« Song of The Day | Main | Search By Salary »
Is The "Traditional Venture Capital Model" Broken?
According to The New York Times, Sevin Rosen has decided not to raise Fund X (ie their tenth fund) because:
“The traditional venture model seems to us to be broken,” Steve Dow, a general partner at Sevin Rosen Funds, said in an interview.
That is an opinion not to be taken lightly. Sevin Rosen is a quality firm with a ton of experience doing venture deals over almost 30 years.
But it reminds me a bit of the analysis that Paul Ferri and Howard Anderson have put forward in recent years. The model that worked for the past 30 years isn't going to work as well for the next 30 years, that's for sure.
But it doesn't mean that the "venture capital model" is broken. It means that we have to adapt to the changing nature of the technology business.
When Brad and I sat down in mid 2003 to write a business plan for Union Square Ventures, we listed the trends we saw developing in the technology business. These are some of the big ones:
1 - commodization of the core infrastructure of the technology business
2 - community powered development environments - ie open source
3 - software delivered as a service over the internet
4 - a movement toward lightweight web services - ie web 2.0
5 - the globalization of technology development and consumption
Taken all together, these are big changes to the technology business. We have left the phase where the infrastructure gets built. That's done. Those investments arent' going to pay off that well anymore. We are now in the phase where the services get deployed on top of that infrastructure. We are in what Carlotta Perez calls "the Golden Age" where technology gets deployed throughout society (and I mean the global society, not just the developed world).
And on top of all that, we have entered a new phase in the capital markets where the IPO market is not nearly as attractive of an exit as it used to be. Sevin Rosen, in its letter to its investors, described:
“a terribly weak exit environment,” a reference to the dearth of initial public offerings and to a market for acquisitions at valuations that it considers too low to deliver the kind of returns that venture investors expect.
I'll take exception to a some of that analysis. The IPO market certainly isn't what it used to be, because of Sarbanes Oxley, because of the really bad companies we in the VC industry foisted on the public markets in the late 90s and the long memories of institional investors, and because many entrepreneurs don't want to run public companies anyway. But the M&A market is really quite healthy. Talk to any of the M&A bankers you know and you'll find out that they are having great years. Maybe they can't get us the valuations "that venture investors expect", but that is the venture industry's fault because we've overfunded our companies to the point where we need a half billion dollar exit to produce a decent return.
So we need a new approach to the kind of companies we fund and we need a new approach to how we fund them and how we get out of them. I don't see that as a "broken model", just a model that we need to tweak. The answers are pretty obvious actually.
We've got to raise smaller funds.
We've got to do less "hard tech" and more "soft tech"
We've got to figure out how to make great returns on $100mm to $250mm exits
We've got to limit our IPOs to our very best companies
I actually think that many firms have already made many of these changes as part of the brutal restructuring of the venture capital business in the 2001-2003 time period and are much better off because of it.
But there is one more issue in the Sevin Rosen letter that I want to address and it's this part:
Explaining its decision, Sevin Rosen, which has offices in Dallas and Silicon Valley, said that too much money had flooded the venture business and too many companies were being given financing in every conceivable sector.
Yup. Too much money chasing too few good deals. That's been the chorus since I got into the VC business in the mid 80s. It's been that way for at least 20 years and it's going to be that way forever more. It's also true of every major asset class out there, real estate, buyouts, hedge funds, energy, etc.
Which means you have to be with the best managers who have a strategy to navigate through an "efficient market" and make it work for them. I am confident that there are many good VC firms in business today who can do that and that the "VC model" isn't broken for everyone.
October 7, 2006 in Venture Capital and Technology | Permalink
Comments
I would say that VC's should shy away from advertising models that are based on Google and Yahoo. They should also shy away from the gamble that a company will be quickly flipped. If the following questions are answered with yes, then it might be a good opportunity:
1) Is the business model sustainable WITHOUT relying on another companies advertising scheme?
2) Will the demand for the product last at least 10 years?
3) Is the product or service "ahead of it's time" by 3-5 years?
