Growth Times

Josh Kopelman, Managing Director of First Round Capital, wrote a great post today building on Fred Wilson’s VC math problem, and call Why VC Performance Has Fallen Off A Cliff.

I argued in a recent post that in parallel to the “moonshot” approach Josh rightly describes as the norm for VCs,  there must be a model that focuses on extracting revenues from a portfolio of tech companies with lesser risk.

Overall, it’s pretty clear to me that what we call VC companies should cover the entire risk-return frontier for any early-stage tech company, because that would allow large investors to place their bet as they like in this category. I’m not suggesting VCs turn into bankers or private equity investors, but there is a clear case for filling the early-stage funding gap towards tech ventures that hold less risk and more proven revenue models than moonshots.

For all the analytical firepower of VCs, it feels a lot like playing this field is still an art not a science. If really, VCs take a classic portfolio approach to early-stage returns, like I’d argue they should, then risk-return is a continuum and the industry ought to cover it entirely to offer interesting options to large-fund investors.

Which brings me to this: the expectation of a 20% return yearly is completely unrealistic, when the average growth rate for the world economy is 2-3%  (tidbits from my finance classes at Stanford – I don’t think our average growth rate has gone much above that since I finished my degree there…) If VCs as an industry grows faster than that rate, then by definition it will have to return to the mean (back from the moon) sooner or later, hence the cliff. Risk has nothing to do with this, since we are talking about a risk-return continuum in a vast portfolio managed by the entire VC industry – over time the failed companies bring you back to that 3% mean.

If you can do better than 2-3%, or say 5% to be a bit more optimistic about the growth capacity of our system, then you’ve nailed some distortion in the market and/or you’re taking more risks than you should. It’s hard but possible to do that as an investor, but impossible to do it sustainably as a large industry. Sooner or later, the industry will lose big, just like gamblers. Keep in mind again that I am talking about the VC industry as a whole, not individual players here – there is much variability there.

The problem with promoting those 20% rates is that it fuels hype and bubbles – the only viable mechanism to achieve those returns for the entire VC industry, if not a sustainable one. So I think it would be great if VC as an industry could stop pretending it can do much better than the mean, and focus instead on offering a decent continuum of risk-return options to their investors based on early-stage plays. From that angle, VCs are just expanding the range of investment options available and that, I think, would be good enough for everyone.

Unfortunately, the current system is set up to create monopolies of sorts by maintaining a complete imbalance between money pools and money needs. VCs are encouraged to bet on moonshots because that’s how, individually, they can make it and retire (with that feeling of intellectual superiority one gets for betting on the right horse at the tracks). They don’t lose much money on failed investments, but they make tons on successful ones, so of course they swing for the fences. The first thing VC firms should do is take a good look at their compensation system and rehaul that.

As things go well and returns grow, a few investors that actually beat the mean quite consistently (there will always be some – they are the right dots in the normal distribution of investors) make everyone hope over time that they can too – and thus the system as a whole progressively takes more risk without realizing it.

Meanwhile, companies with a lower risk-return ratio – but not low enough to warrant a bank loan – have a heck of a time finding money. Angels fill some of that gap, but while they’ve structured themselves greatly in the past few years, they don’t have the discipline a VC firm could bring, which only would attract the big money from the big funds.

Unlike what some observers think, I’m convinced the VC system is here to stay. But not without adjustments – either angels will structure themselves more and more to fill the void VCs left, or VCs will get back in there as they should. The overall lesson as a VC is that you can shoot for the moon if you wish, but keep your feet on the ground, because your industry will go back to the mean sooner or later.

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To any current or would-be entrepreneur, I highly recommend the following video of a presentation this month by Aaron Patzer, CEO of Mint, which was recently sold to Intuit for $170 million.

At first I thought it was a bit long, at 22 minutes, and so I figured I’d only watch the first few minutes. 23 minutes later, I am writing this blog post. Aaron goes over the start-up creation and growth process in practical details, even presenting slides from his own original pitch.

One thing, I’m not a fan of the first advice he gives, about focusing entirely on the product and hiring only engineers when you start, which has some truth to it in a number of situations but can lead to complete trainwrecks in others. Someone on the team needs to tie your development to a market need and a winning revenue model – it may not have to be a business person, and a well-atuned engineer can do that as Aaron shows, but it’s got to be someone with a certain ability to think ”market”. Leaving that detail aside, his advice is a gem.

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Develop, Fund, Market, Scale Aaron Patzer, entrepreneurship, Fundraising links, growth stages, Mint.com, Start Up

As previously announced, I was at Communitech last Friday to talk with their Product Management group about the key challenges to launching blockbuster tech products. I decided  to tackle the divide between Techies and Biz types, as this has consistently been one of the main hurdles I saw at the ventures I work with. I was a little worried as at first I expected possible controversies over some of the points I brought up, but to my surprise this resonated well and strongly with most people in the room. About half the room were techies and the other biz types, so the distribution was spread nicely in the middle. There were no punch exchanges, mud fights or even light food fights (or food light fights for that matter).

