Venture Capital – time for V3.0
It's impossible to escape the debate of whether Venture Capital is "broken" – tech blogs, national newspapers, even the overheard conversations in my favorite coffee shop (Café Del Doge in Palo Alto and no, I'm not an investor, just a happy patron!) debate the "death" of venture capital.
Like any "system" that has been "enhanced" over decades, the architecture of the venture capital business isn't broken but has fundamental issues that slow or even limit its ability to adapt to new market requirements.
Few companies survive a major architectural overhaul of their main product family.
Years ago I lived through just such a transition at Tandem Computers as the operating system and related system software (small things like the transaction monitor, database, communication products etc.) all had to be overhauled to deal with faster processors and larger memory.
The original system had been designed in the 70's when the idea of more than 255 processes in a CPU was considered a "huge" number – you can probably guess that the process id was encoded in 8 bits. Years later, the CPUs were so much faster that you couldn't run them at 100% utilization because of that process limit. The process id and similar system data had to be made larger – the ramifications were staggering in their impact.
Project EXCEED was the code name for the project to remove operating system limits. It was originally estimated at 300 man years of work – in the end it "exceeded" that by several multiples – consuming a large percentage of the development staff. This was a critical time as the "open system" transition was accelerating. Tandem missed the wave, lost market share as its systems were relevant to a smaller market niche and eventually was acquired, first by Compaq and then by HP.
Venture Capital firms are caught in an architectural transition:
- Too much capital in the aggregate.
The supply of capital into Venture funds isn't balanced by the market exit potential (IPO, M&A) to generate an acceptable rate of return. The same things happened with capital inflows into the LBO funds which I wrote about back in January 2007 (but was my concluding observation about early stage capital off the mark!).
Many Limited Partners believe that Venture Capital isn't an asset class but an ACCESS class – the majority of venture returns have been generated in the past 10 years by a very small subset of firms. If you could get into those firms you were going to make a return – or at least that was the theory…
- Too little operating expertise.
The bubble run up resulted in the inflows of two forms of capital into Venture firms… money and people. The expansion in human capital attracted a lot of very smart people but with little operating experience.
You wouldn't want a medical procedure to be performed by someone who had been trained but was about to conduct their 3rd or 4th procedure - on YOU. Yet in the VC world this happened with new VCs sitting on the boards of private companies and dispensing guidance and business advice. The rapid growth exceeded the capacity of the experienced VCs to mentor the new folks coming into the business.
- The Internet effect.
A little discussed side-effect of the Internet is how it eliminated latency in information flow and flattened access to data. We see this everyday – the speed at news travels approaches the speed of light – Google search makes even obscure data easy to find (you just have to know what to search for!).
But this same improvement means that ideas, concepts, description of problems etc. quickly spread to be known by many people. The time advantage of knowledge has been reduced and places an ever larger premium on being the first mover and flawless execution.
- Technology markets are mature
It is much harder for a startup to break into a mature market than one that is emerging. The technology has become mission critical with the target customers and they don't want to take risks on new entrants. Similarly, the scale and performance requirements necessary to make meaningful improvements require much larger amounts of capital.
Like many of the technology companies they funded in the past, few Venture firms will successfully weather this transition.
I wonder if there isn't another factor to consider… as the H1N1 flu pandemic began the question was posed whether Google Trends had provided an early warning of the developing problem (for those who knew to look!). I'd seen Google Trends when it was first released but had forgotten/ignored it for a long time.
I pulled up Google Trends and entered search terms like "startup" and "venture capital" – the results were surprising to me – here's the chart from Google Trends on "startup":
Google Trends (startup) – All regions
Google Trends lets you drill down by region – the results for "startup" are fractal – as you drill down the data looks the same (except for regions like China and India).
A search for "venture capital" looks more pronounced…
Google Trends (venture capital) – All regions
I've debated these trends for several months – it's possible that the trend is a result of knowledge about startups and venture capital becomes increasingly well known and so people don't search for it. That could explain the difference in the regional data for countries like China and India.
To counter this, I look at the number of friends and business professionals returning to work in major corporations. One of my friends remarked that after working for 10 years in 3 startups, all he had to show for it was long work hours, an under market paycheck and weak benefits. He has a point.
Hard to know!
VC 1.0 was the beginning of venture capital where experienced investors carefully nurtured companies with modest capital. Markets were just beginning to emerge as new technology developments provided productivity improvements or solved critical business problems.
VC2.0 was the Internet and resulting bubble.
So what will VC3.0 bring? This architectural re-design is "in play" and uncertain.
While this is underway I think there are two areas that deserve your attention… I characterize these as Fire and Water.
Big problems or unmet needs create a fire – big pain and urgent need. If you decide to play with fire you must execute with perfection and precision. You won't get a second chance and VC investors should quit funding the moment execution becomes flawed or someone else does a better job.
Difficult problems or emerging trends benefit from an approach like the erosion of water. Relentless and slow like a river or getting into the cracks and freezing to break down the problem faster like ice. Build entry barriers with fundamental IP, good execution and careful deployment of capital – together with deep and meaningful strategic relationships with established companies that realize they need your help.