Is VC too Fat and Happy?

Posted on Jul 8, 2009 | 44 comments


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Much criticism has come of our industry in the past few months and in my opinion much of it is deserved (but I’m definitely a believer in the meme that VC isn’t broken but some of the participants are (see here, here and here)). But the VC industry is too fat – a thoughtful piece by Paul Kedrosky on shrinking the industry by half is here.

The latest to weigh in was the NY Times with this well written piece in yesterday’s paper.  I think it propely captures the moment and questions whether the structure of the industry for the past 10 years is the the right one for the next 10.  In my opinion it also makes Tim Draper truly seem out of touch … we need more VC money to “spread the wealth to the seven billion creative minds out there.” Really? WTF?  I’m prefer to assume he was quoted out of context since I’m told Tim isn’t a bad guy.  (UPDATE: Great response from Bill Bryant of DFJ is here.  As I said, I had hoped it was out of context).

My own views echo those in the NY Times article and come from my experience of raising VC as a entrepreneur over 2 companies and 8 years and working with 9 firms that invested and many VC’s that issued term sheets that we never closed on.  Here are my conclusions:

1. There is way too much money in VC – Lowering the amount of money will be healthy for VC’s and  start-up companies.  When I was a start-up CEO I always believed in charging a fair price for the products that I created.  But in 1999-2001 so much money went into our competitors that people were willing to low-ball on price to win deals because they (we all) had too much VC money that would fund our losses.  In today’s world this is worse – people are willing to offer products for free funded by 2 years worth of VC money (and I’m not even talking about ad supported businesses).

2. Fund sizes have been way too large – I remember pitching on Sand Hill Road in 2005 for my second company, Koral, and I told VC’s that I only wanted $2 million.  A number of investors told me that their minimum was $5-8 million and they encouraged me to take more money, “because I’d need it.”  Luckily I was on company number two and I had already painfully learned the lesson of raising too much capital so I didn’t follow this advice. At the time I couldn’t understand this mentality until it was explained to me this way, “look, I have a $600 million fund.  I can’t invest $2 million in companies and stay actively involved.”

Actually, I get this.  But then I think this fund ought to be a later stage growth equity firm and not a VC or they ought to have more partners in the firm investing smaller amounts. I believe passionately in capital efficient businesses that prove out their model before trying to scale.  This suits the interest of the VC but I believe it suits the interest of the start-up founders even more so.  Some VC firms like Accel, Index and others have created separate “growth” funds with larger dollar sizes for later stage deals – that makes sense to me.

The incentives for many VC’s has been wrong.  They’ve been too happy to have multiple “stacked” funds of large sizes so that their management fees (which are typically 2% of the fund size) can be large.  I don’t believe that VC’s who maximize their fees by having large funds are in the interests of their Limited Partners and I actually believe it encourages the wrong people to want to work in VC. (as I side note I wonder how LP’s can justify this size of management fees for the “mega” funds that have billions of dollars.  Do they think it creates aligned interests to make partners so wealthy on just deploying capital?)

Dana Settle said it well in the NY Times piece.  Start-ups need less money to get going these days and you can get a good return at a $100 million exit provided you didn’t put in too much money and you can get in at an early stage.  Venture exits last quarter on average were just $22 million last quarter (vs. $41 million a year before $60 million over the last 8 years).  I know we’re all looking for the home run that “returns the fund” but to be successful I believe the industry needs more Greycrofts.

3. There are way too many non-operators - I won’t go as far as to say that every VC needs to have been an operator because I’ve worked with tons who I really respect who don’t come from an operator background.  I certainly believe operating experience helps a lot, though, and believe that every firm needs to have a few entrepreneur partners in their stable.  I experienced way too many ex i-banker and consultants who never had any operating experience and had a better grasp on whether my operating margin in year 5 was appropriate vs. an intuitive feel on whether my product would be adopted by customers.

