Notes of Note from John F. Ince

Archive for the ‘Venture Capital’ Category

Grim numbers point to the end of the venture capital era – SiliconValley.com

Excellent analysis of the current state of Venture Capital Investing in Silicon Valley …

How gloomy is this picture for venture capital firms? According to an NVCA survey, 90 percent of venture capitalists who responded expect their industry to contract through 2015.

That trend is well under way. While firms have not started collapsing en masse, they have been quietly shrinking. The number of principals at U.S. venture firms fell from 8,892 in 2007 to 6,828 in 2008. As firms raise smaller funds, they need fewer people to invest.

Some will argue that at least in the area of Web startups, companies can be launched on the cheap, and growing numbers of angel investors — those wealthy individuals who invest at the earliest stages — are stepping in to give these companies a boost. True, but that kind of funding doesn’t work as well for biotechnology, medical devices or cleantech. And these angel-backed companies are small and lean, and don’t create large numbers of jobs.

It’s not just fewer startups, though. When companies don’t go public, they don’t generate the same number of jobs in their later stages. Heesen said the cash raised from an IPO usually triggers an explosion in hiring.

“The real job creation starts far down the road, after they go public,” Heesen said.

Instead of going public, the companies that do show potential now get gobbled up by the Googles and Facebooks of the world. At the same time, valley giants like Hewlett-Packard, Oracle, Intel and Cisco Systems continue their acquisitions of larger tech companies, a consolidation trend that more often than not is accompanied by big job cuts.

So we’re seeing fewer startups and sweeping consolidation. Tie those trends together, and you’ve got a drag on job creation that could weigh down the valley for years to come.

With venture capital in retreat, we must look elsewhere for a new model for startup funding to kick-start the valley’s next era of innovation and the kind of job creation we desperately need.

via O’Brien: Grim numbers point to the end of the venture capital era – SiliconValley.com.

Is ‘conscious capitalism’ the future of venture capital? (Morning Read) « MedCity News

Is “conscious capitalism” the future of venture capital? It is if you ask Silicon Valley lawyer John Montgomery, who’s launching a column on the topic for peHUB. For those unfamiliar with the term, Montgomery lists three key principles of conscious capitalism: Recognizing that a company has a higher “meta-purpose” than just generating profits, delivering value to a wide swath of stakeholders beyond just the traditional management and shareholders and viewing the CEO as a “steward” who must work for the benefit of all those stakeholders.

via Is ‘conscious capitalism’ the future of venture capital? (Morning Read) « MedCity News.

GE teams up with venture capitalists for $200 million ‘smart grid’ fund – San Jose Mercury News

General Electric today announced the creation of a new $200 million fund to stimulate new electrical “smart grid” ideas and detailed plans for a massive rollout of electric car charging stations.

GE, one of the world’s biggest companies with a large stake in the electricity utilities, made the announcement at an event that also featured venture capitalists who are teaming up on the $200 million fund.

GE Chairman and CEO Jeff Immelt said the goal is to marry the creative, entrepreneurial creativity of the venture capital community with GE’s ability to deploy systems on a global scale.

“We can get things going with massive distribution,” he said. “We have 50.000 sales people and 50,000 engineers.”

Paul Koontz of Foundation Capital said the role of venture capitalists will be to “bring entrepreneurial DNA to this effort.”

Venture capitalists see great opportunities to make money by finding new ways to generate, transmit and store energy, as well as to encourage efficient use by consumers.

Ray Lane, of venture firm Kleiner Perkins Caufield & Byers, likened the opportunity to a “slow, fat rabbit” that’s easy to seize.

Electric-car charging stations, envisioned as a vital extension of a “smart” power grid, are being rolled out as carmakers ranging from Tesla to Nissan to General Motors prepare production of more all-electric cars. Coulomb Technologies, a Silicon Valley startup, is also

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developing an electric-car charging station.

via GE teams up with venture capitalists for $200 million ‘smart grid’ fund – San Jose Mercury News.

Scrutinizing Seven Popular Myths About Venture Capitalists

Scrutinizing Seven Popular Myths About VCs

by John F. Ince

As the VC industry picks itself up and dusts itself off it’s a good moment to take a critical look at the popular myths that surround the industry in general.  Here is my analysis of seven popular VC myths:

Myth Number 1:  VCs are motivated primarily by greed.

