-for-innovation plan as just more creeping Socialism.I am of course the fool, for telling the old-boys club to now support a meritocracy, and dump the walled gardens that made it fat-and-happy in the first place.
I knew that switching to free-markets will unleash the protectionist stance in many VCs. But what worries me more is that the opinions and decisions made by this General Partner (GP) impact startups whose successes are predicated on a firm understanding of macro-economics. His responses mean that this GP would simply brush off platform investments that embody free-market principles (eBay and the Apple AppStore for example) as socialistic movements. History proves that is not a good idea.
And that dear reader, is what the rest of the world (and the majority of Silicon Valley) looks up to. We blindly copy methodologies that no longer work in the hopes that 20-years of underperforming past behavior is not indicative of future behavior. It is all someone else's fault.
Start praying.
Debunking free-market myths
But where there is smoke there is fire (aptly considering the many other fires in California) and it is important for the marketplace participants, LPs (money) and entrepreneurs (ideas) who bring real assets to the table, to get a good understanding of free-market benefits. So, let me debunk some free-market myths:Myth #1: free-markets are socialistic movements
A free-market is a self-regulatory instrument that ensures that a true meritocracy prevails, destroying artificial walled gardens such as geography, demography, old-boy status, first-mover advantage etc. A free-market ensures that the quality of the authentic value-add by each participant is evaluated based on its independent merit. A free-market therefor is the ultimate in capitalism, those who build earnest value will prevail.Myth #2: free-markets require a lot of governance
More and different regulation than none, for sure. But the regulation will not come from government but from the marketplace participants (see my blog "Why innovation needs regulation"). When transparancy to all participants (a requirement of free-markets) is implemented, all participants benefit from the exposure and individual merit becomes the governor.Myth #3: free-market transparency is unwanted
Transparency promotes competition, and competition based on merit is good for LPs, VCs and entrepreneurs. Merit yields better value to the detection of outlyers who lay at the foundation of disruptive innovation. LPs will benefit because in the formation of new funds, they can proactively bid to get in on a VC fund they previously only had access to when approached. New LPs can enter the fray and compete at an equal level. Small LPs can bid alongside large LPs. Entrepreneurs gain precious time in dealing with VC that have proven merit, and achieve more attractive valuations and secure better runway support - reducing the infant death syndrome as a result of investor lock-ins. VCs who are comfortable that money is not the only value they offer should feel confident their role is secured by the merit of their value-add.But even if you are not convinced that the current VC performance is a systemic risk, a move to a free-market mechanism that (if nothing else) offers the transparency to all participants, is the fastest way to prove the other side of the argument wrong.
My hope is that we, in the venture business, establish these free-market principles voluntarily and without intervention from the government. But the feedback to my query as witnessed by the protectionist answers from VCs does not hold a lot of promise.
With a systemic risk of $2.9 trillion of innovation-spin-out revenues quickly deflating, we face a similar overruling by the government as healthcare, where rather than a voluntary free-market, a free-market with arbitrage from the government will be forced upon us.
Take your pick.
How to fix VC once and for all
October 11, 2009.
By Georges van Hoegaerden
The venture business needs an overhaul, and below is my low-burden / high-impact plan for change.
Top technology and investment experts, like Larry Ellison, Vinod Khosla, Greg Lamond and many other illuminaries now subscribe to the mediocrity of the current state of venture, with Mike Moritz (GP Sequioa) stating venture has been underperforming for 20 years. I agree.
Direct and circumstantial evidence suggests that the venture business needs a major overhaul, to ensure that the assets of the Limited Partners (money) are effectively lined up with the unwavering assets of the entrepreneur (innovation). Just because the intermediary "dating" service (VC) is broken does not mean we should lead to conclude supply (LP) and demand (entrepreneur) side participants are.
LPs are still looking to deploy high-risk/high-yield commitments and entrepreneurs are still coming up with highly disruptive ideas. The economic marketplace where those transactions occur is simply structurally ineffective.
That means all participants need to adopt free-market principles so that the merit of their work, not an artificially privileged status distinquishes them from others. Such is the necessary, sustainable and thriving foundation for innovation and capitalism.
No one will be able to hide, and the marketplace as a whole will automatically give preference to those participants and their transactions that build real success. Only capitalism based on merit is sustainable long-term.
Above is a simplified chart that depicts the venture marketplace. For those unfamiliar: LPs invest in VC funds who, by virtue of a lead GP invests in the startup of an entrepreneur. LPs set aside a predetermined commitment to the VC fund and GPs make capital calls when required by their investments into startups. GPs allocate a certain runway for startups and at funding time stage their investment in investment rounds to mitigate risk. At M&A or IPO cash is returned to the VC in exchange for the equity position and VC returns a part of those funds (minus management fees and other reserves) back to the LPs.
Because today the cartel VCs have formed around their collective wisdom, outdated execution and dismal returns prevent really smart entrepreneurs from participating in venture transactions to begin with. If VCs believe so firmly in the proprietary value-add of their services to the investment process, why would they be afraid to disclose everything but their secret sauce. Investment dollars into a company can be derived from other sources, but is very cumbersome if not impossible to retrofit to the exact origination and source in the marketplace model.
LPs would have less of a problem disclosing such information and many, like pension funds, already do. But they will need to firm up that reporting to the standards of the marketplace, not an incomplete disclosure that does not match up with that of its peers.
Not all transparency is created equal, in a marketplace the transparency needs to be provided to all participants; LPs, VCs and entrepreneurs in the same fashion. Not just in case of suspected abuse and post-mortem to the SEC, since that kind of transparency does little to promote marketplace merit.
In the same way banks are supposed to report certain transactions above $5,000 should we disclose the investments in private companies above a certain threshold. In other places outside the U.S. (such as Europe) private companies already need to abide to certain disclosures, paving the way for meritocracy.
Entrepreneurs are often proud to disclose how much money their idea generated were it not for acquirers, who afraid of competition often press for non-disclosure. Yet those numbers will now come out of the new marketplace, and competition as a vital ingredient for exits is re-established as well.
Once we have the fundamental transparency of the marketplace in place, the following benefits will surface almost immediately (especially when we apply this transparency retroactively):
Transparency to all participants will act as the dynamic referee in an ever changing venture business. Compared to the past, merit will now closely follow and support the change of innovation, rather than remain stale and outdated. And the meritocracy of the marketplace will also determine whether or not the venture business is too large, too small, or just right. But it would be highly inaccurate and irresponsible to make those decisions based on the workings of the venture business today.
The venture business is too important to our economy (for the reasons mentioned above) and we owe it to the entrepreneurs (across the world) to build a financial system that supports the merits of their intellectual brainpower.
Join me in this effort and feel free to spread the word, syndicate this blog (with proper attribution and link-back) and retweet. Let's make positive change happen.
The venture business needs an overhaul, and below is my low-burden / high-impact plan for change.
Problem
Venture Capital (VC) is a systemic risk to our innovative culture, to $200B in direct asset allocations and to $2.9 trillion in spawned revenues (since 1970, per IHS Global Insight report). Yet VC has produced less than 10% IRR for the last ten years promoting a fear/flight response by Limited Partners (LPs), on the verge of pulling their money out of the sector and investing it elsewhere.Top technology and investment experts, like Larry Ellison, Vinod Khosla, Greg Lamond and many other illuminaries now subscribe to the mediocrity of the current state of venture, with Mike Moritz (GP Sequioa) stating venture has been underperforming for 20 years. I agree.
Direct and circumstantial evidence suggests that the venture business needs a major overhaul, to ensure that the assets of the Limited Partners (money) are effectively lined up with the unwavering assets of the entrepreneur (innovation). Just because the intermediary "dating" service (VC) is broken does not mean we should lead to conclude supply (LP) and demand (entrepreneur) side participants are.
LPs are still looking to deploy high-risk/high-yield commitments and entrepreneurs are still coming up with highly disruptive ideas. The economic marketplace where those transactions occur is simply structurally ineffective.
Opportunity
Technology venture should be producing premium returns because of:- Its infancy, 5/6 of the worlds population is not connected via broadband, exposing a massive greenfield of new unexplored market opportunities.
- Relatively (compared to other sectors) low cost of production, software applications and services require no physical manufacturing.
- Low cost of distribution, the internet distribution is effective and low cost (as long as the product is good enough).
- Immediacy of customer fulfillment, the impact of internet applications is instant.
- Independent ownership of the complete value-chain from idea-to-customer means the risk to success is highly predictable.
Solution
We can all argue until we are blue in the face as to what is a great venture investment strategy, and I certainly have my opinions. But none of that matters. What matters is to create success for those that put assets to work, financial success to the LP and entrepreneurial success to the inventor. What matters is merit not rethoric.Venture investing needs to move from an artificially restricted market to a free-market in which the transparency of, and to all participants identifies and perpetuates the ever changing meritocracy of innovation.
That means all participants need to adopt free-market principles so that the merit of their work, not an artificially privileged status distinquishes them from others. Such is the necessary, sustainable and thriving foundation for innovation and capitalism.
No one will be able to hide, and the marketplace as a whole will automatically give preference to those participants and their transactions that build real success. Only capitalism based on merit is sustainable long-term.
Above is a simplified chart that depicts the venture marketplace. For those unfamiliar: LPs invest in VC funds who, by virtue of a lead GP invests in the startup of an entrepreneur. LPs set aside a predetermined commitment to the VC fund and GPs make capital calls when required by their investments into startups. GPs allocate a certain runway for startups and at funding time stage their investment in investment rounds to mitigate risk. At M&A or IPO cash is returned to the VC in exchange for the equity position and VC returns a part of those funds (minus management fees and other reserves) back to the LPs.
Transparency leads to meritocracy
To enable a meritocracy the marketplace needs to enforce full transparency to all of its participants. At the transaction level by GP, not by VC firm. More important than to feed the Security and Exchange Commission (SEC), the marketplace itself (not a government agency) will then govern its own success:- LPs need to disclose their commitments, how much is drawn, when, running returns and include the fund maturation date
- GPs need to disclose which companies they invest in, how much and at what valuation
- Entrepreneurs need to disclose what exit returns they produce
Because today the cartel VCs have formed around their collective wisdom, outdated execution and dismal returns prevent really smart entrepreneurs from participating in venture transactions to begin with. If VCs believe so firmly in the proprietary value-add of their services to the investment process, why would they be afraid to disclose everything but their secret sauce. Investment dollars into a company can be derived from other sources, but is very cumbersome if not impossible to retrofit to the exact origination and source in the marketplace model.
