Fixing the VC Industry: An Industry Ready to be Disrupted

“there is an opportunity here – disrupt the traditional VC business model”

I wrote those words over a month ago and my mind has been racing ever since. As I dug into the issue a trend started to emerge: older writings said that the VC industry was broken; newer posts have the slant that the VC industry needs to be fixed; and I suspect in the coming weeks, there will be a lot smart people proposing various fixes.

The VC model does need to be fixed, which makes it primed to be disrupted. [For those new to the idea of disruptive innovation, read this.]

Why is it Ready to be Disrupted?

A market is ready to be disrupted when the performance of the product overshoots the requirements of the user. Does this apply to the venture capital industry? Yes. Traditional VC’s have overshot the “needs” of start-ups. It’s interesting that this gap widened, suddenly and significantly, because of large movements in both directions. During the late 90’s venture funds raised too much money and, after the bubble popped, there was too much capital chasing too little opportunity. The performance of the product – available venture capital – snapped upwards and away from the “customers” requirement. The Economist had an interesting article on this in March of 2005 and there was an paper examining this trend released last week.

While this fund raising frenzy was occurring, the “needs” of the customer (start-up companies) fell. The cost of starting a business has collapsed. Advances in technology have had a substantial impact on the cost of starting up. Outsourcing has also had an impact on the cost. Start-ups now outsource work to highly skilled individuals, all over the world, at lower costs. The decrease in the cost of starting a business has caused the needs of start-ups to snap downwards and away from the required performance of the “product”.

These two movements happened suddenly and at approximately the same time, resulting in the equilibrium between VC needs and start-up requirements becoming unbalanced. It’s this unbalance in the market that opens the venture capital industry up to disruption.

There are other reasons that the VC industry is ready to be disrupted, a major one being that the ‘traditional’ VC industry is broken. The VC industry evolved throughout the 80’s and 90’s because of the fantastic returns that could be reaped by investors. New regulations and new trends in how large companies operate have impacted traditional exit strategies. Increased compliance costs, thanks to Sarbanes-Oxley, have reduced the attractiveness of an IPO. There is a decrease in VC exits through this route and until the policy is revised the trend will continue. Another new event that limits the exit strategy of VC’s is the current practice of large companies acquiring start-ups before they’ve grown. It appears that large companies are realizing the attractive deals that can be had by investing in companies, pre VC investment, and are willing to take on the added risk.

Growing venture funds. Falling start-up requirements. Shrinking exit strategies. It sounds like the ‘traditional’ model of venture capital is in trouble. Anyone who thinks the industry is safe because of the traditional barriers to entry better think again.

Historically (as in last month), entrepreneurs have had to put up with ‘traditional’ VCs because the barriers to entry limited competition. Start-ups needed the help of VCs to scale for two reasons: (1) “He who has the gold, rules”; and, (2) the value of the VC’s network. Lately, the barriers have started to fall. With lots of money raised and less money needed (money is becoming a commodity in the venture world) it’s no longer “he who has the gold, rules”, but instead “he who has the gold… competes with everyone else”. Networks, while still very important, are becoming easier to grow and develop. Fred Wilson accurately summarizes the findings of a new study, with an aptly titled post called “No Duh”, with the following statement: “The Internet is the most amazing social networking tool ever invented”. The ease and ability to network through the internet is being used extensively by start-ups to help build and develop their company — putting less emphasis on the benefit of the VC’s network. (Note: this is not to say that their network isn’t needed, it’s simply to say that it’s becoming less crucial).

The barriers are falling. So what? It means that the market is going to become competitive. Once this happens (it already is) the entrepreneur will no longer be shoehorned into dealing with a VC who fits the VC stereotype. There is lots of chatter about the VC stereotype (Google returns 62,500 results for “VCs suck”). The barriers of entry will decrease the need to put up with the stereotypical VC’s, and until they correct their ways, there is an opportunity to compete with the entrenched players.

My final thought on why the market is ready for disruption is focuses on my frustration that I shared in my original post: “VCs lose 36% on the median investment”. The VC industry is a ‘hit’ industry – the investors raise a fund, invest in a number of companies, have a median loss on the investments, but rely on a single hit to yield an incredible return. The world has significantly changed over the past 10 years and these changes have had a huge impact on ‘hit’ industries. Chris Anderson documented this impact in a revolutionary article, The Long Tail:

The theory of the Long Tail is that our culture and economy is increasingly shifting away from a focus on a relatively small number of “hits” (mainstream products and markets) at the head of the demand curve and toward a huge number of niches in the tail.