John Ince’s Analysis: If greed is the same thing as the desire to maximize return on investments, than this not a myth.  VCs take their fiduciary responsibility to their limited partners very seriously, because their LPs give them the opportunity to play this game. To the extent that this is a game, VCs clearly want to win. Their competitive juices flow and they hate it when one of their competitors has scooped up a great deal that they wanted.   A lot of VCs keep track of their successes, by the amount of money they’ve made.  That is their way of keeping score.

But to suggest that VCs are primarily self-serving, also hits wide of the mark,  for their motivations are complex. The best VCs also a great deal of pride  in what they do to helping entrepreneurs nurture their visions.  They also derive satisfaction by playing a role in catalyzing the formation of the high tech industry.

So, if VCs are greedy, it is not  unlike the vast majority of people who go into business.  Venture capitalists are in the final analysis, capitalists.   What particularly irks some entrepreneurs  isn’t that VCs are greedy, but that they have acquired so much leverage, and as a result, seem to be able to bend circumstances so easily to their advantage.

Myth Number 2: VCs are now investing so much capital that they are stretched too thin and they cannot possibly give individual companies the assistance they need and deserve.

John Ince’s Analysis: During the crazy days of the dotcom bubble, this was becoming true.  But the the best firms have recognized the downside here, and are moving to better leverage the time of their GPs by providing them with the resources they need to better assist portfolio companies. Also, as VCs steer more of their capital to existing portfolio companies, the pressure to sit on more boards is diminished.

Myth Number 3:  VC are our societies primary catalysts for the development of high tech and emerging growth industries.

John Ince’s Analysis:  This is now almost boilerplate in VC public policy pronouncements.  Clearly this is more than rhetoric.  But to suggest that VCs are the primary catalysts is to diminish to the role of entrepreneurs.    The high tech boom that has propelled the US economy for the last decade, would never have happened without the growth and maturation of the venture capital industry, but VCs would be nothing without the entrepreneurs who make them what they are.

Myth Number 4:  VCs have been exploiting the recent market downturn to extract a few extra pounds of flesh from the entrepreneurs they purport to support.

John Ince’s Analysis: Valuations are a function of the marketplace. Any value set is a function of negotiation.  Let’s face it,  venture capitalists try set the valuation as low as possible, and the entrepreneur tries to do the opposite.    In this environment, even though there is a lot of capital, most of it being steered to keep existing companies alive, so there is less available for new companies.  That works in favor of the venture capitalist in the negotiation process. According to Vivek Wadhwa, CEO of Relativity Technologies based in Cary, NC “If you speak to a VC, they have all these formulas to come up with a valuation for a company.  But in reality, it’s a game to see what they can get away with.  They’re trying to pay the least money to get the maximum ownership of a company.”  Many entrepreneurs feel they are getting taken to the cleaners with lower valuations, sometimes with anti-dilution clauses kicking in followup rounds of financing. Under these clauses,  early round investors are entitled to increased shares, when a company’s valuation is lower in later rounds of financing,   even if the material facts surrounding their operation improve.  Yes, to some entrepreneurs, this appears to be exploitation, but let’s face it: market valuations 18 months ago were vastly inflated, and the reality of the current market is simply a reflection of that fact.   In the final analysis, VCs still want the dynamic of an entrepreneurs motivational scheme to remain in force.  Remember, VCs are also suffering in this climate, and they have their fiduciary responsibility to investors.

Myth Number 5:  VCs are hugely overpaid for what they do.

John Ince’s Analysis: VC are paid well, very well indeed, but what they do is hugely valuable.   Sure, some VCs have hit home runs that put them in upper stratosphere of income brackets.  But not unlike the lottery, those few cases exist as incentive for the rest of the industry to assume often unreasonable risks, largely on a hunch.   For 20 years, the VC model has been simple.  The “VC’s law of threes” holds that one of three VCs investments will fail, the second will be like watching paint dry and the third be a winner.  The hurdle VCs set varies depending on the environment.  Some require a return as high as 65-70%.  Others are lower. Says, Rick Frisbie of Battery Ventures, “We set a hurdle of a 40% weighted return for each deal, where the average of four different scenarios–best case, optimistic, conservative and downside must produce a 40% return in discounted cash flow on our investments.”  Most top tier VCs want their investment to operate in a market large enough to justify a half billion market cap within the startups gestation period. That gestation period in 1990 was about 6-7 years, but it has been telescoped down to two years.  It will probably settle back somewhere in the range of three to five years.

