A Slightly Different Perspective

I’ve been reading a bunch of posts recently suggesting that the VC model is broken. But guess what? It’s always been broken. As Jeff Nolan points out in a short and sweet post:

there is a permanent structural imbalance in VC that simply doesn’t
change and serves to exacerbate the amplitude of the swings from good
times to bad. There are maybe a dozen VC firms that generate the bulk
of returns, a handful of “individualist” firms that simply chart their
own path to good success, and a whole bunch of followers that get
slaughtered. This was the case in 2001 and it’s the case today.

Jeff’s truth has been the story with the venture capital asset class for the entire 22 years I’ve worked in this business and probably for long before that. Jeff and Matt’s posts were inspired by this presentation that Adeo Ressi of TheFunded gave at HBS recently.

TheFunded – Canarie

View SlideShare presentation or Upload your own. (tags: lp vc)

I don’t buy most of Adeo’s arguments in his presentation but I am not going to critique it. Most of what he says is old news. The chart that TechCrunch picked up in particular is not news and I don’t even think its right. LPs have been telling me that the VC industry has been cash flow negative for years.

Clearly there is too much money and there are too many firms in the venture capital business. The same is true of every asset class I follow. I was at a hedge fund annual meeting yesterday and they predicted a huge number of hedge funds will go out of business in the next 12 months. I think the same will be true of private equity, real estate, and a number of other asset classes.

The venture capital business is changing if you look closely. Many of the biggest and best firms are slowly but surely turning their attention from information technology to energy technology (ET). Not all of them will be good ET investors and the firms that don’t navigate that transition well will struggle. Firms that continue to focus on IT have largely turned their attention to the web where capital requirements are lower and technology and IP barriers are non-existent. Many firms are struggling with these realities and they may decide to throw in the towel on IT. The VCs who came of age in the glory years of IT venture capital in the 80s and 90s are getting older and quite a few have stepped back or retired outright. While it is certainly true that there will be new firms and new VCs who pick up the slack, the reality that money is harder to come by and may stay that way for years will likely force the venture industry to get smaller not bigger.

But be careful what you wish for. We will get a better, more efficient venture capital industry that produces better returns for investors from all these changes. But we may also get less capital for entrepreneurs. Just like there aren’t thousands of great VCs, there aren’t thousands of great venture capital investment opportunities. When the industry is flush with cash, entrepreneurs are the beneficiary. When it is not flush with cash, entrepreneurs will feel it too.

Adeo is seeking "less funds and better funds" and I think he’ll get that wish. But he’s also looking for "more deals and equal treatment". The law of supply and demand suggests that we are likely to get less deals and worse treatment, at least in the short term.

Good entrepreneurs are crafty and will figure out how to navigate this new reality. They’ll do what they are already doing, which is to figure out how to bootstrap and build a business without VC, or they’ll wait longer to tap into VC. In the web sector, that’s a very good approach and I recommend it to every entrepreneur I meet with. In ET and biotech, it’s harder to do that and a tightening of the money supply there is a bigger problem.

The other big factor that nobody is really talking about is the globalization of startup culture and venture capital. The capital that gets invested into venture capital firms and our portfolio companies is increasingly global and will become more so. And the investment opportunities are equally global. Everyone is focusing on what’s going on in Silicon Valley and to a lesser extent the rest of the US startup scene. But what is going on in China and India and other parts of the world is truly mind blowing. And I think we’ll see non-US startups producing a significant, if not majority, of the investment exits within the next ten years. Much of the "sky is falling" prognostication is focused on Silicon Valley and misses the big picture.

So in the wise words of Pete Townshend, "venture capital is dead, long live venture capital."

Reblog this post [with Zemanta]
#VC & Technology

Comments (Archived):

  1. aweissman

    “Much of the “sky is falling” prognostication is focused on Silicon Valley and misses the big picture.”Yes, and the focus on NY or Boston follows the same shirt sighted reasoning – one only needs to look at Europe, and the innovation occurring there. If I was a seeker standing in NY, I would look east before I looked west, and I would stop for a long while in Europe.

  2. bijan

    great post fred.

  3. howard lindzon

    great post, it’s a shame it has to be written so that the people with no experience in the business writing rants can be shut up.Money is always flowing. today a new phenomenon is at hand, but it wont stay that way forever.