The VC industry is currently a ‘hit’ industry, but we’re going to see a change in this. Like the music or movie industries there will still be a market for hits (“the next Google!”) and many VC’s will be happy to wrestle for the hits and maintain a negative median return. There will also be many VC’s who are happy to play in the “long tail” of the industry – a number of smaller investments, with smaller returns, with a positive median investment.

How to Disrupt the Market? (or: “How to Fix the Venture Capital Industry”)

Simple. By meeting the requirements of the start-up at a lower cost, getting a foothold, and then expanding upwards. The important question is how to “meet the requirements… at a lower cost”? The answer, as in most disruptive cases, is simple.

To meet the requirements at a lower cost, and successfully disrupt the VC industry, there are five non-traditional practices to embrace.

Customer Service. Competition is entering the market, money is a commodity, and ideas are numerous. People are the scarce commodity. The stereotype of the VC is that they treat founders poorly. The VC who is regarded throughout industry as “a great guy” will have a definite competitive advantage over the others. Founders will seek out VC’s who are more human and less VC-like.

Already, there are VC’s who are embracing good customer service. Fred Wilson talks about the idea of the entrepreneur as the VC’s customer. And Rick Segal, a Canadian venture capitalist, trumpets the importance of customer service in the venture capital industry (it must be a Canadian thing, eh).

Competing on customer service happens in every other maturing business market, and it’s going to happen in the VC industry. The VC’s who embrace this the quickest will have a competitive advantage.

Partial Founder Buyout. By letting the founders cash out early, VC’s can align attitudes towards risk between the founders and themselves. Paul Graham has an excellent essay on this. Eric Olson takes a central idea of Graham’s essay, allowing the founders to cash out, and provides a simplified explanation of the argument. The argument boils down to this: a founder would rather have a smaller return that’s guaranteed over a larger return that’s risky.

By aligning attitudes towards risks the VC will be able to invest in companies that otherwise may agree to an early-stage sale. There have been a number of small companies with huge potential that have been sold recently by the founders. If the company had been given time to grow the founders may have reaped the reward of the huge potential. However, because of the amount of risk involved, they had the incentive to sell the company early on, for a guaranteed return.

Most individuals are risk averse, and the level of aversion only increases as dollar figures rise. By partially buying out the founders, a VC can lower the amount of risk involved for the founder and access deals that other VCs can’t.

Focus on a Niche. By focusing on a small niche market, the VC can exploit the long tail of venture investing and enjoy a positive median return. The venture capitalist may have to give up on the ‘hit’, but they should be okay with that. They’re leveraging their expertise in the niche market to make a number of smaller investments, that will yield a positive median return.

A venture capitalist who doesn’t rely on landing a hit to prop up their other investments, and instead aims for a number of smaller returns that yield a positive median return, will be able to compete against entrenched VC firms. By going long tail, and being happy with it, the venture capitalist develops yet another competitive advantage.

Don’t Be An ATM. A disruptive VC aligns risk attitudes as soon as they invest, but they shouldn’t simply be an ATM. The VC should provide the young company with as much assistance as possible in the early stages so that the start-up has the greatest chance to succeed. The VC has invested in their niche area and should provide the start-up with industry expertise, guidance and advice. And not just at the quarterly board meetings. They should provide valuable assistance and share their expertise on a regular basis.

There are times when a start-up would benefit from having an expert assume a role within the company for a temporary amount of time. Unfortunately they can rarely afford to do this. The VC team should include members who can parachute into certain roles, for brief periods, to support the company (as in a legal counsel, a CFO-like individual, …). This tool would add incredible value to a growing company.

The disruptive VC should also have a basic set of tools that they can supply the start-up with. Should a start-up spend time searching for a good payroll company, branding company, law firm, accounting firm, …? No. The VC team should find a way to assist with these tasks, and not just by handling the introductions. By freeing time from tedious activities, the VC allows the start-up to focus on the tasks that will add the most value: developing and launching incredible new products/services.

