The New Face of Venture Capital Venture Capital directions for LPs and startups Kevin Lawton March 4, 2010 http://www.trendcaller.com/

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.

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.

Rate-of-change gone hockey-stick The rate of change of technology innovation and cultural generations is steadily increasing:

The rate of change of technology innovation and cultural generations is steadily increasing:

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 rate of change of technology innovation and cultural generations is steadily increasing:

The Stone Age lasted about 2 million years.

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 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.

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.

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.

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:

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:

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 .

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 .

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.

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.

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.

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.

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...

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...

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?

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?

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.

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.

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.

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.

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.

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.

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).

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).

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.

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.

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.

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.

% 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...

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...

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.

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.

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.

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.

The evolution of venture investing Slow follower (1900's): enter established markets.

Slow follower (1900's): enter established markets.

The evolution of venture investing Slow follower (1900's): enter established markets. Fast follower (2000): quickly enter markets that emerge.

Slow follower (1900's): enter established markets.

Fast follower (2000): quickly enter markets that emerge.

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?

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?

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.

Slow follower (1900's): enter established markets.

Fast follower (2000): quickly enter markets that emerge.

New market creation (today): create it real-time.

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.

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.

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):

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):

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

But how can VC scale at early-phase? [For that and other startup/technical trends, contact me] Kevin Lawton http://www.trendcaller.com/

[For that and other startup/technical trends, contact me]

Kevin Lawton

http://www.trendcaller.com/