No doubt they can do the deep analysis and really help at financing time to analyze the pro’s / con’s of venture debt.  And I’m sure they really earn their money at exit time in the sale.  But some of them lack the depth of understanding in the key decisions that each entrepreneur faces.  They have no idea what it feels like to be 3 weeks away from missing payroll with an employee asking you whether it is a good idea to buy a house (should you actually tell them there is a 10% chance you’ll be out of work in 3 weeks?) or customers are entrusting you with orders that you’re not 100% sure you’ll be able to fulfill.  What advice can they give you about dealing with customers in this scenario?  If VC’s truly understood the angst and emotional drain this puts their founders under they wouldn’t bleed you until the 11th hour waiting for your internal financing term sheet so that they get more information or negotiate a better deal with you.  A great VC wouldn’t do this.

I recently debated with some founders the best way to go about laying off one of their employees.  They were telling him they were letting him go for cost control reasons when it was really for performance reasons.  I’ll cover the topic some other day but I believed the right thing to do was to fire him for performance and tell him this.  I gave them 30 minutes of rationale from my experience on why I thought that would help and not hurt with morale.  (btw, they didn’t take my advice ;-) I have been through more downsizing (can you say 2001?) then I care to think about and have had many years of firing based on performance.  It’s burger flippernever fun.  Many VC’s have never had to deal with this “dirty” work and never will.  Sure, they’ve let an analyst or associate go but in the VC world this is very different than cutting a developer on a tight team of 6 developers when each of the remaining 5 could go out and get another great start-up job without a sweat.  Not true in VC.

I like to say that you can’t run a burger chain unless you’ve flipped burgers.  I think we could use more burger-flipping VCs.  I think that’s why so many people are excited to hear about the Andreessen Horowitz fund.

4. In a strong wind even turkeys can fly – I believe that there are way too many VC’s that believe their own hype from the successes that they had in the late 90’s (or frankly from 05-08).  It reminds me of the real estate investors who were telling me what a fool I was not to be buying condos in Florida in 2006.  The difference in VC is that many of the senior people in industry who had past successes don’t have real down side when markets become more _flying_turkeydifficult.  They are simply able to stay in their funds and milk it.  Obviously the industry luminaries like Sequoia, Kleiner Perkins and Accel have continued to prove they can pick the best winners but there are also many who had hits by sheerly being in the market.

Years ago a sage mentor of mine told me in 1997, “don’t assess our company relative to competition now.  In a strong wind even turkeys can fly.  In a down market the best companies separate themselves from the pack.  The weak disappear.”  So it goes with VC.  Eventually those with no leadership will dwindle and help realize Paul Kedrosky’s prediction.

5. Some VC’s lack empathy. Some VC’s simply can’t understand the world of the start-up founders or they’re too far removed from the daily grind to really empathize.  Being a CEO is much lonelier than anyone who’s never done it can imagine.  I know that there are the breakout successes like Google, Twitter and YouTube.  But  the rest of companies go through through cycles.  Even the best companies go through it.  I’m sure that LinkedIn, Facebook, Mint and others have been through tough times.

You don’t have many people to share your problems with because you try to keep it together for all your staff.  You need to come in every day to the office and motivate people even when you have your own self doubt and worries.  You need to hire, sell, talk positively to the press, etc. while blindly having faith that your next round of capital is going to come.  You have co-founder issues.   Your clients grind you.  Your employees need more money to get by.  Your product is shipping late and with some of your key features postponed.  Your crack developer quit to move to NY.  Your spouse or girl/boyfriend is irritated because s/he hasn’t seen you enough.  Or worse you don’t have one and you’re getting too fat.  This is an unbelievably honest piece from an entrepreneur coving this topic.  Have you been there?  That’s when I think you can offer real advice.  That’s where a VC needs empathy.

6. Are some VC’s too old?.  The NY Times article alludes to this.  As for me, I’m not ageist.  I see fantastic VCs in their 50’s/60’s that blog, use Facebook, use Twitter, IM people and use Salesforce.com, Google Docs, RSS Readers, etc. (no, using a Kindle and a Blackberry doesn’t count).  The NY Times piece profiles one of our industry veterans, Alan Patricoff.  He still works incredibly hard.  I don’t know how old Howard Morgan at First Round Capital is but I know he’s not 35.  He travels more than most 35 year olds I know and knows more about what’s going on in early-stage tech than many of these same people.

