The “broken” VC model

There’s a whole bunch of discussions going on about “a new VC model” that supposedly fixes what is “broken” about the current model. You can’t stumble into Memeorandum right now without getting hit square in the forehead with all these posts.

Here’s a couple of them… here, here, here, here, and here. There’s actually a bunch more posts worth reading but it’s not my job to create a laundry list of all the links, just go over to technorati and do it yourself.

After that spectacular setup I am not even going to bother writing about any of these posts.

After 8 years in the venture capital business, which I think still makes me a rookie, I have the following observations to share with you:

  • Venture capital is a cottage industry and whenever too much money comes into the system there is an imbalance which shifts the investment model from demand driven to supply driven. Enter the bubble.
  • When functioning at it’s best, the VC business depends on a fairly predictable mix of serial entrepreneurs, “startup folk”, super smart CTO-types, consultants, academics, MBA-types, limited partners (the “money”), and service providers (mostly lawyers).
  • The serial entrepreneurs are key to the whole mix and really have a lot of power. Their market power increases exponentially as they bring additional people with them, in other words transitioning from a serial entreprenuer to a serial team. They have pricing power and can often pick from several funds competing to get into their deals.
  • The best venture funds are well ahead of the curve, case in point is Brad Feld and his investments in companies like Newsgator and Feedburner… he wasn’t sitting around talking about how great RSS was, he was out putting money to work when most VC’s were googling RSS to find out what it was.
  • Venture funds work best when the limited partners are veteran investors. A corollary to that is that the retail investor has no place investing in venture funds, there’s a reason why the SEC places limits on venture funds in this area. The risks are too great and the value of qualified LP’s goes well beyond the money, but quite often money is the only thing they bring. Most people would be surprised to learn that the richest source of capital for venture funds is from insurance companies, pension funds, universities, endowements, banks, and other institutions. The name brand funds that have raised more than a couple of funds typically don’t take a lot of new money in a new fund, it’s the same people investing over and over again. By the way, recent court rulings have forced publicly held institutional investors to publicly disclose their venture investments and their performance, the result has been that many powerful venture funds are telling their public LP’s that they are not welcome in their new funds.
  • Partners in venture funds are a mixed bag, as an entrepreneur your success with any individual fund is entirely dependent on the partner you are working with. I’ve worked with some partners that were honestly the hardest working people in the company, worked with others that could pick up a phone and make something significant happen for a company, and I’ve worked with others that simply showed up a board meeting in order to ask some questions to make themselves look smart.
  • It wouldn’t surprise anyone to learn that conflict between startups and their investors is often rooted in conflict between the CEO and/or founders and the Board. It was surprising for me to learn, from experience, that the second deadly source of conflict is between the individual investors in a given deal. Either of these conflicts can be very disruptive, but the latter can be deadly.
  • The overwhelming majority of deals that any venture fund will do are a result of relationships the partners have with serial entrepreneurs and other professional investors. This network effect is the reason why the first point is so important.
  • The industry has standardized on much of the documentation that goes with a venture deal. Seriously, you can look at the docs from one company to another and pretty much just change the company name and the investor names.
  • The terms are really (really) important if you want to make money doing venture deals. Things like liquidation preference and seniority can literally mean the difference between making money and losing money in most of the deals that a venture firm will find an exit on.
  • There is friction between younger partners and the old guard. This friction comes from the fact that the software industry is changing on multiple dimensions (technology, amount of capital required, revenue model, tech platforms) and many of the older guys just don’t “get it”. However, a lot of venture funds invest in more than a couple of sectors and manage a diverse portfolio so this friction isn’t always fatal. In fact, the portfolio of diverse investments is probably the single most compelling reason for keeping the current model
  • The “diverse portfolio” concept can be a point of friction, not because these funds are investing in multiple technology sectors but rather because they are investing in different kinds of investments. Trust me when I say that there are a number of venture firms with serious issues because one group of partners is saying “hey we can do buyout deals and get venture returns, why do we need to keep doing $5-6m tech deals?”

I don’t think we need to remake the venture capital model, the basic concept still works well, as it has for over 35 years (actually longer if you take into account 3i, which was formed by the syndicate of British banks following WWII as a vehicle to fund and develop reconstruction).

There are precious few boostrapped startups of any meaningful size and even though startups today are able to build a company with a lot less capital than previous generations I would be reluctant to toss out the VC model on that observation. The simple fact is that while companies like Flickr and del.icio.us are impressive, they didn’t demonstrate that they could be viable self-sustaining companies over time. It may take a lot less capital to build a technology platform, but it still takes a lot of capital to build a company.

My last thought has to do with the intoxication that many of the most exciting technologies today are capable of inducing, however just like I wouldn’t make any important decisions while intoxicated, I don’t think I would opt to “reform” the venture industry on the observations of the last couple of years alone.

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