LPs would have less of a problem disclosing such information and many, like pension funds, already do. But they will need to firm up that reporting to the standards of the marketplace, not an incomplete disclosure that does not match up with that of its peers.
Not public is not private
Economically and to minimize abuse, all companies should be transparent to some extent, including private companies at least to meet the above described marketplace requirements.Not all transparency is created equal, in a marketplace the transparency needs to be provided to all participants; LPs, VCs and entrepreneurs in the same fashion. Not just in case of suspected abuse and post-mortem to the SEC, since that kind of transparency does little to promote marketplace merit.
In the same way banks are supposed to report certain transactions above $5,000 should we disclose the investments in private companies above a certain threshold. In other places outside the U.S. (such as Europe) private companies already need to abide to certain disclosures, paving the way for meritocracy.
Entrepreneurs are often proud to disclose how much money their idea generated were it not for acquirers, who afraid of competition often press for non-disclosure. Yet those numbers will now come out of the new marketplace, and competition as a vital ingredient for exits is re-established as well.
Once we have the fundamental transparency of the marketplace in place, the following benefits will surface almost immediately (especially when we apply this transparency retroactively):
- We will know which VC actually has money to deploy, and entrepreneurs will not be wasting precious cycles
- We will know which VC actually has a reputation of building successful companies
- We will know which GP actually has earned the reputation to sit on a board
- We will know which GP actually has the foresight and credentials to invest in upside rather than downside
- We will know the merit of GP vision, specialties and domain experience
- The meritocracy of investments will support the long-tail of ideas rather than regurgitate its commodization
Low burden change, immediate impact
The goal of this plan is to serve the risk/reward needs of LPs and connect that with highly disruptive innovation from great entrepreneurs. No drastic changes need to be made to the current investment model. No drastic change in the investment pace needs to take place until the meritocracy demonstrates otherwise.Transparency to all participants will act as the dynamic referee in an ever changing venture business. Compared to the past, merit will now closely follow and support the change of innovation, rather than remain stale and outdated. And the meritocracy of the marketplace will also determine whether or not the venture business is too large, too small, or just right. But it would be highly inaccurate and irresponsible to make those decisions based on the workings of the venture business today.
How you can help
I am already working with individual LPs to familiarize them with the specific rollout of this plan, and I invite others to participate (contact us here). I also extend a hand to VCs, some of whom have responded, to become be part of the solution. I would like nothing more for us, as participants to the venture business to solve our own problems, without the need for government intervention.The venture business is too important to our economy (for the reasons mentioned above) and we owe it to the entrepreneurs (across the world) to build a financial system that supports the merits of their intellectual brainpower.
Join me in this effort and feel free to spread the word, syndicate this blog (with proper attribution and link-back) and retweet. Let's make positive change happen.
The nitwits on Sand Hill Road
October 02, 2009.
I could not help but chuckle (again) when Oracle's 30-year-running CEO, Larry Ellison (full disclosure) fiercely yelled out the words from the title of this blog, referring to the artificial arbitration of innovation applied by Venture Capitalists (VCs) we talk about in this blog so often.
Sand Hill Road, for those unfamiliar is the street in Menlo Park, California where the majority of Silicon Valley VC enjoy some of the most expensive office rent in the country and invite their often starving entrepreneurs to "beg" for money. The area is considered the birthplace of Venture Capital.
Larry goes on to say that Venture Capitalists think that innovation is like coming up with a new technology buzzword, expressing his specific dismay with the term cloud computing (watch the Churchill Club interview on YouTube, skip to 47:53 min if you don't like boating).
The reason why I bring that up is four-fold:
- Entrepreneurs are subject to this artificial arbitration (that is applied with the seasonality and commonality of fashion) as the primary method to get their high growth company funded. Entrepreneurs think that "wisdom" leads to success, yet deplorable VC returns prove otherwise.
- Limited Partners (LPs) seem to respond commensurate with their limited allocation in venture (usually less than 15% of total allocation) and their natural inclination is to rest with the excuses (we debunked) from VCs, who never fail to reiterate that cyclical behavior of the financial markets and the economy are to blame for the deplorable returns in venture.
- VCs are downplaying the systemic risk of this artificial arbitration (applied by the venture investor cartel) to our government, stating that $200B of venture investments pose less systemic risk than other asset classes, while completely ignoring that their behavior kills the meritocracy and innovative culture our country was founded upon.
- Other VCs in the country (and around the world) copy the tactics of Silicon Valley investors, with similar results awaiting them.
Still not listening? Stanford, Yale, Harvard and Princeton universities all appear to be suffering from significant losses to their endowment as a result of investments in "alternative" assets, which includes venture capital. To combat, according to PE Hub, Stanford has just raised a $1 billion in a bond offering last April in case of a “true emergency".
By the way: with those Ivy League universities having bred the most renowned economists and professors in entrepreneurship does anyone question whether their expertise is worth the tuition? Are the experts really what they claim?
How much exactly of that depressing news can be contributed to the performance of Venture Capital is not clear to me today (Hedge funds and Private Equity are the most common other assets) yet reports from both CalPERS and CalSTRS pension funds suggest a lackluster contribution of VC across the venture spectrum.
Deaf? Many of my peers in executive positions at Apple, Cisco, Oracle, HP, eBay refuse to enter the venture fray in which the equilibrium of entrepreneur and investor is completely out of whack. The cyclical nature of the downward sub-prime spiral continues to rear its ugly head. The only entrepreneurs that submit to sub-prime investments today are as sub-prime as their investors, incapable of building great fund performance.
The alarm bells are ringing. Limited Partners need to wake up, simply because of the loud reverberation of a vast preponderance of circumstantial evidence. It is time for LPs to listen, not to popular opinion from the people who got them in this financial debacle in the first place, but to people who offer ideas that simply serve entrepreneurs better. The time for change is now.
Passively waiting for consensus on data driven views is guaranteed to lead us to what Larry referred to as an L-shape recovery in the venture business.
VC is dead, long live VC
September 02, 2009.
By Georges van Hoegaerden
I read Bill Gurley's article on "What is really happening to the Venture Capital Industry" and submited my reply. While his article provides a decent explanation of the mechanics of Venture Capital (VC) today, especially for entrepreneurs who want to get to know the workings of VC better, it (again) offers no clues as to how it should work. Those of us working in the venture sector know how LP allocations work, the important question is (just like with innovation): what should a brighter future look like. And Bill's article falls very short on that.
It is true that VC should be the most effective way to get early stage innovation out of the gate. The reality is that in many cases VC is not, and has not proven to deliver the promised value. Some describe the VC sector as broken, others blame it on mechanics, or a too large VC pool, or mega funds, or a sudden lack of exits, or the economy, or anything else they can hang their hat on - with the media having a field day delving into the pros and cons of every argument.
And with money to distribute, the articles from VCs - who created the problem in the first place - gain most of the popular momentum. At this point do we really believe their analysis is credible? But that is why you are now reading this blog too, so lets continue...
LPs expect the venture sector to outpace their other (often less risky) asset allocations and entrepreneurs want to change the world and get rich while doing it (in that order). LPs have not seen more than 10% IRR over the last 10 years from VCs (there are other measurements of VC failures) and smart entrepreneurs shelve their ideas because of unfavorable funding conditions and fundamental misalignment between VC and entrepreneurs (also read my blog Idiot CEOs).
The self-regulatory nature of marketplaces has started; new LPs and entrepreneurs refuse to enter and many currently active LPs and entrepreneurs will take their losses and leave. If the rules of engagement do not change, money hungry entrepreneurs who continue to submit to sub-prime VC will stay, supported by non-discretionary LPs who have the patience to wait for miracles. Unchanged, the future of disruptive innovation is bleak.
The matchmaker in that marketplace better be a VC who understands that simply serving one participant, while depressing the needs of the other will inevitably lead to removal of the arbitrator status in the marketplace. Only a VC with vision who understands free-market principles, and satifies LPs and entrepreneurs simultaneously can generate the meritocracy of ideas that are priceless.
VC is here to stay, but the overinflated personalities with no authentic value-add will be kicked to the curb. For LPs and entrepreneurs it will take some time to recognize which VC is on his way out and which one is on his way in. 7-10 Year VC fund vintages with lack of transparency will do that to you.
But if you read my blogs carefully (or ask my advice) you will learn to spot them from a mile away.
I read Bill Gurley's article on "What is really happening to the Venture Capital Industry" and submited my reply. While his article provides a decent explanation of the mechanics of Venture Capital (VC) today, especially for entrepreneurs who want to get to know the workings of VC better, it (again) offers no clues as to how it should work. Those of us working in the venture sector know how LP allocations work, the important question is (just like with innovation): what should a brighter future look like. And Bill's article falls very short on that.
VC is not an industry
Far from merely an excusable slip of the pen, the self serving pronouncement in the title of Bill's article is indicative of how many Venture Capitalists see themselves; as the center of the universe of innovation. A balsy statement for VCs to make considering that they hold no assets (I'll explain). Some of them go even further by correlating their, should I repeat dismal performance to the capacity of disruptive innovation and even the lack of great entrepreneurs.It is true that VC should be the most effective way to get early stage innovation out of the gate. The reality is that in many cases VC is not, and has not proven to deliver the promised value. Some describe the VC sector as broken, others blame it on mechanics, or a too large VC pool, or mega funds, or a sudden lack of exits, or the economy, or anything else they can hang their hat on - with the media having a field day delving into the pros and cons of every argument.
And with money to distribute, the articles from VCs - who created the problem in the first place - gain most of the popular momentum. At this point do we really believe their analysis is credible? But that is why you are now reading this blog too, so lets continue...
Innovation is a marketplace (continued)
Venture Capital is the arbitrator in the marketplace of innovation connecting the assets of Limited Partners (money) with the assets of entrepreneurs (ideas), both collectively referred to as marketplace participants (supply and demand). Simplified, the VC makes choices and investments (and yes, regulates) on behalf of the LP in return for equity in the assets of entrepreneurs (ideas and execution), of which at exit VC gets a commision (the carry and then some).For any marketplace to thrive, the needs of supply and demand participants have to be satisfied. Only then will each participant come back for more (and tell their friends).