If one questions the value VCs bring to the entrepreneurial equation, one need go no farther than eBay example.  Despite 40% growth quarter after quarter, eBay’s founding entrepreneurs Pierre Omidyar and Jeff Skoll, couldn’t recruit the sort of CEO they needed to run the company. That’s what lead them to Benchmark Capital in 1997.  According to Bob Kagle, General Partner at Benchmark, “At the time Pierre Omidyar, approached us, his company was not only profitable, but cash flow positive.  So he didn’t really need money.  In fact the $3 million that we invested directly in the company, went into the bank and was never touched.  But Pierre felt a professional venture capitalist could be a constructive influence in helping to build the company.  Specifically, Pierre was mature and enlightened with regard to what it takes to build of significant company in terms of experienced and capable executive talent.” With the imprimatur of a top tier venture capital firm, eBay flourished, and none of eBays entrepreneurs today would question the value of Benchmark’s contribution.

Myth Number Six:  With the explosive growth in the industry, an unsavory new breed of VC has begun to infiltrate the industry.

John Ince’s Analysis: This is indeed a myth.  In any industry with the sort of growth we’ve seen in venture capital, there will be some mercenaries–people who enter primarily to get rich quick. But to raise the sort of capital needed to survive in this industry there is a lot of investor scrutiny.  The level of scrutiny can only increase with the recent market corrections.  Those few newer VCs who have lower ethical standards, won’t be VCs for long.

Myth Number Seven:  VCs are risk takers.

John Ince’s Analysis: In a professional sense, VCs take huge risks in their portfolio companies.  But personally VCs are not risk takers.  While some VCs invest their own money in their funds and other investments, the vast majority of what they invest is other people’s money.  Their management fees, ranging from 2-3% of the capital under management, are guaranteed.  Their carrying interest (usually between 20-30% depending on the stature of the firm) on the appreciation in their portfolio kicks in only on the upside.  They share none of the downside risk of their portfolio companies, unless one factors in the possible damage to their reputation when their dotcoms become dotbombs.

Are Venture Capitalists Facing an Identity Crisis?

Venture Capitalists Facing an Identity Crisis

Published in Upside Magazine in 2002

Market Corrections and Pressures to Scale Up Force Reassessment of Priorities

by John F. Ince

Six years ago, when Alan Austin was Managing Director and Chief Operating Officer at Silicon Valley linchpin law firm, Wilson, Sonsoni, he wanted to get away for a ski weekend at Squaw Valley.  Get away he did.  In fact he got stranded for two days in blizzard like conditions.          Recalls, Austin, who now serves at General Partner and Chief Operating Officer of Accel Partners, “It was one of those mid-December days with raw conditions. It was snowing on the top of the mountain.  My companions were tired, so they headed back.  But I had something left in me so I went out for one last run. Well it turned into a whiteout.  That’s like a blackout, but it was all white and I couldn’t see anything.  I got disoriented and turned around 180 degrees. Without realizing it. I skied off the backside of the ridge, out of bounds–into no man’s land. I got more and more concerned.  Nothing was making sense.  At some point I decided that I wouldn’t find my way out that night, and if I didn’t make a shelter I would freeze to death.  So I made a cave in the snow.  I wound up being stranded there for two days and snowed 40 inches.  At the end of that time, it cleared a little, a National Guard helicopter spotted me, and  I was taken to safety.”

Not unlike Austin, the venture capital industry has suddenly found itself in a place far removed from where it hoped it would be 18 months ago. Down the slopes the VCs went, but, like Austin, they ended up on the wrong side of the mountain.   Is it a stretch to compare the recent markets for startup funding to the blizzard that Austin encountered?  Not many think so.   In March of this year, the slide of the NASDAQ achieved the dubious distinction of being most precipitous decline, in terms of percentage, of a major stock market, since the stock market crash in 1929.  Even entrepreneurs who feel they have a clear path to profitability,  have found themselves feeling disoriented in this forbidding investment climate. Market realities are accelerating trends and forcing many firms within the venture capital community to reexamine some of their most fundamental assumptions.

A Profound Transformation?

