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The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
The New Face Of Venture Capital, Part 1
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The New Face Of Venture Capital, Part 1

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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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  • 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 <ul><li>The facts speak.  According to this '03 Roundtable Report : </li></ul><ul><li>  </li></ul><ul><ul><li>&quot;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. “ </li></ul></ul><ul><li>A similar trend can be seen in M&A exits. </li></ul><ul><li>  </li></ul><ul><li>  </li></ul><ul><li>The IPO &quot;window&quot; 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. </li></ul>
  • 3. Rate-of-change gone hockey-stick <ul><li>The rate of change of technology innovation and cultural generations is steadily increasing: </li></ul>
  • 4. Rate-of-change gone hockey-stick <ul><li>The rate of change of technology innovation and cultural generations is steadily increasing: </li></ul><ul><li>  </li></ul><ul><ul><li>The Stone Age lasted about 2 million years. </li></ul></ul>
  • 5. Rate-of-change gone hockey-stick <ul><li>The rate of change of technology innovation and cultural generations is steadily increasing: </li></ul><ul><li>  </li></ul><ul><ul><li>The Stone Age lasted about 2 million years. </li></ul></ul><ul><ul><li>The Bronze Age about 2 thousand years. </li></ul></ul>
  • 6. Rate-of-change gone hockey-stick <ul><li>The rate of change of technology innovation and cultural generations is steadily increasing: </li></ul><ul><li>  </li></ul><ul><ul><li>The Stone Age lasted about 2 million years. </li></ul></ul><ul><ul><li>The Bronze Age about 2 thousand years. </li></ul></ul><ul><ul><li>The Twitter Age is about 3.5 years old. </li></ul></ul>
  • 7. Rate-of-change gone hockey-stick <ul><li>The rate of change of technology innovation and cultural generations is steadily increasing: </li></ul><ul><li>  </li></ul><ul><ul><li>The Stone Age lasted about 2 million years. </li></ul></ul><ul><ul><li>The Bronze Age about 2 thousand years. </li></ul></ul><ul><ul><li>The Twitter Age is about 3.5 years old. </li></ul></ul><ul><li>Market time is compressing: </li></ul>
  • 8. Effects of rate-of-change on VC <ul><li>As rate of change increases, market opportunity time shrinks. </li></ul><ul><li>And the lost opportunity cost of waiting to invest increases. </li></ul><ul><li>By the time VCs are in, it's often too late .   </li></ul>
  • 9. VC response to rate-of-change? <ul><ul><li>Move up-stream to later-stage deals, effectively, &quot;chasing history&quot; where the R-o-C was slower. Result: more competition for known de-risked deals, weak returns. </li></ul></ul><ul><ul><li>Move into capital intensive &quot;green fields&quot; with less R-o-C. </li></ul></ul><ul><ul><li>Flame out when they can't raise the next fund etc. </li></ul></ul><ul><ul><li>Status quo: puts the squeeze on LPs and entrepreneurs to compensate for the broken VC model. </li></ul></ul><ul><ul><li>Blame the economy / credit crunch. </li></ul></ul>
  • 10. Startups need to be adaptable <ul><li>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: </li></ul><ul><ul><li>“ 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 ] </li></ul></ul><ul><ul><li>“ [...] 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 ] </li></ul></ul><ul><ul><li>“ 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 ] </li></ul></ul><ul><ul><li>  </li></ul></ul><ul><ul><li>  </li></ul></ul><ul><li>Change needs to be an intrinsic part of VC/startups. </li></ul>
  • 11. The “execution paradox” <ul><li>An interesting paradox arises in a high R-o-C world: </li></ul><ul><ul><li>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”. </li></ul></ul><ul><ul><li>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. </li></ul></ul><ul><li>Agility needs to be an intrinsic part of VC/startups.  Was: &quot;execute, execute, execute&quot;.  Now: “pivot, pivot, pivot”.  </li></ul><ul><li>Good bye, downside investing... </li></ul>
  • 12. The funding pyramid <ul><li>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. </li></ul><ul><li>Humm..., how to scale to 10,000x? </li></ul>
