I could not leave my previous two “depressing” blog articles out there on a limb for too long without offering a solution. Even though I know that those articles are only depressing to those who cannot see the new opportunities created by the systemic Venture Capital malaise.
I see a grand new opportunity for Venture investing.
The current VC model can never attract disruptive ideas
Venture is on fire and not in a good way. So agreed with me one of the top money-managers who I met with last week in Palo Alto, and manages over $40B in Private Equity, including Venture. Especially since the Venture asset class is so young and has such a bright future ahead, the deplorable performance of its financial instrument Venture Capital (VC) with minus 10% returns across the board has failed, and proves its governance is fundamentally flawed as its recognition of entrepreneurial ideas has not (even) outgrown the technology adoption baseline it rides on.
The financial system atop of innovation has failed, not our capacity as a country to innovate. The primary reason for the systemic malfunction (described in The State of Venture Capital) is the incompatible market model created by VCs (and bought into by Limited Partners) that allows for and continues to stimulate the creation of an investment cartel, a single investment thesis that by definition can never find the outlier of innovation.
According to the money-manager mentioned above, only 35 of 790 venture firms in the US consistently produce some positive returns (not necessarily venture returns as a return of the deployment of venture risk). That means less than 5% of all venture firms, consistently produce a return. And we can only wonder at this time how many of those 35 actually create a viable Venture return, as opposed to a micro-Private Equity return, especially since out of fear Venture has turned subprime more than ten years ago.
That result makes for a pretty depressing outlook for Limited Partners for Venture, with many avoiding or fleeing the asset class altogether. I too would worry about the future of cash infusions in innovation if as an innovator I did not know market fundamentals better.
It takes an entrepreneur to see financial opportunity where none exists today. Regardless of what business you are in, entering a market that relies on a hungry 80% greenfield, that continues to consume rapidly despite the worst of economic fear is an interesting endeavor.
Technology adoption continues to proliferate, yet much of it is coming from more effective curators of innovation, including from corporations such as Apple.
The rhetoric from the current intermediary Venture Capital, while supported over the last twenty years by truckloads of money from LPs (demand) and in which entrepreneurial capacity is more extensive than in the last 14 years (supply), and still cannot perform despite optimal circumstances should just be tossed aside.
Governance of innovation (between the assets of LPs and assets of entrepreneurs) is broken, not innovation itself. Deflation of risk has turned the Venture business subprime, and all metrics (with numbers that cannot be counted on by Dow Jones, Thomson Reuters, PWC MoneyTree, the NVCA, and the likes) of that micro Private Equity deployment is therefore not representative of the opportunities nor the projected demise of Venture Capital.
I agree wholeheartedly with Michael Moritz of Sequoia that we have not deployed the Venture Capital risk profile in the last twenty years, and we rely on a handful of success stories (like Google, Facebook) who in one way or the other have managed to escape the defunct Venture Capital governance (and still got their money) to become successful. Those success stories are the ones that fell through the cracks of the Silicon Valley cartel, they were not the positive outcome of the stifling governance of the cartel, albeit success attempts to claim many fathers.
The opportunity in Venture is to replace governance
Let’s try an analogy to cooking to clarify the opportunity in Technology Venture.
It does not take much to imagine that technology is like water. And water is the substrate to which many dishes are produced. But if the only recipe a Venture Capitalist can recognize and cook up is a soup (and based on the results, very few of them are excellent cooks at that), the measurement of success and the taste of the soup only matters to those who care about consuming soup.
Technology is at the beginning of its discovery that it can be used for much more than just the production of soup, and that it is a vital ingredient to make bread, cookies, rice dishes and almost everything else we consume. Hence the reason why the number of soup lovers or their enthusiasm is no indication – up or down – to the scale of the potential use of water.
The point is that a close look at the performance of subprime Venture will not lead to a viable conclusion whether or not Technology Venture has room for growth. For that, we need to look at the full opportunity in technology and wonder why, with all this money spent, 80% of the world’s population does not currently have access to a useful technology application.
So the trick in Venture is how we define innovation and what risk we apply to it that reaches a broader audience with meaningful socioeconomic value. That we build an economic model in Venture that stimulates the creation of a variety of innovations (dishes in the cooking analogy), and that can only happen once we break up the cartel that has turned Silicon Valley into a monolithic and therefore extreme risk to Limited Partners.
Time to re-invent Venture investing
The best way to innovate is to ignore everything that has happened in the past (especially when performance dictates so) and imagine how Venture should work if you could design it from scratch today. No right-minded individual would develop it the way it works currently.
With the Limited Partners’ interest in mind, we would not design Venture with ten levels deep bottom-heavy diversification, a single investment thesis deployed across most VC firms, extreme fragmentation of assets and risk, and lack of verifiable merit. To support groundbreaking entrepreneurs the financial system needs to reward the outliers in Venture Capital that have the unique capacity to find outlier ideas, and take the prudent risk that reaches massive upside, rather than to engage in risk aversion that secures (often personal) downside.
The grand opportunity in Venture is that such a system is relatively easy to build (I have), with minimal burden to Limited Partners. But even if we do not have a chance to rebuild Venture completely, a single Limited Partner (or a syndicate) can turn this new system in a competitive advantage and reap the benefit of harvesting the enormous greenfield opportunity that is currently ignored. A single VC can turn the deployment of the new model into a unique investment thesis that competes with the complacent investment thesis of the cartel.
Take no prisoners
It is however unlikely that the new VCs will come from the same stables as the current ones. The money-manager mentioned above also expressed his frustration with how many VCs have entirely avoided risk and continue to hobble after the me-too deals, a subject we have written about often concerning subprime VC.
But that should come as no surprise given the limited relevant experience many General Partners have in entrepreneurship (you cannot learn this stuff in school), many have never been an early stage CEO, have never taken companies from the left side of the chasm to the right-side, and lack the foresight and vision (attitude) that would separate them from pure financiers. Venture may be part of the Private Equity asset class, but its demands on General Partners are entirely different, given the unique qualities it takes to build successful early-stage companies. And the insufficient relevant experience of General Partners leads to fear and improper assessment and deployment of risk, a logical outcome of Limited Partners’ commitment to the wrong people.
The impending cannibalization of the new model is what gets the National Venture Capital Association (NVCA) protecting the interests of its members, all in a tizzy. It feverishly deploys every asset it has to blame poor Venture performance on anything but its own responsibility. It uses Limited Partner money to protect and defend their stance to politicians, who seem to accept the rhetoric from precisely those people who created the Venture malaise in the first place. Insufficiently informed, those politicians appear willing to cut them even more slack. Subprime VCs will never have enough resources (governmental or otherwise) to produce healthy Venture returns, and their clock keeps ticking.
The simple solution to better performance in Venture is to build a financial system that stimulates the creation of new investment recipes, so its deployment can reach the popularity similar to the consumption of rice and bread, and the world will be our oyster.
