Don't Be An ATM

Fraser Kelton has an excellent post on the challenges facing the venture business up on his Disruptive Thoughts blog.  I don't know Fraser and have no idea how he's related to the venture business, but he makes a number of excellent observations, starting with this one:

A market is ready to be disrupted when the performance of the product overshoots the requirements of the user. Does this apply to the venture capital industry? Yes. Traditional VC’s have overshot the “needs” of start-ups. It’s interesting that this gap widened, suddenly and significantly, because of large movements in both directions. During the late 90’s venture funds raised too much money and, after the bubble popped, there was too much capital chasing too little opportunity. The performance of the product – available venture capital – snapped upwards and away from the “customers” requirement. The Economist had an interesting article on this in March of 2005 and there was an paper examining this trend released last week.

While this fund raising frenzy was occurring, the “needs” of the customer (start-up companies) fell. The cost of starting a business has collapsed. Advances in technology have had a substantial impact on the cost of starting up. Outsourcing has also had an impact on the cost. Start-ups now outsource work to highly skilled individuals, all over the world, at lower costs. The decrease in the cost of starting a business has caused the needs of start-ups to snap downwards and away from the required performance of the “product”.

These two movements happened suddenly and at approximately the same time, resulting in the equilibrium between VC needs and start-up requirements becoming unbalanced. It’s this unbalance in the market that opens the venture capital industry up to disruption.

I don't know about this "disruption" theme, I honestly don't see the venture business headed for the same kind of hurt as the telecom business or the newspaper business.  But it is true that the supply of capital has increased signficantly and the demand is on the decline.  Those VCs who recognize that and adjust accordingly will be better off in the long run than those who don't.

Fraser goes on to recommend five steps to take advantage of these trends:

1 - Customer Service
2 - Partial Founder Buyout
3 - Focus on a Niche
4 - Don’t Be An ATM
5 - Raise Less. Invest Less

I am not a fan of the Partial Founder Buyout.  How is it in the interest of the entrepreneur to buy out his/her stock for a fraction of what the VC is going to sell it for in 3 to 5 years?  I understand all the arguments about risk mitigation and alignment of interests.  But the killer entrepreneurs I have met over the years would never go for that.  And I love them for it.  Solution number 2 is not for me.

On the other hand, I love number 4.  I never want to be an ATM for an entrepreneur.  That is a recipe for disaster.

I would suggest one rule and only one. Be the entrepreneur's partner. Help him or her. Be there for them. Support them. Counsel them. Share the risk with them. Have fun with them. Laugh and cry with them. And make boatloads of money with them. It's a time tested formula and it will work forever.

Comments

[Marina Architect]

Now we're talking . . . good editorial nose Fred . . . what Jason Fried over at 37 Signals is saying and doing is a better approach from a product development perspective (contrast that Six Apart who is relying on marketing to support product development). This is a key difference. Organic product development unencumbered by VC's versus marketing driven credibility. The latter works in singular cases while the former works in overall. Time to break for the weekend west coast style. Cheers.

[joeblow]

How do you propose VC's share risk with the entrepreneur? Given the entrepreneur is only one investment in an otherwise diversified VC portfolio, there is unbalanced risk from the beginning. Seems like that is exactly what the entrepreneur partial buy-out achieves. A % of your investment goes directly to the entrepreneur, without any potential upside for you - if the entrepreneur fails, that $ is lost, therefore at-risk. If the entrepreneur succeeds, that money is made up in spades by the ROI on the rest of the investment. Another solution is to give the entrepreneurs that you invest in an LP interest in your fund....that might help balance things out as well.

[charlie]

In a start-up situation, exchanging dollars that are then used to pay founding salaries, for equity, is a form of a partial founder buy-out....

[Eric Olson]

I think joeblow makes a good point about partial founder buyout (I like the LP interest idea - interesting iteration of PFB). In one form or another, it could really help the venture business. Sure, there are entrepreneurs who will go the distance with their VCs even though the risk is unbalanced from day 1. However, with so many companies that could go the distance (i.e. Flickr) being sold to companies like Yahoo! it isn't hard to see that something should be done to keep those entrepreneurs in the game.

Also, an optimistic judgement is made that the shares the entrepreneur gives up for PFB cash will sell for a lot more in 3 to 5 years. Judging by the high failure rate for early stage VC backed companies I would say that this is something that the entrepreneur can not count on.

With that said, the idea of PFB is still relatively new and should be given some consideration. It may not be perfect in its current form but with some thought behind it it could really morph into something that works to better align VC and entrepreneur interests.

(Charlie brings up a good point as well. Definitely something I hadn't originally considered in my ongoing posts about PFB at ventureweek.com/blog).

[Eric Olson]

I should also point out that I agree that some entrepreneurs will never go for PFB. I don't think it is for everyone or every deal. I just feel that in some cases it may be able to save some great investments from selling out too early or wanting to. Just another proposed tool for the VC toolbox.

[chartreuse]

I know Fraser Kelton. :)
He's a good guy.
You do have a good eye Fred! Nice catch!