Raise Less. Invest Less. Companies are able to start with less money. VC’s have funds that are too large. VC’s are valuing companies higher than they should be, allowing them to invest enough money in the company to make the investment worthwhile. Artificially increasing the valuation is not a good thing. Clarence Wooten does an excellent job explaining why:

Increased capital is always accompanied by expectations of increased return, which translates to increased time to liquidity and increased market risk. Unfortunately for the entrepreneur, additional capital seldom equals additional return. If the company is going to be sold, the acquisition price has to be significantly higher than it would be had the entrepreneur taken less venture capital to begin with. If it isn’t significantly higher, the entrepreneur stands to lose out on all or a substantial portion of their return.

Raising less money means that the VC can invest less money, making it easier to achieve a great return. Being able to invest less money means two things: (1) the VC doesn’t need to artificially increase the valuation, keeping more exit options open; and, (2) the VC can invest in the company at an earlier stage. This allows the VC to help guide and develop the company in a roll similar to a co-founder.

The disruptive VC is investing in a niche where they have industry expertise – enabling them to add a lot of value to a young company. They also aren’t just an ATM, and the earlier they invest, the earlier they can support the start-up with their toolbox of valuable start-up services.

Raising less money allows the VC to get involved earlier, adding great value through their other disruptive practices at a very early stage.

…
It looks like there are already venture capital firms practicing some of these techniques within select market segments. I’ll discuss those segments, and the firms, in a future post. It’s an exciting time in the venture capital industry. It’s obviously in need of a fix, and that means a disruptive firm can enter the market, establish a foothold, and grow. This is great news for entrepreneurs and terrible news for entrenched (stereotypical) VCs.

Based on the number of posts of “Venture Capital is broken”, and “Venture Capital needs to be fixed” I’m excited to read the posts that will soon be written on “How to fix Venture Capital”. If you’ve made it this far in the post, I’d also be interested in hearing your comments on my thoughts.

Update: After reading this I go and check out tech.memeorandum.com and there is a post from Doc Searls titled “Disrupting the VC Business and Exploring the Because Effect“. It’s great to see that others are thinking along the same lines as I am (especially wrt disruption).

It looks like Rick Segal (who I reference in this post) is giving a lot of thought to this idea as well. I can’t wait to read what he has to say.

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  • DK

    Great post! Very interesting. A good question to ponder about what the next successful VC model will be is: what is VCs true added value? The points above (except for the advice part) sound like sophisticated angel investors or a very hands-on bank. In biotech I think the added value will be more niche – ie VC funds won’t be “life sciences” or “biotech” but “cancer” or “diabetes” funds. This mirrors your point of more niche in the investments. I believe their biggest value is branding. The original 50 VC firms (KP, Sequoia, etc) attach a brand that is hard to beat. A recent paper showing their share of profits have increased over the past 20 years despite the entrance of over 700 new funds suggests that. Fred Wilson branded delicious as a winner…I didn’t realize how significant a boost that was until I saw the 50 or so other sites competing in social bookmarking. I think VC branding enjoys a first-mover advantage…Rick Segal has a great band that will likely enjoy first mover benefits as well, dont you think? Good job!

  • Fraser

    David, great comment (and, yes, family members are welcome here so long as they continue to share good thoughts). You’re thought about brand is bang on. A VC’s brand, like the brand of any company, is vital to its success. I’d be careful not to give Fred Wilson’s brand buy-in of delicious too much credit for the company’s success. It would be interesting to see how many useres each of the 50 social bookmarking sites had before Union Square Ventures invested. I’m willing to bet that Fred invested in the market leader and then leveraged his brand to help make it a success. The fact that the share of the original 50 VC firms profits increased over the past 20 years, despite many new competitors, isn’t surprising. They have a lot of things going for them :) What’s interesting is that this helps to reinforce the notion that the industry is ready for a disruption. Market pioneers created a market and enjoyed tremendous growth. “Me-too” comeptitors entered the market and competed on known and understood features/benefits/and metrics. The industry kept competing by improving these metrics/benefits (in the VC industry – bigger and bigger funds). They’ve begun to overshoot the needs of some segments of the market. This creates an opportunity for a new company to enter the market and compete in these segments using different features/benefits to compete on. I’m not sure which band Rick Segal is in, but I’m excited to hear them next time I’m in Toronto ;) (I’m allowed to make fun of David’s type-o… he’s family!)

