Goodbye VCs, it's been a pleasure

New ventures, start ups, whatever you call them are unique and extremely important to us all: Every company, every commercial value-adder, the core of wealth creation, started up once. And it would be safe to assume that much of the shareholder's wealth is created in the early growth phase.

Thus start ups should have a central and unique position in the fabric of the world's economy. Still, so far their funding needs beyond friends, family and the occasional angel have only been served by the Venture Capital firms, a niche in the financial services industry.

As is rather clear these days, the financial industry sector suffers from systemic flaws so what about those VCs?

Let me take one step back and start with some recent discussions:

First one would be Tim O'Reilly's post aptly named "Work on Stuff that Matters: First Principles".

The principles are rather of the banal kind, but well argued, here are some of my takeaways:

1. Work on something that matters to you more than money.

Whatever you do, think about what you really value. 
Don't be afraid to think big. 
Don't be afraid to fail.

2. Create more value than you capture.

Focusing on big goals rather than on making money, and on creating more value than you capture are closely related principles. The first one is a test that applies to those starting something new; the second is the harder test that you must pass in order to create something enduring.

And he mentions the one's with BHAGs:

Take Microsoft. They started out with a big goal, "a computer on every desk and in every home," and for many years unquestionably created more value than they captured.

Or take Google. Again, a huge goal: "Organize all the world's information." And like Microsoft in its early years, they are enabling others while making a pile of money for themselves. 

3. Take the long view.

...a time like this, when the bubble is bursting, is a great time to see how important it is to think about the big picture, and what matters not just to us, but to building a sustainable economy in a sustainable world. 

The audacious goals of Microsoft and Google leads nicely to a recent Business Week article - "Whatever Happened to Silicon Valley Innovation?"

A couple of highlights:

Venture capitalists' taste for risk has changed for a number of reasons, including the difficulty of taking tech companies public or selling them for lucrative paydays. The result is that venture firms are putting much less money into tech startups than in the past, and the money they do invest goes into less expensive, less risky deals, including social networking startups such as Facebook, Twitter, Yelp, and Digg. These so-called Web 2.0 companies are creating exciting new forms of socialization, information sharing, and entertainment. But some of the Valley's old guard are skeptical they'll grow big and important enough to deliver sizable productivity gains for business and the nation or to produce an upswell in new core technologies. Today's startups "give us refinements, not breakthroughs," says Andy Grove, former chief executive of Intel (INTC).

"These Web 2.0 companies are surfing on the old wave. They're not creating the next one," says analyst Navi Radjou of Forrester Research (FORR).

And my favourite - Andy Grove and the "payday" mentioned above: 

What really infuriates him is the concept of the "exit strategy." "Intel never had an exit strategy," Grove says. "These days, people cobble something together. No capital. No technology. They measure eyeballs and sell advertising. Then they get rid of it. You can't build an empire out of this kind of concoction. You don't even try."

Did Microsoft, Google, Intel, Dell and Amazon spend time on "exit strategies"? Doubt it.

My beef with the question is that it's so revealing, it basically precludes the value focus mentioned by O'Reilly - and in essence it proves that the investor is in the business of betting on a market. "How can we dress up the bride for a market that might happen when we need to make our payday?". Betting on markets is not business building, it's not innovation, it's financial crap shooting.

Worse of course is if the entrepreneur is of the same mind, "build to flip" is a bit sad really.

But why this? In my humble view it's due to two issues:

1. VCs are part of the financial industry, serving the needs of investors.
2. Their funding is time stamped, return of principal and gain is on a set date. 

This creates an unfortunate focus on end date and market mechanisms for when the investment has to be unloaded.

Here's a simplified scenario for illustration purposes:

1. Let's say I raise a 10 year fund for my VC, then go about it to vet and analyse investment proposals.
2. I decide to invest in your new venture in year three. Now we have seven years left.
3. To give myself a bit of leeway I should dump you in six years, which means that you should be well into profitability by end of year five from now.
4. That again means that you should pass break-even in year three or so starting today.
5. To get there we all have to plan accordingly meaning hiring marketing and sales people asap and ramp up that infrastructure to match the planned future volume.
6. The problem of course for any new venture with a great product or service is that the market is fickle in the sense that it's almost impossible to outguess it in any way, it's more normal to have your product used by somebody else and for different purposes than planned than not. Not to mention betting the farm on a theoretical growth curve.
7. Knowing that this upfront blind target shooting will kill off most, I'll use my background in statistics and invest in 10 companies to allow two to become potential huge successes within my given time-frame while the others are written off. Your chance of failure is thus 80%, sorry.

