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Why Don’t Innovative VCs Innovate?
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For a group priding itself on identifying, nurturing and commercializing innovation, it’s ironic that the venture capital industry resides in the relative backcountry of financial innovation. Considering all of modern finance’s experimentation and ingenuity (for better and worse), today’s basic VC model has remained untouched for over a quarter century. It’s as if 18th century traders swapping shares under a New York buttonwood tree agreed, “This is the future of finance.” Why is it that the same investors obsessed with change and the next best thing haven’t applied their considerable talents to their own craft? For decades, this inefficiency was prized by a clubby VC industry as a competitive moat, keeping newcomers out and quietly maintaining a lucrative profession to fund vineyards and Gulfstream jets. But I need not tell you that all isn’t well in venture capital. This isn’t another “VC model is broken” story. It is, however, an assertion that “We VCs need to reinvent the model.” Journalists are only now scratching away at the VC veneer to reveal what industry insiders have privately lamented for some time—the asset class has not returned money to its limited partners in nearly a decade. Forbes’ recent skewering is just the start of a media BBQ. Yes, there may be lots of turkeys in venture portfolios, but meager VC returns are the symptom of a systemic issue. Venture investors require alternate paths to interim liquidity for their 10-year fund structure to make rational sense. The fact that great venture firms operating according to plan—partner with the best entrepreneurs, build great companies—are still finding themselves unable to realize value creation, exposes the critical flaw in the venture model. The answer isn’t passively “waiting for the IPO window to re-open.” Rather than pine for the salad days of tech offerings led by Robbie Stephens, Montgomery, H&Q and Alex.Brown, it must be accepted that the world has changed. Surely the collective intellectual horsepower and sheer will of the venture capital industry can develop a systematic solution. Where to start? VCs are always trying to catch the current—but they missed the wave. The wave of financial innovation over the last 25 years transformed nearly every facet of financial services, from exchanges to student loans. But it entirely bypassed the venture capital industry. It might seem like a peculiar time to extol any virtues of financial engineering. While the current market crisis reveals many of securitization’s downsides, it also exposes the detriment of not having a market capable of providing efficient and structural liquidity for its participants. As an industry, we should work with large capital markets players (with great self-interest of their own) to build a more sophisticated system that addresses the needs of all participants–not just VCs, but entrepreneurs and LPs. A system that incentivizes and rewards early investors and shareholders for risks taken, allows for orderly interim exits and enables different types of investors to participate in the various stages of a company’s development. Secondary funds like Coller, Lexington and W Capital are a valuable part of the ecosystem, but VCs should aim for a more comprehensive solution. Other innovative ideas like the Series FF shares developed by the Founder’s Fund, allowing for partial liquidation by early entrepreneurs, is the kind of creative approach that should be embraced. Goldman Sachs’ exchange-based effort to modernize private equity—the Goldman Sachs Tradable Unregistered Equity—seems the most intuitive answer, but appears to be more focused on traditional PE rather than VC. We should not undermine what makes venture capital unique—but instead reimagine the method by which we finance early-stage companies and harvest investments. It’s time to put our collective fates back in our own hands, rather than remain at the whim of a fickle and ever-more elusive IPO market.
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January 5th, 2009 at 1:59 pm
Coming from a completely different sector - advertising/marketing - 80-90 percent of this column applies. We’ve become challenged by “model reinvention”; eroding margins, increased scrutiny, SOX-related effects, commoditization, the old-media-to-new-media migration and other forms that have elicited countless change-or-die articles.
I have zero insight on the systemic antidote to the VC industry BUT believe there will be an innovation evolution (a.k.a. people will figure out new ways of making $$$). The fundamentals of creating successful companies aren’t broken (talent/team, chemistry, drive, focus) and neither are people’s desire to win.
January 5th, 2009 at 6:12 pm
Peter, a lot of successful VCs do innovate, I bet you could come up with a few examples if you put your mind to it. Here’s five from my list:
(1) Going overseas: It used to be that if you couldn’t drive to a portfolio company, you wouldn’t invest. Then firms such as Granite Global Ventures (now GGV Capital) went to China and invested 50% of their fund there.
(2) Franchising: The DFJ Network. Not something you would have seen 20 years ago.
(3) Growth Funds: Seems like everyone is doing them now, but I’d credit NEA and Sequoia with the first “growth stage” investment platforms. (One might argue that they took the spot of firms such as TCV, Summit or TA, though).
(4) Founder Friendly Funds: The Founders Fund, with its Series FF stock, allows entrepreneurs to take a little liquidity as they go through the startup process. It recognizes that founders typically have more experience and leverage now than ever before.
(5) Do-gooder Funds: New Cycle Capital, the Bay Area Equity Fund and others have tried to add a social-responsibility component to the VC business.
Of course innovation is still the exception rather than the rule.
January 5th, 2009 at 8:41 pm
Another area of innovation is small funds wrapped inside active, well managed groups of angel investors. There are at least three such organizations that are members of the National Venture Capital Association, including the group I run, CommonAngels. The advantage of having an active network is a lot of help in sourcing deals, evaluating them and helping them post-investment while still maintaining a fund size that can deploy relatively modest amounts of capital ($500K-$2M) and generate strong returns on average M&A exits. It’s extremely difficult to run a small fund without this type of network, which tends to provide a lot more direct assistance than “active LPs” would because they are motivated by writing their own checks.
January 7th, 2009 at 8:42 am
The author is correct in his basic view, but financial engineering isn’t the answer. We have a more fundamental problem that will require solutions of equal weight. The entrenched corp. culture, to include relationships with universities, VC firms, IBs, etc. on one hand have succeeded in essentially eliminating alternate distribution channels and exits. Currently there is no other viable exit, and in this market very few corp deals are being done.
Somehow, someway (I have some ideas, but alas I have no incentive to share them with anyone), we need customers amd communities to understand that their future depends on learning to manage healthy markets. That means paying more and taking some risk in early stage companies so that some future competition will exist- particularly in companies and relationships that are two sided rather than one.
I’ve worked with many of the best in the world in this area, and frankly I don’t see or hear anything close to what is needed. I’m not a fan of Gov efforts, but that has been the trend- subsidies at the early stage in some form have been growing enormously in the past decade worldwide.
It matters not whether it’s an angel, VC, PE, - regardless of model, if there are no liquidation options for investors, eventually they will stop investing. The dotcom bubble model- or another variation in alt energy- is NOT what we need. What we need is to return to a real economy where government regulates markets, crises are prevented, competition is encouraged to emerge, and customers don’t cut their own throat. We also very much need governments who support emerging technologies and business- for the sake of innovation and market health, NOT some sort of welfare program that punishes the strong and rewards the weak and/or corrupt.
It may seem like a lot to ask, but frankly that model we used to call capitalism is the only model that has proven to work over time- despite the imperfections. - 02- MM
January 8th, 2009 at 8:35 am
PS- We released a white paper that may be of interest that covers part of the problem in VC and PE relative to the digital work environment- “Unleash the innovation within”.
Like a fool, I’ve shared it on the Web - it’s been well received rather widly:
http://www.kyield.com/publications.html
Cheers, MM