by Georges van Hoegaerden



I was reminded again by how dumb capital has destroyed innovation by listening to Paul Kedrosky's interview with TechCrunch, in which he concludes that The Kauffman Foundation (which Paul represents as a Senior Fellow) may get out of Venture Capital altogether and deploy some of its monetary assets elsewhere.

Not an unexpected move, as I predicted a while ago many Limited Partners (LPs) as investors in Venture Capital (firms) would make, but a somewhat presumptuous conclusion from a respectable foundation that is supposed to be at the foreground and chartered to support the proliferation of innovation. Foolishly, I expected more intelligence from an entrepreneurial foundation than the intelligence displayed by a run of the mill pension fund stuck in a product of their own making.

Nevertheless I applaud the move based on how Paul described the foundation reached that impending conclusion. For we need to rid Venture Capital (VC) of Limited Partners who do not understand the foundational principles of innovation the sector depends on, and who do not understand the deployment of its unique risks. Probably for the same reasons why Michael Moritz of Sequoia Capital twenty years ago did not want to see pension funds enter the Venture Capital fray.

Take responsibility for you own actions (and in-actions)

First off, the reason why Venture has not and unchanged will not perform (at scale) is because of the financial system Limited Partners in Venture Capital have deployed, one that allows Venture Capital firms to take it for an all too comfortable ride.

With multi-tier bottom-level diversification (as described in 2010: The State of Venture Capital), a grab bag of other alternative investment options and ten additional levels of diversification once a VC firm is ready to invest, it should be no surprise that Venture Capital overloaded with derivatives and diversification has lost the merit it was once founded on.

We can now all easily blame 95% of the VC firms who do not produce any consistent returns for their Limited Partners, or Limited Partners can ask themselves the question why they created and participated in a financial system that enables such systemic underperformance.

We, as financiers of innovation need to take the responsibility of how we enabled a flawed governance of innovation.

Mired in "downstream thinking"

But our observations about Kauffman are based on the activities deployed by them over the recent years. The interview with Paul, the types of programs they support and a recent interview of Carl Schramm, Kauffman's current CEO with Charlie Rose all confirm who they have become. The beachhead for downstream thinking.

The entrepreneurial foundation, driven by the principles and money from a magnificent entrepreneur, seems to have made the mistake of confusing deep consensus driven hindsight with the proper definition of innovation; groundbreaking yet unrecognized foresight.

Perhaps not surprisingly since many of the key figures in Kauffman are economists who could not predict the demise of venture capital until it hit them in the face, and consequently have no idea as to how to fix it - as deep hindsight rarely translates into meaningful foresight. Hindsight and foresight are polar opposites.

Rather than to accept the outcome in Venture as a fait accompli, only a real entrepreneurial foundation would start to wonder what needs to be done to tap into the incredible entrepreneurial capacity in this country and model its financial constructs accordingly. Apparently not the Kauffman foundation.

Financial incompetence chokes our country

Now in the grand schema of things Kauffman is a drop in the Venture bucket, with a potentially side effect of dragging down other Limited Partners in Venture who are similarly clueless about how to reinvigorate the arbitrage of innovation. Such an atrophy of Limited Partners is actually a good thing (as it washes out those without proper investment discipline) as long as it is promptly replaced with new Limited Partners who have a more astute and disciplined interest in Venture aligned with the massive greenfield that lies ahead in technology innovation.

Problem is that beyond the danger that Venture as a scalable asset class could unjustly disappear, the malaise of the financial system in Venture may leave a large stain on the potential of the underlying asset, innovation. Already innovation in the U.S. has suffered from twenty years of subprime VC investing that by design can never scale innovative outlier capacity. The damage we already incur is a significant lack of faith, interest and distrust of technology companies by the public.

Because of the underperformance of the vast majority of Venture Capital firms many financiers now begin to think that the potential for innovation has decreased similarly. And that stain causes further mistrust in the sector, increases fear and catapults whatever is left in Venture even faster down the subprime spiral and our country into the lost leader of innovation.

Subsequently, the demise of VC creates some opportunities for alternative venture strategies, new Angel and micro-VC oxymorons that further perpetuate and fragment subprime investments and on average perform even worse than VC firms. Subprime at its best.