I'm not against delivering the best possible value to the venture investors, quite on the contrary, but there should not be any doubt that the best shareholder values delivered over time have consistently been delivered by those who can create a great value for their customers while keeping a good margin.

And the customer is the start-up, the VC is the vehicle and the investor is the passenger. The passengers are always much better off if the driver keeps his eyes peeled on the road.

With this in mind I decided to poke some VC friends to see where they're at these days. My little enquête, although statistically insignificant, seemed to give one clear answer: VCs are moving to the other areas of Private Equity.

The bigger European VCs seems to be moving away from early stage investing, i.e. Venture, into Growth Capital. Mid autumn I counted five who still invested in early stage among the large European VCs, in December I counted four, last week I was down to three.

I sympathise, given their focus - the markets are hard to make any kind of bet on these days - so now they are soliciting established enterprises who suddenly are much more willing to shore up their capital base at much more reasonable valuations.

This in so many ways reminds me of what was called Private Equity in the nineties, the days they had a meaning; consolidate the small and grow the laggards. Now PEs have left that idea behind to become pure asset players shuffling ownership even between themselves (disclosure - did much M&A work with PEs in the nineties).

Thus, dear VCs, it's been a pleasure having you around, sorry to see you all leave but that's all fine by me, it's time for something new, something that'll work better.

Disclosure: This equals a huge opportunity, the biggest I've seen in a long time, and I'm not letting it go without a serious stab. Watch this space in the near future...

Comments

[phil jones]

You mean you'll be investing? Or this is something that Thingamy can take advantage of?

[sig]

Phil, I feel like Hugh M when I say "new evil plan" thus weaseling my way out of the question ;)

[Boyd Mulvey]

I have been linked to this site and so have never read your blog before but I have huge sympathy with this view.

By way of back ground, I founded my early stage venture firm 8 years ago and we are now earning out our best performers having stopped taking in new deals last summer. We are in year 6 of our fund. I am not proposing to raise another Fund in the current market.

I agree with most of what you say regarding life cycle of VC's. Also, as I am based in the UK, I can confirm early stage investors are very thin on the ground and getting thinner.

The main problem is life cycle. VC's are generally funded by long term investors (Pension funds, Fund of Funds, and some very large private investors). The problem is that who else has appetitie for this longevity? Corporates don't tend to have a corporate memory longer than 10 years and (in my experience) actually want companies with timelines/ product to market/ in less than three years unless they are doing the R+D themselves. Most want proof of sales prior to investment although there are very limited exceptions. So who else is there? High Net Worth individuals? You have to assume they are at least in their 40's and most likely 50's before they are financially able to tie up funds of several millions in high risk early companies for 10 years or more. Usually these people are hard to find and would rather personally run a small number of deals. Apart from family offices of billionaires with an appetite outside their core compentencies (which limits the number further) I suggest there are very very few investors who would not expect payback in 10 years. If you compare VC investors with most other forms of investment (public company investors have three month horizons) I think you will find the horizon is already as long as can be expected.
The second main issue is that early stage VC investment is extremely hard work compared to the returns generated. This is why almost all investors who makes a track record increase the fund size and move to later stage deals. This limits the number of successful investment managers investors can place their cash with for early stage deals.
Early stage investment is vital for many many reasons. If you find a better way - I wish you great success.

[Account Deleted]

There is no better company in the world than Google that shows you how to create an online business and earn money online. Really the business model of this company is extraordinary.

[Sunil Malhotra]

This is one of the most relevant and powerful pieces I have seen in a long time, Sig. Many of the reasons I did not choose to have Ideafarms funded by Vulture Capitalists are so lucidly captured in your post.

Exit strategy is something I pooh pooh at. Makes a money lender holding your home to ransom look like a saint! The VC community cannot even imagine the damage they have done to genuine entrepreneurship. Some of it will not be undone for generations.

I love your allusion to the investor being the passenger. How irritating to have a passenger sit in the back seat while you're driving, giving you instructions about when to step on the gas when he has never even learnt to drive.

I join you in wishing VCs farewell and hope they will never return. RIP