  • http://www.opennorthvc.com DK

    Great post! Very interesting. A good question to ponder about what the next successful VC model will be is: what is VCs true added value? The points above (except for the advice part) sound like sophisticated angel investors or a very hands-on bank. In biotech I think the added value will be more niche – ie VC funds won’t be “life sciences” or “biotech” but “cancer” or “diabetes” funds. This mirrors your point of more niche in the investments. I believe their biggest value is branding. The original 50 VC firms (KP, Sequoia, etc) attach a brand that is hard to beat. A recent paper showing their share of profits have increased over the past 20 years despite the entrance of over 700 new funds suggests that. Fred Wilson branded delicious as a winner…I didn’t realize how significant a boost that was until I saw the 50 or so other sites competing in social bookmarking. I think VC branding enjoys a first-mover advantage…Rick Segal has a great band that will likely enjoy first mover benefits as well, dont you think?

    Good job!

  • Fraser

    David, great comment (and, yes, family members are welcome here so long as they continue to share good thoughts).

    You’re thought about brand is bang on. A VC’s brand, like the brand of any company, is vital to its success. I’d be careful not to give Fred Wilson’s brand buy-in of delicious too much credit for the company’s success. It would be interesting to see how many useres each of the 50 social bookmarking sites had before Union Square Ventures invested. I’m willing to bet that Fred invested in the market leader and then leveraged his brand to help make it a success.

    The fact that the share of the original 50 VC firms profits increased over the past 20 years, despite many new competitors, isn’t surprising. They have a lot of things going for them :)

    What’s interesting is that this helps to reinforce the notion that the industry is ready for a disruption. Market pioneers created a market and enjoyed tremendous growth. “Me-too” comeptitors entered the market and competed on known and understood features/benefits/and metrics. The industry kept competing by improving these metrics/benefits (in the VC industry – bigger and bigger funds). They’ve begun to overshoot the needs of some segments of the market. This creates an opportunity for a new company to enter the market and compete in these segments using different features/benefits to compete on.

    I’m not sure which band Rick Segal is in, but I’m excited to hear them next time I’m in Toronto ;)

    (I’m allowed to make fun of David’s type-o… he’s family!)

  • Scott Converse

    Great stuff! I wonder how much the VC’s can actually change though. Look at the recording industry. It’s similar. They are clearly under siege. The smart thing to do with be to figure out how to take advantage of the disruptions in their markets and create new businesses around what that market is making happen. Instead they resist, oh man do they resist. VC’s deal in a similar space. Intellectual property and creativity. Both required of great musicians and great startups. And, as you noted, like music, it’s a hit’s business with the long tail largely ignored. Unlike the record companies who go after their customers in court, I doubt the VC’s will sue the startups for not taking their money, but I wonder if they’ll actively try to fight the changes being brought on by lower startup costs, a limited set of exist strategies and lower overall ROI investments. I’m CEO of a startup that’s about10 months old and about 6 or so months into development with a product that’s in beta and about to go 1.0. I’ve been talking to VC’s, but I haven’t been really pursuing it. We run cheap. Our monthly burn rate is 4 figures (yea.. four). Co-lo charges for our servers and enough to pay rent for some of our younger/less solvent guys is all it really takes to keep the doors open, at least for now. The main reason we’re looking at potential VC money is because there are bunch of guys behind us who, with big cash infusions from VC’s, could leapfrog us. We’re not sure we want VC money, but we’re reasonably sure we’re going to need it. Why? Because of the threat of VC money in other people’s (competitors) hands. Kinda circular isn’t it? My guess is a change in the VC industry is going to have to be driven as much from the startup side as the VC side. Guys like us do more self funding/bootstrapping and take some angel money, and just say no to the VC’s. It’s tempting though. Life really IS easier if you have a (reasonable) salary, a nice enough group workspace and some money to do real marketing. But it feels, especially now that the real costs of a startup are so much less than they were a few years go, like we’re selling our souls, not to mention majority ownership in the company. I can say this: If all you older tech guys (and I mean all of you..) who got out with some money took some percentage of your money, and some percentage of your time, and became very active angels it would put a very big dent in the early stage VC business. I know this happens now, but it’s underground and invisible to most new startups. As everyone know, the real value (and largest returns) are almost always in the early stage investments. Dare I say that a truly organized national Angel network (or set of networks) might even change the landscape of the business? Maybe. Just maybe.

