Dave Winer offers his suggestions for reforming the VC industry. Mathew Ingram disagrees with Dave and says “venture capital didn’t create the bubble.” Other opinions from the bloke-o-sphere can be found here, here, here and… oh, why don’t you just go look on tech.memeorandum for the latest.
I’m sure you’ve been wondering, “what does Anne 2.0 think?” because everyone wants to know what a stay-at-home mom high on vanilla mac nut Kona coffee has to say about the future of the venture capital industry.
I don’t have an answer as to how VCs should change, but I, like so many others, feel certain they must. I’m going to give an economic explanation of what’s happened and perhaps that will point to some economic answers as to how they might best transform themselves.
The Web technology space looks like a market becoming ever more efficient. That means the days of VCs skimming huge amounts of money off the top of the Web soup will soon come to an end. It means the end of abnormal profit.
Let’s review Econ 101, specifically what conditions are required for perfect competition:
- Atomicity
- There are a large number of small producers and consumers on a given market, each so small that its actions have no significant impact on others. Firms are price takers, meaning that the market sets the price that they must choose.
- Homogeneity
- Goods and services are perfect substitutes; that is, there is no product differentiation.
- Perfect and complete information
- All firms and consumers know the prices set by all firms (see perfect information and complete information).
- Equal access
- All firms have access to production technologies, and resources (including information) are perfectly mobile.
- Free entry
- Any firm may enter or exit the market as it wishes (see barriers to entry).
That sounds like Web 2.0 to me. We see atomicity as individuals like Gabe Rivera prove you don’t need venture capital or even any co-workers to produce something of huge value and as web services find they must drop their prices sometimes to zero to compete. A great example of homogeneity is seen in the proliferation of news aggregators, most of which are good substitutes for one another. The blogosphere promotes perfect and complete information about prices and features of competitors’ offerings. Open source software, technical forums, and cheap services like web hosting and performance stats provide equal access to everything anyone needs to create something. Barriers to entry? What barriers to entry exist on the Web, at least for citizens of first-world countries? None. Free entry, check.
The beauty of perfect competition is seldom seen in the real world, but we are witnessing it emerge on the Web. What’s so wonderful about it is the benefits that perfectly competitive markets bring to consumers, nay to the whole world as resources are deployed in the most efficient way possible: goods are offered at the lowest possible price and are produced at the lowest possible cost.
Consider again abnormal profit:
Supernormal Profit, also referred to as abnormal profit or pure profit, is an economic term of profit exceeding the normal profit. Normal profit equals the opportunity cost of labour and capital, while supernormal profit is the amount exceeds the normal return from these input factors in production.
The opportunity cost of labor and capital is likely a whole lot lower than the wild returns VCs saw during the first Internet bubble and also lower than what venture fund investors expect. Returns that adequately compensate investors for the illiquidity, risk, and high costs of venture investments may be possible in the areas of tech that aren’t converging on a perfectly competitive market, for example VoIP projects that require hardware development and manufacturing or biotech investments requiring uncommon expertise and huge upfront research costs. But typical Web 2.0 startups like news aggregators, Ajax start pages, calendar applications, and so forth are unlikely to make lottery winners of VCs, their investors, or anyone else. Without the supersize returns, it’s hard to see how VCs focusing on Web services will survive in their present form.
18 Comments
Super post, Anne. That kids’n'kona thing is really workin’ out
– Stuart
While I don’t agree with many of Winer’s ideas, I do agree that the VC industry is in serious trouble. It has been for some time, actually … and it will get worse before it gets better.
What’s amusing to me is that you don’t see many of the usual VC bloggers covering Winer’s post in depth. I guess current or potential Limited Partners might not like reading that in many sectors and in certain geographical regions, there is just too much capital in play.
Anne, what you describe means that not only is there little reason for VCs to invest in the startups on parade–but that most of the web 2.0 companies don’t have much to differentiate themselves and therefore there are unlikely to be succesful. It doesn’t look like there will be any big names emerging from that group.
And yes, barrier to entry is almost nothing. Except, barrier to users is high. Entry is free but acquiring users/customers is expensive.
That’s why first movers that have managed to get users/customers, are ahead of the game, and are above the noise level from “Me too!” startups that come along later.
The future for most VCs (and some have already done this) is to start their own companies and start doing what they say they can do.