I think it’s more about mentality and willingness to accept the creative destruction of the new without being jaded by your past.  I remember a conversation I had with a prominent older VC from Sand Hill Road 6 months ago who decided to call it quits.  I asked him why and he said, “I just realized that it’s all changing so fast and I don’t have it in my to want to learn all the new technologies that everybody in their 20’s are playing with.”

Blogs are reshaping the publising indutry.  Companies like TopSpin Media are finding new distribution channels for musicians.  Twitter is chaning our communication landscape.  Cloud computing is coming and will change the IT industry.  Young people do place real value on virtual goods and define their self worth through online brands the way we do in our offline lives.  People will spend hours translating movies, adding restaurant reviews and updating Wikipedia for nothing more than to be part of a community and be “Internet famous” to that community. Virtual reality and augmented reality are real phenomena and not this year’s fad.

As one senior VC partner lamented to me “kids these days don’t read physical newspapers any more” and I showed him how much news I could consume from so many more sources than he could through RSS feeds and after showing him he still didn’t get it.  Some people never will.

My advice to entrepreneurs – find a VC you feel can really relate to you and your company on a personal level.  Find people that are in it for the passion of building great products and love the rush of the start-up.  Find “egg breakers” willing to take risks.  And be careful of VC’s that have a gleam of easy money in their eyes.

Update: several people asked me for VC’s that do “get it.”  There are many and I don’t want my post to be seen as damning of the whole industry – just several players in it (not to mention that many hedge funds did venture investing in the past 3 years who had no previous VC experience).  Here just a quick, non comprehensive list of some obvious VC’s who do get it:  I think there’s a host of VCs who do get it.   True Ventures, Foundry Group, Union Square Ventures, First Round CapitalFounders Fund, and I obviously I feel GRP Partners in LA (who funded 2 of my companies and I worked with for 7 years before I chose to join).  There are obviously many, many more.

  • http://www.dynamicsynergy.com Mark J. Landay

    Mark,
    I read the same NYT article, and agree we need more Greycrofts. Additionally, I would welcome the experience of a VC who has been through the cycles as long as they are in touch with the current market. I can’t imagine someone investing in something that they are not familiar with or have not done proper due dilligence. A good board is a mix of backgrounds.
    Keep the great post coming!

  • http://www.AudioMicro.com Ryan Born

    Another killer post Mark…there’s quite a lot of data here, enough for 3 or 4 posts even…Quite an interesting stat about venture exits last quarter on average being just $22 million (vs. $41 million a year before $60 million over the last 8 years. Yes – the entrepreneur road can be quite lonely at times and having a VC that’s been there before as an entrepreneur, keeps a level head when things are tough, and stays positive and encouraging will really make a difference.

  • http://www.vrixx.com santino

    hi

    another well written piece! content in para 5 is so true could relate to every bit of it..

    regards

  • http://www.feld.com Brad Feld

    Great stuff Mark. Love the Tim Draper call out…

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  • masterstrack

    Mark,

    Following your strong points I’m on the same page. If you like another way of putting it – there is a complete disconnect with the amount of VC money in funds waiting to be invested and the amount of money a start up needs.

    If fact my belief is that there is a huge gap in the market for what I’m calling Hands On Business Angel.This combines a small investment and a part time chairman role to get stuff done.Micro VCing with real operatonal know-how. Look forward to more posts. Regards Ian

  • David Smuts

    What a great insightful read! Well done Mark.

    So please tell me…., Are VC’s going to change?

    Don’t think so- too ingrained in what they’ve been taught. Only new innovating entreprenuerial VC’s can change the game. So where are they?

    all the best
    David

  • marksuster

    Ian, agree that there is a funding gap for early stage angle investing. We need more of that. Thanks.