  • http://www.clickcaster.com Scott Converse

    Great stuff! I wonder how much the VC’s can actually change though. Look at the recording industry. It’s similar.

    They are clearly under siege. The smart thing to do with be to figure out how to take advantage of the disruptions in their markets and create new businesses around what that market is making happen. Instead they resist, oh man do they resist.

    VC’s deal in a similar space. Intellectual property and creativity. Both required of great musicians and great startups. And, as you noted, like music, it’s a hit’s business with the long tail largely ignored.

    Unlike the record companies who go after their customers in court, I doubt the VC’s will sue the startups for not taking their money, but I wonder if they’ll actively try to fight the changes being brought on by lower startup costs, a limited set of exist strategies and lower overall ROI investments.

    I’m CEO of a startup that’s about10 months old and about 6 or so months into development with a product that’s in beta and about to go 1.0. I’ve been talking to VC’s, but I haven’t been really pursuing it. We run cheap. Our monthly burn rate is 4 figures (yea.. four). Co-lo charges for our servers and enough to pay rent for some of our younger/less solvent guys is all it really takes to keep the doors open, at least for now.

    The main reason we’re looking at potential VC money is because there are bunch of guys behind us who, with big cash infusions from VC’s, could leapfrog us.

    We’re not sure we want VC money, but we’re reasonably sure we’re going to need it.

    Why?

    Because of the threat of VC money in other people’s (competitors) hands. Kinda circular isn’t it?

    My guess is a change in the VC industry is going to have to be driven as much from the startup side as the VC side. Guys like us do more self funding/bootstrapping and take some angel money, and just say no to the VC’s.

    It’s tempting though. Life really IS easier if you have a (reasonable) salary, a nice enough group workspace and some money to do real marketing. But it feels, especially now that the real costs of a startup are so much less than they were a few years go, like we’re selling our souls, not to mention majority ownership in the company.

    I can say this: If all you older tech guys (and I mean all of you..) who got out with some money took some percentage of your money, and some percentage of your time, and became very active angels it would put a very big dent in the early stage VC business. I know this happens now, but it’s underground and invisible to most new startups.

    As everyone know, the real value (and largest returns) are almost always in the early stage investments.

    Dare I say that a truly organized national Angel network (or set of networks) might even change the landscape of the business?

    Maybe. Just maybe.

  • Eric Olson

    Good point Scott. I love the idea of a more organized Angel network. It does make a lot of problems disappear right off the bat mainly because Angles don’t have investors because they are the investors. Because of this they have no time/exit or money (meaning too much of it) constraints. The only thing that would be hurt by this revolution are the LPs who invest in VC funds since a lot of them are college endowments and non-profits who use their investment returns to futher the good that they do. However, they could join the Angel network as an organization and make their own investments.

  • http://www.ventureweek.com Eric Olson

    Good point Scott. I love the idea of a more organized Angel network. It does make a lot of problems disappear right off the bat mainly because Angles don’t have investors because they are the investors. Because of this they have no time/exit or money (meaning too much of it) constraints. The only thing that would be hurt by this revolution are the LPs who invest in VC funds since a lot of them are college endowments and non-profits who use their investment returns to futher the good that they do. However, they could join the Angel network as an organization and make their own investments.

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  • Fraser

    Fred Wilson adds to the conversation http://avc.blogs.com/a_vc/2006/01/dont_be_an_atm….rel=”nofollow”>with this post. http://avc.blogs.com/a_vc/2006/01/dont_be_an_atm….

  • Carey Ransom

    A conundrum indeed: entrepreneurs need less money and investors want to put more money to work on fewer deals. Organized angel groups are filling some of these gaps, but opportunities for newer models definitely exist. Through Internet organization and localized support, investable funds continues to find and fund worthwhile ideas. Maybe the startup incubator model will finally make sense and be profitable for all involved.

  • Fraser
  • http://blog.truverse.com Carey Ransom

    A conundrum indeed: entrepreneurs need less money and investors want to put more money to work on fewer deals. Organized angel groups are filling some of these gaps, but opportunities for newer models definitely exist. Through Internet organization and localized support, investable funds continues to find and fund worthwhile ideas. Maybe the startup incubator model will finally make sense and be profitable for all involved.

