Is VC too Fat and Happy?

Much criticism has come of our industry in the past few months and
in my opinion much of it is deserved (but I’m definitely a believer in
the meme that VC isn’t broken but some of the participants are (see here, here and here)). But the VC industry is too fat – a thoughtful piece by Paul Kedrosky on shrinking the industry by half is here.

The latest to weigh in was the NY Times with this well written piece
in yesterday’s paper.  I think it propely captures the moment and
questions whether the structure of the industry for the past 10 years
is the the right one for the next 10.  In my opinion it also makes Tim
Draper truly seem out of touch … we need more VC money to “spread the
wealth to the seven billion creative minds out there.” Really? WTF?
 I’m prefer to assume he was quoted out of context since I’m told Tim
isn’t a bad guy.  (UPDATE: Great response from Bill Bryant of DFJ is here.  As I said, I had hoped it was out of context).

My own views echo those in the NY Times article and come from my
experience of raising VC as a entrepreneur over 2 companies and 8 years
and working with 9 firms that invested and many VC’s that issued term
sheets that we never closed on.  Here are my conclusions:

1. There is way too much money in VC – Lowering the
amount of money will be healthy for VC’s and  start-up companies.  When
I was a start-up CEO I always believed in charging a fair price for the
products that I created.  But in 1999-2001 so much money went into our
competitors that people were willing to low-ball on price to win deals
because they (we all) had too much VC money that would fund our
losses.  In today’s world this is worse – people are willing to offer
products for free funded by 2 years worth of VC money (and I’m not even
talking about ad supported businesses).

2. Fund sizes have been way too large – I remember
pitching on Sand Hill Road in 2005 for my second company, Koral, and I
told VC’s that I only wanted $2 million.  A number of investors told me
that their minimum was $5-8 million and they encouraged me to take more
money, “because I’d need it.”  Luckily I was on company number two and
I had already painfully learned the lesson of raising too much capital
so I didn’t follow this advice. At the time I couldn’t understand this
mentality until it was explained to me this way, “look, I have a $600
million fund.  I can’t invest $2 million in companies and stay actively
involved.”

Actually, I get this.  But then I think this fund ought to be a
later stage growth equity firm and not a VC or they ought to have more
partners in the firm investing smaller amounts. I believe passionately
in capital efficient businesses that prove out their model before
trying to scale.  This suits the interest of the VC but I believe it
suits the interest of the start-up founders even more so.  Some VC
firms like Accel, Index and others have created separate “growth” funds
with larger dollar sizes for later stage deals – that makes sense to me.

The incentives for many VC’s has been wrong.  They’ve been too happy
to have multiple “stacked” funds of large sizes so that their
management fees (which are typically 2% of the fund size) can be
large.  I don’t believe that VC’s who maximize their fees by having
large funds are in the interests of their Limited Partners and I
actually believe it encourages the wrong people to want to work in VC.
(as I side note I wonder how LP’s can justify this size of management
fees for the “mega” funds that have billions of dollars.  Do they think
it creates aligned interests to make partners so wealthy on just
deploying capital?)

Dana Settle said
it well in the NY Times piece.  Start-ups need less money to get going
these days and you can get a good return at a $100 million exit
provided you didn’t put in too much money and you can get in at an
early stage.  Venture exits last quarter on average were just $22
million last quarter (vs. $41 million a year before $60 million over
the last 8 years).  I know we’re all looking for the home run that
“returns the fund” but to be successful I believe the industry needs
more Greycrofts.

3. There are way too many non-operators – I won’t
go as far as to say that every VC needs to have been an operator
because I’ve worked with tons who I really respect who don’t come from
an operator background.  I certainly believe operating experience helps
a lot, though, and believe that every firm needs to have a few
entrepreneur partners in their stable.  I experienced way too many ex
i-banker and consultants who never had any operating experience and had
a better grasp on whether my operating margin in year 5 was appropriate
vs. an intuitive feel on whether my product would be adopted by
customers.

No doubt they can do the deep analysis and really help at financing
time to analyze the pro’s / con’s of venture debt.  And I’m sure they
really earn their money at exit time in the sale.  But some of them
lack the depth of understanding in the key decisions that each
entrepreneur faces.  They have no idea what it feels like to be 3 weeks
away from missing payroll with an employee asking you whether it is a
good idea to buy a house (should you actually tell them there is a 10%
chance you’ll be out of work in 3 weeks?) or customers are entrusting
you with orders that you’re not 100% sure you’ll be able to fulfill.
 What advice can they give you about dealing with customers in this
scenario?  If VC’s truly understood the angst and emotional drain this
puts their founders under they wouldn’t bleed you until the 11th hour
waiting for your internal financing term sheet so that they get more
information or negotiate a better deal with you.  A great VC wouldn’t
do this.

I recently debated with some founders the best way to go about
laying off one of their employees.  They were telling him they were
letting him go for cost control reasons when it was really for
performance reasons.  I’ll cover the topic some other day but I
believed the right thing to do was to fire him for performance and tell
him this.  I gave them 30 minutes of rationale from my experience on
why I thought that would help and not hurt with morale.  (btw, they
didn’t take my advice 😉 I have been through more downsizing (can you
say 2001?) then I care to think about and have had many years of firing
based on performance.  It’s never
fun.  Many VC’s have never had to deal with this “dirty” work and never
will.  Sure, they’ve let an analyst or associate go but in the VC world
this is very different than cutting a developer on a tight team of 6
developers when each of the remaining 5 could go out and get another
great start-up job without a sweat.  Not true in VC.

