Subprime Venture Capital is akin to the subprime lending market, and we predict the bottom will soon fall out of subprime VC, too, spurred by the fear of economic pressure and the depressing returns of expiring post-911 venture funds.
Just like working for Carnival Cruise looks glamorous but is not the way to explore the world, unsuspecting young entrepreneurs who fall for sub-prime investors will soon discover that building those technologies has all the glamour but few of the rewards associated with innovation. Regardless, many chasing the mighty dollar will fall for it.
Here is how entrepreneurs can recognize a sting from subprime VC:
Step 1: We like the idea, but before we invest, please finish the product some more, then come back
Step 2: 6 Months later, you finished the product. Great, now prove it works by getting 100,000 daily users, then come back
Step 3: Fantastic, now we’ll take 60% of your company for $1M
Ouch, that hurts.
Ad 1/ Technology development is the investment risk we understand; timely applicability to a market is the real issue. So, proving that the entrepreneur can build a product can easily be derived from the entrepreneur’s vision, knowledge, and credentials in that space juiced up with some kitchen-sink prototyping. On top of that, a 6-month self-funded development timeframe with 2-3 developers can hardly yield a sustainable competitive advantage anyway, so R&D development proves nothing.
Ad 2/ In many cases, it is impossible to land 100,000 users before you have a critical mass of product capabilities. That critical mass comes from an R&D investment that generates substantial differentiation and rarely from tip-toeing into the marketplace. Marketplaces, for example, only grow when a critical mass of supply and demand are lured in and participate. This often requires bolstering technology to support all constituents rather than minimize it. Too many technology products are already entering the market unfinished due to underfunding and yielding false negatives.
Ad 3/ Control and valuation of the company directly indicate the future success of an early-stage company. Most technology success stories are derived from retained majority control by its founders and CEO (Facebook, Google, Twitter, eBay, etc.). Investors are terrible operators (no surprise given their background and experience) and should not want to own a majority stake in their companies out of self-preservation.
Additionally, the danger of these tactics deployed by sub-prime investors (many of the prominent venture funds deploy fashionable sub-prime tactics, too) is that it marginalizes technology innovation and provides a dangerous breeding ground for the fund performance as well:
A/ Venture Capital is meant to stimulate the high-risk/high-yield asset class as defined by its Limited Partners; the sub-prime strategy described here (anecdotally) serves nothing more than the low-risk / low-yield segment of the technology asset class.
B/ No fund larger than $100 Million can support the management attention needed to spur these tiny injections. As a result, sub-prime investors just constricted what they thought of as exciting innovation with too little time and too little money to provide critical market entry.
C/ Very few low-cost entry deals yield the disruption that prices out favorably to make any dent in the return of the fund. Venture funds need a few significant returns to keep LPs returning for more.
The only early-stage investors who may be able to turn sub-prime deals into prime are the investors who:
– have proven to be successful operators themselves
– support the vision before the product is there
– have great syndicates to support the entire runway of a disruptive market entry in the future.
Investors that can turn sub-prime into prime can be counted on one, maybe two hands. People like Marc Andreessen with his new AZ (Andreessen-Horowitz) fund come to mind. But entrepreneurs not stung by these visionary investors may just as well hop on that cruise ship and enjoy life some more.
The economics of big technology plays have not suddenly changed; the cost of developing technology may have declined slightly, but competition has increased exponentially. So, we prefer to focus on high-risk and high-yield plays simply because they only create disruptive innovation that can keep VC firms in the business.
The challenge for early-stage entrepreneurs remains to create unbridled and disruptive innovation that finds only one investor who believes in it. If many more do, believe me, the technology is just not disruptive enough. So, be ready for some controversy.
Finding the right investor amongst 700+ U.S. firms requires entrepreneurs to understand and read the dating game. If they don’t, we’ll be happy to help. But get to us before you’ve been stung 217 times.