VentureBeat’s Entrepreneur Corner has a must read post today on the recent history of the Venture Capital business model. Every entrepreneur should read this, particularly those looking to raise venture capital and in the enviable position of being able to select the right investor for their company.
The author, Steve Blank, walks the reader through four distinct exit market cycles and discusses venture capital behaviour and philosophy in the context of those market cycles. The title of the article is a bit misleading as it posits whether or not you can trust VCs under 40. I’ll return to that later; suffice to say for now that it is one of those titles intended to stir controversy, but not fundamentally of value.
The first cycle Blank covers is the 80s and 90s, where exit markets, particularly the public equity market required five quarters of profitability. As Blank states, the implications for venture investors during that period of time were clear:
What this meant for entrepreneurs and VCs was simple and profound – and is entirely underappreciated today: VCs worked with entrepreneurs to build profitable and scalable businesses. In this time, a successful business was one that had paying customers quarter after quarter, not one that was flipped or hyped to the market despite a lack of earnings or revenue.
Venture Capitalists on the board brought a firm their expertise to build long-term sustainable companies. They taught companies about customers, markets and profits.
Blank then goes into detail on two subsequent phases. The “IPO Bubble” (August 1995-March 2000) and the “Rise of Mergers and Acquisitions” (March 2003 – 2008). In each phase he articulates the warping effect of these markets on VC behaviour. In both phases, he makes the basic point that VCs were building companies to be sold prematurely to a greater fool; either into an overvalued IPO market or to a frothy strategic acquirer. The notion that stable revenues and profits were a key part of the formula for a successful exit was still missing. One might refer to this as “momentum” investing.
Back to the Future
And finally, Blank makes the case that 2009 will be a back to the future period where VCs will have to return to the fundamentals of building real value in their portfolio companies in order to generate meaningful returns for their investors. I think Blank is dead on here.
But I’m here to say that some of us never left the approach of working with entrepreneurs to create fundamentally valuable operating companies. My Partners and I at Meritage believe that venture capitalists have to work with entrepreneurs to create fundamental value. This core belief is the very reason for our unusual – and I believe innovative – organizational design. Four of my Partners are in a special category we call Operating Partners. Each is a successful, serial entrepreneur. Each has started companies, raised venture capital, dealt with venture capital boards of directors, and despite those boards, had successful exits. They are full-time, long-term employees of our firm and members of the General Partner. The shortest tenured has been here for five years; they are not like EIRs or Venture Partners. We won’t make an investment unless one of them represents us on the Board of Directors of that company and when they do, they invest their personal capital in the Company along side the fund. They stay with that Company for the life of the investment; cradle to grave. Each is limited to no more than four boards at a time so that have the time and focus to truly assist the entrepreneur. Our whole system is about creating value over a five to eight year investment horizon, not about momentum investing. Momentum comes and goes, trends ebb and flow, markets change. But fundamental value endures.
Does this mean that the traditional VC skill-set is no longer required? Not in my opinion; it takes a myriad of skills, and resources to help a company. The classic VC skillset is alive and well. But not all VCs are created equal. And here is where I’ll diverge from Blank. I don’t think the value of a VC has anything to do with the age of the venture capitalist you select. When I look at an entrepreneur, I don’t evaluate them by age, I evaluate them by experience, wisdom and judgement. I know many 55-year-old entrepreneurs who don’t have these characteristics and a lot of 30 something entrepreneurs that do. I’ll back the wise 30-year-old entrepreneur 7 days a week and twice on Sunday. Likewise, the value of a VC has everything to do with philosophy, wisdom and judgement; and alignment with the nature of your investment opportunity.
Evaluating a VC
What I encourage entrepreneurs to do is to evaluate the VCs philosophy. Are they a momentum investor or are they a fundamental investor trying to build a real operating company? Are they interested more in the theme of your investment than in the fundamental value-creating engine of your company? Do they get caught up momentum buzzwords like web 2.0, eyeballs, mobile, etc., or are they more interested in the needs of your target customers, the vertical market you are attacking and the sustainability of your competitive advantage. Answers to these questions will shed insight on how the VC attempts to create value for their investors.
Momentum investing is inherently neither bad nor good; the same for fundamental investing. But these approaches do work differently in different exit markets. In my personal opinion, we’re in a market cycle that will disproportionately reward fundamental investors and not momentum investors. In fact, fundamental investing works great in any market. Momentum investing often outperforms in strong markets and underperforms in weak ones.
In the long-term, I believe that the fundamental approach is a better fit with entrepreneurs trying to build fundamental operating company value. It is not right for everyone; is it right for you?
(Cross-posted @ Non-Linear VC)