Two weeks ago at a dinner in San Francisco put on by Finance4Founders, Venture Hacks blogger (and serial entrepreneur) Naval Ravikant spoke to entrepreneurs about how they should approach fundings (via VentureBeat).
He gives some great insights into the funding process that all current and prospective entrepreneurs should read, whether they need funding now or not—besides, how often do entrepreneurs not need money? ;-)
My favorites are numbers 3 & 6. Number three is very true; the more you swallow your pride and go out looking for help, the more opportunities for growth (and funding) you will run into. Being stealthy is important, but don’t be so worried about people stealing your big idea that you close yourself off from the people that can truly help you succeed. I also agree with number six—though the title is a little misleading—sometimes entrepreneurs get so wrapped up in trying to explain the minutae of what they are doing and how each concepts leads into the next, that potential investors end up bored and confused. Show that you’ve done your homework and clearly articulate the vision you have for your company; don’t leave any huge gaps in logic, but let your potential investors fill in the small gaps they are interested in during Q&A.
As a follow-up to my last post Silicon Valley still matters, I have posted below a portion of an article by Valley entrepreneur and finacier Georges van Hoegaerden. I believe it to be a spot on assessment of the past decade of venture invesment, and I share his views on how venture will need to “behave” in order to rebound. As I alluded to in my previous post, venture will need to get back to its roots and invest in truly innovative business opportunities where the technologies and market approaches represent a fresh approach with genuine promise. Venture investments have always been risky, but the potential payout has traditionally been worth that risk—not so with VC investments generally over the past decade.
The systematic risk of venture capital
As a result of a lack of meaningful segmentation and guard rails by many me-too VC funds, LPs have actually invested deep rather than wide in information technology (as the included chart points out). For the last nine years that has created a massive number of false positives and false negatives and a continued downward spiral that attracts only entrepreneurs that comply with this risk-deflated investment mold, rather than attract entrepreneurs with truly disruptive ideas (that hold their value in any economy). So, for the last 9 years LPs have invested deep in a risk-averse technology sector while they expected their 10-15% venture share of total allocations to be applied to the inverse.
Many LPs are ready to cut all but their top quartile VC funds from their portfolio by flushing them through (i.e. letting them run their course without re-upping new commitments). That means over the next 5 years we are going to see many VC firms disappear, some replaced with new VC firms with more relevant entrepreneurial pedigree and investment models that are as unique as the strategies of the entrepreneurs.
New regulations by the government and tougher practices by LPs will make our industry more transparent and aim to create a platform in which the old aristocratic VC model will be replaced by a model that supports a meritocracy at every level of the investment pyramid. That is a fantastic development for entrepreneurs and VCs who are attracted by - and deserve - the merit.
Big stakes, big returns, fewer players, better innovation
LPs expect bigger returns (before larger commitments) from their allocation in venture and the only way to get it is to deploy risk. VC is designed to be the intermediary between the LP and the entrepreneur to mitigate that risk for LPs. Yet because of the aforementioned commoditization of VC investment strategies the VC model has failed to produce.
With LPs retrenching (to perhaps another asset class), the VC firm that wants to survive better articulate a clearly differentiated investment strategy with new GPs that can recognize and attract more disruptive (and sustainable) innovation, knows how to commit and helps make its portfolio companies work.
A new day
To create better returns for LPs, VCs need to rethink how to pick better companies with more disruptive (and sustainable) innovation and invest in upside rather than downside. The smart entrepreneurs are out there (we talk to them), waiting patiently for the right investment climate to light up their flame. Remember, great innovation can afford to be patient.
Silicon Valley still matters
Yes, Sarah, Silicon Valley still matters. BusinessWeek’s Sarah Lacy wrote a few things last week that I completely disagree with in her post Does Silicon Valley Still Matter?. While the thesis of her article seems to be a question, upon reading it you know right away what she thinks the answer is… no. She bills the Valley as a has-been of tech innovation, and leads readers to believe that since “the information superhighway is [already] built” and the computing and networking sectors are slowing down, there isn’t much more innovation that can come out of the Valley.
The common theme of her article is that the Valley has become more of a place for those who want to play it safe—investors and entrepreneurs alike—than for the truly innovative and risky start-ups. While I disagree with her billing of Facebook and Twitter as ‘truly innovative’ (let’s be honest, while social networking is an interesting concept you really can’t have a “business” without a viable business model), I agree that many new companies have been started and funded here over the last few years that focus on small markets (like iPhone apps) and there has been less investment in breakthrough technologies that provide innovative leaps forward. Why is this? Well, I think that alongside those with innovative ideas and business models the Valley has attracted those who want to make a ‘quick buck’. Software and web have always had very low overhead and high margins (for those companies with viable business models), and I think its natural for investors and entrepreneurs to minimize risk. Other investors are looking for opportunities and innovation overseas in BRIC markets, but the fact remains that a huge majority of venture funding is centered in the Valley. In many cases, those innovations around which strong, lasting companies can be built will be ported over to the Valley where it is very easy from a regulatory standpoint (state and federal) to build and profit from a business. There are opportunities to use exisiting technology to beneifts foreign markets, but true innovation will flow through Silicon Valley for a good while longer… the Valley is far from giving up its crown as the world’s epicenter of innovation.