LPs expect the venture sector to outpace their other (often less risky) asset allocations and entrepreneurs want to change the world and get rich while doing it (in that order). LPs have not seen more than 10% IRR over the last 10 years from VCs (there are other measurements of VC failures) and smart entrepreneurs shelve their ideas because of unfavorable funding conditions and fundamental misalignment between VC and entrepreneurs (also read my blog Idiot CEOs).
The self-regulatory nature of marketplaces has started; new LPs and entrepreneurs refuse to enter and many currently active LPs and entrepreneurs will take their losses and leave. If the rules of engagement do not change, money hungry entrepreneurs who continue to submit to sub-prime VC will stay, supported by non-discretionary LPs who have the patience to wait for miracles. Unchanged, the future of disruptive innovation is bleak.
Long live the VC
But although the marketplace (in its current incarnation) may and should die, its participants never will. There will always be a need to deploy high-risk/ high-yield assets and there will always be entrepreneurs that can produce disruptive innovation. All it takes is a new marketplace in which the meritocracy of ideas from entrepreneurs is matched with discretionary support from LPs.The matchmaker in that marketplace better be a VC who understands that simply serving one participant, while depressing the needs of the other will inevitably lead to removal of the arbitrator status in the marketplace. Only a VC with vision who understands free-market principles, and satifies LPs and entrepreneurs simultaneously can generate the meritocracy of ideas that are priceless.
VC is here to stay, but the overinflated personalities with no authentic value-add will be kicked to the curb. For LPs and entrepreneurs it will take some time to recognize which VC is on his way out and which one is on his way in. 7-10 Year VC fund vintages with lack of transparency will do that to you.
But if you read my blogs carefully (or ask my advice) you will learn to spot them from a mile away.
Why innovation needs regulation
August 21, 2009.
A ban on advertisement of healthcare drugs on national television in The Netherlands. Free public phone calls in Singapore, just a one-time 10 cent connection charge. Mandatory health inspections in restaurants in North Carolina, with regularly updated door-posted scorings. Those are great examples of how government regulations provides better quality of life to its citizens.
But in the United States we generally balk at any form of government regulation as if it is poised to erode the freedom we set out to create. It makes for good press to publicly support a free world and anarchy rather than the opposite. Being a freedom fighter is good karma.
Regulation is not an option, but a requirement
But regardless of government involvement our world is riddled with self imposed regulations. We stop when pedestrians cross the road (regardless of whether they should), and show more respect to elderly than we are often given. We raise kids as best as we know how, and send them to the best schools we can afford. Most of us are decent people who respectfully comply to our individual interpretation of the definition of decency; a set of self-imposed regulations.Regulations, self-imposed or governed, are the foundation of free-market principles (see our extensive coverage on free-market principles in our blog entry Marketplace Rules). And free-markets only function well when they stimulate or enforce behavior that builds transparency and trust, pulling in new participants and thereby allowing the marketplace to grow itself.
Everything in life is a marketplace (in the macro-economic sense of the word). And we have the option to growth those marketplaces based on a meritocracy, or create excessive walled gardens that, when the impact on our economy becomes too big, risks the enforcement of regulations by our government.
Innovation is a marketplace
In large part early-stage innovation in The United States is fueled by the investment dollars from Limited Partners (LPs), allocating their money to invest in the ideas of the entrepreneurs, using Venture Capitalist (VC) as their conduit and decision maker. In the marketplace of innovation the LP and the entrepreneur represent supply and demand with the VC acting as the arbitrator of the marketplace.The preponderance of evidence makes for a lousy marketplace in which the VC acts as the Emperor with no clothes:
- Less than 10% IRR of the venture sector in the last ten years
- Few truly disruptive innovations are born
- The number of entrepreneurs are declining (according to Kauffman, see attached chart)
- The number of LPs and investment dollars are declining
The VC as the systemic risk to innovation
It is ironic that so many VCs who are vehemently against government regulation (and put their efforts at attempting to stave it off) actually are themselves the ones that aggressively use arbitration to regulate (with their peers) the restrictions that are put upon the entrepreneurs. They collectively set standards on deal intake, technology focus, valuations, syndications, geographical proximity etc., and allow for very little deviation that is inherent to a marketplace meritocracy.Simply put, VCs are the ones that violate many of the free-marketplace rules (stay tuned for a detailed deep-dive) and prevent the innovation marketplace from prospering, thereby inhibiting the creation of disruptive innovation.
Why we need new regulations
Frankly, we messed up and we should be ashamed of ourselves.Innovation is a crucial ingredient to our economy, as explained in my previous blog entry The Systemic Risk of Venture Capital. We need to remain at the forefront of innovation for our immediate benefit and how we set an example for (not arbitrate) the rest of the world. Innovation has a big impact on GDP growth and spirit.
We, marketplace participants and government should do our part in fixing the innovation marketplace that is so sorely broken. Our government should force VCs to exhibit transparency (one aspect of marketplace rules). LPs should do a better job of hiring VCs with relevant early-stage operating experience to create more trust. The integrity of the new marketplace we create together will improve the integrity and quality of entrepreneurs it attracts.
We are responsible
The point I am making is that every marketplace requires pretty much the same amount of rules and regulations to instill transparency and trust, no matter where you apply that marketplace. The owners of the marketplace, by virtue of their performance, get to decide how much of those regulations they can deploy themselves. Bad performance with big economic stakes is punished by government intervention.So, rather than to discourage and blame the government, we as marketplace participants should instead re-install the support for free-market principles in innovation that promotes the meritocracy, spirit and entrepreneurial capacity that this country was founded upon.
Stop blaming someone else and join me in this effort for the sake of our global competitiveness.
The Silicon Valley emperor has no clothes
August 08, 2009.
In the words of Danish poet and author Hans Christian Andersen, Silicon Valley has become the emperor who wears no clothes. Many Venture Capitalists (VCs) like the emperor will hold their head high and continue their procession for the sake of protecting their management fees.
And even though more than 77% of funds will finagle themselves into the top quartile performance bracket (according to a recent study) and persuade LPs to hang on, the simple fact remains that very little disruptive innovation is born. And without disruptive innovation (and the risks that such innovation incurs) it is just a matter of time before the Limited Partners (LPs) recognize that the emperor's procession is coming to an end.
It continues to amaze me how certain people and organizations (specifically the NVCA, desperately hanging on to the past) continue to protect the failed "dating service" between the assets of the LPs and the assets of the entrepreneurs, and continue to blame external circumstances on the miserable performance (less than 10% IRR) from the last ten years.
A recent conversation with a Mercury News technology journalist confirms again how many VCs still blame their underperformance on anything else but themselves (see how we debunk their excuses). Another reason why the crop of current VCs could never be or align with entrepreneurs, real entrepreneurs would never stop until they get it right. If VCs are so entrepreneurial, why don't they innovate themselves out of this malaise?
How did we get here?
In the early days of VC, originating from Bill Draper's first innovative financing, the sector produced more than 40% IRR. New LPs, attracted by those generous returns, flocked to the sector and deployed massive amounts of money to VC, without properly validating the GPs relevant entrepreneurial credentials. And with VCs improperly calculating risk, the wrong companies are funded - in large numbers. With almost none of them able to fool private or public markets, regardless of the state of our economy. That's where we are today.Innovation is not the problem
But just because the current VC "dating service" is broken that does not mean the LPs or the entrepreneurs should lose faith in the monetization of disruptive innovation. Both should simply seek to establish a more effective dating service, one that focuses and supports upside, rather than worry about downside risk.Entrepreneurs should refuse to work with investors that improperly assess business risk, money from the wrong investor is a dead-end street anyway. But most influential will be the immediate action from LPs who should close their underperforming commitments (instead of flee), reset their fund requirements and require more relevant operating credentials from General Partners (Venture Capital requires more relevant early-stage credentials and vision than other Private Equity sectors).
New opportunities abound
With the foundation of technology established (chipsets and the internet) the next wave of innovation comes from platforms and applications (macroeconomic marketplaces), all of which can be developed anywhere. Combine that with the dysfunction of Silicon Valley VCs and you have the perfect storm of starting new entrepreneurial endeavors in other geographies.Innovation should not and will not just come from Silicon Valley, but it will only thrive in the hands of investors who understand that the cost of disruptive innovation is priceless. So, simply starting technology innovation elsewhere is useless if it is not matched with an investor who has the experience and foresight to see what others don't: a unique innovation he wants to put his all behind.
The procession continues
The sheer size of LP commitments outstanding to the VCs will keep the emperors procession going for a while, and the VCs refusal to criticize themselves is a sign that it is incapable of recovery and self regulation. We need new VCs, with a new mindset and a different DNA to get there.While there were more important reasons for me to move (with my family) to the East coast, I certainly do not regret not being there when the naked emperor continues his procession through Sand Hill Road. My focus will remain on helping LPs understand how to invest in Venture Capital and how to regenerate the impressive returns the sector is still capable of producing -- or show it to them myself.
We are after all at the beginning, not at the end of technology innovation.
Why VCs need relevant operating experience
July 18, 2009.
[The article has been supplemented by a more recent "Why VCs really need relevant operational experience, now"]
I frequently get asked by individual Venture Capitalists (VCs) whether I really think General Partners (GPs) need operating experience to be more effective (as if my blog is not clear about that). And just recently HP's Venture Group seems to agree with me.
That topic was also recently challenged by Daniel Primack from Reuters' PEHub (I know he likes a good debate) who decided to make a statistical point that there is no correlation between fund success and GP operating experience.
Yet my short answer is: "yes, but it depends".
What my answer does not depend on is Daniel's statistical analysis of the Forbes Midas List and loosely matching credentials to his sample. With more than 90% of VC not making a real profit (above the asset class expectation of it), the 10% Midas sample can hardly be called statistically representative. And even if it would, a highly inefficient market (created by the ineffective "dating service" VCs currently provide) does not statistically represent the workings of the efficient market we wish for. And the majority of the Midas List GPs have their "success" firmly rooted in a timeframe when "turkeys could fly". Should I go on?
But most importantly, statistics are derivatives - not drivers - of market behavior, in the same way liabilities and assets are opposites (read "Rich Dad, Poor Dad"). It is unwise to apply a derivative (statistic) as a driver for market decisions. All experienced entrepreneurs know that.