My recommendation to Limited Partners:

• We are at the beginning of the technology evolution. Keep in mind that less than 20% of the world's population has access to meaningful technology innovation to enhance their daily life and improve productivity. A fantastic investment horizon lies ahead and as the youngest asset class in your portfolio, technology Venture has the most attractive economics and if deployed correctly, phenomenal potential for massive returns short term.
• Venture Capital, the way deployed as a financial instrument today cannot support groundbreaking innovation at scale. Not because of a purported "Voodoo" of technology, but because of the systemic improper deployment of risk. Unchanged Venture Capital will continue to create self-induced risk, and therefor consistently produce deplorable returns for Limited Partners.
• You can't teach an old dog new tricks, so don't expect better LP returns from the existing crop of VC General Partners. For twenty years Venture Capital has been given virtually unlimited freedom to deploy their optimal investment thesis, with massive market pull and the ability to control all the strings with regard to the governance of innovation. Tightening financial incentives does not magically turn subprime GPs prime and does nothing but dissuade new prime GPs who want to clear the air (the subprime ones will hang on for dear life as long as possible, even if you tinker with their management fees).
• The deployment of the financial system that drives the deployment of risk in Venture Capital needs to be re-invented (we have). Investing in Venture unchanged is the definition of insanity. The solution is not a deeper understanding of Venture Capital's complexity, but a dramatic simplification and accountability of its foundational principles.
• Stick to your knitting. Get out of Venture if all of this is too much hassle for you. You may miss out on the incredible opportunity that lies ahead in technology Venture but your passive presence in the sector does nothing but perpetuate subprime and hurts the performance of our economy in the long run.

Tags: Kauffman, Limited Partners, Innovation, Angels, Sequoia

By Georges van Hoegaerden



To complete my affectionate series of "idiot" articles (idiot CEOs and idiot Limited Partners) I am adding idiot entrepreneurs to the list.

Idiots

Idiots are those people who continue to participate in a marketplace that was designed to marry the two most important assets in Venture, Limited Partners with money and entrepreneurs with ideas, governed by Venture Capitalists (VCs) to the dissatisfaction and under-performance of them both. Not even the public is interested (and certainly not for the right reasons, short sellers are not too picky and may artificially boost its initial IPO value).

We know that the real problems in Venture stem from how risk is applied to the creation of early stage companies, and that more discipline deployed by Limited Partners (the investors in Venture Capital) to a new Venture model will fundamentally improve the governance of innovation in the Venture marketplace.

Until then the only constituent in the Venture marketplace who cannot be called an idiot is the Venture Capitalist who without any personal downside can continue to apply the power of someone else's money to define what innovation is and continues to get away with feeble attempts to convince the public of their value for more than ten years.

Perhaps now you understand how the adjective "idiot" is a compliment of sorts. Rest assured, the behavior of and attraction to idiots can easily be fixed.

Life is hard when you follow

Life is tough for entrepreneurs, especially for those who continue to listen to the compass of Venture Capitalists, ignoring the miserable performance of that compass for the sake getting a little bit of money. With a continued dysfunctional deployment of Venture Capital many entrepreneurs continue to succumb to an arbitrage of innovation that, by default, will never lead to achieving groundbreaking upside. Even when the idea holds merit, the flawed deployment of risk by VCs is sure to suck the life out of it.

So, here is a list of attributes by which you do not want to be recognized as an entrepreneur. An idiot entrepreneur is someone:

• Who believes that technology creates markets, rather than facilitates an electronic distribution mechanism to serve existing macro-economic marketplaces and behavior.
• Who believes and accepts money to build a gating technology proposition in search of a marketplace or without a clearly defined attachment to macro-economic behavior and upside.
• Who believes that they or VCs can actually derive foresight from studying statistics and hindsight intensively, forgetting that unique foresight is the only differential and investible attribute to successful companies.
• Who believes that capital efficiency is a unique business or investment strategy available only to them or the VC and therefor delivers any differential business or investment value.
• Who believes that market execution makes up for a dysfunctional "driving experience" and takes little streams of money to keep trying.
• Who blindly believes that raising money is the first step to acceptance of his idea. Not realizing that the compass of most VCs (95%) does not lead to the creation of value to their investors nor the public, and therefor their willingness to provide money is likely to mean absolutely nothing (or quite the opposite).
• Who calls himself an entrepreneur simply because he follows VC governance of what a hot innovation wave is.
• Who thinks that raising money makes him an entrepreneur, not realizing that raising money is not a vote of confidence from the public.
• Who thinks that raising money is an asset, yet with defunct investor performance across the board and in no less than 95% of cases turns out to yield a significant deficit.
• Who takes money from a VC, without getting to know the investment partner (General Partner at the VC firm) personally.
• Who takes money from a VC, without knowing the vintage and performance of their current or stacked funds. Ignoring blissfully any irrational behavior and panic that is about to come their way soon.
• Who engages with an investor who communicates through the valuation and cap table that majority ownership by the investor is ever a good thing in an early stage company.
• Who engages in fundraising efforts without a good understanding of the product conversion rates and operating credentials, offering many opportunities to VC of shooting holes in the proposition, to say no to the deal or drop the valuation just so you lose control of the company the moment one of your predictions do not pan out.
• Who partners with a first venture investor who cannot lead the complete funding runway, setting himself up for excessive segmentation of rounds, fragmentation of ownership and increased dilution.
• Who believes that authentic IPO value can be built for less than $25M, and dicks around with micro-VCs and well meaning Angels.
• Who does not know the difference between micro private equity and Venture, praying to beat the simple economics of input and output.
• Who takes money to drive Venture growth, but has no $1B upside strategy defined.
• Who attempts to raise money from a VC without a real CEO, leaving the inmates to run the asylum and turning the company over to the VCs at the quickest pace possible.
• Who prefers to take $250K of subprime VC money in return for 30% of the company, instead of getting a line of credit on your $1.4M house in Palo Alto (with a median house price $750K in the bay area). By the way, neither one is a good idea.
• Who creates an iPhone application using Venture money, not realizing iPhone apps do not create venture returns and the top 1,000 applications on the AppleStore make no more than $350K average per year. You and your Venture investor deserve each other, including the idiot adjective.
• Who raises money from a (government) small business fund, not realizing that a venture trajectory is incompatible with small business funding.