How deep that thinking goes will, to a large extent, be a function of how long the storm continues.  But this much is clear:  venture capital is undergoing a quiet and profound transformation.   Not that long ago in the 1980s, venture capital was a quaint little boutique industry, often with a few lawyers and doctors putting in $10,000 or $20,000 apiece.  More recently, VC firms started courting university endowments, pension funds, insurance companies and other institutional investors, who typically allocate 5% of their portfolios to these so called, “alternative investments.” According to Venture Economics, the number of venture capital firms increased from 95 in 1980 to 387 in 1989 to 620 in 1999.  And when smaller firms and angel investor groups are included, some estimate that there are well over 1000 VC firms operating today.

The amount of capital under management by VCs increased from $2.9 billion in 1980 to $29.5 billion in 1989 to $135.3 billion at the end of 1999.   According to Mark Heesen, President of the Natural Venture Capital Association,  “I’ve seen dramatic changes in a very short period of time.  In 1995 the venture capital industry invested $5 billion.  In the year 2000, we were a $103 billion industry.  The industry changed from a group of individuals who invested primarily in Silicon Valley and the Boston area, to an industry that invested in 47 states and the District of Columbia.”   The number of companies receiving venture capital  increased by 35% from 3,967 in 1999 to 5,380 in 2000.  Although venture capital investments did slow a bit in Q4 2000 to $19.6 billion, down from $28.3 in Q3,  the amount of capital under management increased to $134.5 billion.

Institutionalization of Venture Capital Firms

With this transformation, VCs are moving, sometimes reluctantly, towards institutionalization. The growth in size of VC firms has meant the adoption sophisticated management and accounting systems and along with that comes bureaucratic human resource policies and reporting burdens.  Dovetail these trends with the recent market corrections and it all adds up to a growing sense of VC disquiet.   Is is a stretch to call this a VC identity crisis?  You decide.  Some of the industry’s most influential players vociferously disagree.   But clearly the industry’s process of self-assessment has been intensified by financial uncertainty, especially with questions concerning the ability of the mid and lower tier VC firms to raise new funds in the coming years.

Crosspoint Partners, raised eyebrows this January with their decision to cancel a one billion dollar fund with commitments from bluechip institutional investors like Harvard University and the Rockefeller Foundation. Of course, the Crosspoint decision is not irrevocable.  Like most of the top tier VC firms, they have a waiting list of investors that they can tap at any time, so, in essence, it amounts to more of a postponement.  But Crosspoint’s decision has added fuel to an ongoing discussion that goes to the very character of the VC. Crosspoint’s General Partner, Seth Neiman declined to discuss their postponement of their recent fund in the recent Upside interview.  But six months after their decision, rumors continue to circulate.

Crosspoint’s decision  can be interpreted on two levels: professional and personal.  On a professional level, the speculation is that Crosspoint simply didn’t feel they could achieve returns to satisfy investors, and communicated this to their limited partners in an effort to preserve their reputation. This is what is so unsettling to others in the VC community who are no longer seeing the same quality of deal flow they saw a year ago.  Crosspoint’s decision is loaded with implications for institutional investors, especially because Crosspoint has such credibility.  If the LPs buy into Crosspoint’s logic and start asking hard questions of their other funds, what does that mean about the ability of  VC funds of unproven ability to raise funds down the road?

Then there are the personal issues facing VCs, who are often stretched thin, sitting on the boards of 12-15 portfolio companies. One industry VC who wished to remain anonymous, speculated that the decision of Crosspoint’s founding partner, John Mumford not to be a part of the next Crosspoint fund had an important psychological impact on the other partners.  Given Mumford’s decision to walk away from the stressful lifestyle, they also wondered just how much of a commitment they wanted to make, especially looking ahead at the possibility of several years of tough markets. The issue of time commitments of general partners is an especially vexing one for the industry.   According to Mark Heesen, President of the Natural Venture Capital Association. “Because the industry has grown so dramatically in such a short time,  the number of professional venture capitalists has not kept up with this incredible amount of money flowing into the industry. Professional venture capitalists today are more stretched than they ever have been.”

Says Seth Neiman of Crosspoint, “To work as hard as venture capitalists do, it’s going to take a lot of different motivations.  I simply wouldn’t work as hard as venture capitalists do, simply for the money.”  Speaking of the money, by postponing their $1 billion fund each of Crosspoint’s six partners were walking way from upwards of $3-4 million apiece per year in management fees ($1 billion times a 2-2.5% management fee, divided by six partners, less the expenses of running another fund).

