Venture Capital 2.0: Beyond the dark side

The Web is being reborn, post-bubble, as Web 2.0 . Why can’t venture capital do the same?

That’s the question we pondered as we decided to join “the dark side” (as our entrepreneurial friends would say) and formed Venturepreneur Partners.

We have started, managed, acquired and successfully sold several companies. Our own experiences and observations led us to challenge the notion of the standard VC model , which typically looks like this:

• Companies with “breakthrough” ideas are given significant capital to build route-to-market infrastructure (i.e., sales, marketing, support, and IT) with the goal of accelerating growth in pursuit of an IPO or large, later-stage acquisition.

• Of every ten companies funded by VC’s, one or two end up as home runs. The remainder end up as base hits or strikeouts. The home runs fuel the fund and the base hits simply return invested capital. The goal is to deliver an internal rate of return (IRR) that will enable the partnership to raise its next fund.

• About 10-20% of funded entrepreneurs end up rich. The remainder gain nothing more than experience.

Sure, this model has been successful for many top-tier VC’s, but it overlooks a clear market opportunity , and in the current environment , it has become increasingly difficult to sustain. Besides, most of the entrepreneurs who go through this process learn – the hard way – that their acceptance of early funding focused on building route-to-market infrastructure substantially reduces their return, if their companies are eventually acquired.

Potential acquirers heavily discount the value of this infrastructure if the company is sold prior to achieving significant customer and revenue traction. Large companies already have sales and marketing infrastructure that includes customer support, IT systems and management. Plus, they want to brand the acquired product as their own, rather than perpetuate the brand of the acquired company.

Can success be determined prior to investing?

We believe that the majority of early-stage venture backed technology companies are better suited for early acquisition rather than continued growth as standalone companies. How many companies have the potential to become the next Google or Microsoft? Not many. In most cases, channel dynamics, more so than technology, determine market winners.

Furthermore, when a company is in its formative stages, no one really knows if it is going to grow up to become the 800-pound guerilla that dominates its market. Google couldn’t have imagined it would become the dominant search company during its first few years of existence. Microsoft couldn’t have known that IBM would clear the path for them to dominate the PC market for operating systems.

Neither of these companies had “breakthrough” ideas, but they reached a point where momentum and sales took off, largely due to the market oversights of established industry incumbents.

Which brings us to Venture Capital 2.0

Why not invest in capital-efficient companies that capitalize early on technological shifts within markets? Companies whose concepts aren’t always “world-changing,” but that have a clear potential for early success? Why not fund and help position these capital-efficient companies in a way that makes them attractive for early acquisition - if that’s appropriate, while ensuring that they are also attractive targets for follow-on capital, if standalone growth continues to be the best direction? What’s wrong with an approach that offers a dual-path to success for the entrepreneurs and the investors?

This is how we define the new model:

• High market demand is not limited to “world-changing” innovations. Capital-efficient companies focused on addressing unmet needs in large markets can produce significant returns for both investors and founders, by actively creating dual paths to liquidity. One path leads to early acquisition, the other to a traditional later-stage exit.

• Great marketing always beats great technology. Market positioning and product development should occur simultaneously. Early exits require early preparation. Young companies are not acquired by pure coincidence.

• Early, hands-on investing in companies with clear acquisition potential makes sense, but ultimately market dynamics determine the best liquidity strategy. Be right-sized for exit at every stage of the company’s lifecycle.

Read our Strategic Approach: Building Value Not Excess »

Posted by Clarence Wooten & Lori Whitted on June 06, 2005
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