How to Spot Subprime VC
Subprime venture capital, as I described in an earlier post, is easily recognizable Here are some of my metrics. Run for the hills whenever an investor…:
1. Seems more interested in how it is built rather than what the disruptive business proposition is.
Innovation becomes successful when it marries macro-economic value with micro-economic (technology) execution. Technology risk is the least of our worries in Silicon Valley, yet fundamental disruption is crucial and should take up the majority of the discussion.
2. Seems more worried about cost of development than cost of greenfield customer acquisition.
Capital efficiency is a buzz-word investors love to throw around. In most cases they want you to be as cheap as possible. But capital efficiency is relative to the cost and value of customer acquisition. Not all venture capital deals start with a seed round below $250K — more disruptive innovation usually costs more to build well (think iPod, iPhone, iTunes, eBay, etc).
3. Talks about valuations before you’ve explained the value of becoming the market leader.
A favorite trick of investors is to value the company based on its present accomplishments and many entrepreneurs fall for it. Their companies become undervalued and underpriced which leads to early loss of control to investors. And when investors run a company, statistically the chances of success have diminished significantly. Early stage companies should be priced based on the value of the idea and accomplishments along the trajectory of market leadership. Your glass should be seen as half-full not half-empty.
4. Seems more occupied with categorizing the investment than understanding its unique business value.
When investors start categorizing investments in technology categories and subsequently base their investment decisions on them, that means they clearly missed the fact that you business proposition could have value regardless. Again, technologies are not the business, application of technology to a market segment is.
5. Talks about capital efficiency without probing market inefficiency.
Again, capital efficiency is a relative term. When a large market is extremely inefficient it probably means that the absolute cost to enter is high (otherwise someone else would have entered it before you). So, the cost to enter the market is a function of its current inefficiency. Many investors are less versed in inefficiencies than you and therefor misjudge the price it takes to enter. As the entrepreneur you will be faced with the inequitable consequences if you decide to bow down and take the investors’ word for it.
6. Doesn’t question market entry risk, but focuses on cost.
Investment risk is what should be top of mind to investors, but many of them think they have the operational experience to challenge the assumptions of the entrepreneurs. In many scenarios market entry risk can be mitigated by developing a better product, but a better product costs more money to build. At any time would I rather spend a dollar on R&D to make the product better, than spend a dollar on marketing expenses to try and make a “cheap” product land better. So, the right amount of money (not cost) is imperative to disrupt a market.
7. Doesn’t ask about the runway to profitability, but the initial round to get in.
Most companies require multiple rounds of funding. Those rounds are not there for you as the entrepreneur, but for the investor to establish milestones to make him more comfortable. An investor that does not allocate sufficient runway, is effectively selling short on the promise of your company and will cost you months of fundraising efforts at every round.
8. Asks you which other investors you’ve spoken to.
Investors are lemmings, and so you should not disclose who you talk to until you have all their term-sheet on the table. Force them to make their assessment of your company independently. Usually each investor has a different risk analysis of your company and last thing you want to do is add up all the negatives before there is a buying signal on all sides. Herd the positives.
9. Asks you to talk with his associates first.
Associates are graduates that should be used to perform due diligence, not to discover a black swan. Many investors will use associates as a way to offload the workload created by the noise inherent to our industry. The minute you get the associate, you have become noise.
10. Asks you more about your education than your work experience.
Building innovation that is truly unique requires an analytical mind and ignorance to anything else but bottom-line results. Education teaches you how to respond to prescribed scenarios, innovation requires the opposite; an ability to respond adequately to a myriad of circumstances that have never presented itself to you, in that composition before. Any investor that focuses on your (or his) business school accomplishments has a warped view of what innovation really is.
Never forget that a great entrepreneurial idea sponsored by the wrong investor yields nothing but failure. Keep searching for the right partner and don’t bow down to sub-prime investment tactics.
Georges van Hoegaerden is the Managing Director at The Venture Company (www.venturecompany.com ) in Palo Alto, focused on helping companies with technological and market insight, organizational development, team building, selling and managing growth. This post originally appeared on his blog.
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Alan Veeck said on January 9, 2009
Thanks for the thoughtful post – as a VC, I like looking at the relationship from the other angle.
Regarding #3, however – I haven’t crunched numbers, but I bet I can find 10 OVERVALUATIONS for every 1 UNDERVALUATION you can find… if the idea was the only thing this was about, fine; but there are so many other factors that lead to valuation and success (sorry for stating the obvious).
Georges van Hoegaerden said on January 9, 2009
Alan, thanks for your comments. The basis of my observation is that in subprime VC the number of over and undervaluations are irrelevant. I agree many false positives achieve great valuations, the problem is that the great entrepreneurs are being turned into false negatives when they submit to subprime investment tactics. The market of innovative ideas is ineffectively served by VC, and thus the stats of an inefficient market are quite irrelevant.
