Wednesday, August 12, 2009

VC: It's Not Just About the Money

This National Post article reprises a now-popular refrain: the venture capital industry got too big for its own good.
First, the problem with venture capital is not the lack of capital, rather it is excessive capital. Far too much has flowed into the industry in the past decade, flooding companies with cash that should never have been funded, skewing investment valuations and overdiluting the management talent pool.
This is true, but like much punditry it focuses too exclusively on the money aspect of VC. It is certainly the case that money is absolutely key -- it is the fuel that start-ups need in their pre-profitability stage and to accelerate growth in markets where speed is essential -- yet for many years there was a lack of attention paid to the cars they would pour the fuel into and the roads the cars would travel on.

We could sum up the dot-com VC funding criteria to be along the following lines:
  • Is the sector hot?
  • Is the management team able to execute, to reach a required level of product and business maturity before the sector falls out of favour?
  • Are there other investors in the market that are hungry for what this company can become with our investment?
Too often, this is about all they did. There was much talk and busy-work to puff it up, and demands placed on the company's management to help them build a good case, but once the above criteria were met, the decision was made. It was then a matter of negotiating (or bullying) to get the best terms.

Extending our analogy, the company's founders had to build a car sufficiently sound to make it from their workshop to a nearby gas station. If they had no fuel on hand, they could push it there or pick a station at the bottom of a hill. The gas station operator would then look over their handiwork and decide whether to fill it up, or at least give them enough gas to get on the road and make it to the next station. Getting the car on the road and rolling along with some grace was critical since that got the car noticed by others, who were often potential buyers. A car sitting in a parking lot with its tank empty doesn't get noticed, and it is easily passed by cars with gas.

Unfortunately the industry got to the point where the 'vehicles' that showed up the station only superficially resembled cars -- they were more like children's go-carts -- and the gas station owners lost their glasses and couldn't see very well. Soon there was gridlock on the roads with cars burning fuel and going nowhere.

Well, enough of that -- it would be painful to push the analogy further! It is enough to conclude that the last generation of VC model was not sustainable. The author of the National Post article is correct to warn against government diving in to sustain the broken model with taxpayers' money. Except that now we are in a position where we have moved too far backward, where any risk at all is frowned upon, and there is no money at all. This is a particular problem for new companies that have yet to make it to the first gas station. When they do get there, the pumps are shut down or the surly owners turn up their noses at their vehicles no matter how fine they are. Instead they dwell on remembrances of previous losses. The truth is that many of these gas station owners never did have a good eye for vehicle quality.

Can government help? Perhaps. If we still believe in or, better yet, want to build a strong technology sector in Canada, and that there is a future for technology businesses in general, some prudent steps would be helpful. They should do the same as any careful investor: nurture start-ups with small amounts of cash to keep them alive and innovating, and therefore viable when the economy and markets recover. If done properly, the companies will remain fiscally conservative and the government will risk only a modest amount. If the core beliefs prove correct, private investors will gradually come back to the table and fuel the technology recovery with not just money, but the business expertise to build and grow successful enterprises.

Governments should not invest in established and failing businesses. They should invest small amounts in promising and young companies that could become tomorrow's winners. They should not be concerned about building the next Nortel or RIM: that will emerge naturally if the environment is friendly to new and growing companies. While we will continue to see most start-ups fail, if done right the overall net return should be strongly positive.

No comments: