The systemic deflation of innovation’s risk is responsible for the systemic deflation of venture capital returns.
Pierre Lamond, a Silicon Valley legend who has been a Sequoia partner at the Menlo Park, Calif.-based Venture Capital (VC) firm since 1981 has decided to join Khosla Ventures, primarily to do what Venture Capital was designed to do, take risks again.
Having hit on subprime VC for a few years now, his reasoning resonated with me and I looked back at Vinod Khosla‘s “New old-fashioned” model for Venture Capital, he describes in his 2002 presentation as “Funding to Milestones”, as depicted above. Now compare the above chart with the one right below, the VC model practiced by the majority of current Venture Capitalists today, which I refer to as subprime VC:
What quickly becomes apparent from the chart (derived from actual pitches between entrepreneurs and VC) is that supported by the excuse of lower development costs related to web2.0 technologies, the investors have pushed down the majority of the risk onto the entrepreneur.
Call It Whatever
We all know by know that Web2.0 is not a business and still requires the definition of a disruptive business that does not fundamentally yield lower operating cost, but much more disturbing is how investors have reduced their risk and delayed their active participation with a company that, in the end, actually produces lower exits (investors are now satisfied with a 2x rather than 10x return) and no IPOs. We explained in our previous blog how that strategy could not save Venture Capital funds.
While statistically we can time-shift the sub-prime chart to the left and assume nothing has changed by holding up the Moneytree reports, anyone who has walked around in Silicon Valley as long as I have, knows what is going on under the hood.
Unlike people like Vinod Khosla who can assess technology risk before it is built, the majority of investors can’t envision an opportunity until they spot it in their rearview mirror. Today, investors demonstrate by their actions (or lack thereof) what is fundamentally flawed in Venture Capital; the lack of people who can accurately assess risk. In 5-years our economy will be in better shape than it has been, leaner and meaner. Technology opportunities are and will be abound, as it is in the early stages of penetration. This is indeed a time for aggressive investing, rather than a time for crawl-back we see some VCs do.
The sub-prime VC problem will remain when the economy recovers if it is not aggressively perforated by people with real early-stage operating experience who understand that risk is the lifeline of Venture Capital – and join the investment fray.
Stop blaming the economy and take a risk, every day. Only then will you get better at it.
(I will explain the sub-prime chart in more detail later)