I was recently interviewed for a story on the current state of the market in terms of early-stage investing, and how entrepreneurs can raise money these days. Since it will be edited, here is the full transcript.
1. What are your thoughts on the current state of the venture capital industry?
It is in a period of difficult retrenchment. Many of the funds that existed in 2007 may never raise money again. The small number of top tier funds are doing well and raising lots of money, but many of the funds below that level are having trouble raising money or are scaling their fund-sizes down.
2. Many venture capital firms have closed their doors in the last decade. What factors most heavily influenced this trend?
I think a departure from their original model was at the root of the difficulty. Many VCs delivered eye-popping returns during the original dot.com bubble of 1997-2000, and as a result, tons of capital poured into the asset class. Fund sizes ballooned, firm sizes and expenses ballooned, a dependence on management fees began to take root, and the firms began to look for ways to put all that money to work, and drifted out of their core competencies in some cases.
At the same time, the economics of starting a technology company changed, so many of them needed less money, the market sub-$100M IPOs dried up completely, other sources of capital entered the market (professional angels organized into groups and onto platforms, and angel groups got good at syndication), entrepreneurs began to realize that getting married to a VC for ten years and “going big” was not the only way to go (i.e. serial entrepreneurs doing earlier exits).
The net result was that VC returns after the bubble were terrible and their market power was diminished (what used to make them special is that they used to be the only game in town for early-stage risk capital), and LPs began to recognize these factors and allocate a smaller portion of their assets into VC.
3. What did venture capital “miss” or “fail to respond to” that might have been preventable?
They failed to realize: (1) that their traditional model of relatively small amounts of high-risk “smart money” invested by a small group of partners might not scale perfectly to larger amounts of money invested by a larger group of partners and (2) that their market was changing around them and that some of their dot.com returns were a fluke (or at least outliers) and that their model needed to adapt.
4. Is the venture capital framework broken? If so, how would you fix it?
I don’t think the framework is totally broken, it was just abandoned temporarily. It remains to be seen if the mega-funds can deliver good returns over the long haul, but for the most part, a new breed of micro-VC raising smaller $25-100M funds has started to emerge and they are going back to the industry’s roots with a back-to-basics early-stage high-risk value-added smart money approach. I suspect that will work pretty well, at least for a while; if mechanisms democratizing early-stage investing take root, it may upset the apple cart all over again.
5. Do entrepreneurs need venture capital firms?
Just as there will always be a market for low risk, low return investments like treasury bills, there will always be a market for high-risk capital that can be utilized by visionary people to develop new and unproven markets and technologies. So risk capital or venture capital is not going anywhere. Entrepreneurs might have a little more choice in terms of where they get their earliest capital, and therefore “need” VCs a little less in the early stages, but any time you need a big investment in order to scale, VCs are going to be an obvious place to look.
6. If not funded by VC’s, what are other viable options for entrepreneurs?
As I said, capital-intensive plans will always need something like VC, but lighter-weight less capital intensive plans are having much more luck getting their early dollars from angels, both angels in groups and individual angels on various platforms. For some companies, that is all the money they will ever need, especially if they are harvested earlier by means of an acquisition by a larger company. For others they might go on to raise their next round from a larger angel group syndicate, via direct investment from a family office or strategic investor or corporate VC, or possibly down the road via some kind of new direct investment or crowd-funding platform (though I have my misgivings about those platforms as I have pointed out in my previous post Understanding Crowdfunding)
7. Why might these alternatives be more viable, in the long and short-term? Why not?
There is an old joke that until you get an exit, you are a donor, not an investor. In other words, if the goal is to make the entrepreneur successful as measured by some kind of liquidity event for her company, over the long term, alternatives that successfully achieve this goal will be viable and alternatives that don’t will not. In my view money is only part of it, and maybe not even the most important part – investors also need to help companies with strategy, team-building, execution, introductions, and exits. I think angel groups which effectively pool talent and connections to help companies are viable, and I think VCs who are good company builders and help and connect are also viable. I am a little fuzzier on how large “party rounds” with a huge bunch of unorganized investors who don’t know each other, all have too small of a stake to care, have no board seat, and cannot agree on anything will be effective over the long term. That is an unproven model in my mind. Maybe some of those rounds will be rescued by an organized Series B round, but I fear that many many many of them will not (the so-called Series A crunch; though some don’t agree – I am in the middle – I think some poorly-thought-out “party” rounds put together with no strategy will get wiped out).
8. What do entrepreneurs most lack, outside of funding, and do venture capital firms fill that void? Are alternative options like angels and crowdfunding more capable in this regard?
New entrepreneurs most lack help, experience and introductions from people who have “done it before.” I think my previous answer posits that groups of organized investors do a better job helping these entrepreneurs than unorganized masses of investors. So I would associate the model of organized angel groups more closely with VCs in the “more capable” column and I would put loose collections of angels and crowd-funding in the “too early to tell” column.
9. What advice would you give to an entrepreneur today seeking funding? To a venture capital firm? To an alternative funding option?
I would advise them to undertake some really honest self-assessment in terms of the size of the opportunity, the capabilities (and weaknesses of the team) and the capital required to execute on the plan, and then be very deliberate and targeted in terms of seeking out the right type of investor for what they are trying to achieve. If they go to an investor who is a really good fit for them, and they are able to articulate precisely why they have come to them, the honest self-assessment will speak for itself and make the investor much more interested. Too many entrepreneurs have the attitude that any investor will do – take the opposite approach of narrowing it down and looking for the right investor for you, and by virtue of going through that analysis, you might find that fund-raising is actually easier than you expected (not easy, but easier than you feared).