Big hairy audacious thoughts on transformation in VC-land
There 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 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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