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How to Spot Subprime VC
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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. 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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January 9th, 2009 at 2:41 pm
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).
January 9th, 2009 at 3:27 pm
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.
January 11th, 2009 at 9:25 am
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.
January 14th, 2009 at 9:45 pm
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.
January 14th, 2009 at 11:59 pm
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.
January 15th, 2009 at 11:19 am
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?
January 15th, 2009 at 11:40 am
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.
January 15th, 2009 at 2:27 pm
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.
January 16th, 2009 at 2:53 am
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.
January 16th, 2009 at 11:24 am
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.