So, my answer depends on whether you reference the actual or supposed workings of VC.
In today's VC
In today's venture capital ecosystem it is very important for every GP to have relevant operating experience, with the emphasis on relevant. Relevant experience as that of an early-stage CEO in tough times, still producing success.Many GPs can only flaunt past experience from behind the confines of a large brand name conglomerate, rather than the experience of an early-stage CEO, investing his own money, defining a unique company ecosystem, living on borrowed time, raising a few rounds and selling the company. The VCs with that level of operating experience are hard to find and so are their successes.
Why is VC operating experience important:
1/ Many venture funded companies today are built with what I coin as the sub-prime VC model. Amongst many things it means founders need to prove a lot of technological capabilities (see my Khosla reference) before they see an investment dime, and when so, usually receive too little money to hire an experienced CEO. As a result, the board (of investors) runs the startup and thus their relevant operating experience becomes pivotal to the success of the startup.
2/ Relevant operating experience matters, not just any operating experience. Successful startups rely on a clear definition of a unique ecosystem (with divisional expenditures and conversion rates). The last thing an entrepreneur needs is a group of investors who can barely deviate from their business school thesis to meet reality and a world that is in flux.
3/ GPs need to be entrepreneurial to recognize and weigh one. The success of a technology startup is not just dependent on how cool the technology is but requires an operational assessment to figure out whether the business model is sustainable, and whether the application of that technology to a demographic makes economic sense. Operating experience is crucial to validate the combined value of operations and innovation.
I can name probably a hundred other reasons, but that would extend beyond the artificial limit of this blog and your patience.
In new VC
In a new VC structure I would argue for a more balanced makeup of economic managers and operational managers. But that structure can only work when all GPs share responsibility for every deal, rather than today's norm of every GP managing his own subset of companies within the portfolio. Many more things need to change in order for VCs to accurately calculate startup risk, snippets of which I've covered elsewhere in this blog and will cover extensively in my upcoming LP seminar "The Inconvenient Truth of Venture Capital".Alignment with the entrepreneurs
So, until we change the fundamental workings of VC are we bound to hire GPs with relevant operating experience, those that combine that operating experience with the ability to accurately calculate upside risk and align with the entrepreneur.But a VC firm without relevant operating experience is a risky investment (for LPs) and a bad strategic partner for the entrepreneur. The great difference between Private Equity and its sub-class Venture Capital is that the latter can create massive returns, albeit with GPs that are capable of recognizing a diamond-in-the-rough and performing a little bit of heavy lifting when needed or desired; by applying experience and influence.
That, as an operator, makes Venture Capital so much fun for me.
Why VC does not line up with innovation
July 01, 2009.
The biggest complaint I hear and agree with is that Venture Capitalists (VCs) just don't get it and in the words of a VP at Apple, VCs simply don't line up with the needs of entrepreneurs.
Real innovation has no precedent and leaves many VCs, with their platitudes and an army of analytics in the dark in coming up with a reliable reason to invest. I personally had a VC become teary-eyed about the prospect of having to convince the rest of his team about an investment I presented, and I subsequently got it funded elsewhere.
With monetary assets being equal, it takes a visionary or a black swan (whichever classification floats your boat) to separate the good investor from the bad. Great investors have a strong belief that finds solace in an internal compass that is fine-tuned by years of risk-taking. Risk-taking in entrepreneurship or personal life, whichever one shaped that core competency. We have many VCs with strong beliefs, but few of those beliefs are founded on relevant experience.
So, entrepreneurs (and LPs) take note of what is the most important ingredient to look for in the bios of General Partners (GPs). With few exceptions, a GP (General Partner) that has never been a CEO at a startup, responsible for developing and executing its unique ecosystem, is not a great candidate to become a VC. Neither is the GP who has never challenged him/herself personally.
Venture Capital is government
But not only are those investors hard to find, the physical makeup and workings of the current VC construct is diametrically contradicting the decision-making for groundbreaking innovation. As long as the meritocracy at the VC level of the investment pyramid that started Venture Capital is not restored, the artificial arbitration of the current aristocratic model will continue to erode high yield returns.Here is how VC acts like government:
1/ You (still) need to be in Silicon Valley
Just like you need to be in DC to make an impact on politics, do you need to be within 20 minutes of Sand Hill Road in Menlo Park to be on the radar of investors.2/ You need an intro to the VC
In DC you need lobbyists to get anywhere, in Silicon Valley you need to find similar lobbyists that can introduce you to the investor you want to talk to. Most GPs simply refuse to talk with entrepreneurs they have not met before. Entrepreneurs who contact VCs directly will find themselves debating the vision with an academic white swan, dramatically improving their chance to get rejected.3/ Investment decisions require internal consensus
Politics is based on consensus. Likewise, if the entrepreneur is lucky to convince one GP of their proposition, the next monday morning meeting at the VC firm is spent on getting other GPs to agree (except if the first GP is of John Doerr stature). In essence it means a unique invention is shoved through a democratic (government) filter to be validated with chances of a majority vote rapidly approaching zero.4/ Deal syndication requires external consensus
Many VCs don't have the balls (excusé les mots) to make independent contributions to companies and look for syndication to mitigate the risk. Just like in DC where politicians look for peers to join their charter, before they stick their necks out.5/ Lack of accountability
VCs can hide behind the size of the portfolio to select one or two successes to brag about. Just like politicians that hide behind a party and associate themselves with many initiatives and get credit for the few that worked. Quite opposite to the devotion of an entrepreneur.6/ Lack of transparency
To understand politics you need a graduate degree in the subject matter, to understand VC you need to be (or have been) one. Just because the type of businesses VC invests in are private, that doesn't mean VC needs to be.7/ Far removed from its constituents
Not only physically but spiritually many politicians are far removed from their constituents when they enter into office. So are the VCs who prefer to congregate more with each other than with entrepreneurs to develop unique support for disruptive innovation. VCs are oblivious to the many "false negatives" (as described in my previous blog) they don't even get to see, just as many politicians forget that many americans don't vote at all.8/ Fewer real innovations are born here
DC (at least before Barack) is not the place to get anything done, and Silicon Valley choking on a vast supply of sub-prime VC is not the place to get anything really disruptive done. The real world is the market, not the current VC interpretation of it.9/ Long incubation periods
Just like in politics, once the GP secures a fund with the LP the performance of the fund is in limbo for 5-10 years. That is a more secure job than the presidency of the United States. Many GPs stack funds or jump ship before it is about to go under, picking up new management fees under a different fund and LP structure. Another 5-10 years of GP safety lies ahead.10/ External circumstances
Just like in politics, VCs blame their underperformance on anything else but their own decision making. The state of the economy is their welcome excuse, even though startup economics are quite resilient to macro economic aberrations.So, the point of this blog is to emphasize that in order to get VC to create high yield returns we not only need to take a close look at the GPs that take the risk but change the mechanics of VC from a "government" based system to a meritocracy at the VC level of the investment pyramid. That is the message I will develop further (and more constructively, I've hammered on VC enough) in helping individual LPs develop new relationships with VC firms.
The systemic risk of Venture Capital
June 25, 2009.
By Georges van Hoegaerden
The debate is heating up about the impending regulations from the government applied to Private Equity (PE) and its sub-class Venture Capital (VC), fought by the National Venture Capital Association (NVCA) and reluctantly supported by the Private Equity Council (PEC). The latter stating that private equity does not represent a systemic risk. Perhaps not, if the council excludes VC from its membership, but VC as Private Equity poses a systemic risk as the gatekeeper to innovation.
Why the government is forced to step in
The government has decided to step in and we, as participants in the ecosystem should present our government with the facts (good and bad) so it can make informed decisions going forward. If we give the government self-serving information, rather than the facts, we will get punished by regulations that miss their intended target. So, now is the time to separate greed from honesty and shape the regulations that will be bestowed upon us.The most rational explanation as to why the government is tightening our private equity belts came from Bob Grady, Managing Partner at The Carlyle Group (who worked for the government for a while) at the recent IBF conference. He suspects that the government simply wants to reduce the size of the financial services industry as a percentage of GDP (Gross Domestic Product).
Not unreasonable, considering the collapse of our financial system and the discovery of an endless supply of imploding derivatives (and vice-versa). Simply put, the equilibrium between people who create products and those that capitalize on them is out of whack. We need more innovation with fewer derivatives attached to them.
VC is a systemic risk
The creation and growth of the Internet (and all the components around it) could not have existed without the faith and dollars from Limited Partners (LP), deploying their assets through VC firms. Kudos to people like IBF life-time award winner Bill Draper who started Venture Capital by literally knocking on the door of an interesting company, buying his first shares for $20,000. But the last nine years have been dismal for VC performance, almost 900 U.S. VCs producing less than 10% IRR, tarnishing the technology ecosystem and prompting LPs to look around to reallocate money to a different asset class.Why VC needs to work
While venture-backed companies represent around 0.02% of GDP prior to exit, post exit they represent about 18% of GDP (according to the NVCA) and 9% of jobs in America. So, the decision-making process by a VC of what company to invest in is vital to building a healthy economic conversion rate. And I predict information technology will claim a larger stake of GDP as it continues to mature from its infancy. So while VC is a small percentage of the total Private Equity pie invested, it has proven its ability to produce a healthy stimulus to the economy.What has changed
We can look at the statistics from the NVCA and debunk those statistics with reality, but common sense tells us that most of us would be hard pressed to name ten ground-breaking technology innovations in the last ten years. So, if 900 VCs produce this few real innovations, the billowing smoke is sufficient indication of a fire. On top of that companies like Apple show us how to invest in categories (like music) VCs had unsuccessfully invested in for the last 10 years, challenging VC fundamentals to its core.Proper assessment of investment risk
The problem with VC is that it is inherently risky (more than other forms of Private Equity) and with the wrong people running VC firms, the asset - risk - that produces great returns is being sucked out of the investment equation.Smaller funds, feverish syndications, easy exits are all instruments that create more rather than less derivatives to the creation of disruptive value. VCs now sell to LPs a similarly ill-fated pattern of risk as sub-prime lenders sold to their investors. Hence our frequent use of the sub-prime VC classification throughout this blog.
