The Singularity hits Venture Capital (Wilson/Kauffman Redux)
I mean, really, who still wants to be a venture capitalist ? It's fast moving from job to have for new HBS grads with flat abs and trophy girlfriend (or vice versa) to labour of love for guys or gals who are willing to commit 15-20 years of their lives and preferably a big percentage of their current and future wealth without knowing whether they will ever make money. Shocker ! For all we know VC's might start to feel and act more like entrepreneurs by the time we are done with all of this. Now that would be something.
Let's recap an exciting week (and build on the real time rant I wrote post the Kauffman report).
Last week, we first got a new "bombshell" Kauffman report calling LP's out as being co-dependents for the terrible performance of VC, fundamentally complicit of the mess we are in (read Felix Salmon or watch Deirdre Bolton with Harold Bradley, Kauffman's CIO). And then we have Fred Wilson telling us that should venture capital die, there's always be blogging. I mean, come on, even Freddie ? The man on top of the networked world, the oracle of Silicon Alley, the Meme of Union Square ? That's like Obi One's light sabre turning to red. Whatever is happening to the Force? I an now expecting Chris Dixon to say he is turning to Venture Capital, and then I will be officially confused.
In any event, the Jedis have finally come home to roost: it's hard to see, barring irrational behavior (a big if, admittedly), how our world is not going to go through accelerated shrink and turmoil in the coming years.
I am seeing both a threat and an opportunity.
The schizophreny of the venture capitalist
If you think about it in simple terms, VC's are trying to reconcile two seemingly contradictory objectives.
- Find the "Glimmer of Greatness": VC's want to fund risky, extremely high upside opportunities that can turn into fund returners.
- Control Capital Intensity: VC's want (or should want) to limit the amount of capital they put at risk before risk is reduced or a company is in scaling mode.
They want to back great "world changing" entrepreneurs who will build "awesome" companies. They also (rationally) want to cut their losses in companies that are not working out and focus all of their energy on the ones that have the potential to deliver big. They want to love entrepreneurs, but they may have to fire them one day. Each partner needs to overcome his or her own aversion to loss and have the courage to let go of companies that are not on the right track, support their partners whose startups are taking off, and redirect the precious investment reserves that they had allocated to their own babies in doing so. Venture partnerships need to collectively find winners and drive as much cash at reasonable valuations as they can into these stars.
It takes a special balance of passion, determination, respect, empathy, suspension of disbelief and pragmatism to do this well and consistently. It also takes partnerships that work together as one and have the intellectual honesty to recognize what's working and not working to pull this off. It's hard. It's much harder to do it well and for a long time.
The Mexican debt problem and the great LP awakening
Limited Partner allocations into venture capital are driven by classic portfolio diversification theory, driving fixed allocations into the venture asset class regardless of whether this money could be put to work in the best funds. As far as I can see, there was limited collective thinking amongst LP's in terms of making sure that the startup market did not end up flooded with money. In the process, so many competing VC groups got funded that no one ended up making much money (smart people destroying each other's returns). Fear of missing out leads to over-allocation. I heard this called the Mexican Debt Problem : if you hire Mexican debt specialists, you will end up with Mexican debt on your books, no matter the quality of that asset class.
What the Kauffman report does is fire a deafening shot across the bows of LP's telling them : you are complicit in perpetuating this cycle of underperformance. You have also allowed perverse conditions to flourish, under which management fees ensure that VC's accrue significant wealth regardless of the outcome. This is a meaningful message, and I am sure LP's are sitting up and taking note.
Mantra: Venture (generally) does not scale
I am taking a few data points from a whitepaper written by Sante Ventures which I found very interesting.
- Large funds rarely perform: "No venture fund larger than $750M has ever returned more than 2.0x to its limited partner investors. Fewer than a dozen funds larger than $300M have. On the other hand, over 250 funds smaller than $300M have cleared that same bar"
- Yet capital concentration is the norm: "Venture capital has become increasingly concentrated in large funds since 1998, with 50-60% of all new capital raised in the asset class committed to funds larger than $300M. Before 1998, fewer than 40 venture funds over $300M had ever been raised. Since then, more than 600 funds have."
- Exit averages suggest optimal fund sizes of $150-200M: Of 534 reported exits of a venture-backed U.S. healthcare or life science company in the decade between 2000-2009. Of 534 exits during that period, the average amount of equity invested was $56M and the average exit value was $156M6. By number of total companies, 45% exited at $100M or less, 68% at $200M or less, 83% at $300M or less and 90% at $400M or less7.
That is not to say that these "classic" maths are the be-all and end-all of venture analysis. I do see "post-stochastic" scenarios for massive value creation, you just need to be one of the 5 or 10 funds who can reliably harness these.
Disruptive forces at work
VC's love to talk about disruption, and now it is their turn to be disrupted. The primary driver of changes are:
- Rise of the founder-led companies. Savvy founders know how to fundraise, play the VC game. We've moved to a world where deal mechanics were opaque and VC's had control to one where founders call the shot. Trace it back (symbolically) to Babak Nivi's VentureHacks, started in 2007, or the work of Paul Graham.
- Rise of the marketplaces. As deal terms have become simpler, funding is becoming "a product". Series Seed standard terms are a perfect example. When documents become standard, price is the only variable of competition (if you exclude for a second alignment, relationship and social contract). Standard contracts make startup funding fluid. That in turn makes it possible to start markets in everything, such as Angellist, SecondMarkets or Kickstarter) together with associated information products (Klout for clout, TheFunded for reputation, Twitter followed counts for reach — all early and imperfect proxies). See Semil Shah's writeup on the topic.
- Rise of alternative sources of finance: we're talking both the good (Kickstarter, Angellist, great new angels), the scary (too many new angels) and the downright ugly (I remember VERY vividly what happened to startups last time they decided to take hedge fund money, and now every one of these fairweather friends wants an Instagram). Just read Angel No More by Michael Copeland on Wired. The big risk here is correctly identified by Wilson in the Forbes article: a massive influx of capital, perpetuating a stage of market overfunding through a different route.
Radical transparency ultimately applies to all actors in the marketplace, but marketplace disruptions like these do not make the opportunity go away: it modifies how the game is played. Part of what Kauffman tells us is "mother and apple pie" when it comes to running a venture firm. But combined with all the other elements discussed you have something that looks like a serious discontinuity in the venture model.
So where's the opportunity exactly ?
The world is awash with too much money chasing too few great opportunities. The LP's are shutting their wallets. The markets are getting transparent and disintermediated. And you tell me you see opportunity in this ? As they say in Texas, hell yeah !
Entrepreneurs in my world still want:
- Lead investors who can pull rounds together with them
- Good advice to help them continuously iterate and execute
- Someone to help them recruit talent
- Someone to help them dream and think big thoughts
If the classic shape of a seed has been thrown out of the window, so be it. If entrepreneurs come in seeking cash on the explicit understanding that they are putting together a diverse syndicate to help them run a series of experiments called "a company" with no notion of probability of success, that's cool by me. If crowd-funding platforms help them access top flight investors at speed, all the better.
Where am I going with this ? I don't know the outcome of the "great seed experiment" any better than the next man. But frankly it's hard for me to see how all of this does not afford opportunities to fund better entrepreneurs faster. Because that, fundamentally, is all that we do: enable the best entrepreneurs that we can find to build the best companies that they can build.
As with any solid disruption, all we have to do is find a way to harness it. More on that later :-)