What to do?

Truly groundbreaking innovation is no longer recognized by the majority of Silicon Valley investors. The Venture business has turned subprime more than 20 years ago and only the delayed response by Limited Partners makes it seem like it has some of its former gusto left.

Entrepreneurs are relegated to the investment thesis emitted by overwhelmingly subprime VCs (some refer to using the oxymoron: micro-VC, which in actuality is not Venture but micro Private Equity) and Angels who, each with their own performance issues, have turned innovation into a commodities business.

Groundbreaking innovation that taps into attachment of existing macro-economic behavior does not evaporate easily and has plenty of time to wait until a new Venture model capable of attracting prime risk (and rewards) is up and running again. That type of innovation can simply not be discovered by subprime VC (let alone Angels), plenty of examples in the past have proven that out. So, unless you know how to get to the 35 out of 790 VC firms that do know how to deploy risk and produce returns, of which we estimate 3/4 do so by deploying diversification, alternative investment strategies or similarly subprime gating tactics, you should keep your job until this subprime VC maelstrom has lost its strength -- or until our systemic fix to Venture is in place.

For those people who aim to follow the investment waves of the current investors, by all means keep trying. Maybe, just maybe your pot of gold will be at the end of a rainbow.

Tags: Entrepreneurs, IPhone, Innovation, Valuation, Angels, Subprime, VC, Venture, CEO

By Georges van Hoegaerden

I just came back from a trip to Europe and let me tell you: Belgian chocolate, raw herring from Holland and ficelle from France - nothing is more authentic and delicious.

But few of these travel well or find a large deserving audience in the United States. Much like technology.

The state of the technology industry and the accompanying investment ecosystem in the US are quite a bit more developed than in Europe, 15 years at least.

In the US, roughly $30B per year is poured into early stage companies by some 300 investors in my backyard in Palo Alto, not including Private Equity deals. In contrast, only a handful European early stage VCs exist and the majority of all european investments are late stage investments done by Private Equity firms.

In Europe, early stage VC valuations hover around $1M, compared to $4-7M in the US. As a result desperate european entrepreneurs often default to Angels that show some flexibility, but those investors are often very inexperienced with the technology sector and early stage investing or the combination. They made their money somewhere else. Because of the young history of technology success in Europe, very few european investors (either VC or Angel) have actually had the personal experience of building an early stage technology company from scratch.

To sum it up, european investors (with a few exceptions) take large early equity stakes, provide limited relevant business insight and push those companies to early profitability (even at 250K euro investment levels). Selling a product or a service too hastily, before it is ready to enter a global marketplace delivers NO validation of the business, good or bad. But it is a sure way to slow down its innovation and differentiation.

So, underdeveloped access to quality early stage money makes life of entrepreneurs in Europe quite difficult.

But, let's assume you passed the bar on all the above and your company is on its way to the United States. No one can stop you in the pursuit of the great early exit opportunities only Silicon Valley can offer.

So here are some things to be aware of:

1/ A cherry, picked by an investor in Europe is not always a cherry in the US. Be sure you understand - or seek advice about the timing differences between continents that attract follow-on investors in the US. Some of that timing has to do with technology, but market timing is even more crucial.

2/ Plan ahead. Allocate a larger fundraising runway than you would in Europe. To US investors foreign companies are yet another risk they need to mitigate. By default you are less attractive than a US company.