  • 13. Seed-only VC <ul><li>There are now a number of seed-only / incubator style funds. Startups funded this way will get out-leveraged in later rounds. </li></ul><ul><li>Lack of future funding leverage equals poor future returns across this style of VC. </li></ul>
  • 14. Current VC model <ul><li>This is where a large swath of VC has moved: less risk, more competition for known deals. </li></ul><ul><li>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. </li></ul>
  • 15. The “Franken-VC” <ul><li>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? </li></ul><ul><li>Likely path: they'll mostly chase “brand name” and “superstars”.  I.e., an out-sized EIR program. </li></ul>
  • 16. Monolithic funding VC <ul><li>VC which funds from seed to exit. This may work for small funds which have a number of potential deals in their network. </li></ul><ul><li>Issue#1: Scalability of attacking the enormous ideas market. </li></ul><ul><li>Issue#2: Scalability of funding for those deals which go bigger than planned (think Facebook). </li></ul>
  • 17. Future: 2-staged rocket approach of VC <ul><li>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! </li></ul><ul><li>Stage II : this style carries startups to large exits.  Some will compete on their &quot;Rolodex value&quot;. Others on better terms.  This is really Private Equity, not Venture Capital. </li></ul>
  • 18. Bootstrapping / friends & family <ul><li>Incapacitated VC is missing out on the entire base of the pyramid.  Common quotes from the street: </li></ul><ul><li>  </li></ul><ul><ul><li>Startup : &quot;I'm skipping VC and going straight for revenue -- VCs are a waste of time.&quot; </li></ul></ul><ul><ul><li>Startup: &quot;We got some friends & family money together and are skipping VCs this time.&quot; </li></ul></ul><ul><ul><li>VC: &quot;Wow, that sounds like a great idea.  Let me know when you have customers & revenue&quot; </li></ul></ul><ul><li>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. </li></ul>
  • 19. % of startup owned by VC <ul><li>Acquirers buy the team & technology, not the VC.  The VC share of the exit is overhead.  Thus, VC returns are inversely correlated to %-owned. </li></ul><ul><li>Beware of VCs who brag about high %-owned!  Poor returns follow... </li></ul>
  • 20. VC meets capital efficiency <ul><li>Sand Hill Rd office space costs 8x to 10x that of cheaper space! </li></ul><ul><li>Steep overhead & fee structures squeeze returns for LPs and startups. </li></ul><ul><li>VC industry returns will down-trend until VC firms operate with the same sensibilities that startups do. </li></ul><ul><li>VC fee structure is a competitive advantage for more agile firms.  </li></ul><ul><li>The top echelon (“Rolodex”) VCs are likely to retain higher fees.  This will drive the divergence between Stage I & II VC. </li></ul>
  • 21. Market sizing fallacy <ul><li>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? </li></ul><ul><li>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? </li></ul><ul><li>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. </li></ul><ul><li>Market agility is a competitive advantage in the new VC model. </li></ul>
  • 22. The evolution of venture investing <ul><ul><li>Slow follower (1900's): enter established markets. </li></ul></ul>
  • 23. The evolution of venture investing <ul><ul><li>Slow follower (1900's): enter established markets. </li></ul></ul><ul><ul><li>Fast follower (2000): quickly enter markets that emerge. </li></ul></ul>
  • 24. The evolution of venture investing <ul><ul><li>Slow follower (1900's): enter established markets. </li></ul></ul><ul><ul><li>Fast follower (2000): quickly enter markets that emerge. </li></ul></ul><ul><ul><li>Does VC know what’s next? How does one invest in the future without seeing the trend? </li></ul></ul>
  • 25. The Evolution of VC <ul><ul><li>Slow follower (1900's): enter established markets. </li></ul></ul><ul><ul><li>Fast follower (2000): quickly enter markets that emerge. </li></ul></ul><ul><ul><li>New market creation (today): create it real-time. </li></ul></ul>