Another more charitable theory sees Crosspoint’s move as a mature and responsible decision given the current market realities and the fact Crosspoint already has almost $500 million in their existing fund, yet to be invested.  But a more cynical theory sees the move as a self-serving, marketing ploy designed to differentiate themselves from the greedy pack of other VC firms.   Those of this persuasion wince a little at some of Crosspoint’s public statements that take the rest of the industry to task over the issue of management fees.  Whatever the interpretation of events, it is clear that Crosspoint has stirred controversy, by attempting to seize the high moral ground.

Pressures to Scale Up

The Crosspoint controversy also raises deeper issues about where the industry is headed.  Some of the industry’s most influential players are wondering if the same trends towards consolidation that characterized, commercial banking,  investment banking, law and accounting are lurking ahead for VCs.    Although venture capital may not be subject to the same economies to scale of investment banking, it is not immune to the market pressure to grow, especially in the critical area of deal flow. Says, Manny Fernandez, former President and CEO of Gartner and now a General Partner with SI Ventures and Chairman of Gartner,, “Although in the beginning,  the value add of the VC is operational involvement, in the final analysis, the venture capital industry is all about deal flow. ”

In an environment when many of the best entrepreneurs are waiting the sidelines it becomes increasingly difficult for smaller firms to sustain the quality of deal flow and this suggests that the pressure  will only increase for VC firms to scale up. Says Ronnie Skloss of Brobeck, Phleger & Harrison LLP, “We probably won’t  see outright consolidation of firms in venture capital, but we’re likely to see  increased raiding of talent by the VC  firms that better weather the fallout from the downturn in the technology sector.”

This becomes an especially attractive option for the top tier firms, who have no immediate problems raising additional capital.  Says Dennis Roberts, who brings 35 years of experience as an investment banker, commercial banker and more recently as head The McLean Group, “The economics of venture capital argue for the same scalability that VCs want for their portfolio companies. If a fund is small, it can’t hire enough good people to analyze and do deals.  By the time a firm has paid office overhead, legal fees, support services, acquisition costs and partner salaries, there’s not a lot of money left over at the smaller firms  for quality deal analysis.  I personally wouldn’t put my money in a firm with only $25 or $50 million under management.”

So the days of the boutique VC firm may be numbered as the industry places a growing premium on the speed through which they can move dollars through the pipeline.  Firms like San Francisco-based, Round1 are seeking to bring efficiencies to the private capital markets  by using the Internet to automate workflow and increased information transparency. But even Round1’s CEO, Jamie Cohan acknowledges, “There are established behaviors to overcome for an industry where personal relationship have played such an important role.  But those same behaviors create limitations. We believe it is inevitable that private capital markets will see the same level of standardization and information access  that you see in the public markets.” Not everybody agrees with that prognosis. According to Bob Kagle, General Partner at Benchmark, “I’m not sure that the venture capital business scales per se.  The unit of production in our business is the general partner’s time and availability to serve on the board of directors.  There are only so many boards that one individual can effectively serve on.”

If the VCs give in to the market pressures to scale up, how might that change the character of VC involvement with their portfolio companies?  And it also has potentially profound implications for the culture of an industry, where intuitional hunches, networking, and the nurturing of personal relationships are key determinants of success. Is this ultimately compatible with the sort of assembly line mentality that comes with pressures to increase deal flow?

Entrepreneurs Feeling the Pinch

And this disquiet has filtered down to the entrepreneurial community.  Many entrepreneurs now find themselves in situations like Alan Austin,  trying to live by their wits, building a financial cave in the snow,  hoping that National Guard helicopter with a few sympathetic VCs in it will spot them below. Many entrepreneurs have turned their business plans around 180 degrees from what they had when they set out to seek capital. According to Bob Kagle, General Partner at Benchmark, “Companies raised an enormous amount of money prior to proving themselves as a viable businesses.  What’s happening now is we’re reverting to the mean. You’re seeing both entrepreneurs and venture capitalists return to fundamentals and treat capital as a scarce resource.”

A Shakeout Ahead for Smaller VCs

Make no mistake about it,  not only for entrepreneurs, but also many of the newer and smaller VCs this is a game of survival.  Through a random sampling of VCs, a consensus emerges that of the estimated 1000-1500 VCs in existence today, as many as half will not be around in a few years.  In the history of investment banking or commercial banking is any gage, these projected attrition rates are probably inflated, but with exit strategies through IPOs all but blocked off, the portfolio pipelines of VCs are getting clogged.