  • Phil Sim

    I agree that perhaps the incubator model’s time has come. Most important is the access to experts – marketing, financial, tech, what ever’s needed – so that entrepreneurs don’t make those company-destroying blunders that so often cause good companies to die before their time. We started our company in 2000 a few months after the crash on the most minimal of costs, got bottom-line neutral in a matter of months and haven’t needed any cash since. However we made some fundamental mistakes over the past five years that really set-us back – you just can’t put a dollar figure on that stuff…

  • http://squash.wordpress.com Phil Sim

    I agree that perhaps the incubator model’s time has come. Most important is the access to experts – marketing, financial, tech, what ever’s needed – so that entrepreneurs don’t make those company-destroying blunders that so often cause good companies to die before their time. We started our company in 2000 a few months after the crash on the most minimal of costs, got bottom-line neutral in a matter of months and haven’t needed any cash since. However we made some fundamental mistakes over the past five years that really set-us back – you just can’t put a dollar figure on that stuff…

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  • Daniel Popov

    Interesting discussion. What I am surprised by, however, is the superfluity with which everyone asserts that start-up and development costs have fallen drastically. It is a key premise of the argument that the VC model needs to be shifted, but it has not been examined carefully enough. I would try to make two points: (a) While hardware costs have, indeed, contributed to a large fall in the initial fixed costs, the product development costs that are essentially labour costs have not been affected by outsourcing or offshoring as much as people would like to believe. (b) The typical VC can adapt to these changes ‘within’ the current model – ‘disruption’ is too strong a word, and I am sure this is not mere semantics. On (a) – Bnoopy (July 29, 2005) does note the phenomenal drop in the hardware/infrastructure costs. I would not dispute that. Yet hardware is a ‘set-up cost’ (the maintenance and/or depreciation components are minimal in the high-tech industry) whereas. The cost that will multiply your burn-rate is the labour costs associated with your product development. It is here that the costs are unlikely to fall, despite outsourcing to offshore centers like India because most of the IT-subsectors where US VCs invest are what I would call ‘professional software design’ where atomization of the product development process is either impossible or, if possible, carries an immense downside risk. I think the fallacy in the Fraser’s (and Rick Segal’s, who has a challenging piece on this also) argument is a focus on a relatively narrow sub-sector of IT-sector innovation. Namely, they zero-in on the ‘consumer-focused’ innovation – technology serves as a tool to implement an entrepreneurial idea. Fraser’s citation of Posima is an excellent example here. Posima does bring an extremely useful service by enabling efficient, quasi-professional website design. Yet this is only a small part of what the high-tech sector is all about. If you look at Thomson’s VenturExpert database, ‘computer software’ makes up less than half of total IT-sector VC investments in 2005 and significantly less before that. Indeed, disaggregating this sub-sector further, one sees that amongst all the different software headings, “Banks/Financial Institutions Software” and “Firewall/Encryption Software” are the two largest software components. These are ‘professional software design’ cases and are only two examples amongst many others in the same sub-sector. (incidentally, feel free to get in touch with me if you would like to see the charts I refer to – VenturExpert is proprietary and I’ve had to work a bit to get these data together). If you talk to the programmers who build these things, the product development process is fundamentally iterative – from the functional specification sheet, through to the technical specification sheet, writing of the code and, finally, testing. And I am simplifying the process. Offshoring of these tasks would involve a major change to the management structure – you would have to ensure that your functional spec sheet is extremely detailed, your tech. spec. sheet is meticulously thought-through. All this pales in comparison with the problem of dealing with code-writing decisions that have to be made by experienced programmers, not simple code-writers, as the software idea is actually realized. All this may sound trite, but with your programmers sitting in South Asia or Russia or even Eastern Europe, you WILL have communication issues and your development process can be bogged down for periods of time that are unacceptable for a startup that is trying to get a product to market. An entrepreneur is faced with the choice – reach for the low-hanging ‘fruits’ of lower programmer wages but be prepared for the ‘worm’ inside them of poor technical performance. On (b) – The opportunity for lower labour costs during the product development stage are thus fraught with downside risks I outline above. The VC, however, has a niche here – to ameliorate some of this risk through his/her network capacity. Offshoring of product development needs to be managed, and the skills necessary are not what an entrepreneur is likely to possess – this is a clear opening for VCs. More specifically – the VC may be able to offer an entrepreneur access to a dedicated offshoring ‘body-shop’ where a (preferably proprietary) relationship with this shop and management methods, to handle the differences in product development model due to offshoring, have been honed over some significant period. This suggestion merely emphasizes the ‘don’t-be-an-ATM’ idea in Fraser’s post and is one step towards the ‘VC-as-incubator’ concept that he discusses in his later post. Undoubtedly, the other characteristics of an incubator may be invaluable for a seed company, but the focus here is on the lowering of product development costs. Interestingly, this is something that a VC firm, with capital behind it, can have a clear advantage over an angel, or an angel network, even allowing for the prior that lower start up costs permit these private investors to support a startup to a more mature stage than before. I can see some drawbacks here, naturally. One is that the process of writing innovative software, at some core, cannot be atomized further. The definition of such a ‘core’ depends on the nature individual project and cannot be set a priori. There will always be heightened risks in sending large parts of product development across a couple of oceans. Grafting such radical outsourcing tactics will, by definition, be marked by ‘teething troubles’. Yet, a recent poll of relatively young, high-growth firms by PriceWaterhouseCoopers noted that the two things that are on the minds of the high-tech firms are – ‘lack of qualified workers’ and ‘developing new technologies/services’. Combine these two facts and outsourcing may soon grow to become a competitive necessity, rather than an advantage.

