Venture Capital Stimulus Plan – The Big Picture

First off, you’ve probably noticed that I tweaked the design of VentureDig. It’s running on Thesis now — one of, if not the, best blog themes. I really don’t know why it’s the best. Everyone seems to say it’s the best because, well, “It’s the best.” So, since I have it now, it’s the best. Plus some kick-ass investors have adopted the theme lately, too.

Here’s a famous little fable that will make sense in a sec:

It was six men of Indostan
To learning much inclined,
Who went to see the Elephant
(Though all of them were blind),
That each by observation
Might satisfy his mind.

The First approached the Elephant,
And happening to fall
Against his broad and sturdy side,
At once began to bawl:
`God bless me! but the Elephant
Is very like a wall!’

The Second, feeling of the tusk,
Cried, `Ho! what have we here
So very round and smooth and sharp?
To me ’tis mighty clear
This wonder of an Elephant
Is very like a spear!’

The Third approached the animal,
And happening to take
The squirming trunk within his hands,
Thus boldly up and spake:
`I see,’ quoth he, `the Elephant
Is very like a snake.’

The Fourth reached out his eager hand,
And felt about the knee.
`What most this wondrous beast is like
Is mighty plain,’ quoth he;
`’Tis clear enough the Elephant
Is very like a tree!’

The Fifth who chanced to touch the ear,
Said: `E’en the blindest man
Can tell what this resembles most:
Deny the fact who can,
This marvel of an Elephant
Is very like a fan!’

The Sixth no sooner had begun
About the beast to grope,
Than, seizing on the swinging tail
That fell within his scope,
`I see,’ quoth he, `the Elephant
Is very like a rope!’

And so these men of Indostan
Disputed loud and long,
Each in his own opinion
Exceeding stiff and strong,
Though each was partly in the right,
And all were in the wrong!

So, oft in theologic wars,
The disputants, I ween,
Rail on in utter ignorance
Of what each other mean,
And prate about an Elephant
Not one of them has seen!

Thomas Friedman wrote an Op-Ed article today that was buzzing with responses. Some supported his reasoning, some stated valid counter-examples and some blasted him.

Friedman espoused a venture capital bail-out; instead of an auto-industry bailout.

You want to spend $20 billion of taxpayer money creating jobs? Fine. Call up the top 20 venture capital firms in America, which are short of cash today because their partners — university endowments and pension funds — are tapped out, and make them this offer

I found Fred Wilson’s post interesting as he argued against Friedman’s point.

[Venture Capital has] too much money in it, not too little. Just ask the limited partners who have been overfunding the venture capital business for the past 15-20 years what they think. You don’t even need to ask them. They are taking money out of the sector because the returns have been weak.

And the top 20 firms in the venture capital business are the least in need of a bailout of any group I’ve ever thought about. These firms, the Sequoias and Benchmarks and Accels and Kleiner Perkins etc etc can raise a fund anytime they want. Accel raised a ton of money last fall in the midst of the worst global financial meltdown in my lifetime.

The venture capital business is an asset class where the top 10-20 percent of the firms make 80%+ of the returns. That’s how its always been and that’s how it will likely always be.

I see valid points in his post, as well as Friedman’s argument. I really can’t say which side is correct; however, I have a hard time agreeing with Fred in one respect. You see, I’m a small-business guy. I’m an advocate of entrepreneurship. After all, that’s what America is founded on. I know that Fred holds the same belief. What I have a problem with is that there are plenty of viable ideas out there that are simply not getting funded. Fred argues that there is too much capital in the venture sector. Yet, hardly any entrepreneurs are getting a lick of it. I find this odd. Where’s all the capital going to? Management fees?

The problem with both Friedman’s and Fred’s reasoning is that their argument centers on a debatable premise. Both cite the “top 20 VC firms.” Fred cites the Sequoia’s, Benchmarks, Accel and Kleiner Perkins as reasons that the VC sector is doing just fine. The problem is that those firms are later-stage funds. They’re cash cows. To accountants, they’re “the big four.” The problem with these firms is that they’re profoundly risk-averse. I would almost liken them to mutual funds that invest in later-stage clean tech/brick-and-mortar/proven web businesses.

Like the two blind men who described an elephant very differently because they couldn’t see the full-picture, so too is the reasoning between Friedman and Fred Wilson. Perhaps both Friedman and Fred Wilson are right—in some respect:

First, let’s check out the latest finding’s from the most recent NVCA report:

• Venture capitalists are predicting a slowdown in seed and early stage investment in 2009 with 60 and 64 percent of respondents indicating declines in those company stages respectively.
• These predicted declines are reflective of the dismal exit market and the inability of venture capitalists to make substantial new investments of time and money.
• While 96 percent of VCs predict that more venture firms will not be able to raise money in 2009, a lower percentage, 85 percent of respondents, believe institutional investors will reduce commitments to venture capital asset class.
• An overwhelming number of venture capitalists (72 percent) do not expect the IPO market to re-open for portfolio companies until 2010 or beyond.
• Bottom line: Most venture capitalists are predicting a very difficult 2009 but anticipating a much improved 2010

Here are some more facts that you should scan:

• Fact: The economy is down
• Fact: Entrepreneurs that should be funded aren’t getting funded
• Fact: Seed-stage investments are the source for innovation, and is also the riskiest
• Fact: Later-stage investments must first be brought to life through seed-stage investments and the entrepreneur’s sweat
• Fact:  The Big Four, as always, are generating returns through safe/later-stage investments
• Fact: Seed stage firms are pulling back their investments
• Fact: Today, more than ever, Limited Partners wish to avoid risk inherent in seed-stage investing
• Fact: Because of this seed-stage drought existing venture funds are careful with their investments, and the quantity of investments is low (that is, until the plug is pulled through capital calls)
• Fact: With a seed-stage VC drought promising start-ups are dying out

Wrapping Things Up:

The problem both individuals are trying to solve: Early stage innovation is dying out due to lack of funding

• Solution proposed by Friedman: Venture capital stimulus plan. Instead of investing in auto-industry, invest in the top 20 VC firms that are struggling to retain capital commitments.
• Solution proposed by Fred Wilson: Venture Capital has too much funding, citing the big four (later-stage, safe investments) as dominating returns.

Like the six men of Indostan. Parts of both solutions are correct. Friedman is right, in that, it’s sensible to invest in the venture capital sector rather than the auto industry. Fred Wilson is right, in that, later-stage VC’s are doing fine. However, they’re failing to grasp the big picture: early stage entrepreneurs are dying out. More than ever, a seed-stage stimulus package is needed.