Much criticism has come of our industry in the past few months and in my opinion much of it is deserved (but I’m definitely a believer in the meme that VC isn’t broken but some of the participants are (see here, here and here)). But the VC industry is too fat – a thoughtful piece by Paul Kedrosky on shrinking the industry by half is here.
The latest to weigh in was the NY Times with this well written piece in yesterday’s paper. I think it propely captures the moment and questions whether the structure of the industry for the past 10 years is the the right one for the next 10. In my opinion it also makes Tim Draper truly seem out of touch … we need more VC money to “spread the wealth to the seven billion creative minds out there.” Really? WTF? I’m prefer to assume he was quoted out of context since I’m told Tim isn’t a bad guy. (UPDATE: Great response from Bill Bryant of DFJ is here. As I said, I had hoped it was out of context).
My own views echo those in the NY Times article and come from my experience of raising VC as a entrepreneur over 2 companies and 8 years and working with 9 firms that invested and many VC’s that issued term sheets that we never closed on. Here are my conclusions:
1. There is way too much money in VC – Lowering the amount of money will be healthy for VC’s and start-up companies. When I was a start-up CEO I always believed in charging a fair price for the products that I created. But in 1999-2001 so much money went into our competitors that people were willing to low-ball on price to win deals because they (we all) had too much VC money that would fund our losses. In today’s world this is worse – people are willing to offer products for free funded by 2 years worth of VC money (and I’m not even talking about ad supported businesses).
2. Fund sizes have been way too large – I remember pitching on Sand Hill Road in 2005 for my second company, Koral, and I told VC’s that I only wanted $2 million. A number of investors told me that their minimum was $5-8 million and they encouraged me to take more money, “because I’d need it.” Luckily I was on company number two and I had already painfully learned the lesson of raising too much capital so I didn’t follow this advice. At the time I couldn’t understand this mentality until it was explained to me this way, “look, I have a $600 million fund. I can’t invest $2 million in companies and stay actively involved.”
Actually, I get this. But then I think this fund ought to be a later stage growth equity firm and not a VC or they ought to have more partners in the firm investing smaller amounts. I believe passionately in capital efficient businesses that prove out their model before trying to scale. This suits the interest of the VC but I believe it suits the interest of the start-up founders even more so. Some VC firms like Accel, Index and others have created separate “growth” funds with larger dollar sizes for later stage deals – that makes sense to me.
The incentives for many VC’s has been wrong. They’ve been too happy to have multiple “stacked” funds of large sizes so that their management fees (which are typically 2% of the fund size) can be large. I don’t believe that VC’s who maximize their fees by having large funds are in the interests of their Limited Partners and I actually believe it encourages the wrong people to want to work in VC. (as I side note I wonder how LP’s can justify this size of management fees for the “mega” funds that have billions of dollars. Do they think it creates aligned interests to make partners so wealthy on just deploying capital?)
Dana Settle said it well in the NY Times piece. Start-ups need less money to get going these days and you can get a good return at a $100 million exit provided you didn’t put in too much money and you can get in at an early stage. Venture exits last quarter on average were just $22 million last quarter (vs. $41 million a year before $60 million over the last 8 years). I know we’re all looking for the home run that “returns the fund” but to be successful I believe the industry needs more Greycrofts.
3. There are way too many non-operators – I won’t go as far as to say that every VC needs to have been an operator because I’ve worked with tons who I really respect who don’t come from an operator background. I certainly believe operating experience helps a lot, though, and believe that every firm needs to have a few entrepreneur partners in their stable. I experienced way too many ex i-banker and consultants who never had any operating experience and had a better grasp on whether my operating margin in year 5 was appropriate vs. an intuitive feel on whether my product would be adopted by customers.
No doubt they can do the deep analysis and really help at financing time to analyze the pro’s / con’s of venture debt. And I’m sure they really earn their money at exit time in the sale. But some of them lack the depth of understanding in the key decisions that each entrepreneur faces. They have no idea what it feels like to be 3 weeks away from missing payroll with an employee asking you whether it is a good idea to buy a house (should you actually tell them there is a 10% chance you’ll be out of work in 3 weeks?) or customers are entrusting you with orders that you’re not 100% sure you’ll be able to fulfill. What advice can they give you about dealing with customers in this scenario? If VC’s truly understood the angst and emotional drain this puts their founders under they wouldn’t bleed you until the 11th hour waiting for your internal financing term sheet so that they get more information or negotiate a better deal with you. A great VC wouldn’t do this.
I recently debated with some founders the best way to go about laying off one of their employees. They were telling him they were letting him go for cost control reasons when it was really for performance reasons. I’ll cover the topic some other day but I believed the right thing to do was to fire him for performance and tell him this. I gave them 30 minutes of rationale from my experience on why I thought that would help and not hurt with morale. (btw, they didn’t take my advice ;-) I have been through more downsizing (can you say 2001?) then I care to think about and have had many years of firing based on performance. It’s 
never fun. Many VC’s have never had to deal with this “dirty” work and never will. Sure, they’ve let an analyst or associate go but in the VC world this is very different than cutting a developer on a tight team of 6 developers when each of the remaining 5 could go out and get another great start-up job without a sweat. Not true in VC.
I like to say that you can’t run a burger chain unless you’ve flipped burgers. I think we could use more burger-flipping VCs. I think that’s why so many people are excited to hear about the Andreessen Horowitz fund.
