Venture Fratricide (continued)

I have blogged about this Venture Fratricide concept on a number of occasions.

Venture Fratricide is when other VC firms back companies that compete with an existing venture-backed company.

Venture Fratricide is very common and it is one of the most disturbing aspects of the venture business to me.

In my first post on this subject back in March of last year, Giordano commented:

Uhm... forgive me for asking, but isn't that called "free market"?

Right you are Giordano.  Capitalism is about darwinian survival.  And maybe it is a good thing that venture capitalists are free to fund whatever strikes their fancy.

Entrepreneurs are also guilty of entrepreneurial fratricide.  When they see one of their brethren doing something interesting, they jump in and try to do it better.

So possibly all this competitive frenzy is a good thing.

But what do you do when you have invested in a company which has worked for years to attain a position of leadership in a market which is now developing nicely and you see your friends in the business thinking about funding some new entrants?

Do you sit back quietly and watch them do it?

Or do you actively try to convince them that they are making a mistake?

Or would that just backfire and convince them even more to make the investment?

It's a tricky issue.

I used to take the former approach which was to sit back quietly.

But I am not going to do that anymore.

If other firms are doing their diligence on a competitor to one of our companies, I want to be called by those firms.  In return, I am going to attempt to talk to the VCs that are behind any competitors to companies that we consider investing in.  I think that is the right way to handle this issue.

I also think it is smart to call or visit the CEOs and/or founders of the companies that a potential investment will compete with.  That's the best way to assess the competitive dynamic.  You can learn a lot that way.

This all might sound like collusion to entrepreneurs, but I think its the right way for the VCs to behave.  And it might just reduce some of the crazy overfunding of market sectors that has plagued the venture business in recent years.

UPDATE:  This post caused a lot of controversy and comments.  At some level, I like that because it means it struck a chord.  But after reviewing all the comments, its clear that I did not communicate my point very well.  I am not advocating "club investing" or even "collusion" of any sort.  My point was simply that the venture business is full of investors who don't do enough diligence on potential investments, who don't spend enough time assessing the potential size of a particular market, and who don't take the time to understand the extent of the existing competitive dynamic with any degree of care, and therefore pump money into a "hot" market segment until it is grossly overfunded. I think that's a bad thing to do and I am simply advocating more communication and diligence in the VC community to avoid that in the future.

Comments

[Scott]

It's late here where I am, so maybe I'm just missing the point. But, it seems to me that what you are implying is that once a VC has invested in a company in a particular industry, other VC firms should stay away from that industry (unless, I suspect, they want to make follow-on investments in the original VC-funded business). Am I understanding you correctly?

[Shivering Timbers]

Oh boy, I don't even know where to begin on this one.

First, you correctly noted that this idea smells a lot like collusion. In fact, I think there's a gentleman on line 2 from the FTC who wants to talk to you right now....

But even if you can make it past the legal sniff test, let's think through some of the implications.

What you're proposing is essentially a "club" (sounds better than "cabal") of VCs who would consult each other before deciding to invest in competing companies. The desired result would be that some companies would not get funded which might otherwise get backing.

The first problem is convincing another VC to pass on an investment because it competes against your own company. One option is to convince the other VC that it would be a losing proposition--but the argument has to be either based on public information (which the other guy should already know if he's done his homework) or you have to pass along something proprietary. Big nono.

Another argument could be built around a humanitarian approach: "these guys deserve a chance, please don't bury them!" I don't think that one is going to fly.

What's really going to happen is a lot of horse trading: "If you pass on investing in Electrotelenet, I promise not to put money into Chipoltedyne." I think history shows us that this is the way groups like this usually operate, and it mainly benefits the already-powerful.

In other words, if you've got a billion-dollar fund to throw around, you can use this kind of syndicate to your advantage. But if you run a smaller fund, the only way to get ahead will be to curry favor with the big boys.

Worse, by funding fewer startups in a given category, you reduce the odds that the category as a whole will be a success, since there will be fewer chances to hit the magic combination of technology, market, and distribution. Imagine (for example) if the VC Club had decided that Alta Vista didn't need any more competition, and froze Google out of the market for money.

But despite all these negatives, I don't think your proposal would actually do anything to prevent overinvestment in promising technologies.

You are correct that overinvestment is a problem, and it can kill a nascent market just as surely as underinvestment. But if a market is hot, you won't be able to keep VCs from wanting to invest. If you can (somehow) enforce a rule that limits which companies will get funded, all you will do is increase the demand to invest in the lucky few. This will push both valuations and investments up (just as we saw during the bubble, when everyone was chasing too few good Internet ideas), making it that much harder to make money on those companies which get showered with cash.

And we all remember what happens when a startup gets too much venture investment, right? (Hint: Webvan, Pets.com, Packet Video, TellMe....all companies which raised over $100M in venture financing. You do remember Packet Video and TellMe, right?)

[Derek Scruggs]

I'm with Shivering Timbers on this one. Furthermore, I believe "overinvestment" is actually quie rare. In 1986 Michael Dell started his company in an "overinvested" sector. There was something like 100 PC companies back then. Dell proved that the problem wasn't overinvestment. Just bad investing.