  • marksuster

    re: the meme that VC isn’t broken but some of the players are … I think there’s a host of VCs who do get it. I could never be comprehensive here but I’d include True Ventures, Foundry Group, Union Square Ventures, Founders Fund and … I hope I can say, GRP Partners in LA. We’re entrepreneur friendly and hands on. Thanks for your comments.

  • Reader

    First time reader, via Brad Feld. Great article, but why are all your links sent to bitly rather than the actual destination? It makes them tough to read because mousing over the link tells me nothing.

    This is a blog post, not a twitter message!

  • http://www.cleanmycellphone.com Nima Shar

    Ha! Bet some of those VCs never had to live on Taco Bell 3 nights a week to get by…There’s no sub for the real experience.

  • marksuster

    Ha. Thanks, Nima. I guess I’ve used that example a few times in public ;-)

  • http://youarekillingme.net SteveR

    Great post Mark (brave too1)

  • http://www.cleanmycellphone.com Nima Shar

    So that was you! lol That example really hit home with me, you know, and I was never really sure who said it ;-) Excellent post!

  • marksuster

    Oh, well. Might as well call it how it is.

  • http://www.mvmpartners.com Scott Shapiro

    Great post Mark!

    When can we get you on the disqus bandwagon by the way?

  • marksuster

    Thanks Scott. I’m already a Disqus user. I will be converting from WordPress.com to self hosted in a couple of weeks and will be plugging in Liggit, Discus and several other things. Best, Mark

  • http://www.schwartzgroup.com Bob Schwartz

    Mark
    love this, well written from both sides.
    Bob

  • John Morris

    Mark:
    Excellent post. The VC business model needs a major reset. The asset category is losing favor. The industry needs to revisit its roots in oroder to survive. Your support for the entrepreneur is impreswsive and refreshing.

  • http://www.virsto.com Mark Davis

    Right on. From the entrepreneur’s perspective, your points 3, 4, and 5 really hit home.

  • Siddharth Chaw;la

    Great insights and very useful for entrepreneurs like me!

    Siddharth

  • http://www.waytooearly.vc HLMorgan

    Excellent post Mark. Agree with all of it, though I think a little better of Tim that you and Brad. And thanks for the no ageism :) I”m actually going to be 40 this year (in hex).

  • http://www.growvc.com valto

    Excellent post Mark! I have a strong believe that you will make an excellent VC, don’t ever give up on your entrepreneurial roots and become one of those “cynical VC’s”.

    I also agree that there are at least some other good VC’s out there like those you listed in one of your replies.

    Also about this overall problem in VC industry, we are betting that entrepreneurs “hold the key” to change this industry for better and overall both parties should stop looking at the funding process as, us against them and start the thinking from “are we (entrepreneur and VC) the best combination to move this forward” – in relationship terms “would we make good parents” instead of “I want/need what you have”

    At the moment and for some time already, there is such an unified understanding sweeping the industry, pointing out that current model is not sustainable. This means disruption to make it better, more sustainable model, will eventually happen and we feel that entrepreneurs are those that will make it happen. Like in so many industries before this one.

    And in this particular industry even more so, because they are in middle of it. After all there are no start-ups without entrepreneurs…

  • marksuster

    Thanks for the comments, Howard. Re: Tim … I can’t comment on him as an individual because I haven’t worked with him (although obviously I know many who have). My comment is geared not at him but at his quote in the NY Times. I always wince when I hear certain CEO’s of start-ups proclaiming too bullishly that they’re changing the world when we as investors know what their internal financial statements look like. I think it sends the wrong message to people reading in the news or watching on panels who don’t necessarily know better. For me Tim’s quote is the same. It sends the wrong message to readers who might not know that it is the over funding of the sector and too many VCs that has driven down returns and created too many bad companies (although he’s entitled to his opinion and clearly doesn’t agree with this).