  • 26. The Evolution of VC <ul><ul><li>Slow follower (1900's): enter established markets. </li></ul></ul><ul><ul><li>Fast follower (2000): quickly enter markets that emerge. </li></ul></ul><ul><ul><li>New market creation (today): create it real-time. </li></ul></ul><ul><ul><li>Building blocks (next): multiple startups enable a market. </li></ul></ul>
  • 27. The Evolution of VC <ul><ul><li>Slow follower (1900's): enter established markets. </li></ul></ul><ul><ul><li>Fast follower (2000): quickly enter markets that emerge. </li></ul></ul><ul><ul><li>New market creation (today): create it real-time. </li></ul></ul><ul><ul><li>Building blocks (next): multiple startups enable a market. </li></ul></ul><ul><ul><li>VC sponsored competition for each building block (next): </li></ul></ul>
  • 28. The Evolution of VC <ul><ul><li>Slow follower (1900's): enter established markets. </li></ul></ul><ul><ul><li>Fast follower (2000): quickly enter markets that emerge. </li></ul></ul><ul><ul><li>New market creation (today): create it real-time. </li></ul></ul><ul><ul><li>Building blocks (next): multiple startups enable a market. </li></ul></ul><ul><ul><li>VC sponsored competition for each building block (next): </li></ul></ul><ul><ul><ul><li>Fund multiple early-stage plays for important building blocks. </li></ul></ul></ul>
  • 29. The Evolution of VC <ul><ul><li>Slow follower (1900's): enter established markets. </li></ul></ul><ul><ul><li>Fast follower (2000): quickly enter markets that emerge. </li></ul></ul><ul><ul><li>New market creation (today): create it real-time. </li></ul></ul><ul><ul><li>Building blocks (next): multiple startups enable a market. </li></ul></ul><ul><ul><li>VC sponsored competition for each building block (next): </li></ul></ul><ul><ul><ul><li>Fund multiple early-stage plays for important building blocks. </li></ul></ul></ul><ul><ul><ul><li>Let the markets sort out the winners. </li></ul></ul></ul>
  • 30. The Evolution of VC <ul><ul><li>Slow follower (1900's): enter established markets. </li></ul></ul><ul><ul><li>Fast follower (2000): quickly enter markets that emerge. </li></ul></ul><ul><ul><li>New market creation (today): create it real-time. </li></ul></ul><ul><ul><li>Building blocks (next): multiple startups enable a market. </li></ul></ul><ul><ul><li>VC sponsored competition for each building block (next): </li></ul></ul><ul><ul><ul><li>Fund multiple early-stage plays for important building blocks. </li></ul></ul></ul><ul><ul><ul><li>Let the markets sort out the winners. </li></ul></ul></ul><ul><ul><ul><li>Merge & winnow. </li></ul></ul></ul>
  • 31. The Open Sourcing of contracts <ul><li>Heavy legal fees & contracts are crippling to early startups! </li></ul><ul><li>A new trend is emerging to reduce costs of contracts: </li></ul><ul><ul><li>Sep 2007: &quot; Reinventing the Series A &quot;, Ted Wang, attorney at Fenwick & West. </li></ul></ul><ul><ul><li>Aug 2008: &quot; Cut your legal fees using Y Combinator’s funding documents &quot;, Y Combinator/Wilson Sonsini Goodrich & Rosati. </li></ul></ul><ul><ul><li>Feb 2010: &quot; Series Seed &quot; launches, pioneered by Ted Wang & Andreessen-Horowitz.  Nine investors signed on already . </li></ul></ul><ul><li>Note: firms who don’t endorse this won’t be competitive for early deals.  Result: poor performance for the Stage I style of VC. </li></ul>
  • 32. Summary: the new face of VC <ul><ul><li>Focused on producing startups with intrinsic value (not IPOs). </li></ul></ul><ul><ul><li>Endorses/encourages the agile startup model. </li></ul></ul><ul><ul><li>Focused on upside investing. </li></ul></ul><ul><ul><li>Holistically a Stage I VC (not a Franken VC): </li></ul></ul><ul><ul><ul><li>Thrives at the initial funding level. </li></ul></ul></ul><ul><ul><ul><li>Funds back-to-back until at least reaching market value. </li></ul></ul></ul><ul><ul><li>Balanced % of ownership. </li></ul></ul><ul><ul><li>Low overhead / competitively low fee structure. </li></ul></ul><ul><ul><li>Funds multiple (even competing) startups to build markets. </li></ul></ul><ul><ul><li>Adopts reduced-complexity early-phase contracts. </li></ul></ul>
  • 33. But how can VC scale at early-phase? <ul><li>[For that and other startup/technical trends, contact me] </li></ul><ul><li>Kevin Lawton </li></ul><ul><li>http://www.trendcaller.com/ </li></ul>

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