Thanks, Stuart. I’m stuck with the kids and addicted to the Kona, so it’s a good thing they haven’t totally compromised my ability to think and write.
Class V, I think that the next five or ten years is going to be really interesting in many sectors… seems like returns are likely to be flat. So much capital, not much to do with it.
Tom - I like your idea that most VCs should get out there and start their own companies. Some of the suggestions for how they should change, like offering more support and services to entrepreneurs, transform them out of their main role as funding agencies. I’m very curious to see how it evolves. And I agree that most Web 2.0 companies don’t have very good prospects.
I agree, except for one thing. Building a company with profitable sustainable revenue from volume will always require capital. The current startups are moving quickly but most lack a sustainable revenue model. It’s easy to get a few customers, hard to get a few hundred thousand and really difficult to get millions.
The key as always is focus on customers, build a great team, execute and when needed use capital wisely
According to your definition at the top, this part isn’t right: “We see atomicity as individuals like Gabe Rivera prove you don’t need venture capital or even any co-workers to produce something of huge value and as web services find they must drop their prices sometimes to zero to compete.”
Atomicity has nothing to do with whether people need VC - it’s because they are small (and so they don’t need VC or co-workers also). The huge value is not part of atomicity either. Atomicity does require competition which does require some interchangeability and commoditization, which we are seeing with web services.
Yes, Pete, I agree that building a company with sustainable revenue will require capital. Perhaps bank loans would be more appropriate than venture capital in the case where returns look more like normal than supernormal profit.
Cade, you’re right, I got a bit of my big argument mixed up in the example of atomicity. Thanks for the correction.
I guess this holds up in the US - but outside of the US it is a totally diff’t story - maybe that is why there are so many China focused vc funds now - oh, wait, is it happen’ in Asia now, too?
“Without the supersize returns, it’s hard to see how VCs focusing on Web services will survive in their present form.” - Anne 2.0. You’re absolutely correct. The smart ones have moved on. Web services, IT, groupware (calendars, RSS) cannot be funded. In fact, if you get funded for this type of venture, you’re dealing with a brain damaged VC firm and you should run far and fast away from them.
Most VC firms lament the lack of “innovation”. To me, this means “ideas that can generate returns the size of late 90s/early 20s”. It also means that the VCs don’t want to spend more than $10K to $50K on a single venture. The ironic part about this is that the smart firms are sitting on piles of money waiting for “innovation”. They plow cash into their existing ventures because they have no where else to go.
The smart VCs have moved on: power, biomechanics, material science, etc. Some have funded startups whose purpose is to seed other startups with technology.
(The best place for Kona coffee is outside Captain Cook on the Big Island. You drive into a coffee grove right to the roaster. You watch the coffee beans come off the belt into bags. You pay the pay the man, go home immediately, perform the addiction preparation ritual and get blasted. Try to minimize the time from the roaster to your actual sip to about 30 minutes.)
Adam, yes, maybe you’re right, lots of opportunities for abnormal profits in Asia.
SRW, good translation of the VCs’ lament re: innovation. I wonder if one way this supposed bubble will differ from the last one is that very few people will become multimillionaires from it.
That Big Island coffee sounds great. I’m on Maui but I might be able to get over there for a weekend or even a day and sample java fresh from the grove. Thanks for the tip.
The VCs want more control (i.e. ownership %, board seats, etc) now. There’s very few deals that give the company more than 35%. That percentage has to cover founders, employees, consultants and vendors.
The point is that the VCs are only obliged to their own partners and their limited partners but not the entrepreneurs. These days I expect that out of $100M (a typical deal size) IPO/M&A exit one founder will become a multimillionaire. A similar deal in 1997 would probably be about $300M-$400M and might generate 10 employee millionaires.
(I’m embarrassed to be telling someone from Hawaii about coffee, though I have not had good luck with coffee from Maui.)
/The smart VCs have moved on: power, biomechanics, material science/
Oh yes, and software is dead. This is why VC’s miss every wave, they’re non-technical herd animals driven by fashion.
SRW, I am probably in one of the best positions of anybody to take advantage of a tip about coffee on the Big Island, so you shouldn’t feel embarrassed about offering it. I don’t think I’ve actually tried Maui coffee, except maybe by accident. Now I’ve got to figure out a way to get to Kona before we move…
I am not a VC, instead I am an angel investor, but I am somewhat knowledgeable about VC economics.