As a result of a lack of meaningful segmentation and guard rails by many me-too VC funds, LPs have actually invested deep rather than wide in information technology (as the included chart points out). For the last nine years that has created a massive number of false positives and false negatives and a continued downward spiral that attracts only entrepreneurs that comply with this risk-deflated investment mold, rather than attract entrepreneurs with truly disruptive ideas (that hold their value in any economy). So, for the last 9 years LPs have invested deep in a risk-averse technology sector while they expected their 10-15% venture share of total allocations to be applied to the inverse.
Moving forward
Many LPs are ready to cut all but their top quartile VC funds from their portfolio by flushing them through (i.e. letting them run their course without re-upping new commitments). That means over the next 5 years we are going to see many VC firms disappear, some replaced with new VC firms with more relevant entrepreneurial pedigree and investment models that are as unique as the strategies of the entrepreneurs.New regulations by the government and tougher practices by LPs will make our industry more transparent and aim to create a platform in which the old aristocratic VC model will be replaced by a model that supports a meritocracy at every level of the investment pyramid. That is a fantastic development for entrepreneurs and VCs who are attracted by - and deserve - the merit.
Big stakes, big returns, fewer players, better innovation
LPs expect bigger returns (before larger commitments) from their allocation in venture and the only way to get it is to deploy risk. VC is designed to be the intermediary between the LP and the entrepreneur to mitigate that risk for LPs. Yet because of the aforementioned commoditization of VC investment strategies the VC model has failed to produce.With LPs retrenching (to perhaps another asset class), the VC firm that wants to survive better articulate a clearly differentiated investment strategy with new GPs that can recognize and attract more disruptive (and sustainable) innovation, knows how to commit and helps make its portfolio companies work.
A new day
To create better returns for LPs, VCs need to rethink how to pick better companies with more disruptive (and sustainable) innovation and invest in upside rather than downside. The smart entrepreneurs are out there (we talk to them), waiting patiently for the right investment climate to light up their flame. Remember, great innovation can afford to be patient.Venture Capital as the derivative in the investment pyramid between the assets of the LPs (money) and the assets of the entrepreneur (innovation) needs to provide a better service to both parties (or else it will be tossed out as a "dating service").
Until we fix VC, will it remain a systemic risk to our asset class, economy and frankly our reputation as the most innovative country in the world.
How LPs should deal with VC
June 15, 2009.
Last week's 20th anniversary of IBF Venture Capital Investing Conference (congrats to Alex Scott and Christina Riboldi) in San Francisco was a unique opportunity for me to witness the atmosphere between 487 Limited Partners and General Partners (also referred to as Money Managers by LPs).
My first ringing of the closing bell on Nasdaq followed by a packed premier event of the Asian American Association of Investment Managers (AAAIM) at The Harvard Club in New York, with keynotes from Julian Robertson, CEO of Tiger Management and David Rubenstein, founder of The Carlyle Group gave me some great insights into the world - and thinking - of LPs.
It is clear from these sessions that LPs (and Fund-of-funds) are misled and confused about how to improve the performance of Venture Capital (VC). The VC sector of the Private Equity asset-class has been plagued with dismal performance of less than 10% IRR (Internal Rate of Return) for the last 9-years, leading some LPs to question and reduce allocation (US: 10-15% of total assets per firm, Europe: ~4%) in a sector that deserves quite the opposite.
The emerging opportunity in technology VC
The technology sector which is my passion for the last 30-years is at the beginning, not the end of its emergence. Perhaps the top-level indicator of the innovative runway we have ahead of us is the following: more than 5/6 of the world's population does not yet use a computer connected to high-speed/broadband internet today. And all should and will, given the right technology. That's where technology innovation comes in; not just in connecting people to the internet but in deploying innovation that uses the internet as a distribution mechanism. The way we use the internet today is rudimentary, and many new technology stacks will emerge to improve its impact on everyday citizens.Given the early days in the life-cycle of the technology sector relative to any other sector or asset-class is; low-cost to produce, low-cost to distribute and because of the internet has immediate customer impact with independently short sales-cycles. That means with relatively little money in, a massive impact can be produced, virtually instantly. A great investment allocation opportunity for LPs still lies ahead.
Why the VC sector is not producing
In the words of Cesar Millan, the popular dog whisperer on National Geographic, who states that the behavior of the dog is the responsibility of its owner, so should LPs demand control of the behavior of the VCs. Like dogs, VCs exhibit primal behavior that can make them great money-managers, but only when they are controlled. An issue even The Carlyle Group recognizes by including a code-of-conduct in its recently published annual report. LPs should let go of the leash after VC performance becomes apparent, not before.-- Risk deflation
VCs sell well upwards to the LP at fundraising time, but they seem to have forgotten that they need to serve the entrepreneurs just as well. In the investment pyramid between the dollars from the LP and the ideas of the entrepreneur, the VC is simply the derivative that should serve both. Today it does neither. The money-tree report further hides the ugly reality under-the-hood as the funding stages have disrupted the equilibrium between entrepreneurs and VCs and steadily turned VC into loan-sharking.
-- Lack of relevant experience
Most VCs in Silicon Valley simply have no relevant operating experience that allows them to service the needs of entrepreneurs adequately (see sub-prime VC). And that in turn creates a massive amount of false negatives and false positives to which no liquidity mechanism (from the NVCA or Tim Draper) will suffice. Beginning in the early 2000s, the VCs have simply consistently invested in entrepreneurs that submit to sub-prime innovation and terms.
-- Lack of vision
No surprise that, according to a conversation with a chinese private equity investor at the AAAIM conference, recently 12 highly successful chinese immigrant entrepreneurs left the U.S. disappointed to go back to China because the VCs did not allow them to take the helm at their own companies. They will in China. Smart entrepreneurs simply won't submit to sub-prime VC, leaving the VC (and therefor indirectly the LP) alone in their spiraling sub-prime demise.
To echo Jessica Reed Saouaf, Managing Partner of Hall Capital Partners (with $17.5B in assets under management) who describes at IBF that the VC business today is too institutionalized with too few visionaries to create promising returns. LPs need to do a better job in sourcing, segmenting, controlling and demanding transparency so the behavior of VCs remains an extension of the LPs investment brand and integrity.
The myths LPs are being told
But the incumbent VCs are not taking this criticism without a fight, a fight to hold on to their cushy management fees and plush existence. From the focus of their rebuttal (by way of pump-and-dump liquidity plans, annex funds etc) you can gleam their true nature, they worry more about protecting their downside than improving their upside.A welcome exception to the majority of followers of the auto company's plan to fixing VC are the younger VCs like Jason Green (Emergence Partners) and Paul Holland (Foundation Capital) who on the IBF panel proclaim that, unlike the NVCA they do not lie awake at night about the impending increase in capital gains tax on their carry. Instead, just like great entrepreneurs, they worry first about delivering value and returns, trusting that personal wealth will naturally follow.
Here are the most frequent myths I hear VCs attempt to imprint on the LPs that I want to debunk here quickly to prevent a further slide down the sub-prime spiral:
-- It's the economy; new fund - stack fund - annex fund
Nonsense: even the most successful startups do not achieve revenues or market-share above 10% of their total-addressable-market (TAM) during their private funding cycle. That means that 90% of the total-addressable-market is still not served effectively. With a few exceptions it is hard to imagine that a 10% decrease in market will have any affect on the success of the startup. I would argue that in a down-market the opportunities for new technologies improve considering the fact that an early adopter can more effectively compete with 90% of its competitors. So, conversion rates of companies with macro-economic differentiation should improve and so will their market-share and revenues and consequently the opportunities for great exits.
-- We are in a down-cycle, we will bounce back; new fund - stack fund - annex fund
Nonsense: the barrel of a downward spiral is cyclical too, be sure to recognize the difference. Sub-prime investments have no exits and will not yield valuable fund returns, no matter what the liquidity structure is. VC portfolio choices that cannot withstand the test of time simply have no fundamental differentiation and independent future. And a GP that cannot distinguish between prime and sub-prime will never be successful.
-- Companies are cheaper to build; new fund - less money
Nonsense: I have heard LPs echo the term "Capital Efficiency", and it is a trap. Not just for the entrepreneur but for everyone in the technology ecosystem. Unlike in the past, no product can withstand the scrutiny and the power of social networks unless it is really well built, offers fundamental and disruptive value and delivers authenticity and trust. Only then will users adopt it. And since distribution is virtually immediate, more competitors will spring up to provide the noise that makes life harder. So products are actually more expensive to build and requires a different ecosystem makeup and funding trajectory for the company. VCs that look for smaller funds demonstrate further misalignment with reality and therefor exits.
-- There are not enough great ideas; new fund - less money
Nonsense: but sub-prime VC behavior and terms turns off great entrepreneurs. Only idiot CEOs and unsuspecting entrepreneurs submit to terms that hands control and destiny to underperforming VCs. Other forms of artificial arbitration such as geographic distance of 20 minutes moves the VC even further from the meritocracy it should be looking to embrace. The institution on Sand Hill Road is severely limited by its lack of peripheral vision of technology and the world.
-- New (government) regulation is strangling exits; new fund elsewhere
Nonsense: the bar has been raised for technology companies as it should. No longer can public markets be fooled by valuations that have no value. Real value jumps the hurdles of regulations with ease (as witnessed by OpenTable and Rosetta Stone). The current startup inventory, that was subject to sub-prime investment tactics to begin with, may not be able to get to the finish line. Such is the punishment for lack of independent differentiation and value.
-- The grass is greener in green; new fund - hot market
Nonsense: I have witnessed the rush to these "hot-pockets" before but hot-on-supply does not equate to hot-on-demand. Or as Julian Robertson says; "there is a difference between having a bakery and baking bread". Contrary to technology, greentech is expensive to produce, expensive to distribute, relies on long sales cycles and arbitration (subsidies, politics etc. ) that is beyond the control of the startup (and much more complicated in its regulative risk than, for example, healthcare). A dependency on government is very dangerous in meeting the time-to-money milestones for early stage companies and fund returns. I believe in the value of green-tech and energy-tech to create a greener planet, but I don't believe the current VC funding models with former technology GPs looking for greener pastures can support its early financial success within the current funding vintages. It is ironic to see VCs use the capital-efficiency slogan under the same roof as their capital intensive strategies for energy-tech.