I posted my presentation on Slideshare, so you can find it below. I had two hours at Communitech so this is quite a long deck of 40 slides. It’s all there. For those who attended, note I revamped quite a bit of it and there are several slides I didn’t show during our discussion. So you  can take a fresh look at it.

Slideshare did a poor job with the graphics so, for example, the cover page I was so proud of is all scrambled. Time permitting, I am available to deliver this presentation at other forums and welcome invitations. Rest assured I have unscrambled slides to present.

Canadian entrepreneurs, Develop blockbusters, business plan, commercialization, consultant, Digital divide, divide, Fundraising links, go-to-market, market hit, marketers, mental models, monetization, Product manager, Revenue model, Science and Technology, techies, venture

Canadian Business totally misses the mark in its poorly researched editorial on Ontario’s Green Energy Act and the Emerging Technologies Fund in the June 15 issue.

I support innovative ventures in the cleantech space on a daily basis through my consulting practice at Growthroute Ventures, and I recently co-authored an article entitled “Could Ontario be the Next Germany?” with regard to both the Act and the Fund, published in Renewable Energy World Magazine, the most widely-read magazine on clean energy.

As we all know, Ontario has been pouring money by the billion into the car manufacturing industry and other dinosaurs. It is about time some public support be devoted to innovation in cleantech. The Green Energy Act is modeled after the German incentives, which are recognized in the industry as widely successful. California, which Canadian Business refers to as a great model, has in fact been seriously discussing moving towards the German system. But more importantly, Canadian Business’s assertion that California’s model is significantly different in its support of clean energy — claiming it does so less selectively– is downright incorrect. Among many other examples, the western State pays a premium for 5 years on all solar photovoltaic projects, and offers select incentives to wind and biomass projects. This “winner-picking” approach Canadian Business criticizes is a constant in the energy industry, as a quick look into the huge tax incentives our government is offering for oil sand exploration, or all the public money that has gone into nuclear power R&D, would have told the editor. The support now offered to cleantech is a minuscule fraction of those amounts. If Canadian Business advocates for a leveled field, it should make sure it is looking at the entire field first.

As for the Emerging Technologies Fund, it is again just a drop going to innovation against the ocean of dollars poured into the US car manufacturing black hole. Canadian Business forgets to note that Quebec recently announced the launch of a fund offering over 3 times the amount of Ontario’s fund, and that la Belle Province is increasingly being seen as much more supportive to innovation than Ontario. Dismissing the Ontario’s ETF initiative on the basis that there is little venture capital money to match, and that “most VC-backed investments fail”, demonstrates a serious misunderstanding of how venture capital works. VCs bet that out of 10 investments, nine are going to fail or just get by, and one or two are going to make up in a big way for all the others. The metric that matters here is the investment ROI on the entire fund, not on individual investments. The VC industry raises its money from larger funds, who allocate their investments based on ROI and risk. Until now they had found it quite lucrative to place bets on VC funds.

But Canadian Business argues that VC investments are inherently too risky. Taking the magazine’s logic to its conclusion, it is not advocating against the Ontario fund as such, but against the VC model as a whole, in essence saying that VC investments are bad investments, and that no money should be put into that model. The truth is, the VC model may be under fire, but again, one needs just to take a look at the broader picture to see that is but a flawed assumption: how about the recent financial returns from the securities industry, the car manufacturing industry, or real estate? If we are to invest anywhere, I say putting more money in the hands of VCs (and angels too, by the way) is as good a bet as any. Actually, it is a much better bet.

The VC industry in the US is widely seen as a critical catalyst for the rise of the Silicon Valley. Companies like Google, eBay, Facebook, Cisco Systems and a number of other innovation heavyweights act as vivid proof that the model works. In my daily job, I constantly witness how the quasi-permanent lack of funding for early-stage innovation in Canada stifles growth and highly-qualified employment. I am not arguing against Canadian Business on the importance of letting markets do their magic, and getting out of the way, but at a time when the government is distorting those by throwing money at any moribund dinosaur that can still shout, I say any effort to direct funds to the innovative sector through the existing channels should be encouraged and supported. Certainly, reducing taxes and removing regulatory barriers to all forms of investment is needed (making it easier for US VCs to invest here is a definite need!), but it does not prevent other initiatives that leverage the power of targeted incentive towards sectors of strategic importance for our collective future.

Shame on you, Canadian Business, for popularizing half-baked arguments on the Green Energy and Green Economy Act and Ontario’s Emerging Technologies Fund. You couldn’t serve the purpose of traditional corporate money-grabbers any better, at a time when the job-creating innovative economy is in dire need of your support.

PS. And while I’m on Canadian Business, what is it with its choice for the “25 most influential people in business“? All white male except for one woman! The magazine might want to drink a bit of its own medicine, see their last-page article “Women wanted“, as I doubt there aren’t more females or visible minorities in the top 25…

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Canadian entrepreneurs canada, cleantech, emerging technologies fund, Fundraising links, green energy act, innovation, innovation policy, Ontario, venture capital, ventures