How VCs kill innovation

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False negatives

I believe no General Partner at any Venture Capital (VC) firm I know intentionally sets out to destroy innovation, yet the destruction of innovation is the outcome of the economic model under which Venture operates today. Let me elaborate.

First, proof is in the pudding

First, without regard to economic models, Venture with its highly intertwined and syndicated ecosystem has produced negative 4.2% ten year returns for Limited Partners (the investors in Venture Capital firms). With only 35 of 790 (or so) VC firms making any consistent money for Limited Partners (according to a prominent Silicon Valley money-manager) more than 95% of VC firms are therefore posers who deploy the incorrect arbitrage to what constitutes innovation and what produces (any kind of) value. As such the compass of most VCs in Silicon Valley has proven to be incorrect and attracts hordes of wannabe entrepreneurs who eagerly submit to their false pretenses in order to raise money for their fashionable startups.

So, whether you believe in my analysis of the economic model that lies at the foundation of this problem is irrelevant. Whatever the model, the evidence clearly demonstrates Silicon Valley’s self-made version of the Venture Capital model does not work (save for a few firms with investment networks so entrenched, large, diversified and greased with newly introduced evergreen horizons offering many opportunities to hide).

Venture Capital itself is responsible for the massive noise of false-positives that makes many General Partners not see the forest through the trees anymore and forces them to revert back to blaming the government, the economy or anything else they can hang their hat on, dutifully supported by their NVCA lobbying organization.

Negative VC returns severely hurt the reputation of innovation and the opportunities for the next generation.

Second, no cartel scales

While a cartel can prove to be a valuable singular investment opportunity for investors, Limited Partners (such as Institutional Investors) rely on the performance of a sector or asset class to produce consistent out-weighted returns. Limited Partners can therefore not rely on an underlying investment cartel, but need to rely on an economic model that consistently attracts the outliers of innovation and adapts progressively over time.

Hence the impromptu investment cartel deployed by Silicon Valley VCs chasing the same kinds of companies and dominated by syndicates, collusions and complete transactional in-transparency to all of its marketplace participants, is economically incapable of producing meaningful returns for Limited Partners.

The flight response of Limited Partners leaving the asset class as a result of the underperformance of the investment cartel, kills opportunities for the outliers of innovation the cartel is economically equipped to ignore.

Third, improper deployment of risk

One can argue about the validity of the fuzzy Private Placement Memorandums (PPM) of VCs, with many copied directly from the PPM of a prominent VC firm in Silicon Valley (and therefore in direct support of my second argument) that have successfully raised $250M or larger Venture funds. Or the many VC firms with General Partners that lack relevant entrepreneurial experience themselves.

Be that as it may, any deployment of monetary resources that syphons through ten levels of diversification is economically doomed to fail.

Ten levels of diversification of investment risk is how Venture money from Limited Partners through Venture Capital is deployed to a startup, indicating not only an extreme fragmentation of risk and dollars, but a lack of investment discipline and a lack of confidence to the stated investment thesis. That fragmentation of risk has resulted in fragmentation of investment rounds needed to support the runway of a company, so much so that raising money has become a bigger distraction to many startup CEOs than running the business.

Investor owned companies with overpowering board control, disjointed interests and fear driven exit requirements hurt entrepreneurs who strive for the creation of meaningful Social Economic upside.

Fourth, one can’t keep fooling the public

The public plays a crucial role in Venture many VCs have forgotten about. The public is not only an investor (and board member of the investment committee) in many Institutional Investor (and other Limited Partner) vehicles, but is also a buyer/user of early stage technology products and if all goes well, provides the cash infusion for a healthy Initial Public Offering (IPO) of the startup company in the stock market, and thus providing an investment return.

With the public having been fooled in the late 90s by the bursting of an investment bubble in technology companies, their vote of confidence in IPOs with artificial valuations and little Social Economic Value remains justifiably low ten years later.

Today the public still votes with its wallet.

Rather than adapting their pursuit of companies that drive real Social Economic Value, many VCs still passively rely on the acquisition hunger of public companies who in the race for market share dominance, can still be fooled to believe that buy is better than build.

Yet a VC investment thesis that is predicated on predicting the holes in a public company’s convoluted business strategy is a dangerous proposition, in which no wisdom prevails. Innovation becomes an utter gamble, rather than an intentional deployment of vision. Good luck getting rich in Vegas.

Fifth, bad custodians of innovation

In the matchmaking between the assets from Limited Partners (money) and the assets of entrepreneurs (ideas), the VC as the arbitrage has proven to be a uncaring custodian of innovation. Limited Partners for years have not gotten the returns they were “promised”, and entrepreneurs have been submitted to fragmentation of risk and dollars that distracts them from creating real Social Economic Value the public wants or needs. Where a VC’s role is stimulate each constituent to provide extreme upside, all most VCs managed to do was protect their own (often personal) downside.

Corporate innovation proves many VC excuses (cyclically, economy, consumer spending) flat-out wrong and manages to produce impressive numbers with a more effective breeding ground for entrepreneurial ideas. The fundamental premise of Venture Capital as the best suited vehicle to produce monetizable innovation has been eroded by its own dysfunctional economic model.

Currently, the best place to innovate is at a visionary corporation.

Kick in the butt

Venture Capital is just as dead as American rapper Nas proclaimed the death of hip-hop with his song in 2006. All that song did, according to rapper and self-made business mogul Jay-Z (Shawn Corey Carter) in a recent double whammy interview on Charlie Rose and on Oprah’s OWN Network, is induce a much-needed change in the musical genre. That same change is needed in Venture Capital.

The wide open greenfield opportunity in technology innovation dictates there are many more opportunities to be had, just not driven by a Venture Capital model that is economically unsound.

Entrepreneurs will evolve, the real question is: can Venture Capitalists?

 

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About Georges van Hoegaerden

Georges is a serial entrepreneur, venture catalyst, 4x CEO, board director turned innovation economist (by fate). His ideas have raised $14M in venture capital and produced over $100M in returns. More.