An Outdated Investment Model
For a number of reasons, I believe that the model used by many venture capital firms is in dire need of a retread. While the model has shown to be profitable in the past, this appears to be more a lucky, accidental result of circumstances rather than through proactive application of sound business principles. These thoughts here are based on my somewhat limited exposure to working with venture capital firms, certainly talking to others and following the news, but also sitting down with a couple of VC’s and walking through this.
First off, let’s not worry about the whole argument that in tech, the landscape has changed dramatically. The evolution of frameworks and social media is to the point where you don’t need massive capital to get an idea off the ground, and people with a spark can indeed get going ‘out of their basement’. We’ll also ignore the whole argument about the economy, the fact that confidence is at or near a low for our lifetimes, and it is probably not the best time to be out hunting for capital. Yes, I know that Twitter just got another $35M, for a valuation between $200M and $250M. There will always be outliers, and there will always be bad investments. In some ways, this does tie into my key point.
As investors, how do venture capitalists manage that investment?
From my experience, technical due diligence (at least in this neck of the woods) is an afterthought, a checkbox that needs to be filled in before the cheque is cut. Usually, if the investors think they can get along with the management team (that they might easily replace downstream), if there is some attractive intellectual property (can you say ‘provisional patent’?), and there appears to be a viable market and exit opportunity (show me the money), the decision has already been made. The tech due diligence is a cursory peek under the hood to make sure there are no scary items there.
For the most part, the results of this tech due diligence have been very similar. In essence, the small group with the idea work pretty well together (they are often starting up after working together somewhere else), are working on a shoestring (hence the need for capital), and do not yet have a great deal of client interaction (they might be building out their IP, they may have a few beta customers, or these days with an internet play, they may have up to a few thousand bums in seats).
What this means for a due diligence report is that the practices they have in place will sustain a team of this size, and are usually characterized as informal decisions being made based on daily interactions. The product usually hasn’t been completely shaken out by the user community or only has a subset of its entire feature set, often driven by the priority on speed to get things moving and prove their technology. In other words, things appear to be OK for now, but with a huge investment and additional development, all bets are off: the team dynamic will change dramatically, and there is a very good chance that latent quality issues will raise their ugly head in the near future.
That is for the reasonably sound investments. I recall one due diligence effort where I discovered significant dysfunction in the organization, enough for me to prepare a report with a huge red flag and recommend against any investment. As I was in the midst of this discovery, there was a press release indicating that the $5M was raised! Alas, time bore out the result that this was indeed a poor investment.
Usually, though, things look good for now, but there are possible storms ahead in the areas of how the team works together and the quality of the delivered product. The money is invested, and right away about half of it is used to blow the team out to maybe five times its current size (for an initial round). Along with that investment, there is rarely any attempt to manage the growth of that team. The emphasis that comes with this investment is a push for speed and functionality, as time is of the essence. There is an urgency in proving the technology, in getting those lead customers so that the product can be validated to a larger audience, so that we are all closer to that wondrous exit.
The result of this is the infamous model of 6 dogs, 3 break-evens, and one spectacular win out of every 10 investments.
I would argue that the results can be skewed significantly in the direction of more spectacular wins, fewer dogs, with just a little care around sustainability of operations. Knowing that the team dynamics will change significantly with the investment, part of this should go towards ongoing monitoring of that dynamic, tuning it so that the organization continues to operate as efficiently as possible. Knowing that the latent quality challenges for the product will come when it is finally released or completely fleshed out or beaten up by thousands of users, part of the investment should focus on planning for this and building prudently.
If the average organization is running at about 40% rework, I would argue that startups and initially funded companies that I have worked with are easily well above that value. Let’s be conservative and put that number at 50% rework. If half of the $5M investment has gone to R&D efforts, this means that $1.25M is the cost of inefficiency for this money. This also means that the product will be delayed, the newly-grown sales organization won’t have as compelling a product to sell, and there is an increased chance that the company will run out of money before they hit the home run.
Unfortunately, this message doesn’t seem to resonate for some reason. In speaking with several people in that sector, it is apparent that ongoing focus on operational efficiency lags way behind apparent speed as the driver. In addition, for all of those 6 dogs and 3 break-evens, there doesn’t appear to be much in the way of review of the results. While the big wins make the news and everyone celebrates the victory, everything else gets shuffled under the rug, or ends up dragging on with sustaining investments that still have a relatively low chance for success. At least two people have admitted that there is no analysis of the dogs to determine what they could do better. I’d love to be proven wrong here, but I’m not holding my breath.
I genuinely think that investments can be far better managed. While this holds true for the bigger venture markets, it is also a message that holds true for the smaller angel community, as well as for those companies that are trying to succeed based friends-and-family investments and cash flow. Almost any shop, with a little digging, can find rich nuggets of improvements in efficiency that will lengthen their runway, and provide a higher likelihood that they will still be around to celebrate that big win.
Now more than ever, we need to be aware of how we are investing our funds to make sure we thrive as a business. Old models that happened to accidentally provide a return in the past may need to be shaken out. – JB