-- The grass is greener global; new fund - new fund elsewhere
Not yet: as we move up the technology stack and specifically the investments in software, the origination becomes less relevant, I will yield to that (although I see still see an entrepreneurial quality difference), but startup investments should reside where the execution is, regardless of origination. While other geographies score well on low-cost manufacturing (and programming), real disruptive ideas and the majority of early adopter markets (driven by the frantic pace of unbridled capitalism) still reside in the U.S. So VC funds should be equipped to handle international deal sourcing (and be the first investor in) and only become truly international once the remote exits prove to justify an independent local operation. For that to happen, creation, execution and exit values need to yield appropriate dynamics. Remote execution and exit values remain sporadic today, but that may change as those markets develop and emerge as prominent technology visionaries and consumers.
How to fix VC
Optimizing VC is probably easier than most LPs think, since the issues plaguing VC have to do with regaining fundamental leadership of the investment ecosystem. Simply put, LPs need to become "VC whisperers" (to use the Cesar Millan analogy), those that can control the performance of VC so the leash can be loosened. The good news is that none of the deficiencies in VC are rooted in the complicated micro-economics of technology, contrary to what some GPs may want you to believe. But it is important that LPs hear more than the repetitive sugar-coating from underperforming VCs and keep a close eye on entrepreneurs who actually represent the monetizable assets.-- No more "duh" PPMs
No more Private Placement Memorandums (PPM) that look remarkably like a wish-list without substance. Yes, I've seen the memorandums produced from brand-name VCs that get replicated by many other VCs in the valley. No right-minded VC would accept a business plan from an entrepreneur that looks like that, neither should an LP. The quality of the PPM is a direct indication of the quality of the VC fund and should help LPs clearly segment the risk associated with technology investments. LPs have invested deep rather than wide in the technology sector, hence the birth of many false positives.
-- Assess the GP's unique vision
Many of the PPMs talk about rearview mirror analyses, but the only advantage one investor has over any other is his forward looking views on the industry, or vision. So LPs need to assess the risk associated with that vision, much of which again is related to macro-economic impact rather than technology waves. GPs should be able to demonstrate that their unbridled vision in the past came true.
-- Assess the GP's relevant operating experience
To become a valuable partner to the entrepreneur the GP needs to be able to prove relevant operating experience related to the investment thesis and specifically to the segmentation. Information technology is a broad sector and experience in consumer technology differs from the application of technology to healthcare. Being able to help entrepreneurs develop a large vision with tangible baby-steps is a skill that GPs need to master to improve the size of disruption and returns. That experience needs to map directly to the investment thesis in the PPM.
-- Assess the GP's track-record for deal sourcing
Getting your hands on real disruption requires a proactive approach to finding the "diamond-in-the-rough". Many early stage entrepreneurs, hurt by sub-prime VC tactics, need help thinking bigger. The size of the disruption, rather than the cost of entry is crucial. Finding deals that can be turned in game changers is fundamental to the success of great returns.
-- Hire an expert
All this deep-diving may be too much for an LP who has nearly 90% of its assets allocated to other asset-classes, so the smart thing to do is to hire an expert that speaks the language of the entrepreneur and ensures that the needs of LPs and entrepreneurs are effectively met through an intermediate VC vehicle.
Conclusion
Crucial to the success of the technology sector is to do the opposite of what most VC funds are currently setup or guided to do. To follow Warren Buffet's advice: when everybody is investing using sub-prime tactics then now is the time to do just the opposite. Venture Capital is a sector that can produce great returns when it takes great risks, not when it becomes risk averse, and fragments and commoditizes investment dollars. Deflating the risk through sub-prime investment tactics has killed the want to innovate, and may lead to an accelerated intellectual exodus that will hurt our economy as a whole.Apart from fixing what is broken I think the time is right to fundamentally restructure early stage innovation and make its financial support just as innovative as the inventions themselves. Facebook sets a good example of how it taunts with the institutionalized investment "rules of Silicon Valley".
LPs who cannot see the massive opportunity in technology should simply exit from Venture Capital. But continuing to support sub-prime VC funds is a sure way to continue down the spiral of suboptimal returns we have been stuck with for the last ten years and damage the innovative ecosystem our economy depends on.
So dear LP, go big or go home. And when you plan to go big I will make myself available to put words into action. I cannot wait to turn this page.
The auto company's plan to fixing VC
May 18, 2009.
The National Venture Capital Association (NVCA) has released its recovery plan (4-pillar plan) to fix Venture Capital that is eerily similar to that of the auto companies. It focuses on the prolongation of (their) life rather than on the quality of its product; the ability to spawn meaningful innovation.
Now I am sure Dixon Doll, from his perch atop a $1.6B Venture firm, means well but his purview is severely limited by his role as chairman as one of the most closely held investment clubs in the nation. Its members, ninety-something percent of the U.S. VCs are simply not incented to present all options for improvement, and certainly not one that would include self-cannibalization.
Nothing in this plan covers the stimulus and meritocracy required to spawn and monetize disruptive innovation. The plan mentions entrepreneurs, as the real value creator in this equation - in passing - only once (slide 11) amongst its thirty slides. The plan seems to forget that the entrepreneur is the real value creator, not the VC.
The plan, like the plan of the auto companies boasts of past accomplishments (count on two hands; poor result coming from 800 VCs, but we all know that) and how it puts a lot of people to work (it better when $28B of LP money is dispersed; what else would you spend it on), yet it offers no clues as to the fundamental resurrection of IPOs and meaningful M&A. Could it be that VCs simply picked the wrong companies to invest in? Could it be that the driver, not the car caused the accident?
Faster and easier liquidity paths, using the suggested liquidity platform, does not make up for ill-defined risk assessment applied by many VCs. I predict, such a platform will then be used by VCs who are stuck with many false positives as the pump-and-dump platform to hide their bad choices. The proposed structure of the NVCA reminds me of an intermediary company/fund that tried very hard to sell me equity in some of Kleiner Perkins (KPCB) later stage companies. I happened to know a little more about those companies and their products and gracefully declined.
We don't need more complexity in the Venture Capital business. We need to flatten, segment and remove derivatives in the same way we are about to remove derivative structures from the banking world. We need Venture Capitalists that can quickly be held accountable for their actions and implement transparency that offers LPs the instruments to do so. After all, the VC is merely a derivative in the process of innovation.
Fixing VC will be remarkably easy when you consider the needs of entrepreneurs and I plan to present my entrepreneur focused plan to the LPs soon. A further descent down the sub-prime spiral (in which all participants are entangled) makes it hard for some to see the forest through the trees and find a solution. But the current situation is bad for Silicon Valley, for our leadership position in an increasingly global technology landscape and detrimental to our economy as a whole. That is why I care. I care about the meritocracy we talk about so often but so poorly deliver on, with capitalism as the excuse.
I don't want to see other countries walk away with an optimized model of our technology innovation, like we seem to lose many other innovations, just because they understand that (at least local) meritocracies require some form of regulation, transparency and other aspects of free-market principles. Capitalism, just like football, requires rules in order to flourish.
The NVCA plan is a bad plan because it does nothing to fix the false negatives and false positives VC produce today, one that is currently shutting out meaningful innovation. And it demonstrates how it continues to treat entrepreneurs with remarkable ignorance.
Your car did not cause the accident
May 04, 2009.
What does that title have to do with technology innovation and investing? A lot apparently to my brain.
VC spin doctors
The recent flurry of articles by individual Venture Capitalists (with catchy titles such as "VC rightsizing") along with the help from their association (the National Venture Capital Association, NVCA) spin a wonderful story as to how external circumstances have closed IPO windows and reduced M&A valuations. "Helped" by an ailing economy, Sarbanes-Oxly, and other new regulations VCs blame their inability to spot real innovation on anything else but their own choices. Good luck trying to convince the police officer that your car was really to blame for the accident, and the VC malaise we are in.
Didn't your football coach teach you in school that you can't blame the referee for your loss, even if the referee made the wrong call? He would tell you to man up and just play better so there is no room for error. Isn't that what VCs expect from their entrepreneurs when they go to market?
And that is what I am now telling VCs.
No more excuses
I don't believe for a moment that Google, Facebook, Twitter, Rosetta Stone and OpenTable have or will consider their ability to go public on just the pressure of regulations or the process of going public. Those companies have a macro-economic value that is resistant to - perhaps - cumbersome rules. And companies that can't jump the regulatory hurdle should frankly not be allowed to play in the big league of public markets and offered an opportunity to stain the reputation of technology innovation.
A major issue that great new venture funded companies face now is their ability to overcome the erosion of trust (as the currency of success) caused by its many sub-prime predecessors. For the last 10 years sub-prime VCs have collected sub-prime innovations which, without prior resistance propelled meaningless valuations into unsuspecting public markets. The likelihood of the current VCs (gathered at the NVCA) regaining that trust is as likely as a cheating husband regaining the trust of his wife -- it will take more than blaming everyone and everything else.
What matters is the entrepreneur
Moreover, the efforts of the NVCA described in their recent presentation emphasize the wrong point. The conservation of relentless entrepreneurs, not the VCs, is the real issue at hand. A VC, at best is a derivative, not the creator of disruptive innovation. For too long have inexperienced VCs been allowed to attract and perpetuate false positives and false negatives that have now clogged up the entrepreneurial ecosystem. And the only way to attract better entrepreneurs is to attract VCs with a vision as impressive as their personal entrepreneurial experience.
So, yes, I am in total agreement with Barack Obama's stance on imposing regulations to curtail the erosion of trust in the public markets. The importance of a vibrant technology ecosystem is crucial to our economy (that part of the NVCA pitch I agree with), and fund and endowment managers need to do a better job of sourcing, segmenting and keeping their VCs on a tight leash.
All free-markets require rules
No regulation that embraces the spirit of innovation can be more damaging than a continuation of the current sub-prime VC model greased up with efforts to exit out even easier and faster. Thankfully, fund managers have woken up and realize that moneys are best distributed to people who add value rather than simply extract money.
Instead of greasing the skids for VCs we need to find capable risk managers who measure up to capable drivers, likely to avoid accidents altogether. So stop examining the vehicles, but rather take a close look at who is in the driver seat.
A VC revolution in the making
April 19, 2009.
Last week I was invited to attend (thank you Brenda Chia, president AAAIM) the panel discussion "Market Changeup: Fund Management as a Business", with Priya Mathur (Board director of CalPERS, California Public Employees' Retirement System; one of the biggest investor in LPs and VC funds), David Fann (President & Chief Executive Officer, PCG Asset Management), Jan Le Chang (Vice President, Centinela Capital Partners), Phil Phleger (Morgan Lewis) and Bob Grady (Managing Director, Carlyle Ventures).