4. In a strong wind even turkeys can fly – I believe that there are way too many VC’s that believe their own hype from the successes that they had in the late 90’s (or frankly from 05-08). It reminds me of the real estate investors who were telling me what a fool I was not to be buying condos in Florida in 2006. The difference in VC is that many of the senior people in industry who had past successes don’t have real down side when markets become more 
difficult. They are simply able to stay in their funds and milk it. Obviously the industry luminaries like Sequoia, Kleiner Perkins and Accel have continued to prove they can pick the best winners but there are also many who had hits by sheerly being in the market.
Years ago a sage mentor of mine told me in 1997, “don’t assess our company relative to competition now. In a strong wind even turkeys can fly. In a down market the best companies separate themselves from the pack. The weak disappear.” So it goes with VC. Eventually those with no leadership will dwindle and help realize Paul Kedrosky’s prediction.
5. Some VC’s lack empathy. Some VC’s simply can’t understand the world of the start-up founders or they’re too far removed from the daily grind to really empathize. Being a CEO is much lonelier than anyone who’s never done it can imagine. I know that there are the breakout successes like Google, Twitter and YouTube. But the rest of companies go through through cycles. Even the best companies go through it. I’m sure that LinkedIn, Facebook, Mint and others have been through tough times.
You don’t have many people to share your problems with because you try to keep it together for all your staff. You need to come in every day to the office and motivate people even when you have your own self doubt and worries. You need to hire, sell, talk positively to the press, etc. while blindly having faith that your next round of capital is going to come. You have co-founder issues. Your clients grind you. Your employees need more money to get by. Your product is shipping late and with some of your key features postponed. Your crack developer quit to move to NY. Your spouse or girl/boyfriend is irritated because s/he hasn’t seen you enough. Or worse you don’t have one and you’re getting too fat. This is an unbelievably honest piece from an entrepreneur coving this topic. Have you been there? That’s when I think you can offer real advice. That’s where a VC needs empathy.
6. Are some VC’s too old?. The NY Times article alludes to this. As for me, I’m not ageist. I see fantastic VCs in their 50’s/60’s that blog, use Facebook, use Twitter, IM people and use Salesforce.com, Google Docs, RSS Readers, etc. (no, using a Kindle and a Blackberry doesn’t count). The NY Times piece profiles one of our industry veterans, Alan Patricoff. He still works incredibly hard. I don’t know how old Howard Morgan at First Round Capital is but I know he’s not 35. He travels more than most 35 year olds I know and knows more about what’s going on in early-stage tech than many of these same people.
I think it’s more about mentality and willingness to accept the creative destruction of the new without being jaded by your past. I remember a conversation I had with a prominent older VC from Sand Hill Road 6 months ago who decided to call it quits. I asked him why and he said, “I just realized that it’s all changing so fast and I don’t have it in my to want to learn all the new technologies that everybody in their 20’s are playing with.”
Blogs are reshaping the publising indutry. Companies like TopSpin Media are finding new distribution channels for musicians. Twitter is chaning our communication landscape. Cloud computing is coming and will change the IT industry. Young people do place real value on virtual goods and define their self worth through online brands the way we do in our offline lives. People will spend hours translating movies, adding restaurant reviews and updating Wikipedia for nothing more than to be part of a community and be “Internet famous” to that community. Virtual reality and augmented reality are real phenomena and not this year’s fad.
As one senior VC partner lamented to me “kids these days don’t read physical newspapers any more” and I showed him how much news I could consume from so many more sources than he could through RSS feeds and after showing him he still didn’t get it. Some people never will.
My advice to entrepreneurs – find a VC you feel can really relate to you and your company on a personal level. Find people that are in it for the passion of building great products and love the rush of the start-up. Find “egg breakers” willing to take risks. And be careful of VC’s that have a gleam of easy money in their eyes.
Update: several people asked me for VC’s that do “get it.” There are many and I don’t want my post to be seen as damning of the whole industry – just several players in it (not to mention that many hedge funds did venture investing in the past 3 years who had no previous VC experience). Here just a quick, non comprehensive list of some obvious VC’s who do get it: I think there’s a host of VCs who do get it. True Ventures, Foundry Group, Union Square Ventures, First Round Capital, Founders Fund, and I obviously I feel GRP Partners in LA (who funded 2 of my companies and I worked with for 7 years before I chose to join). There are obviously many, many more.
I run a monthly meeting called the VCA that represents the majority of Southern California venture capital firms. My goal is to bring in informative speakers who stretch our collectively thinking on topics that will influence our investment strategies and use it as a way for us to share our experiences in ways that I hope benefit the Southern California technology ecosystem.
4. 70% of Korean population has Internet speeds > 5mbps (and avg = 15 mbps) – don’t bet that the Koreans won’t innovate on online content (slide 30). Larger online game market ($1 billion) than Japan despite 1/3 population and 1/2 GDP per capital (slide 99). Way ahead of the US on mobile gifting.
5. More than 90% of Japanese mobile subscribers are on 3G networks (vs. 20% in the US) (slide 30), More than 50% have mobile TV & NFC chipsets (slide 87). Mobile ARPU = a staggering $110 / month for content and commerce alone (slide 88). Massive fall-off in ringtone and massive uptick in full songs (slide 89) —> still think we shouldn’t be watching what’s happening in Asia? Sales of avatars in social games nearly 50% of total revenue eclipsing revenue from affiliate transaction, ads or paid games (slide 97). Mobile game content revenue > PC game revenue (slide 98)
Posted by Mark Suster 
Both Sides of the Table 