â€œthere is an opportunity here â€“ disrupt the traditional VC business modelâ€
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 VCâ€™s have overshot the â€œneedsâ€ of start-ups. Itâ€™s interesting that this gap widened, suddenly and significantly, because of large movements in both directions. During the late 90â€™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 â€“ available venture capital â€“ snapped upwards and away from the â€œcustomersâ€ 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 â€œneedsâ€ 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 â€œproductâ€.
These two movements happened suddenly and at approximately the same time, resulting in the equilibrium between VC needs and start-up requirements becoming unbalanced. Itâ€™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 â€˜traditionalâ€™ VC industry is broken. The VC industry evolved throughout the 80â€™s and 90â€™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 VCâ€™s is the current practice of large companies acquiring start-ups before theyâ€™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 â€˜traditionalâ€™ 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 â€˜traditionalâ€™ VCs because the barriers to entry limited competition. Start-ups needed the help of VCs to scale for two reasons: (1) â€œHe who has the gold, rulesâ€; and, (2) the value of the VCâ€™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) itâ€™s no longer â€œhe who has the gold, rulesâ€, but instead â€œhe who has the goldâ€¦ competes with everyone elseâ€. 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 â€œNo Duhâ€, with the following statement: â€œThe Internet is the most amazing social networking tool ever inventedâ€. 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 VCâ€™s network. (Note: this is not to say that their network isnâ€™t needed, itâ€™s simply to say that itâ€™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 â€œVCs suckâ€). The barriers of entry will decrease the need to put up with the stereotypical VCâ€™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: â€œVCs lose 36% on the median investmentâ€. The VC industry is a â€˜hitâ€™ industry â€“ 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 â€˜hitâ€™ 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 â€˜hitâ€™ industry, but weâ€™re going to see a change in this. Like the music or movie industries there will still be a market for hits (â€œthe next Google!â€) and many VCâ€™s will be happy to wrestle for the hits and maintain a negative median return. There will also be many VCâ€™s who are happy to play in the â€œlong tailâ€ of the industry â€“ a number of smaller investments, with smaller returns, with a positive median investment.
How to Disrupt the Market? (or: â€œHow to Fix the Venture Capital Industryâ€)
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 â€œmeet the requirementsâ€¦ at a lower costâ€? 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 â€œa great guyâ€ will have a definite competitive advantage over the others. Founders will seek out VCâ€™s who are more human and less VC-like.
Already, there are VCâ€™s who are embracing good customer service. Fred Wilson talks about the idea of the entrepreneur as the VCâ€™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 itâ€™s going to happen in the VC industry. The VCâ€™s who embrace this the quickest will have a competitive advantage.
Partial Founder Buyout. By letting the founders cash out early, VCâ€™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 Grahamâ€™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 thatâ€™s guaranteed over a larger return thatâ€™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 canâ€™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 â€˜hitâ€™, but they should be okay with that. Theyâ€™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 doesnâ€™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.
Donâ€™t Be An ATM. A disruptive VC aligns risk attitudes as soon as they invest, but they shouldnâ€™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, â€¦). 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, â€¦? 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. VCâ€™s have funds that are too large. VCâ€™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 isnâ€™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 doesnâ€™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 â€“ enabling them to add a lot of value to a young company. They also arenâ€™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. Iâ€™ll discuss those segments, and the firms, in a future post. Itâ€™s an exciting time in the venture capital industry. Itâ€™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 â€œVenture Capital is brokenâ€, and â€œVenture Capital needs to be fixedâ€ Iâ€™m excited to read the posts that will soon be written on â€œHow to fix Venture Capitalâ€. If youâ€™ve made it this far in the post, Iâ€™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.