  • marksuster

    Thanks for your comments. I agree that the industry starts with the entrepreneur as posted by Fred Wilson: see – http://bit.ly/3osRm4 and my comments to this post:
    Me:
    As a former CEO and now as a VC I agree completely. I’m seeing the Dave Winer meme that it should be about the user and about the company. He’s got it wrong. In supporting the vision of the CEO (the primary job of the VC) sometimes it means enabling their vision and sometimes it means challenging it (but not making final decisions for them). If the VC feels that the product isn’t complete or doesn’t solve enough of a customer problem then the VC should debate the topic with the CEO to be sure that he/she has a strong enough vision. If a VC picks a CEO that doesn’t know how to lead a company then you backed the wrong horse in the first place. Interpersonal skills are some of the most important attributes of a successful entrepreneur. So in the end, it’s all about the CEO. Thanks for your post.

    fred wilson:
    Dave Winer has a point. Users are a critical stakeholder. But the person who dreams up the idea, turns it into reality, and drives the vision is the most critical piece of the startup equation

    Me: Dave’s comment on Twitter, “If Fred were an investor in my (fictitious) company, I’d insist he represent the interest of both users and the company and put me last.” I like to quote the founder of Southwest Airlines, Herb Kelleher, who said (I’m paraphrasing) that, “Everyone in the industry says put customers first. I think that’s wrong. I put employees first and customers second. By hiring the best customers and treating them accordingly I ensure that they are the people who provide the best customer service in the industry.” And so it goes in VC. I try to back the best CEO’s (and founders) who are people that I feel understand the need to serve users through great products and lead teams and treat them with respect. In doing so I serve the needs of users and the company. But my customer is still the CEO (and co-founders).

  • http://ocvcblog.com Marc Averitt

    Good stuff, Mark! Keep it coming.

  • http://www.sigmapartners.com/gretsch.php Greg Gretsch

    You make some very good points that could only be made by someone who has sat on both sides of the table.

  • http://www.flagcapital.com Diana Frazier

    One of the many beauties of your fund, Howard, is that it captures all ages, many levels of experiences, diverse contacts,( and I could go on and on) ..and it is small. But the other QUALITY characteristics are paramount. Small is not the main driver. ( PS I’m 40 too…wink wink.)

  • marksuster

    Thanks, Greg. As you know from my experienced talking with you when we were fund raising, you were one of the good guys that I loved hanging out with! And as I wrote in a blog post back in 2006, I learned a lot in the fund raising process which is why I found VC meetings so valuable. We got shelled a bit in the Sigma Partners full partners meeting on some issues that honestly we hadn’t thought enough about. It helped strengthen our thinking. Specifically on the topic of whether we could really serve both the corporate clients (like salesforce.com) and the SMB’s at the same time. Thanks for the comment.

  • http://thomassessa.blogspot.com/ TSessa

    First things first. Great post Mark!

    Is it possible though that the problem isn’t too much money in VC but that you have firms/funds dedicated to certain sectors that don’t need the level of money these firms/funds have on hand? You could certainly make a valid argument for a fund dedicated to alternative energy or hardware that has a size of $200M+. Much more difficult to justify when talking about social networking.

    Great points on the operator/non operator as to me this seems to be the crux of the problem and always the line of question I go down in my mind when discussing the value of venture capital. Given your experience as twice an operator would love to hear more about the differences in approach when raising money the first and second time.

    As for the level of money sloshing around in VC, is this something the markets will fix or is this something the entrepreneurs need to fix? Being an entrepreneur once and not having to seek funding I can’t answer this so will just throw it out there: is money or experience more important when selecting a VC firm? Intuitively the answer would be experience but my feeling is the data might say something else and probably depends.

    By the way, wouldn’t many of the concerns you raised be moot or non-existent if all VC partners were previously operators?

    Also, not to be disrespectful in any way but how does your firm get around some of the problems you mentioned in the article with $600M to allocate?

  • marksuster

    Thank you for your comments. Quick response:
    – the market will fix the over funding in the sector. Endowments and the like are ramping down their investments in alternatives already
    – there are definitely more capital intensive businesses where large investments are required – you’re right. Life sciences, wireless hardware, alternative engergy, etc.
    – re: GRP Partners – we’re a $200 million fund with 4 investment partners. That seems perfectly sized to me ;-) We (as too many people in the industry do) list total assets under management, which is a (somewhat) meaningless number because it includes all of our prior funds. It shows you that historically we’ve invested a lot of money. But our current fund is brand new (we’re in the first year) and we’re actively deploying capital.

