Fixing Venture Capital

Several of the comments to Cringely (continued) and Fisking Calacanis asked me if I had read the Change This manifesto called Fixing Venture Capital by Joel Spolsky.

Yes, I have read it.

Joel makes some good points, but I think he’s wrong that the venture capital business needs to be fixed.  Some VCs should be fixed, but the business as a whole works pretty well.

Here are the major points Joel makes in his manifesto:

  • VCs only want 100 to 1 returns and are willing to risk everything to get them while entrepreneurs want a safe high probability bet.
  • VCs are so inundated with business plans that they become focused on the process of whittling down opportunities instead of finding the best opportunities.
  • The "standard VC deal" is unfair to entrepreneurs and smart ones won’t take it.

Some of this is familiar territory as Jason’s rant articulated a few of these themes as well.

The first two points are accurate about some VCs, but not the best VCs. The third is the classic situation of one side not understanding the other side.

I’ll take each of them in order.

  • VCs’s only want to hit home runs – I don’t think this is true. I’ve worked in three venture capital firms and have worked on over 150 deals with probably close to 500 firms in the 18 years I’ve been in the VC business.  My experience is that VCs are interested in making every investment work and are not in the "hits" business. It is true that if the investments don’t work, the VCs have an interest in getting out of the deal so it doesn’t consume any more capital, but that happens in about 1/3 of all early stage venture capital deals. The other 2/3 end up turning into businesses that the VCs are happy to work on and commit more capital too for as long as it takes for them to become sucessful.
  • VCs are too overwhelmed with incoming deals to pay attention to the good companies – This is absolutely true of the bad VCs. But they don’t end up staying in business longer than a couple funds. The best firms don’t focus to much energy on looking at everything that comes their way.  They identify a set of markets they like, articulate their strategy clearly as possible, and then go out and find the deals that fit into their strategy.
  • The standard VC deal is unfair to entrepreneurs – Joel focused on two aspects of the "standard VC deal", the "liquidation preference" and the "no shop". 
    • Brad Feld has a long post on the liquidation preference that anyone interested in this topic should read. This term is designed to protect the VCs from having the company sold by the entrpreneur at a price that gets the entrepreneur a good return, but results in the VC losing money. Not only is it fair, but its been standard practice in the VC business since the 1970s and very few deals are done without it.
    • The no shop isn’t designed to stop the entrepreneur from shopping his deal. It’s designed to stop the "shopping" process once the entrepreneur has selected his preferred investor so that the VC can complete his due diligence and hire lawyers to get the deal documented and closed.  It makes perfect sense that once both parties need to start spending money on deal expenses they should have an exclusive period to close the deal.

I hope nobody takes this as a criticism of Joel’s piece because I think its good that he and others are putting the entrepreneur’s views out there for discussion.

My goal is to get the VC’s views out there in response and insure that a healthy and educated debate results.

I’d love to hear everyone’s comments, either in the comments to this blog, or even better on other blog posts.