3/ Modify your operating plan. Change it from a plan to profitability to a plan to market dominance (which could include profitability but can also have other primary denominations as drivers, such as owning a majority of eye-balls in the consumer space).

4/ Move your headquarters to the US. Without it you'll find very few US investors interested.

5/ Assuming you get this far, be open to a recap. US investors understand the equilibrium of shareholdings will provide the best business value, not exorbitant ownership of the initial investor achieved through a low initial valuation. But since the US valuation should increase significantly, the initial investors should not lose too much net value, if at all.

6/ Hire a local management team that understands how to perform in a petri-dish that is quite different from Europe.

My final recommendation is to be prepared before you come over and not put your head in the sand, I can give you a long (and still growing) list of foreign companies that were forced to move back.

For larger US VC firms there is a fantastic opportunity to scout for technologists in Europe and fold them into their US investment model before they've taken in too much local money. I see technologists in Europe building innovation that is at least as good as the in the US. Remember the most delicious chocolates from Belgium?

But, the worlds largest chocolate factory is Hershey's located in the US. The name of the game remains matching sufficient technological capability to a fast growing market, in the same way Hershey's reaches a much larger audience than Belgian chocolates - with a quality that is good enough for most. Market timing, not technology, is key.

Tags: Investment, European, Private Equity, VC, Angels, Marketplace, Markets, Silicon Valley, Palo Alto

By Georges van Hoegaerden

I visited the entrepreneurs week at Stanford this week where many MBAs were walking around with new business ideas. Since we raised a fair amount of money ourselves in the last 10 years we've been focused on startups, I wanted to give some advice that may be helpful to any first time entrepreneur:

1) Define the end goal of the company in a newly defined market
The determination of pre-money valuation, even for the first round, should be based on the disruptiveness of the company when it grows up. The goal is to find the investor that understands the path to that goal, not an assessment of the current value of the company. The starting valuation then becomes a reverse calculation from that goal.

2) Don't set a valuation, but have one in mind
The valuation is usually suggested by the investor, but ofcourse, you don't have to take it. Ask your potential investor to value the company after you give them the pitch, the outcome of that tells you whether the investor really understands your unique proposition. If it is too low, it may be because the clarity of your pitch. If not: walk away.

3) Have an operating plan ready
An operating plan defines how you turn technology into a business, without it there is simply too much room for debate and depreciation. Show investors you know how to run the business. The more you do the easier it is to cement your use-of-proceeds.

4) Find an investor you truly like
Every entrepreneur deserves to be treated with respect. Waste no time talking to deep pockets with awful personalities, but don't be afraid to get some straight talk. Check TheFunded.com for war stories and ask around. Later, when business gets tough bad guys usually get a lot worse.

5) Define business disruptiveness
Building technology is one thing, but yielding a disruptive business value is even more relevant. The latter is defined by macro-economics, not just a more clever way to improve existing technology.

6) Take passion over domain expertise any-day
Find a lead investor that has passion for the business problem you are about to solve. An investor that claims to have domain expertise is usually the one that doesn't understand disruption within or across that domain.

7) Don't get squeezed
Investors like to put investments into past investment categories and make an assessment of how much it costs to build your business. Don't let them stray too much from what is in your operating plan, if you do you will get punished for it later, both on the execution side as well as in excessive dilution.

8) Know the investment allocation
Usually a little harder to do with angels but VCs should have a total investment amount allocated to the business. Ask them for the total allocation upfront, so you know when you need to go shopping somewhere else. Also, don't be afraid to ask who else needs to sign off on this deal within the VC firm, in most cases it is a very democratic process internally with a primary sponsor. After your first meeting you should get in front of a General Partner, talking terms.

9) Control your own eco-system
Investors like to wiggle around and determine how much money should go into R&D, Sales, Marketing, Business development, Support and G&A. Too much money in marketing is usually an indication the product or service lacks real viral adoption and that should be avoided. If the balance of this eco-system is not guarded heavily by the entrepreneurs the result is an excessive bleeding and further dilution in subsequent rounds.

10) Balance your board
A board without a balance of technical and business expertise can really bring a company down when the going gets tough. The technical board members will spend too much time validating deep technology progress without real affinity for the bottom-line. On the flip side a demand for too early revenues can have disastrous effects on product or service readiness and customer experience. Keep them both in check.

Be honest and transparent, too much talk without real interaction with a prospective investor is a bad sign. Paint a realistic risk-management picture, in which you describe both the pluses and minuses, not unlike the way a VC sells their risks in a Private Placement Memorandum (PPM) to its limited partners. Feel free to e-mail us if you need help.

Tags: Investment, VC, Angels, Markets, Eco-systems, Business Model, Startup, Innovation