Posted by Tom Foremski - July 28, 2010
[This guest post is extracted from a longer article: Saving Silicon Valley.]
Georges van Hoegaerden was born in The Netherlands and came to Silicon Valley to work at Oracle. He soon jumped head first into the startup life and became a serial entrepreneur. But he quickly became disillusioned with VCs and a VC industry that lacks proper governance and consistent execution. He is passionate about reinventing the entire VC industry.
In this post he warns that Silicon Valley is on the brink of a serious "implosion" because 95% of VC firms are not making money for their investors. Many VCs are risk averse, they don't have the business experience needed for the job, and they are happy living off of generous management fees rather than working hard to build successful startups.
He points out that there are tremendous business opportunities ahead. We are still at the very early stages of a massive technology boom with just 20% of the world's population having access to any meaningful technologies. The VC industry should be expanding rather than contracting.
By Georges van Hoegaerden, Managing Director, The Venture Company
Some people do not understand why I do what I do and why I bother, and underestimate my determination to fix Venture Capital. Certainly there are much easier ways to make money than to pursue the obliteration of an investment cartel, in which seemingly everyone belongs to the club.
I came to the U.S. on my own with some hard earned chunk of change in my pocket, invited by Marc Benioff (now Salesforce.com CEO, then Oracle VP) and Larry Ellison (Oracle's CEO) who wondered why I was able to sell their (then) emerging products while they couldn't.
I left Oracle with fond memories as soon as my green-card was approved and jumped in Silicon Valley hoping to find more intelligence there.
My first startup was a group of consultants with a horrible business plan, and I told them about my opinions in a way only I can. Instead of fleeing, they came back and asked for guidance (management incubation). We turned the company into a product company and raised a double digit series-A post 9/11. The company was sold in 2006 for triple digits.
As a board member my encounters with Venture Capitalists quickly made me question their catalytic value. I went on to build a few other successful companies and had a brief part-time stint on the "dark side". A clear pattern of defunct VC governance and execution started to emerge.
The startling revelation, as proven out by the empirical evidence I have delivered for quite some time now is that according to a renowned money manager 95% of Venture Capital (VC) firms are not making any consistent money for their investors (Limited Partners).
And that means Silicon Valley is at the brink of a serious implosion.
Imagine what would happen if only about 35 of 790 VC firms were to survive in ten years from now.
Alarm bells should be going off by now, but few appear to be paying attention. Why not, you say?
Well, much of the money pumped into VC firms comes from Institutional Investors (pension funds, endowments, insurance companies etc.) with bulk loads of cash reserves they want to put to work. They dedicate a predetermined amount (usually by board consent), between 10% and 15% of those reserves to alternative investments of which a portion is then allocated to Venture Capital.
To make a long story short, a tiny portion of assets from Limited Partners (even the non-institutional ones) is devoted specifically to Venture and a loss or break-even of less than 5% of total assets does not evoke a lot of emotion. Hence optimization discussions with Limited Partners about Venture turn with the agility of a big freight ship.
The alarm bells are getting muffled even more. Institutional Investors have built majestic constructs supporting the deployment of their Venture Capital assets. Many invest in Venture Capital through fund-of-funds with a "specialization" in alternative assets, a fuzzy term for anything that is not mainstream.
And thus the actual performance of Venture is hidden behind the performance of the grab-bag of other financial instruments that resides in those fund-of-funds.
And it gets worse. VC firms themselves have been allowed to diversify their risk by embedding alternative investment strategies within the firm, and in worst cases even within the same fund.
In short, Institutional Investors have stacked derivative, upon derivative, upon derivative (with of course zero marketplace transparency) and appear surprised performance of Venture Capital has lost the fantastic upside that made them all want to get in some 20 years ago.
And the mess does not end there.
The mushy multi-tier asset allocation constructs allowed many General Partners entry to the Venture Capital business who have no credentials of being there. Their lack of experience and foresight has turned into fear and with it the implementation of Venture Capital risk has turned predominantly subprime.
As a result Venture Capital risk has produced over the last ten years no more than micro Private Equity returns (less than 10% IRR), squandered about $1.7 Trillion in funds and eroded public trust in companies that never had any social economic value to begin with.
That fear from inexperienced General Partners in VC firms further exhibits itself by the deployment of 10 levels of diversification of risk when a VC firm makes an investment into a startup. Extreme fragmentation of assets and risk protects VC downside (making good money off management fees for 12 years) more than it protects upside, and thus Limited Partners are poised to lose out again, regardless of the economic circumstances.
Limited partners deserting venture
Improper deployment of risk cannot be mitigated by economic recovery. Venture needs a reinvention from the top. But who cares?
Everyone in or around Venture should. The worst thing that can happen to a sector is that investors stop caring, and many have. Many Limited Partners will not renew their commitments and simply get out, and allocate their 5% of Venture Capital elsewhere.