I see many great innovations being discarded by subprime VC and subprime VC tactics by complacent industry titans everyday (but of course I see a lot of startup noise too). As much as you praise the bay area for its entrepreneurialism I think you have a great opportunity as a non-Silicon Valley investor to set a new standard for investing that doesn’t throw the baby away with the bath water.
Richard Grogan-Crane said on January 11, 2009
As an ex VC partner and entrepreneur, this article is right on the nail. Unfortunately I think many VC’s fall into this category. Doing some due dilligance on the VC and the specific partner in advance is the way to go.
just.a.guy said on January 14, 2009
I have also spent some time on both sides of the table, as a VC and as an entrepreneur.
The article is generally correct but I have to also take issue with #3. If VCs are chronically undervaluing startups, where are the excess returns? why have most funds not had significant carry distributions since 1998 or so?
The answer is that there is still too much capital chasing too few interesting deals/companies, and VC returns will continue to underperform until the great shakeout that started in 2001 resume in earnest, which I believe it will very soon.
Georges van Hoegaerden said on January 14, 2009
I think we will never know if there are too many VCs or not, if we don’t change the way we invest first.
The reason why ideas are underfunded is that ideas are pushed to comply to an artificial VC rulebook (all VC share) that make all deals share the same risk profile. An example is the Web2.0 nonsense. Therefor there is a distinction between undervalue-ing an idea versus undervalue-ing a company. I am not debating that once a company gets funded the value is what it is, and perhaps accurately priced. But my real problem is that VCs fund the wrong ideas (false negatives and false positives abound) and only price them within their cost boundaries.
You may have noticed that VCs price companies based on cost rather than opportunity. That is the problem.
Matt said on January 15, 2009
I’m not sure that you can make the claim that somebody has the ability to spot a “black swan”…by definition, a black swan is an unpredictable event. In hindsight, it appears people were able to predict it because there are always going to be some people positioned correctly based on the probability distribution of market participants.
Also, in terms of valuating a company based on the “opportunity”, is the “opportunity” 100% of the market? If 4 startups are valued at each owning 100% of the future market share, then they are on average valued at 4x more than they should be. I would argue that even in bust times, average venture valuation is too high…as “just a guy” says, where are the excess returns?
get back to work said on January 15, 2009
regarding #1, i think you have generalized the situation too much.
As a cleantech VC, the business value proposition is always easy for us to understand. With the wide variety of science projects and “perpetual motion machines” that we see, technical due dilligence is the most important factor. Most companies we see don’t pass that technology stress test.
Understanding technology will seperate the cleantech winners from the pack.
Georges van Hoegaerden said on January 15, 2009
Regarding black swans, the reason why I drew the analogy is that to investors most macro-economic factors are unpredictable to them. Most VCs have no clue about what fundamentally disrupts markets because they are too technology (rather than market focused) focused. Real innovation comes from an amalgam of micro and macro-economic factors, most of which is predictable after some rudimentary empirical testing. But yes, I don’t fully subscribe to the full depth of the Taleb theory.
Regarding opportunity, I define a real opportunity to yield no less than 30% marketshare and you’ll be amazed how few players in a market actually achieve that status (but you can get away with that be defining markets very narrow, hence my blog that markets don’t exist). But the real issue is that VCs put ideas through a investment funnel that commoditizes the risk profile of those ideas, meaning they are valued for their compliance to a VC cost model, rather than the value of the original disruption they came to the VC with. Great ideas are beaten down to comply with artifical pricings and reduced (rather than improved) chances of success.
Cleantech is a whole different story. I know nothing about cleantech but (as I mention in my blog cleantech VC doubts) I think the majority of the investors underestimate the effect of macro-economics and the regulations that have been engrained on our society that makes for a very unattractive time-to-exit runway. Just like healthcare the regulatory hurdles (not the quality of great innovation) will make for very challenging and unpredictable outcomes. Internet technology is much better positioned to produce consistent returns because there is no regulation to stop it from spreading like wildfire.
Hope that clarifies my viewpoint, or check my blog at venturecompany.com/opinions for more depth. After 10 years of running startups and some time on the VC side as well, I sincerely enjoy the debate to improve our technology ecosystem.
just.a.guy said on January 16, 2009
On this point I have no idea what you’re on about: Most VCs have no clue about what fundamentally disrupts markets because they are too technology (rather than market focused) focused.
In my experience of having worked with over 30 co-investors at the Board level and having nearly worked with far more (in doing diligence on their companies’ follow-on rounds), I would say that only a small handful of VCs I’ve met are technology focused at all, and are instead at best functionally literate on the technology side. That isn’t a bad thing (they have networks of experts they tap to do deeper technical evaluations). We must hang out in very different corners of the early-stage technology company universe if you think there are too many technology-focused versus market-focused VC’s out there.
