The pressures to put money to work are increasing. Entrepreneurs who hit Sand Hill Road looking to raise one or two million dollars, end up walking away wondering if they should raise more. We've experienced this phenomenon first hand. We've helped raise hundreds of millions of dollars for our portfolio companies. We typically have more difficulty finding co-investors who are willing to invest less than two million dollars than finding much larger co-investors.
Compounding the problem, there is an increasing sense of urgency to hit bigger and bigger home-runs. Venture capital is a hits-driven business. Take away a few homeruns and returns look mediocre at best.
Smaller hits no longer move the needle. Investors chase hot deals while small or "low-beta" opportunities are overlooked. Billions are invested in companies targeting big, fast-growing markets, and great people are recruited into those companies hoping to create "the next big thing." Companies get over-funded, and feeling pressures to grow quickly, they ramp-up to high burn-rates and experience high rates of failures, which are acceptable as long as enough winners materialize. The sobering reality is that most venture-backed companies are sold for less than $50 million, if they don't go out of business. The typical deal will lose money.
Some people might read this and say that there is nothing wrong. Failures come with the territory and VCs are supposed to take risks. Paradoxically, despite high failure rates, entrepreneurs think that VCs don't take enough risks. They get turned away because their teams are not “proven,” or there is not enough market traction, compelling technology, or big enough upside potential. In the quest for big hits, a lot of stars have to be lined up.
Bill Reichert, in his "Small is Beautiful article," offers a good explanation for why investment criteria are narrowing. Clayton Christensen offers another theory. In an article entitled "Changing Values: The Disruption of Venture Capital," he observed that "entrepreneurs with disruptive innovations are finding it harder and harder to capture the interest of VCs...while there is too much capital pursuing sustaining innovations."
Whatever the reason, in the game of venture lotto, "too much money chasing too few deals" is an oft-cited phrase among VCs who find themselves in competition for deals. The most sought after deals are led by proven managers. Especially popular are entrepreneurs who have made money before - they get investors lining up like sheep.
Ironically, the people who end up creating the blockbusters are usually unproven managers. They emerge from the fringes, and start small, in niche or overlooked markets. They take time to learn and iterate and burn very little capital before turning profitable. They follow a slower, but lower-risk path. In our own portfolio, the companies which raised less funding not only performed far, far better but had much lower failure rates.
Microsoft took 11 years to go public. They were also profitable by the time they took venture funding, as was the case at Oracle, Cisco, Intuit, eBay and many others. Companies such as Adobe, Autodesk, Broadcom, Dell, EMC, HP, IBM, Motorola, Paychex, RIM, Qualcomm, SAP, and SAS never raised traditional venture funding. A common trait across all of these companies is that the founders retained large equity stakes (and helped build their companies for many years, even decades). Combined, these companies have a market cap of $1.2 trillion dollars (this list is not comprehensive). SAS, still a private company, has been ranked by Fortune Magazine as one of the best companies to work for in America every year, with six top-10 ratings.
Entrepreneurs can't count on a portfolio. The best ones we know are much more risk-averse than conventional wisdom might suggest. They don't take foolish chances. They spend money as if it were their own. They observe, listen and adapt; but fundamentally, they strive to control their own destinies, which is best done by generating profits. They do need a little capital, but they want help and advice even more. Being an entrepreneur is, at times, a very lonely endeavor.
Getting back to a point made in our last article, even the best people will struggle in a bad system. We have to stop playing lotto with our money and with people's lives. What would happen if we cut fund sizes to dedicate more time and energy to small investments? By not obsessing over "moving the needle," could we increase hit rates and, paradoxically, hit even bigger home-runs? Companies built on solid fundamentals need less capital and more time. The management fees wouldn't be as good, but wouldn't we be better off in the long run? To pull it off, VCs would need to reduce personal burn-rates (due to lower management fees), work harder to support entrepreneurs, and develop more patience.
There is too much money in the hands of deal pickers (and deal flippers). Driven by ambition, ego, or envy, we are marching down a dangerous path. Every VC should consider which is more important - building companies or picking deals? If the answer is not obvious, we'd recommend the hedge fund business which is much more lucrative (and scalable) for traders and deal pickers. Entrepreneurs need help and advice as much as capital from their investors. Money can be made in many ways but venture capitalists have a special role in the investment world - to help entrepreneurs build companies.
The lines have started to blur between the hedge fund, private equity, and venture capital industries. Maybe that is part of the problem. But, as investors, we have no-one else to blame but ourselves for reaching out too far and too fast. Warren Buffet once wrote:
The most important thing in terms of your circle of competence is not how large the area of it is, but how well you've defined the perimeter. If you know where the edges are, you're way better off than somebody that's got one that's five times as large but very fuzzy about the edges.
We'll end with a question - if you don't know where the boundaries lie, is there really a competence?