Your fundemental point is based on the assumption that VC firms make a “supernormal profit”. I discuss some about venture capital economics in my post On Being an Angel http://www.lifewithalacrity.com/2006/01/on_being_an_ang.html — if we start with an hypothetical venture capital fund of $500M, it will have 47 losses and 2.5 successes. The fact that that they invested $25M and recieved $250M for the each successes doesn’t show the the losses for the failed ventures. Add in 3% annual management fees, inflation over 10 years, and the 20% carry for the VCs, many VC funds don’t do as well for institutional vendors as the stock marketplace. These numbers are very transparent to the institutional investors, so if the VCs were making too much money, they’d be pushing these numbers significantly down.
BTW, I don’t want to be an apologist for VCs. I’ll be the first in line to chear the a replacement for our current methods of venture capital. But we can’t replace them unless we understand them. In my opinion almost all of the perceived problems with VCs exist because economic and sociological consequences of their niche.
Hi Christopher, thanks for stopping by and commenting. I saw your comment on Amy Wohl’s post but I didn’t want to create a profile there, so didn’t respond.
Disclaimer: I’m an armchair economist and an armchair VC watcher. Sounds like you have real experience and real numbers to argue from.
Yes, my argument hinges on the presence of supernormal profit. But it’s the VC partners who got it, not the institutional investors. The 3% management fees, the 20% carry–that’s more than what they should have gotten in a perfectly competitive market for financial intermediary services. Why did institutional investors put up with it? If the returns didn’t make up for it, I don’t know why they wouldn’t just go with more liquid and safe investments.
It’s like the hedge funds of today. For the past few years, they’ve been able to demand these outrageous fees because they exploited inefficiencies in the markets and produced above-average returns. Now that so many people are pursuing similar hedging strategies, the opportunities for supernormal profit are being squeezed out and hedge funds aren’t compensating their investors for the costs that those investors pay to invest with them. So, investors are moving on.
Again, I’m basing this on my armchair view of it all. I don’t invest in or run a hedge fund, but I do have a subscription to the Wall Street Journal
I’ll have to read your article when I have more time. I’m very interested in pursuing this analysis further. I’m also interested in what people think is going to happen with Web 2.0 type services–will people just fund them with a credit card and then charge users to create revenue? Is advertising truly feasible as an ongoing revenue generator for say, a newsreader or a mashup builder? I’ve heard Bloglines hasn’t added advertising to their service because they think users wouldn’t stand for it. So how are they making any money to sustain themselves?
Thanks again for the comments, and I’ll look forward to reading your article when I’ve dug through my morning work.
Dear Anne: I am a bit perplexed as to why VCs are offering still such large bucks to web 2.0 ventures…this technology is about collaboration and user input…so really websites like StumbleUpon and others generate massive user communities, but I honestly don’t see how these companies turn a profit. After the VC capital is used up, then what? I think Web2.0 is exciting from the tech standpoint, but for the average business person, how is a profit generated? These are indeed strange and undefined times. Regards, Keith Johnson, Hollywood, FL
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[…] This discussion reminds me a little of the one around venture capitalists that happened back in January, wherein I proposed that venture capitalists are doomed. It’s right out of Econ 101: competition drives out profits. The consumer benefits from lower-priced goods. Now, I don’t want to be naive and think there’s no disadvantage to what Google’s doing. As Kedrosky and Foremski point out, there are drawbacks: Google may not keep supporting these free services if it succeeds in killing off money-charging competitors. People do get put out of work when cash cows die. I don’t agree that Wall Street won’t consider this in its valuation of Google, because it only adds to the air of inevitability around Google’s eventual victory over everyone else. And that brings us back to the possibility of a monopoly, which is indeed a concern. Call me a bad mix of Democrat and Republican, but I think the market will work pretty well and when it doesn’t, the government anti-trust division will step in. […]
[…] I say: the revolution’s for real. But older generations don’t get it. And when I say “older generations” I’m not so much referring to age as to mindset. If you still think that the old ways of doing things–massive VC funding, centralized and topdown operations, locating the heart of your work in Silicon Valley because you’ve seen others succeed that way, looking for supernormal profit–you’re part of the older generation. […]
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[…] Why Venture Capitalists Are Doomed […]