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Why venture capital is producing sub-par returns, and how it needs to operate going forward to be competitive.

Why venture capital is producing sub-par returns, and how it needs to operate going forward to be competitive.

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The New Face Of Venture Capital, Part 1 Presentation Transcript

  • 1. The New Face of Venture Capital Venture Capital directions for LPs and startups Kevin Lawton March 4, 2010 http://www.trendcaller.com/
  • 2. The IPO myth
    • The facts speak.  According to this '03 Roundtable Report :
    •  
      • "Morgan Stanley studied every single technology IPO over the last 22 years in North America. Only 1 in 20 startups made it to an IPO, and only 1 in 20 of those companies actually created shareholder value afterwards. [...] So the overall success rate is 0.25 per cent or 1 in 400. “
    • A similar trend can be seen in M&A exits.
    •  
    •  
    • The IPO "window" was never the real issue.  Lack of value in startups was symptomatic of a broken VC model.  In a sustainable model, returns track value created.
  • 3. Rate-of-change gone hockey-stick
    • The rate of change of technology innovation and cultural generations is steadily increasing:
  • 4. Rate-of-change gone hockey-stick
    • The rate of change of technology innovation and cultural generations is steadily increasing:
    •  
      • The Stone Age lasted about 2 million years.
  • 5. Rate-of-change gone hockey-stick
    • The rate of change of technology innovation and cultural generations is steadily increasing:
    •  
      • The Stone Age lasted about 2 million years.
      • The Bronze Age about 2 thousand years.
  • 6. Rate-of-change gone hockey-stick
    • The rate of change of technology innovation and cultural generations is steadily increasing:
    •  
      • The Stone Age lasted about 2 million years.
      • The Bronze Age about 2 thousand years.
      • The Twitter Age is about 3.5 years old.
  • 7. Rate-of-change gone hockey-stick
    • The rate of change of technology innovation and cultural generations is steadily increasing:
    •  
      • The Stone Age lasted about 2 million years.
      • The Bronze Age about 2 thousand years.
      • The Twitter Age is about 3.5 years old.
    • Market time is compressing:
  • 8. Effects of rate-of-change on VC
    • As rate of change increases, market opportunity time shrinks.
    • And the lost opportunity cost of waiting to invest increases.
    • By the time VCs are in, it's often too late .  
  • 9. VC response to rate-of-change?
      • Move up-stream to later-stage deals, effectively, "chasing history" where the R-o-C was slower. Result: more competition for known de-risked deals, weak returns.
      • Move into capital intensive "green fields" with less R-o-C.
      • Flame out when they can't raise the next fund etc.
      • Status quo: puts the squeeze on LPs and entrepreneurs to compensate for the broken VC model.
      • Blame the economy / credit crunch.
  • 10. Startups need to be adaptable
    • Changing directions used to be a near-death experience for startups.  Now, it's common fare.  Let's look at some quotes from the street:
      • “ The pivot - what do successful startups have in common? Pivot is the ability to change directions quickly. The difference between a successful and an unsuccessful start-up is the number of pivots a start-up makes before it dies.” [ Eric Ries ]
      • “ [...] some things that startups that aren’t run well do: You don’t change direction fast enough. Every startup should be looking at its direction every month or so.”  [ Robert Scoble ]
      • “ In the average Y Combinator startup, I'd guess 70% of the idea is new at the end of the first three months.” [ Paul Graham ]
      •  
      •  
    • Change needs to be an intrinsic part of VC/startups.
  • 11. The “execution paradox”
    • An interesting paradox arises in a high R-o-C world:
      • Those startups who are adapting and changing like they should, are not “executing” against their prescribed milestones.  Consequently, they will get eaten up by VC with all the “downside investing”.
      • Those startups who are not adapting and changing like they should, are apparently “executing”.  In a high R-o-C environment, these are statistically likely to be failing.
    • Agility needs to be an intrinsic part of VC/startups.  Was: "execute, execute, execute".  Now: “pivot, pivot, pivot”. 
    • Good bye, downside investing...
  • 12. The funding pyramid
    • The funding pyramid increases exponentially in scale as one moves downward. The seed round folks have to wade through 1,000x or 10,000x as many potential deals as do Series B VCs.
    • Humm..., how to scale to 10,000x?
  • 13. Seed-only VC
    • There are now a number of seed-only / incubator style funds. Startups funded this way will get out-leveraged in later rounds.
    • Lack of future funding leverage equals poor future returns across this style of VC.
  • 14. Current VC model
    • This is where a large swath of VC has moved: less risk, more competition for known deals.
    • Returns will continue to be poor across this style of VC, with fewer outliers leveraging Rolodex power for good returns. International competition is exacerbating this trend.
  • 15. The “Franken-VC”
    • Assembled from body parts of poor-return styles. Bolt on a separate seed fund. And how does this handle the 10,000x bottom of the pyramid?
    • Likely path: they'll mostly chase “brand name” and “superstars”.  I.e., an out-sized EIR program.
  • 16. Monolithic funding VC
    • VC which funds from seed to exit. This may work for small funds which have a number of potential deals in their network.
    • Issue#1: Scalability of attacking the enormous ideas market.
    • Issue#2: Scalability of funding for those deals which go bigger than planned (think Facebook).
  • 17. Future: 2-staged rocket approach of VC
    • Stage I : this VC style specializes in raising startups all the way from scouting ideas to the point where they have obvious value (revenue, customers, eyeballs, ...).  Leverage for the hand-off!