For the moment, exit activity through mergers and acquisitions remains robust, but if the market slide continues much longer, even this avenue will become increasing littered with debris of dotbombs, and less viable.  The precipitous decline in the market value of firms like Cisco, Microsoft, Lucent and others who have traditionally been active in the M&A market further aggravates the VCs dilemma.  Until a liquidity event occurs, the VC’s capital investment is captive in the coffers of the portfolio company and subject to whole host of unpredictable factors including the viability of technology, the growth of the micro markets, the strength of the management team and the effectiveness of their sales and marketing effort.  Even after a liquidity event, with today’s depressed stock prices, VCs are reluctant to move stocks in their portfolios through either sales on public exchanges or M & A activity. Says Jeffrey Grody, Partner with Day, Berry & Howard LLP and a specialist in M & A activity,  “Although M & A activity is still strong, that really may not be what VCs want.  Sometimes, it doesn’t enable them to achieve maximum return.”

VC Taking a Tough Line on Valuations

Recognizing that their reputation with their institutional investors is on the line, most VCs are taking a tough line in negotiations. Some entrepreneurs feel that VCs are unreasonable, seeking to exploit the current market to extract deeper concessions from their portfolio companies in terms of valuations, especially in followup rounds of financing.  But VCs defend their stance, pointing out that the market is the ultimate determinant of values and that valuations in earlier rounds were clearly inflated.  Says, Jeff Grody, “In tough times, the golden rule applies.  Those with the gold make the rules.”

Although such figures are difficult to verify, an Upside sampling suggests that upwards of 50-60% of their investment funds are now going to prop up existing portfolio companies. Says Howard Schwartz, CEO and Founder of  ShareSpan Wireless, “Valuations of companies are divided by four or five from where they were last year.” Woe be those entrepreneurs who have neither a cash hoard or customer base with the sort of bluechip companies that will make skeptical VCs pause from their frenzy and take notice.

Few Options for Entrepreneurs

Although many talented entrepreneurs are on the sidelines waiting for market conditions to improve, others have little choice but to continue to make the rounds with VCs. According to Garry Hemphill, founder and CEO of VHB Technologies in Texas, “What we’re seeing now is that VCs want a slam dunk. Now they not only want you to be in beta testing with customer testimonials, but they’re also looking to mitigate their risks through partnerships with other VCs firms.  They need to know that when you need to go for the next round of financing,  that other firms VCs will be there.”   Says Schwartz, “VCs are asking a lot more questions.  They’re telling us to close the deals, book the revenues and then come back.  With this market, they know they can wait thirty days and your deal will still be there.”  One of ShareSpan’s investors and board members, Arnold  Kroll, Senior Advisor from Burnham Securities offered this admonishment to Schwartz, “Companies don’t go out of business from dilution.  They go out of business by not getting the money they need.” But most entrepreneurs accept the new market realities and realize that they have little leverage in the negotiation process.  Says Gary Hemphill, CEO of VHB technologies, “There plenty of bloodletting going on right now.  They don’t say no.  Their game is to sit on the fence and wait.  In the process they’re removing any bargain chips you might have have, in the negotiation process.”

Vivek Wadhwa, chief executive of Relativity Technologies in Cary, NC is more blunt.  He says, “”Companies absolutely are being raped by venture capitalists. The VCs wanted me to accept a lower valuation without even knowing what the valuation was, or how the company was doing. That is what pissed me off so much.  Their attitude was that we should take a cut and suffer the anti-dilution consequences just because they were losing money on their other investments.”  Wadhwa’s solution?  He went out and secured a $2 million working capital loan and $3 million line of credit instead.

Hoping for Divine Intervention

So, like Alan Austin, out there at Squaw Valley in his snow cave, both VCs and entrepreneurs are wondering if they are in fact doing the right things–without certain knowledge of how long the storm will continue.  Austin remembers hearing the sound of rushing water in his vicinity.  He knew that if the took a wrong step and fell into the stream, he was history.  So should he stay put and wait for a rescue or venture out? Should VCs be investing their time in raising new funds, when their reputation might be tarnished by bringing their investors lower returns?   Should VCs be pumping more capital into companies to keep them afloat, when nobody knows for sure when the market will bottom out?  Are they throwing good money after bad?  Says Manny with SI Ventures and Chairman of Gartner, “Our position is that if financing financing will not last the company  one year, and if the company is not profitable after that, we will not invest.  You have to make tough decisions in this environment and sometimes you just have walk.”