Compared to last year (written up here) the opinion of the people at the top of the innovation food chain was remarkably introspective:
Venture Capital is broken in some fundamental way.
So much so that PCG predicts a revolution and a complete redesign of the Venture Capital model, with CalPERS nodding in agreement. CalPERS has gone from a yearly review of their asset allocation to quarterly and is currently debating new hybrid asset allocation models. That means less dependency on VC, and more on other vehicles. At the same time it is looking to reduce its relationships to only the top quartile VCs and getting out of the mid and bottom tier ones altogether. Annex funds, created to fill the void of fleeing late stage investors, are not found to be interesting as the majority of the funds currently in the pipeline will not produce positive returns anyway.The sentiment from the fund managers was that they are literally "fed up with the rock star parties from VCs that don't produce returns". A conclusion clearly not received by all funds as we hear (from a trusted source) that general partners at a downtown Palo Alto walking-dead VC firm are still fetching $1M yearly salaries each, this year.
Everything is going to change.
VC is not dead, but everything is under review. Fund managers are now for the first time talking to each other to fundamentally change the outcome of the game, regardless of the state of the economy. They all admitted that none of the widely used mathematical risk models prevented the precarious situation that now forces even CalPERS to pay close attention to its balance sheet and carefully manage available investment cash.Limited Partners are looking for full transparency of the VC funds, going as far as wanting to see their balance sheets and who is holding their securities. Under the magnifying glass are VC management fees (no more 25%), splits, as well as exorbitant fees gained through stacked funds. Co-investment with endowment funds are debated as they are too over-allocated in the equity vehicle to provide sustainability. We may see more monolithic investments in VC as a result.
All fund managers think clean-tech and health-tech are interesting asset classes, but think the fleeing from technology is somewhat worrisome, they have become weary to over-allocate anywhere. Globally, no economy has proven to show any disparate advantage, the asian and china plays fell equally as hard as the US and elsewhere.
Moving forward, but not so fast.
New VC funds will need to come up with a better story. The creators of the new VC funds will likely be experienced operators (just like at the start of technology evolution), removing the pure money managers who failed to add substantial value. They are expected to, as a team, have demonstrated an ability to warehouse deals before, deliver a unique value proposition to the investment climate and provide substantial value to the disruptive proposition of their portfolio companies.CalPERS is eagerly looking to invest in emerging money managers who in due time (2-3 years expectancy to close a new fund) can expect their renewed support. So far, in the first quarter of 2009, 3 new funds have been invested in (compared to 47 all of last year) and no significant uptick is expected until this summer.
Clearly fund managers are licking their wounds, in a holding pattern for some positive news on the economy and perhaps some much needed regulation with regard to transparency. Rest assured, no fund manager seems to debate the value of venture capital as an investment vehicle, it is here to stay.
Help is on the way.
The great outcome for entrepreneurs is that fund managers (as we predicted) from now on will pay close attention to the type, behavior and performance of VCs that allows entrepreneurs to build new companies more effectively.Good times are coming.
The trap of "Capital Efficiency"
April 15, 2009.
More than 10 years ago I read an article in the San Jose Mercury News in which many complained that Venture Capital (VC) funded companies rarely produce viable and sustainable businesses. To no real surprise we find ten years later that the public markets have no appetite for technology companies and the majority of its VC firms are under water, soon to drown.
With angel investments (left to support the idea-stage of company formation) severely depressed by economic downturn, new VC funds (from an ex-Googler, Marc Adreessen, Manu Kumar etc.) spring up to fund the early stages of technology innovation with $250K injections and fill the gap.
Capital Efficiency is the popular buzzword some of these new investors claim as the new investment category (after outsourcing has failed to live up to similar promises). Sounds promising doesn't it?
It is not. "Capital Efficiency" is a trap.
1/ Companies are not significantly cheaper to build these days
The macro-economics of bringing products to market have not changed at all, mainly because customer behavior has not fundamentally changed.
While new marketing and distribution channels such as social networking promise to provide more effective ways to reach targeted customers, the high noise-level in those channels erases the temporal benefits gained from its early adopter stage. What remains as an advantage is "merely" the quality of the technology proposition in the eye of the beholder, regardless of how that proposition reached its prospective buyer.
So, rather than spending lots of money on old-school decibel marketing, technology companies now need to spend more money on building products that have fundamental macro-economic differentiation and a customer experience that delivers real (disruptive) value. As a result, and I know from experience, it is actually more expensive to build a successful technology company today, because no company can make the false promises it could get away with in the past. Social networking kills false promises really quickly.
2/ Tippy-toe loans yield investor lock-in
A $250K loan (convertible note, usually with restrictions) is an investment that provides no ability to hire professional management that has the experience and ability to turn technology into a macro-economic game-changer early on - or better yet - manage an effective company ecosystem through its life-cycle.
Now the unsuspecting technology entrepreneurs, proud of their newly acquired capital infusion, are dependent on the investor and his pool of syndicates (necessary to provide sufficient runway) to determine when and how that critical conversion (from technology to a business) occurs.
That determination is not the expertise of an investor but worse, has moved the control of a company's business strategy from the entrepreneur to the investor. Relinquishing that kind of control is counter to the fiduciary responsibility in developing a company's independent and most valuable future.
3/ Investors should not run companies
The majority of Silicon Valley investors have never personally ran a company, or if they did, grew up in strong winds that made even turkeys fly. Great investors invest in companies, not in technologies. They are known for their ability to spot the combination of a unique idea, the right timing and an experienced management team to allow that company to operate on its own accord.
In the end, few investors have the time or experience to manage anything beyond milestones established through board control. As a famous investor once said: "I am a better investor than an operator, otherwise I would have become one - you can make more money that way."
Building technology proves nothing
Don't get me wrong, I am excited that new investors with a better pedigree enter the investment fray. I just wished that instead of creating small fragmented funds, they had formed a larger early-stage investment fund with like-minded peers through which they could deliver on the original promise of Venture Capital, and that is: generate big returns from taking big risks.An investment strategy that keeps entrepreneurs on a leash with micro-investments looks an awful lot like loan-sharking to me. To those who take it, don't be surprised if the bite is deep and quality of life will be severely diminished.
Consider yourself warned.
The economy is not the problem
March 06, 2009.
By Georges van Hoegaerden
Pierre Lamond, a Silicon Valley legend who has been a Sequoia partner at the Menlo Park, Calif.-based Venture Capital (VC) firm since 1981 has decided to join Khosla Ventures, primarily to do what Venture Capital was designed to do, take risks again.
Having hit on subprime VC for a few years now, his reasoning resonated with me and I looked back at Vinod Khosla's "New old-fashioned" model for Venture Capital, he describes in his 2002 presentation as "Funding to Milestones", as depicted below:
Now compare the above chart with the one right below, the VC model practiced by the majority of current Venture Capitalists today, which I refer to as subprime VC:
What quickly becomes apparent from the latter chart (derived from actual pitches between entrepreneurs and VC) is that supported by the excuse of lower development costs related to web2.0 technologies, the investors have pushed down the majority of the risk onto the entrepreneur.
We all know by know that Web2.0 is not a business and still requires the definition of a disruptive business that does not fundamentally yield lower operating cost, but much more disturbing is how investors have reduced their risk and delayed their active participation with a company that, in the end, actually produces lower exits (investors are now satisfied with a 2x rather than 10x return) and no IPOs. We explained in our previous blog how that strategy cannot save Venture Capital funds.
While statistically we can time-shift the sub-prime chart to the left and assume nothing has changed by holding up the Moneytree reports, anyone who has walked around in Silicon Valley as long as I have, knows what is really going on under the hood.
Unlike people like Vinod Khosla who can assess technology risk before it is build, the majority of investors can't envision an opportunity until they spot it in their rearview mirror. Today, investors demonstrate by their actions (or lack thereof) what is fundamentally flawed in Venture Capital; the lack of people that can accurately assess risk. In 5-years our economy will be in better shape than it has been, leaner and meaner. Technology opportunities are and will be abound, as it is in the early stages of penetration. This is indeed a time for aggressive investing, rather than a time for crawl-back we see some VCs do.
The sub-prime VC problem will remain when the economy recovers, if it is not aggressively perforated by people with real early-stage operating experience who understand that risk is the lifeline of Venture Capital - and join the investment fray.
Stop blaming the economy and take a risk, everyday. Only then will you get better at it.
(I will explain the sub-prime chart in more detail later)
Pierre Lamond, a Silicon Valley legend who has been a Sequoia partner at the Menlo Park, Calif.-based Venture Capital (VC) firm since 1981 has decided to join Khosla Ventures, primarily to do what Venture Capital was designed to do, take risks again.
Having hit on subprime VC for a few years now, his reasoning resonated with me and I looked back at Vinod Khosla's "New old-fashioned" model for Venture Capital, he describes in his 2002 presentation as "Funding to Milestones", as depicted below:
Now compare the above chart with the one right below, the VC model practiced by the majority of current Venture Capitalists today, which I refer to as subprime VC:
What quickly becomes apparent from the latter chart (derived from actual pitches between entrepreneurs and VC) is that supported by the excuse of lower development costs related to web2.0 technologies, the investors have pushed down the majority of the risk onto the entrepreneur.
We all know by know that Web2.0 is not a business and still requires the definition of a disruptive business that does not fundamentally yield lower operating cost, but much more disturbing is how investors have reduced their risk and delayed their active participation with a company that, in the end, actually produces lower exits (investors are now satisfied with a 2x rather than 10x return) and no IPOs. We explained in our previous blog how that strategy cannot save Venture Capital funds.
While statistically we can time-shift the sub-prime chart to the left and assume nothing has changed by holding up the Moneytree reports, anyone who has walked around in Silicon Valley as long as I have, knows what is really going on under the hood.
Unlike people like Vinod Khosla who can assess technology risk before it is build, the majority of investors can't envision an opportunity until they spot it in their rearview mirror. Today, investors demonstrate by their actions (or lack thereof) what is fundamentally flawed in Venture Capital; the lack of people that can accurately assess risk. In 5-years our economy will be in better shape than it has been, leaner and meaner. Technology opportunities are and will be abound, as it is in the early stages of penetration. This is indeed a time for aggressive investing, rather than a time for crawl-back we see some VCs do.
