Thursday, May 17, 2012

Have VCs Gone Too Timid?


Several articles have lately been speaking of decline in the VC culture and performance.  These arguments posit that the VCs are (a) not backing truly disruptive innovation, (b) sprinkling capital across too many young companies that are founded on racy hope, not viable business models, and (c) investing in a vast number of me-too ideas that smack of Wall Street’s momentum-driven culture.  You know, grab a fast mover and sell off to the next fool before it starts to crash.

These discussions are fueled by multiple trends.  One is the hyped up valuations of social networking companies, both in public and private markets, that defy measurable metrics and financial logic.  Though a handful of companies have generated remarkable returns for a handful of VCs, most observers see signs of a boom-to-bust cycle rather than a sustainable return to healthy investments and returns. 

The other is lackluster financial performance of the venture firms in the last decade.   A recent report by the Kauffman Foundation, the entity that founded the Kauffman Fellowship program to train the next generation of VCs, highlights the sub-par distributions from their investments in venture firms. 


Some people believe that a basic problem is the excessive capital chasing marginally good ideas.  Because the cost of starting a new software company has declined to a tenth during the last decade, almost any smart team with a good idea gets funded.  While the number of venture funds continues to shrink, new angel investors are sprouting every day.  And now you also have the crowd sourcing phenomenon.  Consequently, a surfeit of startups with marginal profitless solutions are jostling for the attention of half a dozen potential acquirers.  Quite naturally, a vast majority of them will meet a disappointing end.  In this view, VCs are a victim of circumstance, not the perpetrators.  The forces that are disrupting the venture model and accentuating the problems stated here have been well summarized here.
Source: www.ideachampions.com

But it’s not the complete story, for it does appear that the investors are giving scant attention to ‘innovative’ companies that are bringing forward ‘real’ solutions and business models.  While the zany iPhone app startups are enjoying ever-higher valuations, the company which is trying to solve a real problem – cleaning water, saving energy, or manufacturing the next generation nanomaterial or robot – can barely entice a VC to take his phone call. 

Those who hope that the force of entrepreneurship will power our job growth are usually disappointed at the current crop of venture funded companies.  Yes, some tony startups with zany iPhone apps may be acquired for a few hundred millions by Facebook, but it is highly unlikely that they will create new jobs, improve the economy, or fix any one of the myriad problems affecting the planet and its denizens.  Will this kind of entrepreneurship lead our way to a brighter future?

Unlikely.  But this is not abnormal - it's just that we are in the lull before we are hit with 'the next big thing'. 

Once every decade or so, we go through a step change in innovation when a remarkably disruptive platform is created.  Witness the ‘major’ shifts brought about by innovations in semiconductor, integrated circuits, communications, wireless industry, personal computing, genomics, the Internet, and social networks in the previous decades.  Even earlier, we saw global shifts in our energy, transportation, telephone, aviation, and industrial infrastructure.  During the period between these major shifts, we go through a vast array of incremental innovations that seek to exploit and expand the new major platform.  These periods are characterized by intense competition, amplified expectations and disillusionments, and industry rationalization and consolidation.  Currently, the new iPhone apps and the cloud applications are valid examples of platform extensions.  This is perfectly rational.

What would be irrational, however, if these incremental innovations somehow crowded out the next revolution in technology.  But they never do, for the truly disruptive innovations tend to come from the left field.  The last two major phenomena in technology - the iPod/iPhone/iPad and the Facebook - had little to do with mainstream VCs.  Apple turned around under guidance of a CEO who had been previously fired for incompetence, and Facebook took off because users loved it; VCs just followed the trend.

There is no reason to believe that all entrepreneurs and investors have ceased to be innovative.  After all, we have in the past lived through chaotic transitions that comprised of hundreds of struggling automobile, aviation, hard drive, semiconductor or Internet companies.  But that didn't stop the innovation juggernaut.

Yes, disruptive innovation is hard, unexpected, and invisible.  But who ever claimed that spotting breakthroughs was easy?  They are even harder to spot if you just see where everybody else is looking.

Innovative ideas, entrepreneurs and investors are here.  It has been nearly a decade since we saw the last radical shift, and the time for the next one will arrive soon.  But if you really want to spot them, you have to take your eyes off the highway traffic and watch the side alleys and walkways – that's where they are.

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