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Thursday, October 18, 2007

Venture Capital: the truth behind the myth

After spending quite some time helping entrepreneurs, I am know convinced that the VC model has evolved to a point where it is starting to die from too much success, creating another bubble in its own world:

- Too much money, too little time, resulting in smart people being hired to track the deals, but who have no clue what entrepreneurship is about and spend too much time in spreadsheets. Not a good recipe for success.

- Too much money resulting in a funding gap getting bigger and bigger: in 2006 the average initial investment from VC firms went from 5.9M$ to 6.2M$, and VC firms only invested in 700 "seed and early stage" deals, while angels invested in about 50,000 of these. Big money, later stage deals also means that the return are going to be less, how often can you expect a 10x from a C series investment?

- And beyond the returns on one deal or another, the results overall are not that great: VCs themselves will tell you that out of 10 deals 4 will die, 3 will do so-so and only 3 will do ok to very good. But even worse, the rest of the world will confirm that something is wrong: if you take a look at the Inc magazine top 500 companies, in 2006 only 7% of these were funded by VCs or private equity. So it means that 93% of the fastest growing companies were not part (did not get in or fell out of) of the famous and so well advertised VC process - VCs have been missing something.

- Even VCs are getting tired: raising funds is getting more difficult, and the business is getting very tedious, getting away from the passion of entrepreneurship (what I believe the "old school VCs" were about) and into a more austere financial world (the smart but arrogant MBA with no clue about what is happening in the trenches)

So what next?

- While VCs seem to be lost, the angel community is thriving: about the same dollar amount as done by VCs is invested by angels each year, but it is done by 250,000 to 300,000 individuals investing in many more deals at much smaller amounts. The good news is that if I go back to my 93% of the Inc top 500 companies, the average initial startup capital for these companies was $75K. So it seems angel investment is the right place to be. And these angels are now getting organized into angel groups to spread risk and help scale (sharing the work of screening, due diligence etc...), and they are starting themselves to raise funds (typically from individuals) to increase their reach if needed.

- Angels are getting the good deals: while I have no numbers on this, I have heard VCs tell me that their best deals were referred by angels rather than by other VCs. And I see now VC firms trying to get back into the early stage through scheme such as Charles River Venture Quickstart program, or YCombinator.

- So while it is easier and more sexy for the press to keep talking about the successes of famous VCs (Stories about Yahoo, Google, Skype and who's next?), the real work of value creation is being done somewhere else.

- Beyond the investment aspect, I think the key to success is that we are talking about individuals who are often time contributing their experience directly into the business, mentoring the entrepreneur through his/her own venture. People investing in people, something that looks like the P2P work we see happening in the Open source community, but applied to entrepreneurship. My bet is that this is where the future is...

PS: thank you to my partners Jean-Xtophe and Alberto at Melcion Chassagne et Cie for some of the homework on numbers