[Michael Parekh]

Slow blog day, Fred? or do you just like poking the bee hive with a stick?

[Randy Zaia]

Does the "C" in "A VC" stand for "capitalist" or "central planner"?

[Jason]

Whoa.... the first thing I thought when I read this post was: collusion, collusion, collusion!

If people want to attack the same space go for it... dealing with a flooded market is part of the fun of being an entrepreneur... if any entrepreneur can't handle copy cats they should get out of the business.

I love the fact that there are 25 or blog networks that are modeled after Weblogs, Inc. Some of them are doing interesting things that we can learn from, and most of them are started and left to die a slow death.

However, they all build up our position.

Look at it this way, if we have the #1 automotive blog with 200,000 page views a day and 20 people star car blogs those 20 folks all battle it out for 100,000 page views and get 1-10,000 each. They splinter the market while reinforcing our lead position.

Noise is GOOD for entrepreneurs.

I think you guys had a really (really) bad experience with Kozmo and Urban Fetch (which was well documented). Those guys were crooks and ripped you off... but that doesn't mean that investors should be in collusion with each other and limit the options of entrepreneurs.

Now, I'm sure that a light amount of collusion does happen on the part of VCs on a regular basis (i.e. the phone call you are talking about), but that sends shivers up my spine as an entrepreneur.

Then again, the market corrects itself... if VCs get heavy handed the entrepreneurs discuss it and they shy away from those VCs.

In fact, what is happening in the marketplace with angel investors funding companies to exit is to a certain extent a reaction to the inside baseball nature of VCs.

You're a great guy and great VC--just so I'm clear here... but this kind of discussion is heading towards a very scary place.

[Mobile Phone Fan]

"Noise is GOOD for entrepreneurs." says Jason Calacanis above. But be warned, dear VCs, that he is a thief who stelas my comic strips and removes copyright to them, that he is a rude boorish person who publishes emails even if they are marked as "not to be published, private".

Jason Calacanis is a plain evil person.

[Alice Marshall]

First, you correctly noted that this idea smells a lot like collusion. In fact, I think there's a gentleman on line 2 from the FTC who wants to talk to you right now...

I had precisely the same reaction.

[B Watson]

Fred, usually I see eye to eye with you, but I can't agree with you on this one. I like other people investing in the spaces I have invested in. Of course there is the ego stroke of being first to market, but there is also a level of market validation that occurs when the investing happens. Compete in the marketplace, that's what it's there for. Tacitly attempting to keep others out, well, that's just not good for anyone. Fund the best company you find and let the chips fall where they may.

[Mobile Phone Fan]

Jason Calacanis was in past spreading lies about me, like for example that I call people homes (I just called one person one day) and that I post comments to his blog under various names (I stopped posting after discovering that he has censorship of comments on his blog).

Undeniable facts about Jason Calacanis:

- he personally publishes emails that are marked as "private not to be published"

- he personally copied my comic strip to his server and removed copyright text from the image file

- his employees are stealing photos from other websites and publishing them on websites of WeblogsInc without giving proper credit, yet he dares to attack main stream media for not crediting bloggers, although his employees from WeblogsInc do the same!

- he censors and blocks comments on his blog and other blogs of WeblogsInc - thus companies that want to get feedback on their products don't get objective view.

[Mobile Phone Fan Fan]

Just so everyone knows, "Mobile Phone Fan" is Jacek Rutkowski, a notorious internet stalker who already has one site dedicated to his perniciousness:

http://jacekwatch.blogspot.com/

If you want the full story on Jackek's extortionary tactics, slanderousness, and harrassment, I suggest you visit Russell Beattie's site here:

http://www.russellbeattie.com/notebook/1008171.html

[Mobile Phone Fan]

Above links contain many lies fabricated by people who practice revange because I have revealed truth about them.

The bottom line is the facts that I mentioned about Jason Calacanis are facts.

[Mobile Phone Fan Fan]

It's no surprise that Jacek will say that everything he writes is the truth, while everything written about him is a lie, is it? Odd that literally dozens of people have had extremely negative interactions with him, isn't it?

[will]

wait a minute, we are not done taring and feathering Fred first. . . jason and jacek please wait in line. . .

besides the collusion issues, entreprenuers also must know that the VC thats visiting you today could simply be here to gather information for a startup he already signed a termsheet with. . .

When the bargaining power between two parties are not equal (VC vs. 90% of Ent). . its hard to condone this type of behavior. . .

collusion & espionage, no wonder CIA has a VC arm

[Scott]

Well, it seems clear by some of the other comments above that I did correctly understand the point of this post. So, let me just say that the market conditions that lead to what you call "VC fratricide" are exactly how the markets are supposed to work -- Econ 101. I don't see any problem with that. It's a good thing because it CAN lead to VC fratricide, if necessary -- which indicates markets are operating properly.

[M]

I saw in Businessweek that TellMe is alive and doing quite well! As for Packet Video, I'm not so sure...

[Mike D.]