It was only after Austin was rescued, that he had time to reflect on the deeper meaning of what happened to him.    Says Austin, “Only in retrospect, did I come to appreciate the spiritual dimensions of the experience.  I really felt there was divine assistance at work with me out there.  I was only a casual churchgoer before the experience, but now I’m much more religious.”  While most VCs and entrepreneurs may not view what their going through as a spiritual experience, they also wouldn’t mind a little divine intervention.

The Creeping Institutionalization Of the Venture Capital Industry

Bureaucratic Inertia Infiltrating Where Swagger Once Held Sway

By John F. Ince

Venture capitalists pride themselves on backing new ideas that have the potential for  taking on “lazy incumbents” and revolutionizing inefficient marketplaces.  Thus it is ironic that increasingly the venture capital industry at large is showing signs of the same kind of organizational inertia that they seek to shake up with their investments. But what passes for innovation today is really little more than imitation.

The greatest limitation of the venture capital industry today is the insecurities that VCs feel about venturing outside the areas that they feel they have deep domain expertise.

Over a career as a financial journalist that spans decades, I’ve interviewed a hundreds of tech startup principals:  successful VCs, entrepreneurs, and angel investors in the tech space.  I almost always ask them what’s the most important factor in their investment decisions.  The answer has become so predictable that I’ve become highly skeptical about it.

They almost always say something to the effect, “We bet on people, not ideas. We’re looking for an intelligent entrepreneur with a successful track record. The idea is almost secondary.”   But can truly great ideas really be separated from the people who generate them?  If not, then VCs and angels today are operating upon a myth?

This is what I’ve dubbed “today’s dominant myth of VC and angel investing.” It’s fool’s gold for investors.  It needs to be critically examined and challenged, because it results is a process that maximizes the clutter of the serial entrepreneur and minimizes the chances that the inspired entrepreneur will be recognized and funded.

It’s a myth based upon convenience–the convenience and relative simplicity of evaluating people and their track record, in preference to the complexities and ambiguities of evaluating the potential of greatness of their ideas.  If the VCs are doing their job, both as mentors and funders, then the power inherent in great ideas will attract the talent needed to successfully execute them.

To understand why investors choose the convenience of this myth, let’s look at the pressures on investors.   First,  investors consider their most valuable and scarce resource to be their time. As a result, most, who are in the business professionally, work from a template for investing that enables them to leverage the value of that scarce resource.  The question for investors is, “Does that template for investing allow them to recognize truly great ideas and entrepreneurs?”

Second, most VCs are answerable to their LPs, who exact high demands in the form of above market returns.  To achieve this, VCs look for a minimum 5x return with a viable exit strategy within five to seven years. They play the odds, always looking for the home run that will bail out their losers.   Even if four of five investments fail or limp along at break even, the home run will more than make up for it, and make them look good with their LPs.

Now, let’s take a look at the history of the tech sector for the last 20-25 years.  If the successful startup track record is so important, and investors are really looking for the home run, how does that jive with history? If we try to pick out the 10 biggest home runs during this period, we’re looking at Microsoft, Oracle, Sun, Apple, Yahoo, AOL, eBay, Netscape, Amazon and Google.  Some might argue for additions or deletions, but for a first cut, it’s a pretty safe list.

Let’s look at the entrepreneurs behind these home runs and ask if they would meet the criteria that investors are using today to screen their portfolio companies?  We’re looking at Bill Gates, Steve Jobs, Larry Ellison, Scott McNealy, Steve Case, Jerry Yang and David Filo, Pierre Omidyar, Marc Andressen, Jeff Bezos, Sergey Brin and Larry Page.   Had any any of them started or run a successful company before their home run?   Did any of these entrepreneurs have the kind of successful track record that investors use as their criteria today?  Obviously not.  In fact, these entrepreneurs all did things differently, and that was part of their genius.

VCs and angel investors are inundated with business plans.  Most plans just go onto the heap.  Let’s assume that the entrepreneur has done a little homework to find the VCs and angel investors who are interested in their space. From that pool, how can an investor recognize the startups and entrepreneurs with truly great potential?  This is the billion dollar question.  To answer it, I’m going to start with a gross oversimplification: there are three kinds of entrepreneurs in the world.

