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Innovation past and future: the Hidden Cost of Venture Capital

Monday Witness

This is the latest in a series of occasional essays that I call The Monday WitnessThis series focuses on social rather than technical issues, for the reasons explained in the first entry in the series.  As always, the opinions expressed here are mine alone.

If you hail from one of the hot beds of high tech - Silicon Valley, say, or (in my case) the Route 128/495 area of Massachusetts, you've doubtless heard the phrase "serial entrepreneur."  What those words describe is someone who has started several companies, and the phrase, when used, is invariably regarded as a compliment.  These days, if such a serial entrepreneur has some major successes under her belt, that makes her one of the elite of the high tech nobility - someone with the golden touch, that can turn ideas into huge returns for founders and investors alike.

But should this really be a compliment?

That may sound like a silly question, until you remember that in order to start a new company, you need to get rid of the old one - or at least leave it in someone else's care.  That isn't how the great companies of the past came to be what they are today, and it makes me wonder where we can look to find the great companies of tomorrow.

A lot has changed over the thirty years that I've been representing emerging companies.  Way back when, venture capital funds were small - $20 to $50 million, and they typically had ten year terms, with options to extend for another three, so that any non-public portfolio stock could be liquidated through an "at-last!" IPO or company sale.  If a fund got lucky and sold a portfolio company early, it plowed the money back into new investments.  In short, VC money was a lot more patient back then.  Entrepreneurs were different, too.  Almost to a man or woman, they wanted to build a company and run it for the rest of their careers. 

All that changed as venture capital got to be more popular with investors.  In the 1990s, successful VCs started changing the deal they made with their limited partners.  In the old days, a VC didn't make a dollar over their modest management fees (1 - 2% per year of the investors' funds) until the fund liquidated.  Then the investors got 100% of their money out first.  Only then did the profit get split up - typically 80% to the investors, and 20% to the VC fund managers.

But then the VCs began to get inpatient.  Why not distribute profits from early cashouts immediately?  And why not claim their 20% share out of those first dollars as well?  Yes, there was a "clawback" provision in the agreements they made with their investors, which obligated the VCs to repay the 20% if the fund didn't end up in the money, but nobody stopped to consider exactly where that money would come from if the balloon ever went up.

The best VCs were showing great returns, too, and pension funds were growing to enormous proportions.  That meant that there weren't enough VC funds with great track records available to accept all of the money that pension fund managers and others wanted them to take.  So if they wanted in, they had to accept the new terms. And, after all, early cashouts made the pension fund managers look good, too.   Suddenly, if a VC fund could raise $600 million - hell, a billion dollars (or more), it did.  And if you haven't guessed already, the management fees stayed at 1 - 2% - that's $10 - 20 million a year on a billion dollar fund to cover salaries and expenses.  You could live very well indeed, thank you very much, on management fees of that magnitude, year after year for entire life of the fund - whether or not you made money for your investors this time around.

For that kind of money, you'd assume that funds would hire up all of the best talent and make many more investments.  But that's not what happened.  Instead, those that raised these enormous funds still intended to make only 25 or so investments.  Of course, there was no way you could possibly invest $40 million per company intelligently - or $150 million, since single-investor companies were rare.  And everyone had to compete for the very best deals, since an IPO would have to pop with a billion dollar market cap in order for the VC investors to meet their numbers after prompting such an outrageous amount in to begin with.  At the height of the nonsense, some Internet startups were paying the equivalent of what not so long before would have been an entire first round of funding on a single Superbowl ad.

Soon, nobody was in the company building business anymore - instead, everyone was into projectile company formation, striving to cash out in an IPO or an absurdly high value M&A transaction before the music stopped, as everyone knew eventually it must. 

And, of course, it did.  Most of the madness abated quickly, as bloated startups cut back ruthlessly, and VCs desperately tried to renegotiate their clawbacks behind the scenes with their investors.  But the world never really went back to its pre-Netscape mentality.  Funds are smaller now, but not small enough, so the best funds are still competing for too few deals, while lots of promising companies can't find anyone to invest in them at all. 

And entrepreneurs are still into flipping companies as fast as they can find buyers - which is exactly what their VC investors want them to do.  What about Google, you may ask?  Don't be surprised to learn that Larry Page and Sergey Brin never lost control of their company to their VC investors.

I was reminded of all this a little while ago, when one of the lions of the New England startup scene passed away.  His name was Alex d'Arbeloff, and he was one of the last of a cadre of remarkable people that helped create the technology scene in New England.  Remembering Alex reminded me how different things used to be in Massachusetts, where modern venture capital investing as we know it was created, and where industry leaders like Digital Equipment Corporation, Wang Computer Laboratories, Data General, and d'Arbeloff's own startup, Teradyne, were launched and formed the cornerstones for one of the major cultures of technology innovation in America.

I reflected on what all that means for the past, present and future of entrepreneurship in my last Startup Scene column for Mass High Tech.  Here's part of what I had to say:

Over the years, it seems, we have become driven to build great returns rather than great companies. Or perhaps we have simply been seduced by the appeal of a system that permits new ideas to be so rapidly conceived, funded and then monetized, simply by feeding them into the maw of a perpetually consolidating industry. Whatever the reason, I miss the days when entrepreneurs — and even venture capitalists — wanted not only to reap great profits, but to build great institutions as well.

I think that there's still a great deal of appeal, if perhaps not as much monetary reward, to be found in building sustaining greatness.  If you agree, you might want to read the rest of the column, which you can find here.

For further installments of The Monday Witness click here.

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Innovation past and future: the Hidden Cost of Venture Capital
Authored by: Anonymous on Thursday, November 06 2008 @ 09:41 AM CST
I was building my second technology company during the dotCom boom and saw another problem with these big VC deals - the riches of the VC-funded companies made life very difficult for everyone else.

Even if you had great technology, and weren't competing directly with a rich startup, those guys had huge marketing budgets and they spend a lot of it well, in the same channels as the rest of us. It was almost impossible to get your message to customers who were turned off by this intense spam-barrage, so selling was VERY difficult. I don't miss that era one bit.

I wonder whether technology wouldn't have advanced fastest without venture capitalists - just technology companies that had to boot-strap themselves or get loans from local banks - giafly.
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