    1. aarondelcohen

      Howard, Andy, and Bijan:Fred’s anaylsis is without question more nuanced and more global in its perspective. Adeo’s set up slides are not very good and do not make a compelling argument for his suggestions here. I argued that here: http://bit.ly/wzg7But I do think Adeo has some interesting points about the structure of the industry, changing mgmt incentives, and standardizing the way we all do business. If you look at Paul Graham’s essays (as all of you do and Fred edits them) there are real inefficiencies to the market. The time horizons are long. The management fees are significant, and the results have been poor for a half-dozen years. Fred I think you’re right that fewer funds means fewer investment dollars but that’s probably a good thing because there is so much me-too investing. Do we need 30 Social networks and 50 widget companies?I suspect all of you believe that it remains early in the digital revolution and that there will be other googles and ebays. Twitter may be on its way. If this is the case shouldn’t we have a healthy dialogue about how to reinvigorate or reimagine the venture asset class? Aren’t Betaworks and Ycombinator experiments in this reimagination and don’t we need more?

      1. fredwilson

        yes, YC and Betaworks are great examples of smart people charting new courses. both were founded and are led by people who’ve started and run companies and have deep experience with technology.

      2. Vaibhav Domkundwar

        Exactly the point. I think VC is broken not mainly for the reasons Adeo argues, but many other and probably more significant. The me-too mentality of investing is a really tough one to digest. For every me-too play that gets funded because a particular firms wants to play in the recent-fad, imagine how many truly innovative but not-so-cool companies (potential Googles perhaps) get rejected. I understand the insecurity of a VC firm that doesn’t have any social network in its portfolio, but there is enough evidence that there are only a few survivors.YCombinator and betaworks are definitely the model of the future for testing ideas, markets and business models without having to go the VC route early on. We are doing something similar at BetterLabs, though at a much much smaller scale. But having been through VC-funded startups where you are always working for raising the next round, I believe super small investments or bootstrapped models like the above are the best way to get to a validated product before calling it a company. The question is if this process of product incubation and validation can be formalized for it to scale. If it can be, then may be the role of VC changes a whole lot.

  4. Kenosha_Kid

    A lot of what is written about the financial sector these days seems to suggest a general incompetence that has been in the making for decades. (Have you seen the Michael Lewis article about the demise of the sub-prime market? Now we are talking about the staggeringly high % of mediocre and copy-cat VCs.) I am beginning to think that there is validity to all this, but I am also beginning to wonder if much of this phenomenon of too little investment savvy is being driven by too much liquidity that needed in the last 10-20 years to find a home… It’s easy now to point fingers at “greedy” Wall Street types and inexperienced VCs that made bad calls, but really what choice was there when so much LP money and just so much money in general had to be put to work? It’s possible that the current malaise is actually the culprit of a monetary system that has for a long time run wild, and that nobody quite understands.

  5. CoryS

    Many investors (in both corporate and VC arenas) don’t understand how to create a vision, articulate it as a thesis and then deploy people and capital to execute on the dream. Investing without vision leads to many wasted dollars and/or safe incremental projects.In following what Umair has been talking about, I’m seeing an increasing need to focus on strategy as meaningful purpose. Honestly, I don’t see the required meaningful purpose in many of the professionals and investors that participate in the game. Not sure that will ever change, though, I’m surprised that so much capital is available to a group that doesn’t get it.

    1. Emil Sotirov

      You probably wanted to say “…to focus on meaningful purpose as strategy”…?