  • Daniel Popov

    Interesting discussion. What I am surprised by, however, is the superfluity with which everyone asserts that start-up and development costs have fallen drastically. It is a key premise of the argument that the VC model needs to be shifted, but it has not been examined carefully enough. I would try to make two points:
    (a) While hardware costs have, indeed, contributed to a large fall in the initial fixed costs, the product development costs that are essentially labour costs have not been affected by outsourcing or offshoring as much as people would like to believe.
    (b) The typical VC can adapt to these changes ‘within’ the current model – ‘disruption’ is too strong a word, and I am sure this is not mere semantics.

    On (a) – Bnoopy (July 29, 2005) does note the phenomenal drop in the hardware/infrastructure costs. I would not dispute that. Yet hardware is a ‘set-up cost’ (the maintenance and/or depreciation components are minimal in the high-tech industry) whereas. The cost that will multiply your burn-rate is the labour costs associated with your product development. It is here that the costs are unlikely to fall, despite outsourcing to offshore centers like India because most of the IT-subsectors where US VCs invest are what I would call ‘professional software design’ where atomization of the product development process is either impossible or, if possible, carries an immense downside risk.

    I think the fallacy in the Fraser’s (and Rick Segal’s, who has a challenging piece on this also) argument is a focus on a relatively narrow sub-sector of IT-sector innovation. Namely, they zero-in on the ‘consumer-focused’ innovation – technology serves as a tool to implement an entrepreneurial idea. Fraser’s citation of Posima is an excellent example here. Posima does bring an extremely useful service by enabling efficient, quasi-professional website design. Yet this is only a small part of what the high-tech sector is all about. If you look at Thomson’s VenturExpert database, ‘computer software’ makes up less than half of total IT-sector VC investments in 2005 and significantly less before that. Indeed, disaggregating this sub-sector further, one sees that amongst all the different software headings, “Banks/Financial Institutions Software” and “Firewall/Encryption Software” are the two largest software components. These are ‘professional software design’ cases and are only two examples amongst many others in the same sub-sector. (incidentally, feel free to get in touch with me if you would like to see the charts I refer to – VenturExpert is proprietary and I’ve had to work a bit to get these data together). If you talk to the programmers who build these things, the product development process is fundamentally iterative – from the functional specification sheet, through to the technical specification sheet, writing of the code and, finally, testing. And I am simplifying the process. Offshoring of these tasks would involve a major change to the management structure – you would have to ensure that your functional spec sheet is extremely detailed, your tech. spec. sheet is meticulously thought-through. All this pales in comparison with the problem of dealing with code-writing decisions that have to be made by experienced programmers, not simple code-writers, as the software idea is actually realized. All this may sound trite, but with your programmers sitting in South Asia or Russia or even Eastern Europe, you WILL have communication issues and your development process can be bogged down for periods of time that are unacceptable for a startup that is trying to get a product to market. An entrepreneur is faced with the choice – reach for the low-hanging ‘fruits’ of lower programmer wages but be prepared for the ‘worm’ inside them of poor technical performance.

