Is the canary really dead? Success and failure of Venture Capital

Last fall (2008), a presentation was given at Harvard Business School, and reposted on SlideShare and TheFunded.com. The primary argument was that the Venture Capital (VC) model is broken, because it does not achieve its primary objectives of “funding growing companies in innovative technology sectors that generate significant shareholder returns.” The entire slide show can be seen here.

Indeed, many elements of the VC model are broken. Primarily, it has the following shortcomings:

  1. It is far too incestuous. It focuses primarily on funding companies within its own network, thus avoiding all the great value opportunities elsewhere. It is highly unlikely that a smart and driven unknown, like Bill Gates or Bill Joy of the current era, is likely to get any real funding. Certainly, if Vinod Khosla himself (although now a venture capitalist in his own right), or Scott McNealy himself, were to look for funding, he would find it in a heartbeat. However, the future Vinods and Scotts, Bill Gateses and Larry Ellisons, will be extremely challenged to find funding.
  2. It is deeply subject to a herd mentality. In many instances, the venture capital industry is like high fashion. What is “in” today, everyone wants, even if it cannot possibly be profitable or have a good exit at that scale; the moment it is no longer “in”, it is impossible to find funding, even if it has reached a point where it now can be highly profitable. There is an old saying, “the market can remain irrational longer than you can remain solvent.” Many a profitable business has collapsed due to an inability to finance its operations beyond the scope of an irrational market, a state currently recurring in the tight business credit markets. Similarly, numerous potentially successful businesses have been unable to find funding from professional investors due to their domain no longer being “in.” What makes this particularly difficult is that most industries, especially the high-technology ones often backed by the VC industry, are those subject to the curve of expectations. Essentially, everyone piles in when the going is good early on, thus leading to dashed expectations, when everyone rushes for the exits. Ironically, at that precise moment is when the actual potential can be realized by well-run companies, especially those with solid management and a strong capital base, yet that is the moment when it is most difficult to find funding, since “that was last year’s play.”
  3. It is weak on rigorous analysis and diversity of investment (which is the first rule of investing). Awareness of the herd mentality should inform a good investor that even if selling pet food online is a good idea, it is unlikely to yield more than one or two successful such companies, as opposed to many. However, rigorous analysis should show that even one online pet food seller is unlikely to reach the billion-dollar market scale in the timeframes normally desired by venture capitalists.
  4. It is narrowly market-focused. As valuable as the high-technology sector is – and I include within this biotech, Internet, nanotechnology, electric cars, new energy and everything else where new technology or new usage of technology is a critical element of the business plan – the overwhelming majority of the economy is due to other areas. For example, in 2007, the last year for which data is available, the entire high-technology sector did not exceed more than 4.25% of US GDP. The rest of the economy is more than 20 times the size of the tech sector. This is even worse when you consider that a solid percentage of that is computer service and design, an area not normally backed by venture capital, and that it includes publishing as a whole, including software. Thus, it is more likely that the rest of the economy is around 25-30x the sector backed by venture capitalists, including the revenues of mature firms. Given that VCs will say, correctly, time and again, that they back the rider not the horse, i.e. the team and not the product/service, the sector should be immaterial provided it has VC-required growth and size characteristics. Once again, rigorous analysis would create great diversity. To be fair, many VCs have expanded in recent years to other areas like retail, but they are few and far between.

In short, VCs have, as an industry, become that which they abhor in companies: slow and plodding, a big mature industry. In order to survive, they will need to recover their roots as nimble, independent-minded, risk-taking firms. They will need to become startups themselves again.

However, given all of the above, it is important to note an important element, to which I alluded in the last shortcoming above. To wit, the VC model is a small subset of capital financing available, and definitely is not for everyone. The VC model is focused on big hits… but the overwhelming majority of companies that need funding are not looking to be (or shouldn’t be looking to be) big hits. They are companies that can generate $5MM, $10MM, maybe $20MM in annual revenues in many years, and are thus good, solid businesses…. that would be destroyed by the “get big fast” pressure of VCs. What these firms need is: (a) an understanding of what the VC model is, so they can avoid it; and (b) opportunities to approach other investors.

A friend of mine recently saw a neighbour of his, a venture capital partner, and proposed a particular business idea. This was likely to be highly profitable in a few short years, with revenues in the several million dollars. For most entrepreneurs, this is a perfect opportunities. For a venture capitalist, this is entirely wrong. As a friend and neighbour, the partner decided to save my friend the headache and effort of trying to raise VC money by warning him off. He succinctly explained, “your business may be viable, but it is not valuable.”

About Avi Deitcher

Avi Deitcher is a technology business consultant who lives to dramatically improve fast-moving and fast-growing companies. He writes regularly on this blog, and can be reached via Facebook, Twitter and avi@atomicinc.com.
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