It is very easy to say that the Silicon Valley edge in innovation will continue to wane as technology shifts away from computing and networking. Those that believe that though, are missing out on the big picture; they forget that Valley-born innovation made computing and networking what it is today. Let me put it another way, the success of computing was born out of the Valley’s innovative culture, computing did not make the innovative mindset. This mindset is not limited to one industry and it never will be. Those who have lived even a couple of years in the Valley know that innovation runs through the veins of almost every company and industry here. I have personally been involved or apprised of some very innovative startups in cleantech, biotech, and devices in emerging industries. During the next decade there will be a true merger between biology and electronics, and Silicon Valley will undoubtedly emerge as the innovation leader of this new biotronics industry.
A great post from Fred Wilson’s blog that discusses a more personal approach to negotiating changes in terms for any type of deal. When I previously worked in real estate investing, it took me a couple of gaffes before I learned this principle. Some people would take offense to my initial offers (that seemed so clear and flexible on paper). At first I tried to explain that “this is how the game works”, then I realized that there is no “game” and it really was my responsibility to walk the sellers through what can be an often intimidating process. Usually by taking the time to explain things and work with them I was able to get even better deals than I had previously detailed using my inefficient document-only approach.
Great idea to put this out there Fred!
The chain reaction of short-term focus
I ran across another opinion today (this time by Jeff Busgang) about the lack of viable exit strategies for venture-backed companies due to the current problems with our financial system. He, however, goes into a bit more depth regarding his opinions on the future of venture funding over the next few years.
I reference his article only because he states very well what I also believe to be the current state of affairs within the VC industry. The lackluster fundraising numbers for Q1 ($4.3 billion allocated among only forty funds! link) show that it is highly likely we will see a constriction in the number and capitalization of VC over the next few years due to the current financial environment—there is simply too much venture capital invested for current market conditions to provide viable exits to the investing firms.
As I discussed last Saturday, the buy-side IPO market is evaporating due to financial system instability and unrealistic expectations (or impatience) on the part of buy-side investors as shown over the past few years. In order to really restore a favorable environment, the capital flow needs to improve and investment banks need to more consistently underwrite the smaller-cap IPOs… in order for that to start happening though, investors need to be retrained and become willing to be invested for the long-haul. Without investor demand, I think it’s quite obvious that IPOs will be largely unsuccessful and unviable for venture-backed start-ups. Therefore, without the ablility to seek funding from the public for their portfolio companies, firms will be forced to focus their efforts on cultivating acquisitions for even their more mature (and successful) companies. While this can still be a viable exit, returns will undoubtedly be lower than a successful IPO, thereby returning less to the firms’ coffers and making less available for future investments. The alternative of course being to hold their companies for longer and hoping for an improvement in the financial environment. Either way, innovation will continue to be stifled by the lack of available capital.
Many web applications that we know and love today are successful because they executed well.
• They rapidly iterated their product and design
• They knew the right verticals to attack first and what the best guerilla marketing strategy was
• They ultimately acquired customers cheaper, retained them longer and milked more dollars out of them
They didn’t win because their technology was necessarily superior, but because they out-executed the competition.”
Scott Shapiro, Momentum Venture Management
Comment by Jack: I agree with what Scott says here, execution is just as important (if not more important) than your technological edge. This is relevant in almost any industry; one company may have the better product, but they can still lose due to flawed execution (think Betamax).
Is venture capital the engine of innovation in America?
I just read a rather compelling argument at WSJ.com by Foundation Capital general manager Adam Grosser who argues that the venture capital industry could literally disappear unless changes are made in our economy. He claims that not only are our banking institutions losing interest in underwriting the smaller IPOs that provide exit opportunities for seed-stage investors, and access to public capital for these smaller companies, but that buy-side investors are also losing patience with the often slow growth of the IPOs they invest in. He says:
Historically, buy-siders have understood and accepted that most economic value isn’t created until five years after a company’s IPO. But now, a focus on unfavorable current EBITDA multiples is displacing long term predictors of success such as market size, growth rate, technology and management experience.
Those of you who know me, know my views on long-term vs. short-term growth as a measure of value. Unfortunately, the markets severely punish corporations that do not consistently post increased quarterly earnings much more than reward those who experience consistent long-term growth. Consequently, CEOs of some public companies are constantly pressured to ensure that those quarterly earnings reports are desirable, often at the expense of long-term growth or creation of true value. Unfortunately, much of this attitude is in fact beginning to affect the small-cap corporations as well (as alluded to by Mr. Grosser). Generally, venture capital firms make their investments without expecting to really cash-in until 5-10 years later. This long-term focus has generally paid off in the form of much better performance than the various stock indexes.
VC funds also tend to focus on markets with high growth or great potential for such growth. Accordingly, capital is often pumped into new, experimental technologies that show promise of great success. Making venture investments in yet unproven companies and/or technologies requires the vision and foresight to anticipate where markets are headed and the future receptivity of advancement; basically, fund managers take a promising technology or idea with a viable business model and follow their “gut-feeling” as to how things wil turn out. This [risky] approach to investing has the ability to fuel the fire of innovation in this country and around the world. U.S. history is full of “garage” innovators, and many of today’s large industries were built from the ground up… why can’t that happen again?
(Answer: It can.)
There is a material difference between what venture capital firms do and what many hedge funds and private equity firms do. We make a long-term commitment to company-building. They don’t.”
"…punish[ing] short-term profit seekers from the hedge fund and private equity industry by treating carried interest from long-term capital gains as ordinary income would end up applying to venture capitalists as well."