4) Do the founders actually need the amount in question (i.e. $5M for a simple website isn't reasonable)?
And if the following question is no:
5) Are the founders blinded by a "quick flip" web 2.0 fantasy?
I'm sorry, but the ONLY reason I would get in touch with a VC or angel investor would be for the advice and expansion of my social network. Funds shouldn't be the only substance behind seeking an investment, and unfortunately "web 2.0" doesn't seem to understand that.
Posted by: Robert Dewey | Oct 7, 2006 12:04:47 PM
So much hype these days and "oh my gods" because everyone has acvoice and to rise above the noise people choses to sensationalize.
To me that just smells of MORE opportunity, not less.
less is more in every industry EXCEPT - creativity.
You never have enough of that in this era of cheap bandwith and distribution.
If you need 250 million to make waves in this day and age you and your investors are suckers.
Posted by: howard lindzon | Oct 7, 2006 4:26:00 PM
It's true traditional VC model is not going to help a new breed of companies. Entrepreneurs who are dreaming of "Powerpoint financing" & VCs who think that paper is bigger than execution is going to suffer. As you rightly said, it takes LESS money to create a service now, on the "golden age" than investing huge money poured into the companies.
Too few deals, Too much money is been a war cry for last 30 years, and things are not different now itself. If today is about web2.0, you can extend that with Clean Energy, Real Estate at their appropriate time period. The more things perceived to be different, finally things are one and the same always :)
Posted by: Narain | Oct 8, 2006 8:21:41 AM
what would you consider better alternatives to Venture Capital. One of my blogging networks just got $2M and its b5media.com
Posted by: colbert | Oct 8, 2006 8:55:08 AM
I fully concur with your business case trends. I would submit that exits for what you describe as hard technology companies are limited by the structure of the end-user portion of the market ecosystem – not as much by the quality of the investments. I have written extensively about this subject and I have gone as far as to publish a book on the subject. During the height of technology bubble, there were plenty of acquisitions and IPOs of poor quality companies hence I would argue it is more then a quality problem. As a result of the decline of technology markets, we are in the “Golden Age” as Carlota describes, but if you read her book [see http://www.amazon.com/Technological-Revolutions-Financial-Capital-Dynamics/dp/1843763311/sr=8-1/qid=1160318523/ref=pd_bbs_1/104-1068541-9747117?ie=UTF8&s=books] you will note that she describes this age as the time of big companies. The Golden Age is a time in which the concepts that were proven to be correct from the prior period, are implemented and extended. This is the work of another generation and the work of big companies. We can see examples of this in the recent boom in PE funds. In the 1990s, everyone wanted to be a VC. In the 2000s, everyone wants to be a PE person. PE firms are in vogue because they have the capital to purchase large, sustainable businesses in stable market constructs. VCs need a lower IPO barrier or large companies that have the ability to acquire. As we still work off the hangover from the technology bubble, the large public companies are not acquiring smaller companies to fuel the VC engine. The reason the large companies are not acquiring startups is because there is no driver in the end-user market to force them to spend shareholder value to expand or extend their business. That is the real problem. External competitive forces do not exist to force the large companies to seek external strategies to expand their business. One trend that has not been written about is the need for PE firms to go beyond their traditional model of acquisition, cost cutting and spinout, sell off, or IPO of the assets. In the Golden Age, top line growth is now required by capital markets to receive credit (i.e. IPO or stock price increase). PE firms will be increasing challenged to show that they can do more then cost cut. They need to show corporate leadership and demonstrate that the health of a company can be improved throughout the product development, go market and revenue acquisition process. The days of cost cutting credit are over. Go look at the stock price of Lucent and Nortel. Companies achieve rewards in public markets because they can increase top line sales, improve margins and generate EPS. PE firms are starting to realize they need to be experts in the businesses they buy. In the same regard, VCs must look forward 3-5 years when making an investment and assume that specific market forces must harmonize for their investments to be successful. Modeling of the market ecosystem will increasing become important to VCs. If I was a VC or if I was working another startup (I am 4 for 4), I would build a three tiered model of the market, model of the company, model of the financial position of the company (most already do this, but few do the first two) and I would update this on a monthly or quarterly basis. To achieve an exit, it requires multiple forces to harmonize.