  • http://www.linkedin.com/in/billbryant Bill Bryant

    Hi Mark,

    I just came across your blog from a PE Hub link. I’m a longtime serial entrepreneur operating out of Seattle with past involvement in over 25 software, internet, mobile and digital media startups, including 3 public companies and a dozen positive acquisitions. (If you’re interested, the listing of companies is available at http://www.linkedin.com/in/billbryant.)

    I’m also a venture partner with DFJ, focused on building their portfolio here in the Pacific Northwest. I’ve led two investments for DFJ over the past 12 months. Prior to joining DFJ, I’d worked with DFJ partners for the past decade.

    I agree wholeheartedly with your points other than #1, so wanted to clarify Tim’s comments on “not enough VC” by putting these in context. His point, which he makes consistently and publically, is that entrepreneurship is now global. Venture investing in the 1960s through the 1980s was relegated to Silicon Valley and Route 128. Starting in the late 1980s, through the ’90s and into this decade, the footprint became US wide, with a few other isolated pockets around the world. (A case in point is Seattle, which had 3 VCs managing perhaps $150M total in 1988, when I did my first startup; it now has > 10 funds who collectively manage ~ $2B.)

    Today, entrepreneurism is a worldwide phenomena: China, Israel, Russia, Estonia, UK, India, Japan, Australia…there is virtually no developed country that isn’t a full participant in the innovation economy that we live in. DFJ has responded by creating an affiliated network of funds that spans 35 cities around the world. We just sponsored the first worldwide business plan competition with Cisco, with the majority of entrants from outside the US. Oh, by the way, DFJ has had six exits > $1B since 2003 (Skype, Baidu, Focus Media…). Not one came from Silicon Valley !

    So its in this global context that Tim’s comments need to be interpreted. I think he’d agree that Silicon Valley has more than enough venture. Less so in Houston, Chicago, Pittsburgh and other geographies where we have domestic presence, let alone the Vietnams and Brazils where there is an emerging class of entrepreneurs (and where we happen to also have presence).

    There is a distribution of capital issue, but in aggregate a greater requirement for capital to support the innovation that is happening all around us. The distribution issue is two fold: geographic, but also “in whose hands lies the money”. Its quite interesting to note that the funds you’ve listed as “getting it” are by and large of recent vintage (Union Square, First Round, True, Andreesen, Founders, Foundry….). Its a good thing for everyone that the mantra “there is too much VC” wasn’t in force when these funds were formed, some as recently as this week !

    Thanks for the writeup and look forward to future posts.

    Regards, Bill

  • marksuster

    Thank you, Bill. Excellent points and I appreciate your response. I’ll add a note to the posting linking to your response. As I said in my post I had hoped his comments were taken out of context and I guess that’s the problem with journalism some times. Having lived in 6 different countries myself I am a big proponent of innovation being led from many corners of the world. I also know the DFJ affiliate model well as I am a very big fan (and co-investor) with DJF Frontier in Los Angeles and think that David Cremin is one of the most respected investors in Southern California. I’ll check out your background and definitely ping you when I’m next in the Pacific Northwest (I’m assuming Seattle?). And if you’re in LA love to connect. Mark

  • Chaz

    Mark,

    I think your assesment is spot on, especially when it comes to what firms you think highly of. If you simply look at the deal flow these days, much of it is being done by the True Ventures of the world, the First Rounds, Shasta’s, Emergence Capital’s. I’d say that of the “old boys” club you really only see Sequoia, Khosla, and maybe August being that active. Where are the Accel’s, Foundations, Benchmark’s, and Bessemer’s of the world? It seems that they are circling the wagons to look internally and nurse their wounds.

    Just my two cents, but I really like the passion and strategy of many of the investors you mentioned.