  6. Charlie Crystle

    Pete would have said “to each his own trash” (liner notes, Quadrophenia).What I find distasteful about some of the conventional wisdom and VC behavior is that VCs are taking the fears and losses of their LPs and foisting them on startups (across the board). They’ve made representations to their startups, both written and in word, and they have contracts and convenants with their LPs.Instead of honoring their representations and convenants across the board–enforcing the contracts and covenants–they instead transfer the fears and losses over to founders, with cramdowns reflecting–wait for it–today’s exit potential instead of future exit potential and performance, which is what they are purportedly investing in. It’s wrong on so many levels.My message to startups: fuck it–build your own economy. Make your own breaks.The VC industry appears to be showing that it is not (this is not universal, of course, and no, Fred, I’m not including you here) a trustworthy partner, and that’s a shame. Venture has always valued capital over people, and proves it in the current environment. Yet it’s the founders and their teams that create the value, not the capital.So get off the VC crack. Stop wasting time presenting and start building your businesses. Really–the amount of useless time spent pitching to VCs or assuaging current ones or negotiating what flavor of ridiculous, opportunistic, land-grabbing cramdown is better spent doing what you can to live up to your own convenants–with employees and customers. If you need to cut, sure, cut. But you owe it to the people you’ve asked to take risks with you to give them the chance to make it work (unless of course there’s no chance in hell).BTW–none of this is directed at any VC, certainly not mine (they have their own set of issues and they are good people). But I will say this: I’ll torch before I’ll take a cramdown. We’ve said fuck it–we’re going to make our own breaks. And that might be the best thing all around. No new ideas, no new employees, no new marketing, just roll up the sleeves, and dig in. The true entrepeneurs will make it happen through shear grit. Dig the fuck in.

  7. Taylor Davidson

    The interesting thing is that there are a lot of different reasons being proposed and promoted about “why VC is broken”. As usual, some are misguided, incorrect or just wrong: but some offer a chance for some reflection as to ways VC could change or grow.VC evolved to solve a need: why should that need always exist in the same way forever?I think most of the people claiming “VC is broken” are entrepreneurs looking for capital 🙂

  8. Chris Dodge

    Thanks for your insights.Do you think VC’s that continue to specialize in IT (mainly Web) will have to take a different approach and look for a larger number of small investments with smaller exists? I understand the overhead complexities of having too many small investments to manage/shepard.However, I think the big opportunity will be the gradual shift to mobile computing over the next 3-5 years. This isn’t particular profound statement, as I know mass Mobile computing has been always “right around the corner” for almost 10 years now, but I do think it’s hit a tipping point with iPhone/Android as a rich/powerful/open computing platform.IT for VC’s may become more desireable when consumers get back to being used to the idea of paying for software and/or features. I know you are a fan of the ad supported model – which I consider a subsidy model – but I think the iPhone App Store may be a proof point that consumers will be willing to pay out of pocket.Is the IT industry becoming all about becoming “small” ? Small investments, small dev/operational teams, small powerful mobile devices, small marketing budgets (via Social Networks, viral approaches), small (low) SW prices, and small investment exits?Maybe that smallness is what is causing friction with the VC model since it’s performance is typically based on a “hit-based”.Again, is an Ichiro Suzuki approach (single’s hitter) an option here that makes sense with regards to Limited Partner’s expectations?

    1. davemc500hats

      >>”… an Ichiro Suzuki approach”exactly. and there are smaller funds & investors who *do* have the smallball / moneyball approach to venture capital investing.if you can establish better selection & filtering metrics, and can have a measurable impact on approach to product development & marketing, you can actually improve outcomes, and take a much more patient approach at the plate that results in higher on-base percentage, and arguably better BOP as well.

      1. Chris Dodge

        “and there are smaller funds…”Do these funds typically have Limited Partners? If so, how are these “Investment Opportunities” (i.e. investments into the fund from the LP perspective) presented and sold to the LP’s? How are expectations set?I think Fred (and others) are saying that VC’s right now are generally unattractive as an asset class for large money managers.How could we make it more attractive as a proposition? I wonder if there’s an opportunity here with all of the Hedge Fund and Private Equity ROI collapse (well, for most not all) to reposition VC funds as more attractive.All of this “smallness” make it’s almost like sound “Kiva-ish” for venture capital – relatively speaking, I guess a $15-20M fund is microfinance to these money managers.

  9. bernardlunn

    Great post with some much needed perspective.