I like to say that you can’t run a burger chain unless you’ve
flipped burgers.  I think we could use more burger-flipping VCs.  I
think that’s why so many people are excited to hear about the Andreessen Horowitz fund.

4. In a strong wind even turkeys can fly – I
believe that there are way too many VC’s that believe their own hype
from the successes that they had in the late 90’s (or frankly from
05-08).  It reminds me of the real estate investors who were telling me
what a fool I was not to be buying condos in Florida in 2006.  The
difference in VC is that many of the senior people in industry who had
past successes don’t have real down side when markets become more difficult.
 They are simply able to stay in their funds and milk it.  Obviously
the industry luminaries like Sequoia, Kleiner Perkins and Accel have
continued to prove they can pick the best winners but there are also
many who had hits by sheerly being in the market.

Years ago a sage mentor of mine told me in 1997, “don’t assess our
company relative to competition now.  In a strong wind even turkeys can
fly.  In a down market the best companies separate themselves from the
pack.  The weak disappear.”  So it goes with VC.  Eventually those with
no leadership will dwindle and help realize Paul Kedrosky’s prediction.

5. Some VC’s lack empathy. Some VC’s simply can’t
understand the world of the start-up founders or they’re too far
removed from the daily grind to really empathize.  Being a CEO is much
lonelier than anyone who’s never done it can imagine.  I know that
there are the breakout successes like Google, Twitter and YouTube. 
But  the rest of companies go through through cycles.  Even the best
companies go through it.  I’m sure that LinkedIn, Facebook, Mint and
others have been through tough times.

You don’t have many people to share your problems with because you
try to keep it together for all your staff.  You need to come in every
day to the office and motivate people even when you have your own self
doubt and worries.  You need to hire, sell, talk positively to the
press, etc. while blindly having faith that your next round of capital
is going to come.  You have co-founder issues.   Your clients grind
you.  Your employees need more money to get by.  Your product is
shipping late and with some of your key features postponed.  Your crack
developer quit to move to NY.  Your spouse or girl/boyfriend is
irritated because s/he hasn’t seen you enough.  Or worse you don’t have
one and you’re getting too fat.  This is an unbelievably honest piece
from an entrepreneur coving this topic.  Have you been there?  That’s
when I think you can offer real advice.  That’s where a VC needs
empathy.

6. Are some VC’s too old?.  The NY Times article
alludes to this.  As for me, I’m not ageist.  I see fantastic VCs in
their 50’s/60’s that blog, use Facebook, use Twitter, IM people and use
Salesforce.com, Google Docs, RSS Readers, etc. (no, using a Kindle and
a Blackberry doesn’t count).  The NY Times piece profiles one of our
industry veterans, Alan Patricoff.  He still works incredibly hard.  I
don’t know how old Howard Morgan at First Round Capital is but I know
he’s not 35.  He travels more than most 35 year olds I know and knows
more about what’s going on in early-stage tech than many of these same
people.

I think it’s more about mentality and willingness to accept the
creative destruction of the new without being jaded by your past.  I
remember a conversation I had with a prominent older VC from Sand Hill
Road 6 months ago who decided to call it quits.  I asked him why and he
said, “I just realized that it’s all changing so fast and I don’t have
it in my to want to learn all the new technologies that everybody in
their 20’s are playing with.”

Blogs are reshaping the publising indutry.  Companies like TopSpin
Media are finding new distribution channels for musicians.  Twitter is
chaning our communication landscape.  Cloud computing is coming and
will change the IT industry.  Young people do place real value on
virtual goods and define their self worth through online brands the way
we do in our offline lives.  People will spend hours translating
movies, adding restaurant reviews and updating Wikipedia for nothing
more than to be part of a community and be “Internet famous” to that
community. Virtual reality and augmented reality are real phenomena and
not this year’s fad.

As one senior VC partner lamented to me “kids these days don’t read
physical newspapers any more” and I showed him how much news I could
consume from so many more sources than he could through RSS feeds and
after showing him he still didn’t get it.  Some people never will.

My advice to entrepreneurs – find a VC you feel can really relate to
you and your company on a personal level.  Find people that are in it
for the passion of building great products and love the rush of the
start-up.  Find “egg breakers” willing to take risks.  And be careful
of VC’s that have a gleam of easy money in their eyes.

Update: several people asked me for VC’s that do “get it.”  There
are many and I don’t want my post to be seen as damning of the whole
industry – just several players in it (not to mention that many hedge
funds did venture investing in the past 3 years who had no previous VC
experience).  Here just a quick, non comprehensive list of some obvious
VC’s who do get it:  I think there’s a host of VCs who do get it.   True Ventures, Foundry Group, Union Square Ventures, First Round Capital, Founders Fund, and I obviously I feel GRP Partners
in LA (who funded 2 of my companies and I worked with for 7 years
before I chose to join).  There are obviously many, many more.

(Cross-posted @ Both Sides of the Table)