A speaker at a recent conference claimed the demise in VC firms to be as large as 30% over the last 10 years, with as much as 50% of venture folks already affected. New Limited Partners to the sector I speak with simply see no reason for getting in, given its deplorable performance.
And Venture Capitalists don't seem to care too much because ten years of a cushy management fee from a sizable fund -- with no way for the public to establish their merit -- gets them setup for life quite comfortably.
Under the cloud of economic insecurity and with micro private equity returns in hand, it is still easier to raise another fund (and thus another ten years of fees) than to admit that not the economy is at fault, but their deployment of risk in it.
Idiot Limited Partners
Many idiot Limited Partners have fallen for their arguments again and Venture continues to spiral further down the slippery subprime slope it has been on for a while. To VC, survival of the fittest has turned into survival of the shrewdest. Or as a General Partner from Sequoia Capital allegedly stated: "We used to have a club, now we just club each other".
But the real impact of all this ignorance has already affected entrepreneurialism. Defunct VC governance has led to a dumbed down investment thesis that will only attract entrepreneurs that submit to that thesis. Hence the quality of innovation that surfaces is limited by the quality of the thesis that is projected.
Subprime entrepreneurs, willing to be enslaved by subprime VC governance continue to tear down the potential of social economic value groundbreaking innovation is supposed to ignite.
Today, glorified programmers and VCs are the inexperienced partners in a dance that only a small audience (not the public) wants to attend.
Huge opportunities ahead
With 80% of the world's population still not having access to meaningful technology applications, the opportunity to spawn new groundbreaking innovations remains enormous.
Technology adoption keeps growing, even when Venture Capital declines in its ability to govern worthy innovation. So, the opportunity dictates that there is much more room for Venture Capital firms to grow, just not for ones that cannot establish a proper investment thesis of innovation.
There is no valid reason why 100 VC firms with a single $100M fund cannot generate a six times return each, except for the improper deployment of risk. Certainly the gaping opportunity in technology dictates that there is also no reason why the total number of Venture firms in the U.S. could not reach 1,000.
The grim impact of doing nothing
The most powerful assets in the Venture ecosystem (see our Venture Primer) are the many entrepreneurs with groundbreaking ideas we have bred in this country. Yet, those outliers of innovation have systemically been ignored by a dumb financial system that favors those willing to be enslaved by subprime risk.
Groundbreaking entrepreneurs have already left the party and quickly become extinct. Lured by lucrative offers they chose to find solace with better custodians of innovation, larger yet agile companies that simply took better care. Many returned home to their country of origin with an Ivy League diploma in their pockets. Silicon Valley, for what it once represented, has begun to implode.
With more than 50% of moneys spent in certain areas of Silicon Valley dedicated to startups, a 90% erosion of that money (from cutting down the systemic underperformance of 95% of VC firms and retrenching of disappointed Limited Parters) leads to an estimated 45% decline in overall jobs.
That in turn creates massive economic deflation to the region and exemplifies why governmental intervention without fundamental reform (the current band-aids will be circumvented quickly) of financial systems in Venture does nothing to prevent the slide it is on.
Our local and federal governments should be all over this case, to prevent a further systemic slide that could turn California into a grave-yard for what has been, and our country from becoming the lost leader of innovation.
Our government has simply not connected the dots between systemic failure in Venture and systemic failures in the economy, just yet. The pain and destruction probably has to become more obvious first.
Outdated financial system
U.S. Commerce Secretary Gary Locke did the usual politically correct thing by inviting members to his National Advisory Council on Innovation and Entrepreneurship with large statures in the old system, yet none in the new. The outcome of that exercise will be as expected, more of the same (yet no one will be able to politically accuse him).
Groundbreaking innovation always comes from the outside, never from the people within. That applies to the innovation of our financial systems in Venture too.
As a reader of my blog, you may not be surprised to learn that the problems in Venture have nothing to do with some deep rooted and mysterious "Voodoo" of technology or innovation. We have an outdated financial system that does not need more regulations of its complexity, but a dramatic simplification and flattening of its marketplace behavior.
The Venture business is the poster child for creating such a new financial system, as its current performance can nothing but improved on.
Innovation can only be saved by a financial system that is truly a free-market system, away from the existing cartel that offers no marketplace (transactional) transparency, and is void of real competition that lies at the capitalistic fundamentals this country was founded on.
So, my self-imposed journey to save America from itself continues, for I have seen its potential.
We can save the fantastic innovative capacity in this country and elsewhere, when we apply the same intelligence of the way entrepreneurs build innovation to the way we fund it.
Without a new free-market financial system in Venture, be sure to strap in for a massive implosion in Venture that will take ten years for many to discover -- yet had been predicted by this annoying whistle blower all along.
At least now you know who he is.