How Venture Capital will change - and Soon

Posted: 6/13/2009 8:29:26 AM
The old world model of venture capital will change fast. It doesn't take millions to implement ideas anymore. The super talented iterate quickly, so must VC.
When I started building startups in college back before the year 2000, building websites was a different ball game. It took millions of dollars in funding to acquire hardware, bandwidth, programmers, designers, graphics talent, marketing, software, and office space. Once you got all that, you had to keep the lights on and your people fed, almost 24 hours a day. As a consultant to these startups, I saw the pattern repeat over and over.

I remember one startup in particular called FirstLook. What a great group of people and talent there. It was an Idealab startup way ahead of its time. Firstlook, the domain still exists, but what is there now is not at all what this great company was doing then. Video streaming, previews, social networking, user generated content. If there had been money to keep the site running, I wonder where it would be now. Not long after I left Firstlook for another project, a scathing article was written about Bill Gross, the man behind Idealab, asking Why is he still smiling after burning through $800 Million in 8 months.

That's just not the way it happens anymore. Imagine what you could do today with $800 Million. Today, you could get 1,000 startups for that much money. Maybe 2,000. Maybe more.

Really, what is a startup? It's a couple of programmers, some cloud computing, marketing, and then some people to keep out the riff raff.

In 2001, starting an internet company cost a lot more money that it does today. It took dedicated staff for infrastructure, databases, and performance optimization. Today, you can get all that built into the platform on which you develop. Scaling is as automatic. Lots of lessons have been learned and incorporated into the infrastructure. Things that were very difficult then, we don't even think about today.

How will venture capital change?


The first way is that VC investors who want to plop down $5 Million or $15 Million on a venture are going to be struggling really hard to find someone who needs that much money to launch their business. It just doesn't take that much money. The money will either move away from software and into more infrastructure heavy ventures like wind farms, mass transportation, and the like...

Or even better, venture capital will stop investing in "ideas". They'll start investing in teams of people who have lots of ideas and the ability to implement those ideas very quickly. The problem with many VC firms is that they simply do not have the software to handle that kind of scale. The irony is that they are spending all their investors' money on software startups without even recognizing that they need software themselves to manage the investments. That's why we get multiple cold calls from the same VC firms "research analysts" to introduce themselves after we've already met.

For the most part, a great idea doesn't need 15 people dedicated to it to see it succeed. Thousands of ideas with 15 people dedicated to them fail every year and the risk/reward ratio is dropping like a rock. But that's the way it had to be. VC would pour tens of millions into ideas that were continually losing steam. They'd think, "With more marketing, it'll work. If we change the business model, it'll work." VC has become a numbers game. The skill is in diversification, not expertise. Much of it is a confidence game -- skilled manipulators win out, more on that later.

In the past, Venture capital relied on ideas bubbling up from the entrepreneurs, but this is the wrong approach. The Venture Capitalists are the ones with their eyes on the market. What venture capitalists need are small teams of 5 to 10 people who can take an idea, implement it, push it out to the world, and see what happens. If it doesn't take off, move on to the next idea -- with the same team -- immediately. If Idealab had put Firstlook on the back burner until its time had come, perhaps they could have recouped their investment. VC needs to invest in ideas -- superorganisms -- that can sustain themselves without a lot of overhead.

The time horizons and the monetary scale of the status quo Venture Capital firm just doesn't work anymore and the Investors are realizing it.

I see the changes happening fairly quickly. Big ideas aren't so big anymore. Most of the internet today, the new things coming out, these are just features. Video upload sites used to be entire companies. Now it's a feature of a social network. In fact, social networking is a feature of almost any content site, be it a blog or an online newspaper. Mark Cuban posted Open Source Funding to his blog and got 300 comments a day for days and days. It was a great idea, but it died, partly because a blog isn't the right place. Within a week, we built a website to manage those open source ideas. It actually only took a couple of days and the website never took off, but who cares? It cost nothing but a handful of our hours. Someone in those comments proposed such a website for $25,000 -- still too much money!

In our status quo world, VC waits for the entrepreneur to bring the idea, but venture capitalists are the ones with the ideas. They know what's out there. They use the internet just like we do.

As I mentioned before, we have gotten cold calls and emails from different research analysts at the same venture capital firms because they didn't have a shared database of start ups they've already contacted. There are too many startups to keep track of even the ones you already know about. What about all the ones you've never heard of?

In a day or two, we could adapt the Open Source Funding to solve that problem and roll it out to every Venture Capital firm in the country. They'd save time, make fewer phone calls, and look a little less unprofessional in the eyes of the startups they may want to fund later. Why would a startup work with a venture capital firm who doesn't even remember having contacted them already just a couple months prior?

These kinds of small problems can be resolved quickly and easily today. The real entrepreneurs aren't interested in an idea they are interested in thousands of ideas. Real entrepreneurs don't get married to an idea, they try something, see if it works, and if it doesn't, they move on to the next thing.

Unfortunately, this is not how VC works. VC works by taking a big idea, funding it with millions, then hoping it explodes. Stop doing that. It's not the way the world works anymore. The risk is too high.