  10. davemc500hats

    Fred, i agree this is old news… sort of. and i don’t agree with all of adeo’s conclusions.but….there are DIFFERENT reasons VC is broken this time around, primarily that larger funds (>$100-500M+) and larger investments ($5M-20M) are out of whack with market trends (towards more & smaller exits, roughly speaking $10-50M).while there will always be a few large funds with great brands / track records who do well, i think most large funds are in trouble — to a much greater extent than smaller funds. the simple fact of the matter is that most startups — at least in the consumer internet / software industry — need MUCH LESS CAPITAL to get their products developed, and can possibly get to break-even on less than $5M (and in some cases, a *lot* less than that).given these very clear changes in the market, most of the current VC funds are not structured very well to take advantage of this, if only based on investment size.i would also argue that very few funds have expertise in the things that matter to most sw / internet startups (and note for the record: tech marketing & design skills are likely just as important as coding & SEO skills), and are thus extremely undifferentiated in the “smart” they bring to their “money”.thus the “VC is broken” claim is true, but for new & different reasons this time around.

  11. gregory

    Re: “LPs have been telling me that the VC industry has been cash flow negative for years.”I definitely agree with that. I got to ask Tom Perkins if there was too much money in VC last year, and his response was “There’s always been too much money in venture capital.” http://bit.ly/pY8L

    1. fredwilson


  12. Jay Parkhill

    This is a really good post for a lot of reasons. Energy technology is also a much better term than cleantech to describe the VC approach to that sector. Thanks for posting it.

    1. fredwilson

      I took ET from tom friedman’s new book Hot, Flat, and Crowded. I think its perfect

  13. Adeo

    The goal of this presentation was (1) to encourage Harvard professors (2) to work with students (3) on creating new ideas and new models for the venture capital industry. Schools are turning out students trained in a broken model – it’s like training mechanics who enter the workforce and break all of the cars that they work on.Yes, venture capital has been broken for some time, so this is nothing new. The problem is that the model has not changed. Arguably, it’s gotten worse. Hopefully, the dire economic circumstances will force a strategic inflection point. Hopefully, sharing the leaked presentation will open up a dialog about the VC model among all stakeholders.Fred, I do not have strong views on how the model should change for the better, but I am certain of one thing: there are THOUSANDS AND THOUSANDS of great companies that require capital, and they can’t raise the money that they need. I know. 200 CEOs apply to TheFunded.com every weekday. I read almost every application, too.These companies can’t get capital from banks, from the broken angel model, and they can’t get it from VCs. If your job, as a VC, is to fund great companies that generate returns, then you don’t need any criticism from me – your model returns are evidence of how well you are doing…My gut reaction is to make the process more transparent and fund companies outside your “comfort zone.” I think that you will be surprised that returns will turn a corner. Just my $0.02…

    1. Jeff Judge

      Great post Fred.@Adeo re: “These companies can’t get capital from banks”, I’ve seen that first hand with my company. I was amazed when we sat down with the banks to show them our cash flows and month/month growth for 2008, and their response was – well, you lost money in 2007. Of course we lost money last year, it was our first year in business and it takes time for product revenue to catch up with expenses. Now that we’re cash flow positive and product revenues are growing every month, we’re at a good inflection point where we want to hire a few more people, need to upgrade our infrastructure and move to a larger office. We’re trying to decide if it makes sense to take a little angel money, or continue growing organically (just a bit slower). Our gut tells us to keep bootstrapping instead of spending time talking to angels – our experience with banks alone was annoying and a total waste of time.

    2. Scott Lawton

      > there are THOUSANDS AND THOUSANDS of great companies that require capital, and they can’t raise the money that they needI believe that. I’ve never understood the VC claim that there’s too much money chasing too few opportunities. I see interesting opportunities everywhere I look.

  14. Charlie

    It seems to me that the objective of the presentation (given its venue) was to be thought and debate provoking. For that, it should get a 10.I disagree the venture model, working for 40+ years, is now broken. What we are missing in the IT industry is a restart on the innovation model that leads to a paradigm shift that fundamentally alters the landscape. Netscape enjoyed its IPO 13 years ago and we have established, if not already mature companies in the long-standing sub-markets of communications, community, commerce and search. New investments are being made in the smaller sub-markets which have the potential to reap generous, albeit smaller returns, IF the investment matches the size of opportunity.More on this is posted at http://www.cosmicvc.com

  15. David B.

    I think there’s some value in almost every critique, and this one is no different. Everyone has to be diligent that they don’t “close the circle” on where they get information and how they understand the world.To this end, I don’t understand why VC doesn’t change to use more of a barbell approach. 95% stay the same, but use 5% to branch into where Angels have traditionally been. How much is YCombinator giving out? Almost nothing. But it can bring early exposure to interesting ideas and solid players.