First, there are novice entrepreneurs.  They’re just learning how the game works.  Their networks are small and of limited value. They may have good ideas, but they’re unsure how to present them and to whom. Their understanding of basic business concepts and trends is just growing.  They may have intelligence and commitment, but it usually has not yet matured into a passion.

Second, there is the serial entrepreneur.  This is someone who knows how the game works.  They come equipped with good analytical tools and an extensive network of contacts.  They’ve been through the drill before, often several times.  They usually have a track record that either speaks for itself or can be sufficiently embellished to  create a level of comfort with investors.  The overwhelming preponderance of investor bets are placed on serial entrepreneurs, because it’s usually most convenient– they’re perceived to be safe bets. Also, serial entrepreneurs are easy to distinguish from novice entrepreneurs on the basis of surface impressions.

But, again, the perceived value of the serial entrepreneur is fool’s gold.   Why?  In period of rising expectations and markets, betting on serial entrepreneurs can brings result for investors on balance.   But in period of declining markets and expectations, like now, this approach is fraught with unanticipated risks.  Investors end up with a portfolio of me-too ventures in increasingly narrow and niche markets that seldom achieve the scale necessary to even break even.

The pack trend of betting on serial entrepreneur is, in the broad schema, unfortunate both for VCs and the tech industry in general.  Why? Because the entrepreneurial ecosystem becomes a closed loop that feeds on its own myths and increasingly narrow thinking.  In other words, the focus on finding a good serial entrepreneurs blinds investors to the much greater potential in the third category: the inspired entrepreneurs.

The inspired entrepreneur is someone who doesn’t build and flip companies for a living. Sometimes the inspired entrepreneur is someone who has taken a few knocks in the real world and has learned from those experiences, analyzed them and come up with a truly game changing vision for a startup. Sometimes the inspired entrepreneur is just a technical genius.  Wherever the inspiration for the startup comes from, it’s usually a once in a lifetime experience.

Inspired entrepreneurs have a feel for fundamental long term trends in society rather than the transient and haphazard movements of markets. They have an uncanny ability to peer into the future with a sense of clarity–integrating widely divergent perspectives and functionalities.  They have a healthy level of skepticism for both conventional wisdom and appearances.  Their sense of guidance flows internally, from gut instincts that are clearly formed, rather than advisors who are focused on momentary and superficial factors.  They have little patience for small minds and limited vision.  They are often brusk to the point of rudeness, intolerant of mediocrity, and direct in manner.

Although they understand the languages of many different disciplines, their ideas can often only be understood by a small circle of highly intelligent people.  The investors passion for brevity and simplicity frustrates the inspired entrepreneur, whose ideas are usually rooted in complexity that defies facile explanations.  This frequently leaves inspired entrepreneurs grasping for resources they need to push ahead with their vision.

The inspired entrepreneur has no intention of doing anything else with their life other than work to make their vision a reality.  The intensity of their inspiration creates a level of commitment and passion that keeps them going even after multiple rejections and shifts in the marketplace of ideas.   But even the most inspired entrepreneur can only take their commitment so far without backing.  Is the cookie cutter approach to investing so biased towards the serial entrepreneur, that “insanely great” ideas and entrepreneurs are going unfunded?

If Larry Page and Sergey Brin were shopping a business plan today, would they get anyone to listen seriously?  From hindsight, most investors would say, “Of course, I’d listen,” but would they really?  Would investors really have listened to two 25 year old grad students with no startup experience, no revenue model, no tested management team in place, for an app that was perceived to be a secondary add on, in a field that was already crowded with well-funded incumbents?

If an inspired entrepreneur comes to an investor with a startup plan that’s truly game changing, but the entrepreneur just isn’t in the mold of the serial entrepreneurs that investors usually bet on, will the investor give that person the time of day?  If the inspired entrepreneur just hasn’t learned to play the game the way VCs are used to having the game played… the attention grabbing elevator pitch … the one page executive summary … the polished powerpoint… the well chosen buzzwords… the highly credentialed management team…  will VCs let that inspired entrepreneur in the door and engage in a serious conversation.   If the answer to that question is “No,” then where are investors who will back the Amazons, Yahoo!’s, eBays and Google’s of tomorrow?