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Big hairy audacious thoughts on transformation in VC-land

theory.jpgThere have been lots of quiet -- and not so quiet -- events lately in the world of Silicon Valley venture capital, all seemingly unrelated at first.

But our conversation recently with Peter Rip, a Silicon Valley-based investor at Leapfrog Ventures, helped crystallize for us how many of these events -- though not all -- may fall into a seemingly consistent picture. See Rip's comments at the end of this earlier post on Mayfield. After reading those comments, we asked Rip for a clarification. You can see his response below, which is in the extended entry.

VC practitioners may be familiar with all of this, but what follows is a summary for those wanting to know more. Also, here's an audio file we made recently on some of this -- if you'd rather listen. (By the way, this file is part of a podcast offering the Merc has just launched on technology, something you can subscribe to. You can learn more here.) And here's our recent Merc paper-version story (free registration) on this, where we had way too little space to cover it all.

1) A torrent of cash from investors all over the world is trying searching for a place to go, and venture capital has become a legitimate place for it. And in venture capital, Silicon Valley's big-name firms are a favorite, because of their experience at building companies.

2) Huge risk in this game, however, means that only the top few venture firms (a few dozen, out of several hundreds) return exceedingly large returns. The overwhelming majority of firms produce poor returns. That's the dirty little secret in VC. The bottom 60 percent of firms will fizzle out, restructure or see major defections in their partnerships.

3) The press by investors to push vast amounts of cash into the top VC firms means, though, some of the VC firms will accept this money. Two things happen. When they get profits from investing this money into start-ups, the VC firms will demand a higher share of those profits -- causing some investors to get ticked off. Second, their greater stockpiles of money means they'll want to deploy more money into the deals they do. That takes them away from early-stage investing, because small companies can't absorb lots of cash too early. Instead, they'll move to invest in more mature tech companies, or they'll move into buyouts -- where, incidentally, there is plenty of action to be had because of the relatively mature tech firms out there needing to restructure.

There will be josting at the later-stage end (registration required) of investing. Private Equity Week's Primack mentions the action too.

There will be moves like one by Rob Chaplinsky, of Mohr, Davidow Ventures, who is leaving early-stage investing, and launching a late-stage venture capital firm, Bridgescale Partners -- first reported by Private Equity Week recently.

4) New York banks went global, circulating their cash in other countries, and having less impact on the local New York economy. The same is happening in Silicon Valley. VC firms are going global. Relatively more action will happen outside, in cheaper places like China. Talent in Silicon Valley will mean the area will still see its fair share of start-ups being funded. But relatively, it might be easier to grow smaller companies into bigger companies elsewhere. Now, a start-up might have only its first five employees here in Silicon Valley, whereas 15 years ago, it had its first 50 employees here. That means less job growth here, which is what we're seeing.

Peter RipÔs clarification:

The VC business here used to be a more or less local business -- local companies, local hiring, local VCs. The only thing that was not local was the capital sources. Scarcity created the great IRRs --
scarcity of entrepreneurs, capital, technology, and the ability to synthesize this together. This is what VCs did. And they practiced this art (in SV) largely by investing in small companies that could hit it big by selling IT innovations to US Enterprises.

Several things have changed in the past few years.

Enterprises got burned with Y2K and the Bubble and are now risk averse on IT. Globalization has hit (1) labor markets (2) technology access (abundance), (3) entrepreneur-sourcing, and (4) end customer market access (to a lesser degree). Open source and Moore's law has reduced the capital requirements for software-intensive businesses. But risk capital remains plentiful on a worldwide basis, but it wants to pour into a relatively few number of VC firms.

So some firms are taking a WW view of their business, chasing Chinese or Indian startups - definitely NOT local -some firms are building big funds looking to put a lot of money to work - definitely not startups -some firms are funding local startups, but (for the moment) shying away from enterprise in favor of consumer deals; but to be competitive, these startups must have offshore development -and there are undoubtedly many other strategies.

I think much of the creative destruction we are seeing in the partnership changes are the result internal conversations about which of these strategies to pursue. Should we be BIG and manage for cash on cash returns? Should we be small and manage for IRR? Should we be global, national, local? Should we do buyouts or startups or midstage?