    On (b) – The opportunity for lower labour costs during the product development stage are thus fraught with downside risks I outline above. The VC, however, has a niche here – to ameliorate some of this risk through his/her network capacity. Offshoring of product development needs to be managed, and the skills necessary are not what an entrepreneur is likely to possess – this is a clear opening for VCs. More specifically – the VC may be able to offer an entrepreneur access to a dedicated offshoring ‘body-shop’ where a (preferably proprietary) relationship with this shop and management methods, to handle the differences in product development model due to offshoring, have been honed over some significant period. This suggestion merely emphasizes the ‘don’t-be-an-ATM’ idea in Fraser’s post and is one step towards the ‘VC-as-incubator’ concept that he discusses in his later post. Undoubtedly, the other characteristics of an incubator may be invaluable for a seed company, but the focus here is on the lowering of product development costs.

    Interestingly, this is something that a VC firm, with capital behind it, can have a clear advantage over an angel, or an angel network, even allowing for the prior that lower start up costs permit these private investors to support a startup to a more mature stage than before.

    I can see some drawbacks here, naturally. One is that the process of writing innovative software, at some core, cannot be atomized further. The definition of such a ‘core’ depends on the nature individual project and cannot be set a priori. There will always be heightened risks in sending large parts of product development across a couple of oceans. Grafting such radical outsourcing tactics will, by definition, be marked by ‘teething troubles’. Yet, a recent poll of relatively young, high-growth firms by PriceWaterhouseCoopers noted that the two things that are on the minds of the high-tech firms are – ‘lack of qualified workers’ and ‘developing new technologies/services’. Combine these two facts and outsourcing may soon grow to become a competitive necessity, rather than an advantage.

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  • Ho

    Well said. I’ve talked about the problem in the VC industry as “venture lotto” (a blog entry from last summer). I agree with most of your comments. However, you overestimate the importance of the “VC brand”. If an entrepreneur needs a VC’s brand to rise above the noise, he/she will never be the next Sam Walton or Bill Gates. I’m curious to find out which VC made SAP, Qualcomm, Broadcom, Adobe, Autodesk, RIMM, EMC, SAS, Dell, or Oracle? All are well known companies but I honestly don’t know which VC should get credit. And yes, Ellison took VC funding from Don Valentine (perhaps one of the top 2-3 VCs of all time) but no VC took a board seat. The 2 VCs who did invest did so after the company was profitable and about to go public (and cashed out shortly after the lock-up, long before another 100x run-up). Reputations of VCs get built on the successes of companies, not the other way around. I don’t know who you might think is the greatest VC in the world but if that VC invested in Delicious (which I guess was branded a winner by its investors), it wouldn’t make the company more successful. In fact, I doubt it would make much of a difference if you had the top 3 VCs in the world invest – and if the top 10 VCs invested, I’d seriously start worrying about their prospects!

  • http://www.altosventures.com Ho

    Well said. I’ve talked about the problem in the VC industry as “venture lotto” (a blog entry from last summer). I agree with most of your comments. However, you overestimate the importance of the “VC brand”. If an entrepreneur needs a VC’s brand to rise above the noise, he/she will never be the next Sam Walton or Bill Gates. I’m curious to find out which VC made SAP, Qualcomm, Broadcom, Adobe, Autodesk, RIMM, EMC, SAS, Dell, or Oracle? All are well known companies but I honestly don’t know which VC should get credit. And yes, Ellison took VC funding from Don Valentine (perhaps one of the top 2-3 VCs of all time) but no VC took a board seat. The 2 VCs who did invest did so after the company was profitable and about to go public (and cashed out shortly after the lock-up, long before another 100x run-up). Reputations of VCs get built on the successes of companies, not the other way around. I don’t know who you might think is the greatest VC in the world but if that VC invested in Delicious (which I guess was branded a winner by its investors), it wouldn’t make the company more successful. In fact, I doubt it would make much of a difference if you had the top 3 VCs in the world invest – and if the top 10 VCs invested, I’d seriously start worrying about their prospects!

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