Interesting. On the one hand, the temptation is to play your investments as you would a common stock portfolio. Basic diversification strategy says to invest in a basket of goods which are negatively correlated to a degree so that if one goes south, the other goes north. But on the other hand, you have the added ethical responsibility that goes along with being a material force your personally funded companies.

You said:

"But what do you do when you have invested in a company which has worked for years to attain a position of leadership in a market which is now developing nicely and you see your friends in the business thinking about funding some new entrants? Do you sit back quietly and watch them do it? Or do you actively try to convince them that they are making a mistake?"

It would seem to me that if it were indeed a good business, you may indeed want your friends investing in similar, competing companies. Why?

1. More companies in the space means a quicker pace of innovation and a generally quicker outcome, good or bad.

2. It's easier (and more fun) to do deals with your friends than with complete strangers. Just because you might talk a friend out of investing in a sector, that doesn't mean complete strangers will stay away as well.

3. They are your friends and it's just fun to compete against people you know! It's like poker, but for insanely rich people.

But then again, I'm not a venture capitalist so what do I know...

[Jeff Clavier]

Whilst I appreciate the logic behind the idea, and you certainly want to dd competitors as much as possible, you'll only get a "no BS" feedback from VCs you have a genuine relationship with. And even these might have interest in preventing you from investing - for example by reopening the previous round, etc.

[Giordano]

Sorry Fred, I'm not convinced. And not only I'm not convinced, but knowing that VCs do that makes me furious.
That's not unlike the major companies in a industry forming a cartel to keep new entrants out, and it's a practice that can badly affect other peoples' lives (enterpreneurs, employees, families etc.).
While I understand that a VC role should not be to invest in copycat and me-too companies, I'd say that he should be completely free to do it if there's a compelling reason too (management, market conditions, something about the product line etc.), without being influenced by his peers. If a VC knows another VC for 20 years and he calls him saying that he's thinking of investing on a company that's in competion with one in his portfolio, how likely is him to say "Please guy, don't do it... the market is already carnage" or "Pass on this deal and I'll pass on the next one"?
In many industries, that would be considered disonhest conduct, or even a crime. Probably is not so for the VC industry, but for sure is fostering the "old boys'network" mentality that, in my opinion, is one of the most damaging factors for innovation.
VC should be agents of change, supporting new, bold and useful ideas and giving everyone who deserves it the possibility to compete in the free market... they shouldn't not mimic the big corporation most despicable habits!

Kind regards,
Giordano

[Jonathan]

Sorry, Fred, Antitrust 101 tells you this sort of behavior with other VCs is almost certain to be considered anti-competitive and a form of illegal bid-rigging under the Sherman Act. And exactly for the reasons you are considering doing it. For better or for worse, the decisions were made a long time ago and aren't likely to change: Federal law favors competition, even if it results in a bubble, and makes certain topics verboten for discussion among competitors. You should definitely have a nice conversation with our mutual friend Mr. Rand. See also: http://www.usdoj.gov/atr/public/guidelines/primer-ncu.htm

[Joe White]

All the comments about legality aside, I think Mike D's comment is the most astute -- more competition grows a nascent market. I have always said that complacency/risk aversion is the start-up's largest competitor. One provider does not a market make....

[Max Niederhofer]

"This all might sound like collusion to entrepreneurs, but I think its the right way for the VCs to behave" (my emphasis).

You're right, it does sound like collusion. Where does the "right versus wrong" decision come in? Why do you think colluding to avoid competition in a nascent market is right? How come you perceive fellow venture capitalists as being "on the same side"? Aren't you guys there to provide us entrepreneurs with liquidity that we don't get from angels, banks or the public market, if you think that you can get a better risk/return than in other markets? Where's the morality of limiting liquidity that you could profit from just to increase the economic rents of a fellow VC company? Aren't you just doing it in the hope that other VCs will reduce liquidity in one of your investment's market in the future so that you can make a bigger profit?

Game-theoretically, I know where you're heading. But how come you don't like competition in your own market? Don't you think it makes you faster, smarter, more motivated than you would be otherwise?

I also don't understand why you think that competition in a nascent market can destroy that market. In my experience, which is not very large, competition in a nascent market grows the category. Furthermore, aren't you underestimating ideas in favour of execution?

I really like your blog, but I really, honestly, don't get the point of what you are trying to tell me here.

Cross-posted to my blog at maxniederhofer.com

[Max Niederhofer]

That should read: "aren't you underestimating execution in favour of ideas?"

[Will]

Interesting to hear from both VC's and enterprenuers out there how many times have they been told by a big name VC that "you either let me in on this deal or I'm going to fund a competitor" or more politely "We are very interested in this space, and is moving forward with an investment, we are looking at various options."

Granted, having a VC beat down your door is kinda nice. And I dont think its ethically wrong for a VC to do this. The point is that VC's (those that can) like to throw their weight around and this collusion case study is just another example.

[James Chen]

I'm with Fred on this one. I think you guys are missing the point. http://purevc.typepad.com/pure_vc/2005/06/the_vc_guild.html