A common misconception about venture capital

Third Panel, Exeter 2011 Day 3The Friday before last I was on an investor panel at the Like Minds conference down in Exeter.  As I’ve mentioned before I do these panels in the hope of making the process of raising money more widely understood and therefore easily accessible, thereby encouraging more entrepreneurs to start companies.  You can find a liveblog of the panel here, and the picture on the left shows me on stage at the event with Sam Sethi of Skadoo.sh.

After the panel session one of my co-panelists, Chinwag’s Sam Michel, repeated something I had said back to me, and that something has been running round my head ever since.  Last week was supposed to be a holiday, although I ended up going to the US for two days, and for us holiday time is family time, and I try to keep the work to a minimum, which means no blogging.  Hence this is my first chance to share the thought.

Hopefully by now you are almost overcome with a desperate eagerness to know what it was that Sam chose to repeat back to me.  The sharp eyed amongst you will have deduced from the title to this blog post that it relates to a common misconception about venture capital.  In fact, ‘misunderstanding’ might have been a better word, and I toyed with the idea of using ‘Why venture capitalists are misunderstood’ as a headline….. (that’s a joke 🙂 ).  The words were (more or less):

Venture capital is for accelerating the development of existing companies rather than funding them at the true startup stage

Sam’s point was that too many people in the UK and Europe think that VCs should fund, or do fund, the true startup stage.  The unfortunate consequence of this misconception is that time is wasted trying to get meetings and investment from VCs, and all to often this turns to dislike of, or even contempt for, the VC industry.  A common perception is that the VC industry is flawed because it doesn’t take enough risk.

That’s unfortunate.

I work as a VC because I believe that for the right companies a timely investment of say £5-20m can accelerate growth and make the difference between being a highly valuable market leader and a much less valuable smaller player.  The caveat ‘for the right companies’ is crucially important though – only a very small subset of companies are in the right place at the right time with the right product and the right team to have a shot at owning a market.  For the rest it is a mistake to raise venture.

Also unfortunate is that VCs are responsible for this misconception.  Not in any deliberate way, but rather because as an industry we haven’t traditionally felt the need to be clear about what we do and don’t do.  One of the challenges is that presenting a clear picture requires getting across a complex message – some VCs do fund the true startup stage, or at least they do so occasionally, whilst most others, including my fund DFJ Esprit, do a small number of seed deals each year.  These are not true startup companies, they usually have at least an early product we can look at, but they are not that far along either.

The fact that sections of the entrepreneurial community believe the VC industry is doing a bad job isn’t good news for anybody.  It can only lead to fewer people starting companies and fewer companies capitalising themselves properly.  It probably also has negative consequences for government policy.

Hopefully this post has made things a little clearer.

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  • VCs exist to make money for their investors. As it happens they decided to use said money to build great companies instead of, let’s say, buying an undervalued company with debt and then stripping its assets or investing in larger public companies.

    They generate superior returns because a) the tech market has higher opportunities for disruption and b) they are former successful execs/entrepreneurs so have big rolodexes and lots of operational experience.

    Wether they should invest in powerpoint or growth it’s a moot point. Different VCs (and LPs too!) have different comfort zones. If their background was banking just do not expect them to understand early stage.

    At the end of the day the world is shrinking so if you complain about UK VCs… well, maybe you have chosen the wrong career path. Just saying.This comment is not directed at Nic, obviously 😉

  • Timely post Nic, especially considering the TechHub event tomorrow.

    Although you’ve clearly stated DFJ’s investment focus and strategy here, has DFJ also considered the evolving trend to get involved at an earlier stage, as recently adopted by the likes of Roger McNamee’s Elevation Partners, Founder’s Fund, Ron Conway’s SV Angel and numerous other of your Silicon Valley contemporaries in order to gain access to promising opportunities earlier in the food chain? 

    They talk about the growing necessity of starting the relationship earlier to ensure they still have a seat at the table if, and when, the successful outliers gain significant traction, and due to the venture capital industry becoming more and more competitive.

    Or, are fund strategies typically set in stone when most VC’s raise their initial capital?

  • Fund strategies evolve, and all good VCs make sure they have license to be opportunistic (which is a partial explanation for the misconception).
    Regarding the move to earlier stage. I think trad VCs (including us) need to evolve their models as capital requirements for startups evolve. For most VCs though, making a wholesale move to a Ron Conway or Dave McClure approach of making large volumes of seed investments won’t work. The investment disciplines and portfolio management techniques are too different.
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  • I agree entirely. That’s the heart of my “pitch a company, not a product” mantra. Entrepreneurs coming out of creative industries, particularly, have got used to the idea that they have persuade someone (the client, the boss, the publisher) to back their project.

    Usually, the business model is defined within that industry, and the key is in reducing the risk inherent in your project. Too many people don’t realise that startups are often about *finding the business model* and obsess about the idea. So they get turned down a lot.

    And then they hate VCs

  • That’s a very helpful blog – thanks Nic.

    As an entrepreneur, I’ve deduced over the past 12 years that this is how most VCs functions – but I suspect that most first time entrepreneurs are not aware it.

    I think there are four things worth adding, if I may

    1. Very early stage is about working part-time (alongside a job or freelance income) whilst the business is formed (I just reviewed Luke Johnson’s startup book – and he says the same)

    2. Business Accelerators are doing an important job in accelerating ‘part-time’ business development and in a way, are the true heart of early stage / very early stage startups – hence very early stage entrepreneurs should focus on joining these programmes rather than raising money

    3. VCs need to be involved in the accelerators or conferences, because, mistakes in how the very early stage business is set up / how it is focused etc… could preclude it from the £5m+ scaling investment that VCs can make in 18 months time

    4. VCs want to invest in teams – not products – as the other commentators have mentions. Therefore, the VCs role in very early stage is to discover (over time) what early stage teams can deliver. We all need to work harder to get this message across.

    So, the early stage / business accelerator environment needs the involvement of VCs – for advice and steerage, but not its money. The money bit comes later…

    Br
    Neil

  • Thanks Neil. You are dead right – VCs should spend time with accelerators – both to help guide the companies and to get to know the teams. As Mark Suster has said we like to invest in lines not dots.
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