The Trap Of “Capital Efficiency”

More than ten years ago, I read an article in the San Jose Mercury News. Many complained that Venture Capital (VC) funded companies rarely produce viable and sustainable businesses. To no real surprise, we find ten years later that the public markets have no appetite for technology companies, and the majority of its VC firms are underwater, soon to drown.

With angel investments (left to support the idea-stage of company formation) severely depressed by the economic downturn, new VC funds (from an ex-Googler, Marc Andreessen, Manu Kumar, etc.) spring up to fund the early stages of technology innovation with $250K injections and fill the gap.

Capital Efficiency is the favorite buzzword, some of these new investors claim as the new investment category (after outsourcing has failed to live up to similar promises). Sounds promising.

It is not. “Capital Efficiency” is a trap.

1/ Companies are not significantly cheaper to build these days

The macroeconomics of bringing products to market has not changed, mainly because customer behavior has not fundamentally changed.

While new marketing and distribution channels such as social networking promise to provide more effective ways to reach targeted customers, the high noise level in those channels erases the temporary benefits gained from its early adopter stage. What remains as an advantage is “merely” the quality of the technology proposition in the eye of the beholder, regardless of how that proposition reached its prospective buyer.

So, rather than spending lots of money on old-school decibel marketing, technology companies now need to spend more money on building products with significant macroeconomic differentiation and a customer experience that delivers real (disruptive) value. As a result, and I know from experience, it is more expensive to build a successful technology company today because no company can make the false promises it could get away with in the past. Social networking kills false promises quickly.

2/ Tippy-toe loans yield investor lock-in

A $250K loan (convertible note, usually with restrictions) is an investment that provides no ability to hire professional management that has the experience and expertise to turn technology into a macro-economic game-changer early on – or better yet – manage an effective company ecosystem through its life-cycle.

Now the unsuspecting technology entrepreneurs, proud of their newly acquired capital infusion, are dependent on the investor and his pool of syndicates (necessary to provide sufficient runway) to determine when and how that critical conversion (from technology to a business) occurs.

That determination is not the expertise of an investor, but worse, has moved the control of a company’s business strategy from the entrepreneur to the investor. Relinquishing that kind of power is counter to the fiduciary responsibility in developing a company’s independent and most valuable future.

3/ Investors should not run companies

The majority of Silicon Valley investors have never personally run a company, or if they did, grew up in strong winds that made even turkeys fly. Great investors invest in companies, not in technologies. They are known for their ability to spot the combination of a unique idea, the right timing, and an experienced management team to allow that company to operate on its own accord.

In the end, few investors have the time or experience to manage anything beyond milestones established through board control. A famous investor once said: “I am a better investor than an operator. Otherwise, I would have become one – you can make more money that way.”

Building technology proves nothing

Don’t get me wrong; I am excited that new investors with a better pedigree enter the investment fray. I just wished that instead of creating small fragmented funds, they had formed a larger early-stage investment fund with like-minded peers through which they could deliver on the original promise of Venture Capital, and that is: generate significant returns from taking big risks.

An investment strategy that keeps entrepreneurs on a leash with micro-investments looks an awful lot like loan-sharking to me. Don’t be surprised if the bite is deep and the quality of life will be severely diminished to those who take it.

Consider yourself warned.

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