Best regards,
W. R. Koss
wrk@koss1.com
Blog http://wrkoss.blogspot.com/
Book: Six Years that Shook the World, http://www.amazon.com/gp/product/1419634690/ref=pd_rvi_gw_1/104-1068541-9747117?ie=UTF8
Posted by: W.R. Koss | Oct 8, 2006 10:57:18 AM
"We have left the phase where the infrastructure gets built. That's done. Those investments arent' going to pay off that well anymore." Fred Wilson, "A VC"
Hey Fred, did you notice the $1 billion market cap of the Riverbed IPO last month? Were you an investor in that deal? Would it have been your best (non-bubble) VC investment outcome of your 19 year career if you had been in it?
(My gosh it is an infrastructure deal, not a web 2.0 gadget for your sorry blog. Do you have a single investment over 19 years, that is still in business, that has a current market cap of $1 Billion? Lets see, thestreet.com has recovered to $300 million, Multex acquired for $195 million, Starmedia acq for $8 million....
Fred, with all due respect, you really are "a clueless Web 2.0 VC in nyc" or, in short, "A VC" but nothing more. BTW, as you spend your time blogging, have you noticed that almost none of the Forbes Midas list of the best VC investors have blogs, and those that do post an occasional insightful post, not daily spouts of dribble? (milk-shake-stand-web-cams, come on)
Posted by: anon | Oct 8, 2006 2:16:45 PM
Fred, I think the basic data and math support Sevin Rosen's move.
To wit, on 10/2/06, VentureWire reported rough 2006 YTD aggregate "exits", which when reasonably extrapolated to full year numbers look like this
$32.0 billion M&A exits
$ 3.5 billion IPO exits
-----
$35.5 billion total projected exits in 2006
2005 numbers looked more or less the same.
I haven't been following VC for 30 years but if thats what "exits" look like in the years to come, its hard to imagine that VC as an asset class really isn't broken.
Because VCs are raising nearly that much every year in new funds.
And simple math says that for VC asset class to be worth investing in (by LPs) then it has to return 3X what goes in, and its not, not even close, returning maybe, maybe 1.5X.
(For you nitpickers out there, yes, VC funds ahve to make their returns over 5-10 years -- but 2005 and 2006 "exits" are not even close to 3X the VC funds raised say, in 2000 and 2001. And yes, it *is* 3X -- because the fees levied by venture firms are so staggeringly huge -- no less than 2% of committed capital per year, every year, or 14% of total committed capital! -- that unless afund returns 3X, it underperforms typical "total market" returns over the same time period.)
So even if VCs use the kind of thoughtfulness and discipline Fred suggests, the asset class as whole seems destined for a very painful few years ahead. Sure VC firms are raising prodigious amounts of dough, and paying themselves huge salaries and perks while showering startups with huge sums, but the game of musical chairs will likely end, and, as the number of chairs will ultimately be quite small, end very very poorly for the vast majority of funds, firms and LPs.
My $0.02.
Posted by: steve | Oct 8, 2006 4:44:11 PM
anon,
too bad you didn't leave a real name and email address or i'd send you my real track record, not your fictional version.
since you don't like my posts, why the hell do you waste your time reading and commenting on them?
and if you rely on Forbes for your list of the top VCs, then you truly are the jerk you sound like
Fred
Posted by: fred | Oct 8, 2006 9:10:15 PM
W.R. Koss is correct that Carlota described the golden age as a time that would be stable and dominated by large companies. She talked of it as a time dominated by production capital (coming from existing companies) rather than financial capital (from investors creating new companies).
Nothing in her analysis, however, contemplated anything like the web economy we have today. The stability she referenced in the "golden age" was the result of huge scale economies. Carlota's historical examples were all large industrial businesses with enormous capital costs. While it is clear that Google and Yahoo benefit from scale economies and many web services companies benefit from network effects, it is not clear that innovative companies will need a ton of capital in order to compete. Google took on Yahoo successfully with $38m in venture capital.