  • http://jontrue.wordpress.com/ jontrue

    Great post Mark. Couldn’t agree more. Great to see talented entrepreneurs (like you) making the leap to the “dark side” to shed some light. We need more creativity, innovation and real entrepreneurship applied to our very own business model.

  • marksuster

    Thanks, Jon. As you know, if I wouldn’t have sold to Salesforce.com I would have taken money from True Ventures (we were only days from signing ;-). Your term sheet was the only one that had no “gotchas” to be negotiated away and the gushing references I got from other True portfolio companies spoke volumes. Let’s find a great place to co-invest ;-)

  • http://www.mvmpartners.com Scott Shapiro

    Nice, looking forward to it!

  • http://avc.com fred wilson

    We gotta meet. I love the way you think and write.

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  • marksuster

    Thanks, Fred. I’ll ping you before my next trip to NY or LMK if you’re out in LA. I’m also often in NorCal.

  • Frustrated VC investor

    One thing is for certain: the 2% management fee on a big fund most emphatically does NOT align the interests of the GPs and LPs. That is the 800 pound gorilla in the room that most GPs simply will not acknowledge.

    I have invested in several VC funds, and I am really tired of the excuses for poor performance from the GPs and their BS rationales given for the 2% management fee. In the end, under the present fee structure, no matter what the performance of the fund, they get rich, while the LPs bear ALL the costs of the fund and take ALL the risks. I am no longer investing in VC until the fee structure changes.

    VC is a great industry for the GPs, but is a sucker’s game for the LPs. Look at the 10 year returns for LPs from the average VC fund–they are TERRIBLE.

  • http://www.caspegroup.com Bob Caspe

    I’m of the opinion that the VC model is broken and always has been. It’s not surprising given that it’s a fairly young industry. My belief is based upon two principals:

    First, the typical method used to “negotiate a deal” often provides unrealistic targets to the entrepreneur and stimuates a spending habit that is inconsistent with finding success except for rare cases.

    We observe that most small business startups fail. I suggest that the VC model actually provokes that outcome.

    My second observation relates to a book that I recently read combined with my own experience as an entrepreneur and now, teacher at a business school.

    “The Drunkard’s Walk” by Leonard Mlodinow has had a significant influence on my understanding of small business and entrepreneurship. That phrase has now become the catchphrase of my current MBA Marketing class as everyone is beginning to internalize what its real meaning is.

    Here’s a synopsis of what I’m teaching:

    At business school the professors all teach that process is everything. One needs to perfect an idea, then from the idea, perfect the plan and finally, go out and do it. I’ve discovered that entrepreneurship is just the opposite. In my class, which is frequently one of the last taken by students on their way to an MBA, I suggest that they forget the concepts that they’ve studied for the past year or two and instead approach small business in a completely different way.

    Large businesses like General Electric have potentially hundreds of thousands of employees and millions of customers. Every day their destiny is mostly shaped by the shear momentum of the organization. Of course, a major economic shift, as we’re experiencing now, can influence them, but, for the most part, the winds that blow have little overall influence on their day to day success.

    Small companies are quite the opposite. Their momentum is infinitely small in comparison. As a result, the random influences around them that occur each day cause wild fluctuations in their performance. For example, the CEO meets a business opportunity by sitting in a fortuitous seat on an airplane, or a snow storm causes the entire engineering staff of one to miss the deadline for a customer.

    Several books have been written about our tendency to see patterns where none exist. In “Outliers” Malcolm Gladwell points out how one’s month of birth in Canada can strongly influence their likelihood of being a successful hockey player though a series of connections that are completely rational but difficult to have foreseen. We often improperly credit an individual with an accomplishment that was driven by external forces. Or, many of my students suggest the use of “mouth to mouth” marketing as their preferred choice and show examples of successful use in the past, but importantly, they can’t demonstrate the critical differences between those that succeeded and those that failed.

    All of the successful entrepreneurs that I know (at least those with some modesty) are able to retell the apparently random sequence of events that conspired together to cause their success. They also all shared many important qualities of rationality, perseverance, likability, etc. – too many to list here, that also contributed to their success, but without exception, each also could credit “the Gods” for happenstances that were critical.

