If we as investors do not change our investor tactics and produce real socioeconomic value, venture capital will inevitably descend even further into micro-PE, and suck the risk and returns out of performance.
The Venture business has got the world upside-down, is what I wrote in a recent comment to a VC and I meant it.
Just as upside-down as many people who buy a house and get a mortgage and confuse a liability with an asset. A great example I heard Robert Kiyosaki (from Rich Dad, Poor Dad) refer to in an infomercial in the background while I was doing work on a quiet Sunday.
Venture should perform much better
From many discussions, publications, public statements and strategies discussed in new Venture videos it is clear how a large part of the Venture community struggles and puts up relative performance metrics (such as meaningless top-quartile definitions) and pad themselves on the back that Venture is still outperforming public markets. All while technology Venture performance should have blown other asset classes and public markets away, by its massive greenfield (5/6 of the worlds consumers) and continued growth in technology adoption (even through the worst of our recent economic downturn).
But Venture is looking at the wrong metric of success.
Focus on upside
The real issue in Venture is that the innovations Venture Capitalists select, barely have any socioeconomic value and therefore by definition have severely limited upside potential. On a scale from Technology to Market, to Execution, to M&A, to IPO, to socio-economic value, most venture investors today look for technologies and apply their risk thesis to the left, or downside of the scale, hoping and praying ever to reach the right.
Frankly, most investors have upside and downside confused, which is the source of their unsatisfactory performance. Technology development is not a testament to ever reaching socioeconomic value. And to demand from entrepreneurs that they build technology is a sign of how they further defer the majority of even downside investment risk to entrepreneurs (“show me what you have built”) as a prerequisite to investing (as we explained about Vinod Khosla’s perspective in The State of Venture Capital).
What we have lost over many years of irrational exuberance in Venture is our ability to spot and target sizeable socioeconomic value. A value defined by the trust of the public as a customer. Not to be confused with an IPO, which is characterized by the trust of the public as an investor (preempted by an investment bank).
In the 90s venture investors pushed valuations without value through the IPO funnel, which led to a loss of faith and a retraction of IPOs post 9/11. The way to regain trust with the public is not to sell them another lie. A lie that is based on nothing but the hope and rise of the economy that is supposed to float all boats again. But to have the public use the product as a customer, and let them make up their mind about its value as an investor. Hence the definition of upside in Venture defined as the creation of socioeconomic value as opposed to an IPO. IPOs will flourish once that public trust from consumers is achieved.
Reverse engineering upside
A fundamental difference in the investment thesis is that as a venture investor, instead of looking at the gating technology proposition, you assess an innovation based on the merit of its ability to change the world (where no prior implementation likely exists). But you as the investor can align with the entrepreneur based on a shared vision, compass, and the likelihood that the support of that socioeconomic value will feasibly occur within the next five years.
And that means that both the entrepreneur and investor share the predictions of the trajectory that builds Social Economic Value, a much better equilibrium between entrepreneur and investor. One in which, according to Warren Buffet, the “owner-oriented attitude far outweighs the periodic downside.” No longer are entrepreneurs pestered with demotivating rounds of ownership dilution based on unpredictable microeconomic aberrations and, no longer do investors waste time to worry about the minutiae that do not affect the socioeconomic outcome.
Rather than planning from a technology starting point, the socioeconomic value is created by back-planning or reverse-engineering upside. Meaning, to develop sizeable socioeconomic value a specific IPO range needs to be achieved, which can be swayed by M&A interest. Which, in turn, is created by excellent execution, stemming from understanding the behavior of marketplaces, which can be served by technology. Technology as the derivative, not as the goal.
The distinction between prime and subprime innovation is simple. Prime innovation is attached to existing macroeconomic behavior (and usually the absence of technology previously) and relatively easy to predict (I would be happy to share examples). Subprime innovation is attached to a technology wave with an early expiration date and little macroeconomic value (the main reason why many acquisitions perform so poorly) that has a minute chance of ever producing viable returns.
Investing different leads to different entrepreneurs
Upside investing applies the proper risk to an early stage Venture; it applies it to the assessment of anything else but technology. Because, as technologists, the creation of technology is the least of our risks. But it requires a VC fund that can carry most of the $25M runway needed to create the success of any disruptive Venture today (yes, “capital efficiency” is a lie). The small funds can continue to deploy their subprime risks, while the larger funds have the opportunity to separate themselves macro-economically, by spawning real innovation.
The minute you as an investor set a different compass and focus on the creation of socioeconomic value; different entrepreneurs come out of the woodwork to subscribe to such an investment thesis. Suddenly you will meet the entrepreneurs that through years of experiencing macro-economic deficiencies, have a vision of how to change the world for the better and as a result generate the large outlier fund returns Limited Partners need to see to stay confident.
Change is inevitable
We may see a slight upswing in IPOs this year, as the economy recovers, micro-PE deals are the best game in town, and those with money to play, regain some confidence. But if we as investors do not change our investor tactics and produce real socioeconomic value, it is inevitable that Venture will descend even further to micro-PE than it already has, and continues to suck the risk and returns out of performance.
And that would be the kiss of death to Venture and to the wide-open opportunities in innovation that still lie ahead.