EntrepreneursStartup general interestVenture Capital

Some challenges facing the venture industry

By January 16, 2009 9 Comments

Anyone who has read my recent posts on the future of venture capital will know I am optimistic about where we are headed.  This post is about some of the challenges that we will face along the way.  And they are not trivial.

Over the last couple of days Umair Haque has set out a lot of the problems facing the venture industry in two posts – Five Problems Venture Capitalists Should Have Solved (But Didn’t) and Asleep at the Wheel of Creative Destruction.  His central point is that as VCs we have collectively failed to generate the innovation that might have helped avoid some of the current problems the world is now trying to find solutions for.

The reasons for that, according to Umair is that VCs have been:

  • too risk averse
  • focused on maximising near term returns
  • confusing immitation with innovation

There is a lot of truth in this.  As is often the case Umair describes the situation as more extreme than I would.  In my view the world is not in as bad a place as he would have it and there is more good in the venture industry than he gives it credit for.  But he is directionally correct.

Which means things need to change.

I think that change will come because:

  • Since the late 1990s the venture industry has been mesmerised by the
    prospect of massive short term returns – initially via the public
    markets and latterly via trade sale of fast growing web assets to
    highly rated public companies.  These short term exit opportunities simply won’t be there, forcing startups and investors to focus on longer term growth.
  • This in turn will shift much of the focus back to fundamentals and away from trying to anticipate where the exit hype will be in 2-3 years time.
  • Significant capacity will come out of the US market, reducing the money for immitators (which largely came from tier two funds anyway).

On their own these are pretty significant changes for the venture industry, but to complicate matters further the areas that are ripe for innovation may stretch the existing venture model both in terms of investment mindset and holding periods.

In his Five Areas post Umair repeatedly seeks new ways of conceiving value – and this creates challenges for investment committees looking to deliver what they have promised to their limited partners – i.e. near certainty of returning 10-30%+ net IRRs.

Two examples:

  • Umair states, and I agree that communications needs reinventing, and that advertising in its current form is not the answer.  The challenge comes when you combine that with the trend towards ‘free’.  Then it can be difficult to see how to exit a business at the sort of levels we need to target in the 3-5 years we have at our disposal.
  • Similarly reconceiving capital markets is tough because they are an integral part of the venture capital model.  The exit is crucial to everything we do and finding a new way to do that could be compared with trying to change the wheels on your car whilst you are driving.

None of this is to say, of course, that these challenges are insurmountable, just that they will be tough.

I think Umair is correct in saying transparency will help which is in part why I am writing this post.  In the final analysis the venture capital industry is a channel for money from limited partners into startups and we have to live within the constraints of that model.  It is easy to say that VCs should be more risk averse and invest over the longer term, and I think we should, but to do so we first need to convince our limited partners (who are our customers) that they should change the terms on which they make funds available to us.

Apologies for a slightly rambling post, but I think the final point I am heading to is that it seems to me VCs on their own aren’t going to be able to change enough to unleash the innovation that Umair describes.  It will also take help from entrepreneurs to find ways to bring their startups close to the 3-5 year exit model and from LPs to stretch out fund terms.