    1. fredwilson

      That’s what we’ve done but not 5%About half of our investments start in the angel round

  16. Steven Kane

    hi fred, i mostly agree that, as with many things, with VC, “plus ca change”but there are a few substantive issues out there that need to be considered* PE and VC historically were “quiet” asset clases/business models and that’s gone away and i think its a loss.i know transparency is usually good for just about everything but i’m afraid its a disaster for VC (and PE and hedge funds).fred, you/USV are a huge exception – kudos to you guys for pulling off your very open and transparent way of doing business.but for most VCs, publicity robs partners and their portfolio companies of the time to gestate and make mistakes, and it generates way way way too many copycats.* current management fees are ludicrious, and are “anti-innovation”.2% of COMMITTED capital per annum means only 80-86 cents of every LP dollars gets invested. which means VCs can’t swing for home runs, they can only swing for grand slams. and thats a recipe for disaster.why o why cant VC firms submit operating budgets to LPs? a VC firm that manages $1BN commitments is harvesting $20MM per year in management fees — radically overcompensating partners rain or shine — exactly the type of setup the same partners would puke on in a protfolio company.the industry needs to radically reduce management fees, and yes, go ahead, radically increase carried interest, up to 25% maybe 30%. that will much much better align the interests of portfolio companies and LPs and GPs* initiate syndiactes and funding mechanisms for the life cycle of a company.making a company come back for more capital every 12-18 months is a terrible use of managements time and an unrealistsic goal (in terms of value creation) and makes everyone fixate on “valuation” — as if there was some rational or market driven way to quantify the valuation of small experimental illiquid highly risky private companies.this is do-able, i think. VCs quietly make assumptions about their portfolio companies lifecycles and funding requirements — when they allocate reserves, and build syndicates — they just don’t share that information with entrepreneurs and LPs. start doing that, and make VC funding into “full company lifecycle lines of equity-credit” and fix the value of common stock, say, at 20% of the exit but only if preferred shareholders get at least T-bill rate of return (like carried interest). make common shareholdesr equity vest and let foundesr decide who gets how much and when (again like carried interest) etc.this will much more closely align everyone’s interests and let everyone focus on building great products and companies and stop the maniacal and ridiculous focus on valuation and never-ending never-pausing fundraising* finally, while it may be true that there has always been too much money in VC, there’s a big difference between my gutters overflowing in a big rain and a tsunami. in VC, i think there’s a tsunami.$40BN per year invested? that situation exists only because that pool generates $2BN per year in management fees, not because VCs genuinely believe there is sufficient return. don’t believe me? take away the no-risk overcompensation (lower managements fees to where VC partners earn salary no greater then 2X the average CEO salary in their portfolio companies) and make it performance based (jack up carried interest) and i wager 75% of partners at VC firms across the usa would disappear, post haste

    1. fredwilson

      So much of this is right on steve but some of isn’t. I think we need to do a point counter point. The best format for that would be live video with audience q&aYou up for that?

      1. Steven Kane

        An interesting idea. Lets discuss offline…

  17. Adeo

    Here are some further thoughts on the presentation and the VC model in a written form:http://www.adeoressi.com/20

  18. Old Hand

    Both of your points are BS!”The VC industry has been cash flow negative for years” : Just because someone has been lame and inefficient for last 10 years, does it give them a license to exist for another 10 years?Entrepreneurs will lose capital if VC industry implodes : Big deal. Are you trying to scare people? Note there are millions (yes MILLIONs) of entrepreneurs in this world who have bootstrapped their ventures. The Silicon Valley spoiled-brats should step out and see how companies are built in the rest of the world with practically no capital.

  19. reiboldt

    oops signed in as the wrong person

  20. Scott

    Fred,I’m curious to what you think of my recent post on this topic. I’ve had some time to think and deeply reflect on the sector, and I believe if a change is to be made we should, one, go back to the roots (fully study Charles Doriot’s philosophy), and two, the model should center on the people.Here’s my thoughts on the model: http://scottdig.com/?p=84Really, any feedback from you is appreciated :-)Thanks,Scott