    The key question is: if random occurrences have a significant influence on our likelihood to succeed in small business, is there anything that we can do about it other than to simply hope for luck?

    And, the key answer is yes. I’m reminded of the joke, but truth of the following observation. If you want to live to ninety years of age, there’s one thing that you can do that, from an actuarial perspective will vastly increase the odds of living that long. It is, simply, to live to eighty nine! Look at the actuarial tables on line. As we age, our life expectancy extends.

    Thus, the critical ingredient to increasing the likelihood of finding success in small business is simply the act of survival. If one cannot determine with any accuracy when the magic moment will occur or which events will conspire to bring us to success, then the only thing that you can be sure of, is that if you go out business before it occurs, you’re dead.

    Survival isn’t simply waking up in the morning with the determination to not die. It requires a plan of action that maximizes your likelihood of not being killed. In small business, survival is equivalent to having a break even or positive cash flow. And, cash flow is contingent upon creating transactions that have value and closing deals with customers that yield profit.

    Note that it is not demonstrating a specific minimum rate of growth year over year. It is simply surviving. Any real entrepreneur will tell you that it is a combination of the thousands of meetings with customers, vendors, peers, employees and the like that eventually lead to the eureka moments that seed business ideas with the critical sparks that lead to eventual success.

    The next important question that I ask is whether our methods for funding small companies lead to a higher or lower likelihood of success. I think that the answer is at this point self evident. If a venture or angel investor presses a company to show year over year growth in the interest of increasing the stock price for attracting future investors, then the pressure that they are applying is the most destructive force that can be applied. It’s that simple.

    Venture capital hasn’t been around for that long a time. It’s quite possible that the methods and concepts that have been used are not optimized and I am suggesting that it is time to consider changing them radically. The skill and resources that investors bring to small companies is invaluable. But, as board members and advisors, the investors must change their focus once the investment is made to one of achieving cash flow neutrality as quickly as possible and then to survive and evaluate new opportunities as they become apparent to the fledgling company.

  • marksuster

    Wow, the only guy I know who writes longer posts than I do! Listen, Bob, you make some good points but I don’t believe that your points really substantiate your initial hypothesis that the VC model is broken. Let me say the following to your argumentation (where I think we agree):
    – much of what makes young companies uber-successful is random (see: The Black Swan, my favorite book of the past 5 years where he makes this case even including Google.)
    – for this reason Taleb states that VC is a perfect business because it has built in diversification. If you no enough smart investing you cannot predict 100% success rates (or even 50%) but if you’re diversified enough you have a higher probability of producing outliers
    – much of success is waiting for the right timing both in terms of customer traction and, frankly, when you exit the business. See: LowerMyBill.com. Reasonble success for some time followed by meteoric growth fueled by the sub-prime market followed by a perfectly timed sale of the company. We all know what the valuation of LNB would be now if it hadn’t sold. That is why I’m a huge advocate of capital efficient businesses that don’t over-raise VC
    – so my hypothesis is that VC isn’t broken, just some of the players in it are

    Thanks for your comments.

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  • Paul Markson

    Great article! Totally agree with points 3,4,5 and 6. Times change, marketing techniques change and obviously strategies do to. You can not compare today's market to the one from its beginnings.We all started to get and sell tips and tricks so there always has to be something new that is not universally known. Find over 4500 investors worldwide at http://www.vcgate.com

  • Paul Markson

    Great article! Totally agree with points 3,4,5 and 6. Times change, marketing techniques change and obviously strategies do to. You can not compare today's market to the one from its beginnings.We all started to get and sell tips and tricks so there always has to be something new that is not universally known. Find over 4500 investors worldwide at http://www.vcgate.com

  • Paul Markson

    Great article! Totally agree with points 3,4,5 and 6. Times change, marketing techniques change and obviously strategies do to. You can not compare today's market to the one from its beginnings.We all started to get and sell tips and tricks so there always has to be something new that is not universally known. Find over 4500 investors worldwide at http://www.vcgate.com