Take the case of http://twitvid.io/ and http://twitvid.com. In the year 2000, it could have taken millions, perhaps tens of millions to get either one of those sites off the ground. Today however, a small group of three, or even just part of a group of an existing company, like EatLime, the makers of Twitvid.com, can take their existing video upload and distribution platform and adapt it to almost any purpose in just a matter of days.

There was a huge fuss at YCombinator about the twitvid squared issue. Paul Graham, the founder of YCombinator, who funded twitvid.io with $20,000 the team behind twitvid.io started the conversation.

Forget Barriers to Entry -- there are none.


They don't exist. I could rip off your website in two days. The people with the power now are the domain squatters. The winner of the twitvid competition will probably be twitvid.com simply because it has .com at the end. I suppose $20,000 doesn't buy a squatted domain and pay for development. That's a whole blog post to itself, but the point remains: technology is not the hurdle anymore.

Not believing it doesn't make it not true


In Confronting Reality: Doing What Matters to Get Things Right Bossidy and Charan talk about how factories are moving to China. It doesn't cut it to consolidate North American and European production centers anymore. Shaving 20% off your costs means a startup in India is going to eat you for lunch.

Venture Capital is going to have to confront a little reality of its own. Over at TheFunded.com, there are currently 326 Venture Capital firms with "no new investments." Of course I don't know if that simply means they haven't entered a new investment or that firm is out of business or what, but that is a hefty number. It's almost shocking that 326 Venture Capital firms exist at all!

What are you waiting on?


If you are a venture capitalist and you are reading this, please tell me what you are waiting for. Seriously, what are you going to do with all that cash? Just burn it on some snazzy business guy with a great pitch deck, but no ability to execute? I'm a software guy and people come to me all the time with idea after idea for a feature. They want millions in funding for a feature of an existing website. Don't laugh. I see features get funded all the time and I can't help but think it's why VC firms have been bleeding like stuck pigs since Q1 2008.

Humans Prefer Cockiness to Expertise


I don't mean to pour salt into your wounds. I read recently that Humans Prefer Cockiness to Expertise, but you gotta stop making decisions like that. I'm from Oklahoma, which is about as far away as you can get from Venture Capital that isn't drilling holes in the ground. They don't understand technology. I went to a couple pitches for companies backed by a state run investment company and I felt so terrible inside because I knew the state was wasting money on ideas that would go nowhere. I can't remember all of them, but one of them in particular is already a parked domain.

Failure is normal


Don't get me wrong. I understand that startups are going to fail. It is exactly this understanding that prompts me to write this post. Build failure into your business model. Instead of funding an idea, fund idea generators. Don't get married to ideas.

Scalable Venture Capital


It's an issue of scalability. How does a venture capital firm manage 100 or 1,000 or 10,000 ideas being generated simultaneously. There are over 8,000 stocks publicly traded on NYSE, Nasdaq, and the Amex. I traded stocks for 2 years, built an elaborate system and examined as many as I could. In 2 years, I only looked at about 1,500 different companies. Most of those were just once or twice. Of those, I invested in perhaps tens. How many of the 6,500 companies I didn't look at doubled or tripled while I didn't even know they exist?

In the stock market world, scalability is implemented through mutual and index funds. The large mutual funds have holdings in literally, hundreds, even thousands of different public companies. Millions of people give these huge funds thousands to hundreds of thousands of dollars and they buy shares, pretty much across the board. They throw a bunch of money at the wall and see what sticks.

The stock market works, because mutual funds can throw 8,000 companies at the wall. Venture capital fails because they can only throw 10 or maybe several tens of companies at the wall. Unfortunately for the investors, everything thrown falls off the wall. So what happens is investors have to throw money at several venture capital firms. The scale just doesn't work. The management fees at Venture Capital firms are tremendous.

Venture capital has relied for too many years on too little diversification. There are 8,000 public companies, but there are hundreds of thousands of startups. Even 1,000 VC firms can't watch them all. There's no way. Probably the vast majority of the ones they do see are garbage. Most of the ones I see are garbage and they aren't flocking to me like they're flocking to the VC's with a lot of money.

Streamlining the investment process


The current process of investing in a startup is long and arduous. Startups have to pitch tens or more Venture Capital firms to have even a hope of a deal. If the VC likes the idea and the team, it takes term sheets, attorneys, board seat decisions. It's a nightmare. What startup wants to go through that?

For too long, Venture Capital has been in the driving seat because they have the money. But today, snazzy startups are going to YCombinator for $25,000, launching in a few months, and destroying incumbents in their market funded by VC firms with millions of dollars. That rocky ride is never going to end for venture capital.

If a VC is going to survive, it absoluately must streamline its processes, reduce time-to-investment, and invest in more companies. The era of the BIG idea is over. Even gene sequencing, which was impossible 10 years ago, can be had for $48,000 today.

Even if you do find the next big idea, you don't have time to make a profit on it. The current pyramid strategy of selling your company to some other company you funded 10 years ago, like Google or whatever, just isn't going to work. Even Google has it's own Venture Fund. I think Google is probably smart enough not to buy a technology company funded with tens of millions of venture capital when they could reinvent the wheel with a couple engineers.