Venture Capital at Cross roads
A follow-up on "What's Wrong with Silicon Valley" in the Business Week, January 12th edition.
 
We all know that venture capital has been fundamental to the enormous rise in wealth during the 1990 and even the 2000s despite the market correction of 2001 and there are some points in the article that I'd like to debate out.


Central to the article was that Venture firms were shying away from the risky bets that were made before the 1990s. An interview with Andy Grove a semiconductor specialist who advanced the cause of Intel as CEO and chairman and saved the US chip industry from Japanese Industrial dominance was remarkable in its insights in what ails the industry -

  1. Short-sightedness of the current pack of Venture Capital industry 
  2. Propensity to satisfy investor returns by working towards exit strategies

It is funny how Venture Capital Industry has "stopped" taking risky bets - in truth this can be partially blamed on the bursting of the technology bubble in 2001 leading to venture capitalists around the world to tread more cautiously in their investments but the fundamental reasons are to be found elsewhere.

 

In the 70's and 80's the world was not uni-polar. The US competed with the USSR on several fronts but principally on defence and space. The former was more a matter of survival while the latter was more of prestige value, with huge amount of government budget allocated to both fields. This meant money for two fields which were paramount in the overall defence strategy of the US - Information and Communication.  This led to notable breakthroughs in applied sciences and engineering. The principal sponsor and market for these technologies was the government and the defence/space industry. Thus the cash lifeline was not the "market" as we might like to think but national interests. The entrepreneurs and financiers came from a closely knit network built around the defence industry where to succeed one needed:

  1. Bright engineers
  2. Trust
  3. Cheap source of finance

And at that time all three were present within the defence and space industries. (The trust factor came from peer pressure which is fundamental to the behaviour in the armed forces)

 

Zoom out to 1990's. The world had largely become uni-polar and as the US didn't need to compete anymore with the now defunct USSR - defence and space budgets as a percentage of GDP actually decreased which had the following implications

  1. Engineering as a well paid profession where engineers could work on cutting edge technology started changing. Instead engineering was seen primarily as a "cost centre" and not an investment leading to outsourcing to cheaper sources thus slowly putting into motion the "death spiral trap" of engineering. Lesser innovation weans away demand for engineers and higher risk in the job for lesser pay makes engineering an even lesser incentive for bright students to take up as a career path.
  2. Breakdown of trust based networks. Now that "business" in terms of off taking of products or services could not be  guaranteed by the military/space - firms had to actually start "selling" and for that "creating markets". This meant creating new networks which could eventually become sales avenues - but his meant "building trust through suspicion" a costly process where negotiation skills become more and more important - this eventually saw the rise of the "sales" CEOs or "consulting" CEOs i.e. CEOs who did not have engineering backgrounds but came from sales or consulting backgrounds as these backgrounds pre supposed that the individuals could get in deals faster through the trust they had built with past clients.
  3. Financing source became typically expensive as the resource necessary to create products was harder to obtain, and the market for the products needed to be created - thus moving VCs to demand typically hurdle rates of 25%.
Thus what we see today as start ups are typical of the consequences of lesser government spending as a percentage of GDP on defence and space industries namely:

1.     Since good engineering is a "rare" resource - most start ups today are "efficiency players" - i.e. there is very little engineering innovation in Web x.0 compared to the innovations which went into creating transistors or integrated circuits. It is easier to create a community based application than a micro chip as the barrier to resources is much lower - (indeed founders of digg and Facebook are University drop outs which of course does not imply that they cannot innovate or understand the nature of innovations but most innovations they will bring will be limited to mathematical optimization in search patterns).

2.     Since engineering costs are low due to the non complexity of products and services, VCs are also not willing to pay top dollars for these resources. VCs being typically humans act in herd mentality and many of them have vaunted MBAs where the notion of ROIC (Return on Invested Capital) is "fundamental" to value creation. This has terrible implications for innovation which in itself is a long process (think of the time it took from the p-n junction to the integrated circuit). VCs thus are drawn to "low cost" start ups (read resource light in assets as well as engineering skills) with higher than ordinary returns in the shortest possible time. This is the nonsensical finance equation which today has precedence over a beautiful navier-stokes or a tunnel effect equation. 

3.      "The shortest possible time" in VC speak is typically three to five years which means that a market needs to exist or be created for the VCs to make their returns. This of course led to the 2001 dot com bubble burst where VCs and Investment bankers colluded to synthetically create a market by passing the risk to "non sophisticated" investors - ( I would say more gullible as VCs are not sophisticated). Earlier VCs could "measure" return by counting the dollars that defence/space was willing to spend and through careful pruning dividends that could be distributed after years of operations.

 So is VC and entrepreneuship doomed and how to get "creative destruction" right ?

 

   1.       We need a big big dream - not of making money, but of a higher cause which will progress mankind, someone to state  that dream loud and clear and goverment to push money to realise that dream.
   2.      If the dream is stated and money is on the table, a competetive process needs to be put in place so that the best "brains" bid for the realization of the elements that will make up the dream. The "best brains" will hire best of class - because "brainy" people often despise being surrounded by mediocre types - and this will lead to higher awareness and participation in the exact and applied sciences. Too many science students are lured by the big bucks offered by investment banks - making money out of money has limits ( read credit crunch).
   3.      VCs will be pruned out. Only the "grand cru" will survive. As money from the government spills in entrepreneurs will go for cheaper source of financing. since Vcs are human they'll want to be part of the big " show and tell" - but will have lesser bargaining power reflected in lower hurdle rates. The ones which will be able to survive on lower hurdle rates are those which have longer relations with limited partners and longer and more realistic track records as well as better networks to benefit the entrepreneurs. After all - isn't capitalism's first tenet - "The fittest survive"

 

 
 

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