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January 29, 2006

Disrupting the Venture Capital Industry

All venture capitalists (VCs)  SAY that they like to invest in disruptive technology; some VCs (the best ones) actually do invest in disruptive technologies.  So it is certainly a fair and relevant question to ask whether new technology or other changes will disrupt the venture capital industry. And, fair and relevant or not, the discussion has broken out all over the blogosphere.

[Note: This post and the ones I quote below are only about venture capital as applied to Internet and software technology; other industries have very different capital needs.]

Vastly oversimplified To oversimplify what he is saying, VC Rick Segal blogs that a VC used to provide both a Rolodex full of contacts which the entrepreneur himself or herself doesn’t have but badly needs and the boatload of cash required to execute on an idea.  Now, Rick says, the blogosphere is the Rolodex through which customers, supporters, and investors can be mobilized and new technology including free and software and services for almost any purpose as well as very cheap hardware often reduce the money required to what an entrepreneur can float on her or his credit card. 

Rick says his own daughters have business ideas which they don’t seem to need him to fund. He interprets this as a wakeup call.

Chronologically in between Rick’s two posts on this subject (here’s the earlier one), Dave Winer who invented or participated in the inventing of many Web 2.0 technologies including RSS, podcasts, and OPML (and who blogged long before blogs were invented), weighed in with a post proposing the disintermediation of VCs and the formation of a public corporation whose initial funding, at least, would come from users which would both provide funding for startups and plow back some of its profits into “pure technology research and development.” It’s the users who create value for startups anyway, Dave argues.  Although he is angry at VCs and accuses them accurately enough of funding too many “me-too” startups in the last bubble as well as ignoring basic research, Dave does suggest that Rick Segal be the CEO of this publicly-traded funding vehicle.

Segal reciprocates the (well-deserved) mutual respect: “My working theory is that a ‘Capital firm’ with Esther Dyson, Mark Evans, Shel Israel, Doc Searls, Robert Scoble, Dave Winer, or some combination, might have value that, along side my money, could bring ideas into the mainstream in a much different fashion with great returns for all.”

Although (full-disclosure) I have been and am an investor in several venture capital funds, I can only comment from experience as an entrepreneur . As an entrepreneur (even more disclosure),  I’ve been dissed by, funded by, frustrated by, helped by, well-advised by, and poorly advised by  VCs – sometimes all at the same time.  From an entrepreneur’s point of view, it doesn’t matter if the VC industry even exists or not (investors feel differently as do VCs); what matters to entrepreneurs is that we get funded.  We accept advice from those who fund us as a necessary evil that comes with the money even though, after the fact, some of it turns out to be pretty good.

Since it is never a good idea to sell more of your company than you have to earlier than you have to, it is a good idea for inventors to take advantage of all the free and cheap stuff that Rick talks about in order to build a prototype or even to begin service without having to raise money first.  The fact that many a business can really be launched without either acquiring a rich uncle or quitting your day job really is a disruptive change.

This disruption affects both the entrepreneur and the VC.  Some entrepreneurs now can get by with no venture capital; others will be able to sell less of their company than would otherwise be necessary because they have demonstrated BEFORE raising money that their idea “works” and maybe even that it attracts users.  VCs, on the other hand, can take less risk by eliminating “untested” ideas and wannabe entrepreneurs who don’t believe enough in their own ideas to build the first beta on their own.

“Show me the PowerPoint” has become “show me the service.”  “Tell me who your potential users are” has become “tell me who your early adopters are.” Companies who are at this milestone are not only ready for funding; they are also potential acquisition candidates. So VCs have to compete from the getgo with offers to simply acquire the company.

But, if one company can get to early adopter status on just sweat equity, so can one hundred others.  Scaling is always harder than we entrepreneurs think it’ll be (and more expensive).  The first employees, benefits, and legal stuff cost a lot more than you think they will – and, even worse, take a lot of your time. Mary will tell you that I have always underestimated the marketing dollars needed to get a good idea – even a very good idea – into the marketplace.  Sure, the Web has enabled many more creative ways to market, but it’s done that for your competitors as well.  This is an arms race.  Arms still cost money.

So, my entrepreneur friends, you are still likely to need VCs - not always, but a lot of the time.  So what’s changed?  Has the VC industry been disrupted?  Is what either Dave or Rick is suggesting the shape of the VC industry to come?

Short answers:

Two big changes are the lower cost of getting started (means less need for VCs early and more for them to look at later) and VCs blogging (a good thing if you’re an entrepreneur).

The VC industry has been disrupted by compression of the time between when a company first needs money and the time it is an acquisition candidate,  Even if an initial round is needed, a second may not be.  Harder, then, for VCs to put money to work.  Moreover, it is likely that the initial round needed will be small, so an extensive and expensive round of contract writing and due diligence simply isn’t justified.  The best VCs are learning how to efficiently put up smaller sums.

Although I would love to have Dave as an advisor (and have benefited from his advice in the distant past) and Rick sounds like a very good VC and both of them have correctly diagnosed industry problems,  I don’t agree with either prescription.  I’m afraid being funded by a public shell would lead to private startups having many of the reporting problems and transparancy issues of public companies without the (dubious) benefits of being public. Publicly traded holding companies for startups have been notable failures in the past.  And a board of advisors – even the brilliant ones that Rick suggests – is still a committee.  Entrepreneurs come to VCs for money.  Committee time is wasted time at best and a dangerous distraction at worst.

Coming attractions:  Putting Small Amounts of Money to Work and How to Read Your VC’s Blog.

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ALL TOGETHER NOW... (UPDATE: Mark Evans , Tom Evslin, and Rick Segal have relevant pieces on this post's topic) Dave Winer has a 5-step idea to disintermediate VCs and directly connect entrepreneurs with users to create a User Internet Capital Corp.. S... [Read More]

» Disrupting the VC Industry: a VC investment Market from Horizon of Stars
The discussion about disrupting the VC business hit the blogsphere late last week. Primarily driven the posts by Rick Segal and Doc Searls. A pause of a few days and Dave Winer has proposed User Internet Capital Corp to disrupt the VC business. Doc Sea... [Read More]

» Has the VC industry been disrupted? from TJ's Weblog
Tom Evslin elaborates on this emerging topic/ idea: "To oversimplify what he is saying, VC Rick Segal blogs that a VC used to provide both a Rolodex full of contacts which the entrepreneur himself or herself doesn’t have but... [Read More]

» Has the VC industry been disrupted? from TJ's Weblog
Tom Evslin elaborates on this emerging topic/ idea: "To oversimplify what he is saying, VC Rick Segal blogs that a VC used to provide both a Rolodex full of contacts which the entrepreneur himself or herself doesn’t have but... [Read More]

I came across Dave Winer's post, "How to reform the VC industry," and found it to be interesting enough to respond. [Read More]


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