Venture CapitalWeb2.0

VC model changing but not broken

By October 18, 2006 January 5th, 2007 6 Comments

I was at another Beers and Innovation evening last night. Good evening I thought, great people and quality panel. Good to hear Umair of bubblegen fame and Paul Pod founder of TIOTI.  Well done Deidre and the folks at NMK.I’m writing this because of a conversation I had with Paul afterwards about whether the VC model is breaking. He was citing Umair on Bubblegen and his own experiences earlier this year when the VC community wasn’t interested in investing 50-100k in TIOTI because the amount was too small rather than anything to do with the proposition.There are a couple of different arguments being made here:

  • Companies need less capital to get going these days (open source software, cheap hardware and hosting, viral marketing etc.) so deal sizes are too small for a lot of VCs
  • A good exit for a web2.0 company might be smaller than VCs have achieved from more traditional investments – e.g. enterprise software
  • VCs don’t get it – the new world is too different

There is merit in each of these, but I don’t think they combine to break the VC model.  It just needs to change, that’s all.

Good companies get going with less money these days, no doubt about it.  So they “need” less venture capital.  I think that has two consequences for us in the VC industry.  Firstly we need to get happy with cash out being a larger component of deals.  When I started in venture in 1999 there were many VC firms who were philosophically opposed to this idea, but I think pretty much everyone these days is changing their mind, some more publicly than others.  Giving a couple of million pounds to an entrepreneur does increase the chances that he won’t be quite as hungry building the business after you invested as he was before it, but that is just an extra risk we have to manage.  The positive spin is that taking some cash out spreads the entrepreneurs risk a little and make her a little less risk averse and willing to aim high with you to build a $1bn company.  So even though companies need less money that doesn’t mean their shareholders can’t find a use for it.

The second consequence of the lower capital intensity of many web2.0 companies is that VC funds will get smaller.  That is a trend in evidence already in the States and to a lesser extent here in Europe.  That way we can invest less money per deal and not end up with an un-manageable number of portfolio companies.

The argument that exits will be smaller than they used to be is something I’m less convinced by.  A few of the classic web2.0 plays have sold out for sub $50m, that is true (Flikr and are the best known), but we are also seeing the bigger exits  with MySpace, YouTube and potentially Facebook.  The other thing is that we are really early in the game here.  Big companies generating big cash have yet to be created, the number of big exits will increase once that has happened.  The success that MySpace is having now in monetising it’s user base is helping.  The IPOs will start to come at this point as well.  To my mind it is good news that the public markets are not getting over-speculative at this point, they are not as good at handling underperformance as VCs or large companies and the last thing we need is another crash.

The final point is from Umair – that VCs don’t get it – and the key thing here is putting a price on social capital.  I am the first guy to admit that is a tough thing to do.  If you have read this blog since the beginning you will have witnessed me struggling with this question.  As I have said before I have come to believe that – you gotta go with traffic.  To my mind that is the evidence that social capital is there and once you have social capital you can figure out a way to drive cash value from it.  There is obviously a lot more to it than this, but the headline message is straightforward.

The challenge for VCs is the pace at which everything is changing.  You can’t wait for the business model to be clear before investing or you will miss the value creation point.  I have started to liken this to aspects of agile development processes in IT.  You start out knowing the direction you are going in and where you want to get to, and you have an idea of how you are going to get there.  But there is a lot of uncertainty and it is expected that the path will change as you learn more on your journey (check out JP’s post The desitination not the route: A sideways look at “agile” for a good explanation of this).  That lack of certainty (and therefore control) is tough for people to get their minds around but it is the new way.  In just about every setting you can’t get the benefits of social software without ceding control and trusting people to go innovate – this is a struggle for management in many industries and as VCs we are fighting with it now.  Investment parameters are changing as a result, but I don’t think it means the model is broken.

As I’ve said in other posts my strong belief is that there is a lot of scope for new companies to become big and successful in the internet space.  Some of those will take venture capital, I’m pretty sure of that.  I’d love to hear if I’m wrong though, this is my career we are talking about here.