I believe that we are entering a golden age from the consumers perspective. If the policy makers do not screw it up, we will see a lot of innovation that results in inexpensive and useful web services for consumers. I think many of these services will be delivered by start up companies funded by financial capital. So while, I agree that Fred did not get Carlota's reference exactly right, I completely agree with his conclusion.
Posted by: Brad | Oct 8, 2006 10:14:43 PM
I'm late to the party but wanted to add my $0.02.
The truth is that every asset class is broken. I am very familiar with with VC market, and with media, and in those markets, investors on the whole, are going to have trouble in the short term. The reason is simple supply & demand. There is too much VC money, there is too much music, there are too many films, there are too many television channels, etc.
But it's really deeper than that. As species, over time we are becoming more and more productive. Technology drives all of it. Caried to the extreme, 20 or maybe 50 or 100 years from now, we will all get our energy from the sun. Highly efficient generators will make all our power so we wont need to buy it.
Food will be generated by Star Trek like devices that take some form of biomass and turn it into nutritious food.
Mechanical devices will be created from materials that are more wear resistant and last far longer, diminishing upgrade cycles other than for new features.
Recently they discovered the genes that cause aging. We now know that these genes turn off our regenerative capabilities (which ages us) in order to avoid creating cancer cells. But I suspect we will fix this and figure out how to drasically reduce deaths by "natural causes".
The point is that the Adam Smith style economic theory needs to be re thought in an era of abundance. I dont know where its all going, but it all comes from the efficiencies created by technology. It will become harder and harder to make money, but over time (we're not there yet) making money will matter far less.
So I guess the point is make your money now. Because while the markets are broken as a whole now, smart people can still make lots of money. That may not be true in 50 years.
Posted by: Hank Williams | Oct 9, 2006 9:08:00 AM
Traditional VC model just needs to adapt to today's trends... below is a modified trend list:
1 - Commodization and standardization of the core technology infrastructure, both software and hardware.
2 - Collaboration-based software development:
* open source
* software delivered as a services over the internet (web services)
3 - Collaboration
* social networks and virtual communities
* user-generated (and entertainment) content
* collaboration-based content
* collaboration-based development (mashups, see #4 below)
4 - Open and global technology development and consumption
ceo
Posted by: C. Enrique Ortiz | Oct 9, 2006 10:07:20 AM
Interesting article. With all the money flying around, makes it sound like a good time to start a company! There are still huge opportunities in technology - business process outsourcing (BPO), energy-efficient hardware and chip technologies, etc. I just think investors (public and private equity markets) need to act like scalpels - carve out the tiny growth markets rather than broad ones.
Posted by: Michael Comeau | Oct 10, 2006 8:55:04 AM
I think you are ignoring some fundamental shifts. Everybody seems to ignore the fact that back in the 'golden age' the real secret to VC's success was that there was effectively only three centers of IT advanced technology excellence - Silicon Valley, Dallas/Austin, and the Boston Rt 128 corridor. The VC's in those locations basically charged monopolistic rents at exit for a scare resource which they had propriety access to - IT innovation. Today IT and tech innovation is broadly distributed on a global basis, as are the capital relationships and information flow. This serves to drive down pricing - and exit valuation. Things have changed fundamentally!
Posted by: Another VC | Oct 11, 2006 11:12:44 AM
The issue with your thesis is that there might not be a lot of $100M to $250M exits, at least in the Internet space. It sounds as though GEMAYANI is going to be busy in the coming 18 months with a bunch of early stage "small" acquisitions ($10 to $80M), and there will be a few companies in the "north of $500M" club. But I don't see a lot of deals in the mid-range - those that would be typical large Series A/Small Series B stage companies.
We'll see...