It is true that VCs often evaluate deals through the lens of their own desired financing structure and cost model, which invariably has to do with fund size and target investment stage and size. Show me a promising early-stage technology company and 10 VCs and I can show you 5 proposed financing horizons and target exit profiles.
To me the real failing in the market here has two instigators. Entrepreneurs are often so anxious to raise funding (ANY funding) that they are willing to alter their plans to fit an interested VC’s financing model, rather than focusing on financing the company to the particular market opportunity and/or the next set of milestones that have meaningful implications for future company value.
How many capital starved angel-funded companies have you seen whose markets are passing them by? how many later-stage or large-fund VC companies have you seen who are overfunded? I’ve seen tons on both sides.
Georges van Hoegaerden said on January 16, 2009
My point is first off that there is a real imbalance between innovation and Venture Capital deals. For example: Apple (as a large company) walks away with the music business after 10 years of VC investments in this space, because they simply have a better structure to innovate, not silo based, but willing to invest across the music ecosystem. That’s just one example, but I can give you many others of a different make-up.
The overwhelmingly subprime VCs artificially restrict the intake of deals and have been doing so for many years. That attracts only entrepreneurs (yes, in large volumes) that submit to the artificial restriction and as such we spiral down to commoditization of innovation, or mediocracy. So, it is true that after 10 years of the application of those artificial rules, the majority of VCs today are confronted only by entrepreneurs that fit their mold. How those deals are constructed (in terms of financing) is irrelevant to me, as they will never produce prime results.
So, to summarize, VCs need to invest differently (see my blog) to attract innovators that think differently. VCs are too focused on the short selling of innovation, rather than making a fundamental impact on how we apply technology to markets and innovate. I quote Cesar Milan, aka the dogwhisperer, in saying that any dog can be helped if we fix its owner – in the same way I think we can fix entrepreneurialism if we fix how we invest.
So, I believe the VCs are responsible for the mess we are in. But do I believe all VCs are behaving badly? No. But I am afraid (and have evidence) many great innovators just don’t want to deal with the hassle of finding a needle in the haystack. And that is not doing our ecosystem a service.
Feel free to contact me directly if you have more questions/concerns.
chenyuchuan said on May 23, 2010
the people who say so itself is subprime, and that make most of the big things happened not in vc backed firm
it is true that technology is not application on itself, but i could assure you people that the technology is that stuff that have much longer life cycle(at least some part) than business model, and it is against most of people’s saying, those who develop technology do not know why they develop that, or they simply do not even do in the beginning, and fundamentally why recently investors like peter thiel said, people are staying away from funding the radical innovation rather focused on piecemeal solution, a good technology could be reused(at the architecture level), or you have to rely on a near perfect plan and big money to ponder the market like slegdehammer, relying on coincidental event which are not cloneable and with very low cost effectiveness, the business model is very shallow and could be refined from time to time the company stablized a very small break-even point
another side effect of capital driven short term gain is like myosip that those who clearly draft a financial plan is usually pointless, because truly those things in the market have many hidden risks not easily planned, that bias the normal psychology of the entrepreneurs to make fast money, making originally possible things impossible under that levity, is microsoft, apple or facebook funded with lots of money in their startup, if money make money, simply do not do business
when talking about education or experience, i have to say, there are many things not coming into industry yet, thus no experience to find, that is why they are called vc, but government lab and acadamia, or places like singularity already have that research very long time, with prototypical design, even though not perfect, using the technology off the shelf available to everyone, how could they call them vc, since only mcdonald have business model innovation, or they could simply build up a website, experience is useful, but not the part about factual knowledge of specific program or industry, but how to deal with people and how to do business regardless of specific industry, education and experience are equally important, it is even important that they even should unlearn the part of experience of specific program in order not to make them as hurdle to accepting and assimilation new things, quite contrast, education is about change, experience is about former things(whose people part make sense but program part do not)
finally, the chinese and indian are dramatically different recently, that they are more like capital and america is more like socialism under corporate welfare and hiararchy, which bred the saying
chenyuchuan said on May 23, 2010
well, i forget to say, market inefficiency is virtually an irony, by warren buffett, look at his strategy, everybody greed while i worry, in late 2008, that is deeply making everyone in panic, he show a strong buy signal, while all others, if your company make money in 3 or more years, most inefficient times is the best time rather than the worst because market clarify itself, oppotunitism will as a matter of time kill the investment banker, while vc shall choose the opposite
much more leveraged buyout could be killed if startup think long enough,like facebook reject yahoo deal, meaning big hinder the small by making the uninformed bow down to severely undervalued proposition which resulted in double loss later on based on a destroyed culture of startups, such tactic only works for those who interested in short term performance driven company that is originally able to change the industry and even the world
the capital society is ruining itself in such a way by developing a system that favor the big and cronism and despise and disable startup culture into that short term driven tactics, no big things could possibly happened again.
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