The sub-prime VC problem will remain when the economy recovers, if it is not aggressively perforated by people with real early-stage operating experience who understand that risk is the lifeline of Venture Capital - and join the investment fray.
Stop blaming the economy and take a risk, everyday. Only then will you get better at it.
(I will explain the sub-prime chart in more detail later)
How sub-prime VC stings twice
March 04, 2009.
Sub-prime Venture Capital is akin to the sub-prime lending market and we predict the bottom will soon fall out of sub-prime VC too, spurred by the fear of economic pressure and the depressing returns of expiring post 911 venture funds.
Just like working for Carnival Cruise looks glamorous but is not the way to explore the world, unsuspecting young entrepreneurs who fall for sub-prime investors will soon find out that building those technologies has all the glamour but few of the rewards associated with innovation. Regardless, many chasing the mighty dollar will fall for it.
Here is how entrepreneurs can recognize a sting from subprime VC:
Step 1: We like the idea, but before we invest please finish the product some more, then come back
Step 2: 6 Months later, you finished the product. Great, now prove it works by getting 100,000 daily users, then come back
Step 3: Fantastic, now we'll take 60% of your company for $1M
Ouch, that hurts.
Here is why sub-prime tactics hurt our innovative ecosystem, just like sub-prime lendings have a negative effect on the housing market as a whole.
ad 1/ Technology development is the investment risk we understand quite well, timely applicability to a market is the real issue. So, proving that the entrepreneur can build a product can easily be derived from the entrepreneur's vision, knowledge and credentials in that space, juiced up with some kitchen-sink prototyping. On top of that a 6-month self-funded development timeframe with 2-3 developers can hardly yield a sustainable competitive advantage anyway, so R&D development proves nothing.
ad 2/ In many cases it is impossible to land 100,000 users before you have a critical mass of product capabilities. That critical mass comes from an R&D investment that generates substantial differentiation, and rarely from tip-toeing into the marketplace. Marketplaces, for example, only grow when a critical mass of both supply and demand are lured in and participate, which often requires a bolstering of technology to support all constituents, rather than minimizing it. Already, too many technology products enter the market unfinished as a result of underfunding and yield false negatives.
ad 3/ Control and valuation of the company are a direct indication of the future success of an early-stage company. The vast majority of technology success stories are derived from retained majority control by its founders and CEO (Facebook, Google, Twitter, eBay etc). Investors are terrible operators (no surprise given their background and experience) and should not want to own a majority stake in their companies, simply out of self-preservation.
Additionally, the danger of these tactics deployed by sub-prime investors (many of the large venture funds deploy fashionable sub-prime tactics too) is that it marginalizes technology innovation and provides a very unstable breeding ground for the fund performance as well:
a/ Venture Capital is meant to stimulate the high-risk / high-yield asset class as defined by its Limited Partners, the sub-prime strategy described here (anecdotally) serves nothing more than low-risk / low-yield segment of the technology asset class.
b/ No fund larger than $100 Million can support the management attention needed to spur these tiny injections along. As a result sub-prime investors just constricted what they thought of interesting innovation with too little time and too little money to provide critical market entry.
c/ Very few low cost entry deals yield the disruption that prices out favorably to makes any dent in the return of the fund as a whole. Venture funds need few big returns to keep LPs coming back for more.
The only early-stage investors who may be able to turn sub-prime deals into prime are the investors who:
- have proven to be successful operators themselves
- support the vision before the product is there
- have great syndicates to support the full runway of a disruptive market entry going forward.
Investors that can turn sub-prime into prime can be counted on one, maybe two hands. People like Marc Andreessen with his new AZ (Andreessen-Horowitz) fund come to mind. But entrepreneurs who are not stung by these visionary investors may just as well hop on that cruise ship and enjoy life some more.
The economics of big technology plays have not suddenly changed, the cost of developing technology may have declined slightly but simultaneously competition has increased exponentially. So, we prefer to focus on plays that are high-risk and high-yield simply because only they create the disruptive innovation that can keep VC firms in business.
The challenge for early-stage entrepreneurs remains the same, to create unbridled and disruptive innovation that finds only one investor that believes in it. If many more do, believe me, the technology is just not disruptive enough. So, be ready for some controversy.
Finding the right investor, amongst 700+ firms in the U.S. requires that entrepreneurs understand and can read the dating game. If they don't, we'll be happy to help. But get to us before you've been stung 217 times.
Introducing the new VC blacklist: 217 and counting
February 23, 2009.
Retail store decorations reminded me that easter is approaching and that set off the memory of an easter egg chart (on the right) I received from an early stage entrepreneur who had been trying to raise money over the past 12 months. In many ways the chart indicates how the Venture Capital (VC) world is filled with the wrong operators (not a lack of money), incapable of assessing risk; I will clarify later.
The enclosed chart includes the names of every investor (VC and Angels) the entrepreneur has spoken to face-to-face (in dark green), conversed through e-mail (in light green) and is scheduled to connect with (in orange).
Needless to say the 217 investors (whom I will not disclose yet, to protect the entrepreneur) that bothered to meet face-to-face include pretty much anyone who means anything in the VC business.
Helped by a tiny amount of seed money and introductions from a well known and respected investor, most investors responded enthusiastically (according to the entrepreneur), yet virtually none have bothered to provide the valuable feedback (or responded back with a decent no) that could lead to a line-of-sight of a term-sheet.
So, we conclude from this painstaking process the entrepreneur went through the following:
- Fundraising takes time, a lot of time
Even with the introduction from a well known VC, carve out one year of your life to raise virtually nothing (a million or so). Most entrepreneurs chase a dream that is chiseled from years of experience dealing with inefficiencies, only to discover that at fundraising time they don't understand (and don't want to understand) the VC microcosm that holds "innovations" hostage. We recommend entrepreneurs to start socializing the idea with VCs the minute they start writing code, to establish a clear target list of investors that can and should do the deal 9 months to a year later. One year ago I would have recommended the entrepreneur to sell his house and raise money that way, easier and better retention of control in the company.
- Investors don't treat entrepreneurs with the respect they deserve
Not responding to the entrepreneur (even when they share valuable connections together) as the majority of the investors on the enclosed chart did is the lowest form of disrespect imaginable. I have written about obnoxious VCs in this blog many times before (reinventing VC, subprime VC, LPs fooled, curse of subprime VC, investors to avoid) and would tell you that those over-inflated personalities contribute that I have no interest to belong to the current VC club (I have been asked). Clearly not everyone was raised by a grandfather (and co-founder of the Mentos candy) who taught us early on that you can be hard-nosed, respectful and successful all at the same time.
- The current crop of early-stage investors are numb
As you notice from the linkages in the chart (hard to see at 6% of original size), many investors have provided referrals to others. But referrals only happen when investors believe "there is something there" (one of their favorite phrases) and pass it along to another investor who may better understand the proposition. In an effective investor ecosystem and regardless of their belief in the proposition, the chart would never grow to be as large as it is. When investors don't like the proposition they will not pass it on, and when they do they will keep it to themselves and work out a deal. So, the sheer size of this chart communicates really well how clueless our current VC microcosm is.
- The current crop of early-stage investors simply don't understand the technology business
The fact that this entrepreneur is thrown around like a rag-doll by some of the biggest "experts" in the VC business says it all. The investor's indecisiveness is an indication of their lack of knowledge and vision that has earned them such a prominent role in the innovation of our industry. But, the best investors weigh risk, they do not need to deliver vision. Experienced entrepreneurs do not need investors to hold their hands in understanding the technology business and just need their investors to get out of the way.
- The current crop of early-stage investors are cowards
There is nothing, I repeat, nothing wrong with a VC saying no, whatever the investor's rational. But this chart shows how none of them can decide on their own - either way. These investor cannot stand to lose a deal they may miss out on (and not saying no will keep that door open), and don't have the guts to take the risk if they thought otherwise. It takes a strong character to be a VC, not an insecure and arrogant one.
- The current crop of early-stage investors are lemmings in rudeness
We knew that they were lemmings already, but now we know they will not only decide to jump off the cliff together but also share incredible rudeness. A sad state of being. No entrepreneur should sign any of these people on to their boards, because if they were not rude to them yet, that behavior will undoubtedly pop up when they least expect it.
- Entrepreneurs need a professional agent
Talking to this many investors and not yielding any takers is creating the smell of a dead fish in the venture community. While great successes like Skype required talks with reportedly about 40 investors and I did 20 on one of mine, the entrepreneur should have forced an early feedback loop with some investors before proceeding to talk to any more. The entrepreneur should pick an advisor or agent that does not allow this to go on for so long. It is sad that we are beginning to look an awful lot like Hollywood to become effective.
Now, notice that I have not discussed the specific proposition of the entrepreneur here and we may actually side with the VCs unable to extract razor-sharp focus from this entrepreneur's broad tale (but we will have the courtesy to tell him that directly). But the validity of the proposition is beside the point made here. Entrepreneurs, while they eat away their family's life savings and make considerable personal sacrifices, deserve the straight talk to help them plan their resources.
It is even more appalling that without any serious feedback the only response from a few VCs is to come back later, build the base technology first (which the entrepreneur has done) and get a critical number of customers. As if at that time the entrepreneur is in need of any fair-weather friends. The true character of the sub-prime VC is shining through again, but I am surprised it includes so many investors I thought better of. No wonder people like Umair Haque become even more enraged, describing VCs asleep at the wheel of creative destruction.
I would suggest the LPs (Limited Partners) to pull back from 80% of their current VC commitment (that are not producing returns anyway) and re-allocate the majority of that money to the creation of new VC firms that target more fundamental diversification in the technology asset class. I hereby offer my services to the LPs that want to take a hard look at that. And I would love to see the remainder of the current "prime VCs" be forced to re-invent themselves by this new influx in the same way entrepreneurs are all the time.
The only way to grow technology innovation is to force the VC business out of its current sub-prime mode and challenge the behavior of the crypt-keepers by making them highly accountable for their performance.
In the words of Ron Conway (a prominent angel investor) who recently stated "it is time for a new crop of entrepreneurs", we surmise "it is time for a new crop of investors" that attracts better innovation.
Radically reinventing Venture Capital
February 04, 2009.