Posted by: Jeff Clavier | Oct 11, 2006 12:16:59 PM
You under-emphasize the effect of regulatory costs on capital formation. If technology and economic trends are considered exogenous, you would still have significant issues for the venture model created by the substantial increase in the cost of going, and being, public.
Posted by: Udo | Oct 11, 2006 1:22:44 PM
This story is a bit bigger here in Dallas, but thought you might be interested in a the follow up. Turns out there might be quite a bit more to the story at Sevin Rosen than first came out. Dan Primack is suggesting that they pulled a snow job on the New York Times:
http://texasvc.weblogswork.com/2006/10/14/dallas-vc-caught-in-snow-job/
Posted by: Alexander Muse | Oct 14, 2006 7:21:28 PM
Fred,
I agree with your thoughts completely. But I guess you've left it midway somewhere.
While you say "The IPO market certainly isn't what it used to be....." you also follow it up by "But the M&A market is really quite healthy..." Now - you figured the problem out here - the one track mind of VCs looking only at exits either thro IPO or M&A - as their liquidity options.
May I conclude your post by saying - the way forward for VCs would be to encourage investments in startups that build products / processes progressively needed by established dinosaurs (with lots of free cash / leveraging power) in 1/10th of the time as might take to build it themselves owing to their complex hierarchy and fat bureaucracy...?
That way, you have a ready acquirer down the road and the M&A market is still strong...!
Posted by: krish | Oct 17, 2006 8:12:36 AM
You might also want to consider the FACT that what really was broken was Sevin Rosen, and their announcement was simply a self-serving attempt to save face.
To wit - When it's 3rd quarter report goes to investors in a matter of days, it will show new writedowns of what I believe will be close to $100 million (yes, $100 million) from three companies (see Airgo for one example).
This is a firm that survived for a long time on the success and reputation of partners who have been out for a long time, it had two totally unrelated heads (TX and CA), and had twice failed in its efforts to recruit and retain talented young partners to the firm.
It should have been a clear portent of things to come when at their 25th anniversary party early this year, the Compaq computer they had out on display and turned on, caught fire.
Posted by: Sorry, gotta be anon | Nov 1, 2006 2:45:05 AM
Hi Fred:
I'm not sure that even shooting for $100 - $250MM exits will be low enough on average. It might have to be that you set your sights even lower, which suggests raising less capital. This will be hard for a lot of VCs to adjust to and there should be winners and losers.
Here's my take on who these will be:
Winners:
- The bluest of "blue-chip" VCs. The Sequoias and KPCBs of the world shine brighter when the maddening crowd is rushing to chase the latest trend of VC investing. They've been there and done that time-and-again.
- Existing Angel Investors who have a track-record. When a space gets hot (i.e., angel investing), those who have been there for a while are the old wise men. Josh Kopelman, Jeff Clavier, and others will see a rise for their services even as others rush in. There will be a flight to quality.
- Traditional VCs who are able to make the leap (including yours) and really differentiate from other angel investors. Although CRV is a great firm, their success is not guaranteed. They need dealflow; their GPs needs to be seen as credible by non-nascent entrepreneurs; and they really need to be able to deliver value to their investments (beyond the simple "we love to roll up our shirtsleeves alongside our investee companies" platitudes).
Losers:
- Stuck-in-the-middle VCs: Those VCs who do a little bit of angel investing and a little bit of traditional are likely to do neither well.
- Former Great VCs who don't adapt to changing times: Remember when Softbank was king of the hill? Hot VCs who have yet to reach the echelon of Sequoia and KPCB are not assured of long-term success. They are also likely to stick-to-what-they-(think-they-)know-best. Dangerous, when the rules of the game are changing
- Later-stage/Mezzanine Investors: They just got even less relevant.
Thanks for the discussion.
Best wishes,
Eric
http://breakoutperformance.blogspot.com/2006/11/are-angels-new-vcs.html
Posted by: Eric Jackson | Nov 4, 2006 6:53:02 AM
I read this post and i like it. May i place some links to this post on my blog?
http://blognoon.com
Thanks!
Posted by: Serhio | Feb 5, 2007 4:53:58 PM