    • Stage II : this style carries startups to large exits.  Some will compete on their "Rolodex value". Others on better terms.  This is really Private Equity, not Venture Capital.
  • 18. Bootstrapping / friends & family
    • Incapacitated VC is missing out on the entire base of the pyramid.  Common quotes from the street:
    •  
      • Startup : "I'm skipping VC and going straight for revenue -- VCs are a waste of time."
      • Startup: "We got some friends & family money together and are skipping VCs this time."
      • VC: "Wow, that sounds like a great idea.  Let me know when you have customers & revenue"
    • Result: VC returns will continue to be sub-par and huge competition will converge on the Stage II style VC/PE.  And the next Google will be boot-strapped.
  • 19. % of startup owned by VC
    • Acquirers buy the team & technology, not the VC.  The VC share of the exit is overhead.  Thus, VC returns are inversely correlated to %-owned.
    • Beware of VCs who brag about high %-owned!  Poor returns follow...
  • 20. VC meets capital efficiency
    • Sand Hill Rd office space costs 8x to 10x that of cheaper space!
    • Steep overhead & fee structures squeeze returns for LPs and startups.
    • VC industry returns will down-trend until VC firms operate with the same sensibilities that startups do.
    • VC fee structure is a competitive advantage for more agile firms. 
    • The top echelon (“Rolodex”) VCs are likely to retain higher fees.  This will drive the divergence between Stage I & II VC.
  • 21. Market sizing fallacy
    • Q : In a high R-o-C environment, where a startup will pivot direction to some degree N times, how can you accurately size a market?
    • A : You can't.  Get over it.  Even if the market oppty is crystal clear, by the time you get there, the competitive landscape will have changed big-time.  VCs spend too much time gaging a market. Imagine initial market sizing for Facebook?
    • Sense the oppty, start early, adapt often.  Fail quickly.  What survives will be your winners.  The rest is self imposed friction, caused by a broken VC model.
    • Market agility is a competitive advantage in the new VC model.
  • 22. The evolution of venture investing
      • Slow follower (1900's): enter established markets.
  • 23. The evolution of venture investing
      • Slow follower (1900's): enter established markets.
      • Fast follower (2000): quickly enter markets that emerge.
  • 24. The evolution of venture investing
      • Slow follower (1900's): enter established markets.
      • Fast follower (2000): quickly enter markets that emerge.
      • Does VC know what’s next? How does one invest in the future without seeing the trend?
  • 25. The Evolution of VC
      • Slow follower (1900's): enter established markets.
      • Fast follower (2000): quickly enter markets that emerge.
      • New market creation (today): create it real-time.
  • 26. The Evolution of VC
      • Slow follower (1900's): enter established markets.
      • Fast follower (2000): quickly enter markets that emerge.
      • New market creation (today): create it real-time.
      • Building blocks (next): multiple startups enable a market.
  • 27. The Evolution of VC
      • Slow follower (1900's): enter established markets.
      • Fast follower (2000): quickly enter markets that emerge.
      • New market creation (today): create it real-time.
      • Building blocks (next): multiple startups enable a market.
      • VC sponsored competition for each building block (next):
  • 28. The Evolution of VC
      • Slow follower (1900's): enter established markets.
      • Fast follower (2000): quickly enter markets that emerge.
      • New market creation (today): create it real-time.
      • Building blocks (next): multiple startups enable a market.
      • VC sponsored competition for each building block (next):
        • Fund multiple early-stage plays for important building blocks.
  • 29. The Evolution of VC
      • Slow follower (1900's): enter established markets.
      • Fast follower (2000): quickly enter markets that emerge.
      • New market creation (today): create it real-time.
      • Building blocks (next): multiple startups enable a market.
      • VC sponsored competition for each building block (next):
        • Fund multiple early-stage plays for important building blocks.
        • Let the markets sort out the winners.
  • 30. The Evolution of VC
      • Slow follower (1900's): enter established markets.
      • Fast follower (2000): quickly enter markets that emerge.
      • New market creation (today): create it real-time.
      • Building blocks (next): multiple startups enable a market.
      • VC sponsored competition for each building block (next):
        • Fund multiple early-stage plays for important building blocks.
        • Let the markets sort out the winners.
        • Merge & winnow.
  • 31. The Open Sourcing of contracts
    • Heavy legal fees & contracts are crippling to early startups!
    • A new trend is emerging to reduce costs of contracts:
      • Sep 2007: " Reinventing the Series A ", Ted Wang, attorney at Fenwick & West.
      • Aug 2008: " Cut your legal fees using Y Combinator’s funding documents ", Y Combinator/Wilson Sonsini Goodrich & Rosati.
      • Feb 2010: " Series Seed " launches, pioneered by Ted Wang & Andreessen-Horowitz.  Nine investors signed on already .
    • Note: firms who don’t endorse this won’t be competitive for early deals.  Result: poor performance for the Stage I style of VC.
  • 32. Summary: the new face of VC
      • Focused on producing startups with intrinsic value (not IPOs).
      • Endorses/encourages the agile startup model.
      • Focused on upside investing.
      • Holistically a Stage I VC (not a Franken VC):
        • Thrives at the initial funding level.
        • Funds back-to-back until at least reaching market value.
      • Balanced % of ownership.
      • Low overhead / competitively low fee structure.
      • Funds multiple (even competing) startups to build markets.
      • Adopts reduced-complexity early-phase contracts.
  • 33. But how can VC scale at early-phase?
    • [For that and other startup/technical trends, contact me]
    • Kevin Lawton
    • http://www.trendcaller.com/