Thursday, November 13, 2008

Is the Venture model broken?

A flurry of thoughtful debate has rightfully begun around a speech and presentation given by Adeo Ressi of TheFunded at Harvard. His presentation argues that the venture model is broken, as evidenced by his belief that the wrong companies are being funded, too much entrepreneurial time is spent raising capital and missteps have brought on the poor returns generated by the industry over the past 5 years. He offers a number of suggestions, with varying degrees of merit, that I won't go into here. But will proffer that, unlike the auto industry, as well put by Thomas Friedman's great op-ed, How to Fix a Flat, the industry is not fundamentally broken, but in the midst of a transformation.

The National Venture Capital Association is celebrating its 35th year and. per the Association, its members have backed companies accounting for 10.4 million jobs and $2.3 trillion in revenue in the US in 2006. As you would expect for an industry that's been around for awhile, is geographically dispersed, and consists of thousands of firms, there is no monolithic venture capital industry. Instead, it's populated by a rich mosaic of niche specialty firms. Some like First Round Capital Capital focusing on the earliest stages of innovation, others like Carmel Ventures successfully concentrate on a fertile geography. True, concentrations exist, but like Judiasm, no centralized authority dictates how to prosecute the business. As was vividly brought home by the performance in the financial and political arena's, diversity is good.

But all is not well in VC land. The exit environment can charitably be called anemic. The lack of IPO's (one last quarter, representing the lowest volume since 1977) has caused a consolidating stable of ready willing and able acquirers who, in a less competitive M&A environment, coupled with diminished multiples will slash their valuation models.

The underpining of our capitalistic economy is that dollars flow to opportunity; where investors can earn favorable risk adjusted returns. Entrepreneurs strive to create companies that build equity value through creating meaningful market share, or through creating an engine that throws of growing cash flows. Venture capitalists seek to invest in these companies and reap a portion of these rewards. It's been that way for more than 40 years...so what's the problem now?

Netscape enjoyed its explosive IPO on the same day that Jerry Garcia passed away, August 8th 1995. The opening of a global market opportunity, mostly unencumbured by geographic borders, presented an historic opportunity for wealth creation (returns to stakeholders) that now strives to maintain double digit growth, mostly through exploitation of niche arenas. A few faux markets have been offered as 'the next internet' but nothing has arrived that replaces the heady decade of 20+% growth. I don't believe 'mobile' is the answer. Not because the growth of subscribers, or the need, is lacking. But, investing in an industry where a small number of gatekeepers controls the distribution channel exposes entrepreneurs, and investors, to a level of risk that is simply too great to bear. Love the milk, but please keep the cow.

Positive trends are nonetheless afoot. Brought to us, not by the monolithic gatekeepers, or the venture industry, but where you would most expect, and hope for it. The entrepreneurs are speaking.

"I need less capital" In software/internet Big Venture Capital is gone. Small markets are best served by small investments.

"I need less people" We will stand on the shoulders of the open source community, use 3rd party distribution (affiliates) and SEO our way to brand building.

"I will innovate" The IT industry has 3 legs that move independently. Software, communications and hardware provide the foundation for value creation. Parodying the parable of the 3 Little Bears, one is reaping the benefit of years of investment (communications), one feels about right (hardware) and the last is ripe for a fundamental shift (software). None of the past shifts were the derivative of big capital (corporate or venture). No reason to expect it will be the next time.

Reminder to self, keep an open mind to the geeky looking/sounding person you meet. They just may be the game changer.

1 comment:

  1. Totally agree with the analysis that the funding requirements have changed whilst fund strategies have remained stuck in a different era.

    The questions we need to focus on next are:
    how do the fund economics work if you assume:
    1. smaller investment sizes
    2. more investments
    3. the exit environment

    Can you manage enough money effectively that it be worth it for the managers and attractive for investors?

    And secondly where o where is liquidity going to come from......

    ReplyDelete