We saw a form of vertical integration during the bubble (recruiting partners, incubators, etc.) in the VC business as firms strove to get relative advantage. This is just another variation.

We (Leapfrog) have placed a bet that "true" venture capital (by that we mean first money in) does not scale - in dollars, staffing, or any other dimension. Things scale as you move up the chain into what I call "venture banking" where businesses have trajectories than just need money, not guidance. When I made the reference to NY as a Money Center, that's what I meant. SV is in the process of becoming a Money Center with WW reach, but the direct impact on the state of the SV economy is weakening in the process.

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Great topic guys! Plese continue to stay on top of it. The currents of change definitely seem to be accellerating lately. After the years of inactivity, the release of putting all that squirrelled up money to work is leading to some predictably peculiar behavior. So fascinating to see how quickly many of the learnings of the past five years are evaporating.

Directly to your point, though, entrepreneurs are a lot wiser now than they used to be too. Two interesting trends to watch on that side: the sharp increase in the direct sale of founder's shares to generate some liquidity and enable investors to put more money into a deal, and deeper due diligence by entreprenuers on who really makes what when full liquidity finally arrives.

P.S. Any way to get a spell checker for your comments?

Mitchel Harad on August 18, 2005 11:00 AM
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This is a fascinating and illuminating discussion. As an engineer involved in development I have noticed a profound change in the local SV startup / VC dynamic in recent post bubble years, and I find my conclusions puzzling and a bit saddening for the future of the valley.

It is very clear that the early stage dynamism that preceded the onset and later fall of the net frenzy is largely fading. People are less inventive in non software areas, and less hands on in more basic and challenging and revolutionary ventures. Outsourcing can only get you so far and sometimes it is a total waste of time when doing real innovative revolutionary work. This is not true for all aspects beign brought inhouse but I find the pendulum has swung so far out of whack that supposedly "good" savvy and "experienced" managers can be totally out to lunch at times not understanding how the actual development lead time is maddeningly and needlessly ballooned out of all possible proportion by overly rigid outsourcing mania. Costs after all are closely connected to speed of development.

As one former boss of mine once said, the greatest cost of all is to miss the market opportunity... ( and you do not have to take this out of context and say this frees you from fiscal sanity, but that speed matters in startups - reduce your time to field a product intelligently. Blind adherence to outsourcing mania is not going to intelligently reduce development times EVEN. Think different here, and think with wisdom....

The valley is seeing relatively few device technology advances come to market / being nurtured the way VCs used to emphasize in their early stage work. And far fewer device technology firms that are being backed, especially backed with follow through to MANUFACTURE.... Too many are thinking that licensing is manna from heaven....

Arbitrage is more like what you are describing, and that is a bit sad actually. Searching for the lowest cost of development staff as a main strategy is quite self defeating and yet VCs have often encouraged local firms to pay exhorbitantly - implicitly or otherwise. This is unspoken and is very wasteful.....

At some time the dynamic re the money being sucked into top tier firms will change and in a final denoument, VC firms will be founded outside of the valley to larger extents than presently....

Compenstation levels in the valley, if you have a core tech position - management or otherwise, is often unrealistic.

Especially in the early stages of fat funding, salaries here often skyrocket to unjustifiable levels, but lost in the exodus of local VC fundings is that local SV infrastructure for tech development - INFRASTRUCTURE and KNOW HOW is unprecedented.

In software intensive ventures, infrastructure is less important, but in tehcnology innovation - devices and processes, the local infrastructure supporting the needs of efficient device innovation is not even remotely matched by anywhere else in the world. For software this hardly matters.

In Hardware, Device Technology and equipment development it is absolutely critical to any meanful substantive efforts possiblity of finding success.

So you can find lower cost, but the key aspects which make Silicon Valley the tech community are repeated nowhere else.

Fund non-software efforts out of the valley is almost lunacy as a pure strategy.

Just my 2 cents. I know why I am here...

Mark Wendman on August 19, 2005 3:59 PM
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The overwhelming majority of firms produce poor returns. True.

However, for every $1 I spend, I earn back $5.

Why VCs haven't found me? :O) Because I don't really need them. And apparently, they love the thrill of losing money.

Primezero Labs on August 21, 2005 11:05 AM
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