What follows builds upon my previous post, Fixing the VC Industry, and will act as a foundation for future posts. The conversation that my last post generated was incredible. I’m humbled and inspired by the kind words and the amount of interest it generated. Thank you.
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The life of a start-up, from brilliant thought to the point where the company scales (thus ending the “start-up” period of the company), consists of three distinct periods. In each period, the start-up finds itself requiring different help and support from VCs. An innovative venture capitalist can obtain a competitive advantage by providing the start-up, in the first two stages, with assistance that doesn’t come from traditional VCs. The third stage mainly requires ‘traditional’ VC services (access to large funds, …) and offers less opportunity for innovation.

Stage 1
Innovation: Incubating Ideas

Innovation, from the perspective of a start-up, consists of two phases and starts with a brainwave, kicking off Phase I innovation, and ends with a product, signaling the conclusion of Phase II innovation.

Phase I innovation is the process of taking that something that wakes you up in the middle of the night – a moment of insight, a brainwave, … – and turning it into a well rounded idea. Phase II innovation is the process of taking the idea and turning it into a product.

Innovative thoughts and great ideas are not a scarce commodity. Brilliant people have brilliant thoughts all of the time. The cost to the entrepreneur, in Phase I innovation, is time – time to fully think through a thought. This step rarely limits innovation.

Innovation starts to become limited when the entrepreneur is asked to spend more than just their time. Phase II innovation generally requires money to develop the product and this is the step that limits innovation.

Unfortunately for the entrepreneur, this is the time when raising funds is the most “expensive”. In terms of the cost of exchanging their currency (ownership) for what they need (money) the entrepreneur will never find a more expensive time. I briefly touched on this idea in my “Less & More” post:

Less Initial Funding. The business plan is untested, the market is unproven. Is money ever more expensive?

The aim during this stage should be to help the entrepreneur decrease the amount of money that will be needed. There has been an attempt to “fix” this innovation roadblock over the past few years: Incubators.

A VC not happy simply being an ATM should create an incubation-like atmosphere to help support the innovation.

There is a lot of assistance that the entrepreneur could use during this period and creating an incubation-like atmosphere is probably the best way for a VC to structure the support network. Let’s examine a number of services that the VC could (should?) provide:

IT: There is a true cost (time and money) associated with setting up the proper IT infrastructure. Having an infrastructure in place and simply allowing the entrepreneur access to it helps lower the cost.

Graphic Design: As the product develops the start-up needs to establish a corporate identity. Finding the right way to communicate with graphic designers is a task and takes time. Having someone who can be a conduit between the entrepreneur and the graphic design company will definitely speed up the process, and the relationship will help depress costs.

Bookkeeping/Accounting: The entrepreneur should not spend time sorting the receipts stuffed in the shoebox. The entrepreneur can’t justify a high priced accountant, but would surly benefit by having access to one.

Engineering support, relationships with machine shops, IP support, R&D tax credit expertise, and on and on and on. This is by no means even close to a complete list of services that an incubator-like atmosphere could offer an entrepreneur. The benefits are huge. Too huge to ignore. This idea is already being practiced and will only increase in occurrence in the years to come.

These incubator-like services add incredible value to a start-up. They significantly lower the requirement for funds at a time when raising cash is the most expensive. They also take tedious but necessary tasks away from the entrepreneur – allowing him/her to focus exclusively on the most important thing during this stage… creating an incredible product.

Once the product is made – and is believed to be incredible – the start-up enters the next stage.

Stage 2
Commercialization: Providing Proof

With a newly complete product many would argue it’s time to scale. It’s not. It’s time to validate. This stage is about proving value propositions, ironing out positioning statements, and figuring out the right foothold to use for market penetration.

Why? Because of the high level of uncertainty it’s expensive to fund the company at this point. An innovative VC should help the entrepreneur (and their investment) by helping to lower the price of money. This can be done by validating value statements, finding initial product users, and locating the correct penetration point. An entrepreneur doesn’t have the skills, resources, or time to successfully complete these tasks, but a VC team does.

Prior to scaling it’s critical to test the various value propositions on potential (small) customers. The testing of value propositions will help find and refine the best one. This will mean that when it’s time to scale, the product is launched with its best benefit(s) forward. It’s crucial that the testing of the various value propositions occur on small customers because the cost of screwing up potential future business – if the tested value proposition is wrong – is small.

This is where a lot of entrepreneurs fall into the faulty logic of: “Why are we focusing on small_company? We should be spending all of our time on large_company. Small_company isn’t worth our time, we need the home run”.

You can swing for the fences and miss. You can chase good money after bad and buy yourself another trip to the plate. And you can swing for the fences and miss again.

Why not load the bases with a number of small singles and then hit the grand slam?

That’s what validating the value proposition is all about.

Finding the foothold is different, yet equally important. When the product launches it needs a group of customers to give it some traction. Why leave it up to the customers to search the product out when it scales?

Here’s what I mean: there are products that are launched and then languish. After some time a small group of customers start using the product in a unique way, getting (potentially different) value from it, and this new market segment causes the product to become a success. Why leave this “discovery”, by what should have been the proper market segment, up to chance? Don’t. Go out and identify that small group of users in the right market segment.

This group of users will be the foothold market. It may be an entirely different group than first thought of when the initial brainwave occurred. But the right value proposition(s) have now been identified and there will be a market segment that will benefit greatly from one of the value propositions. Identifying the proper market segment will help lower the price of money.

What can an innovative VC do to help in this stage? Lots. This is where a VC team that is filled with skilled players, from a number of disciplines, can really create a competitive advantage.

First of all, there is significant skill behind identifying potential value propositions, testing them out with potential customers, outlining possible foothold markets, and validating these hypotheses. A VC team, doing this on a regular basis, can develop an expertise at these processes (practice makes perfect) and can assist, or lead, the entrepreneur through these steps. Also, this is where the VCs rolodex becomes very handy. Testing out value statements on friendly small businesses is much better than testing out value statements on random small businesses. The VC can mine their rolodex and leverage it to produce friendly test sites.

Second of all, this is the stage where the company would benefit from various experts assuming roles within the company for short periods of time. A diverse VC team could, uniquely, parachute support in for a temporary basis and provide world-class skill at a time when the start-up needs it but can’t justify it.

Part of “providing proof” is creating financial forecasts that are as accurate as possible. The start-up better not have a CFO at this stage, but an individual with CFO skills would definitely add value. The VC team could provide a CFO-like individual on an as-needed basis. 2 hours a week. 2 weeks. 2 months. Whatever is necessary.

The same is true of high-level managers, skilled operations individuals, and marketers. The company can’t justify hiring world-class experts in these roles but would benefit by having access to one. The innovative VC team can provide this team of support and earn a competitive advantage.

After identifying the right foothold segment and the proper value statements, the company is ready to scale – the price of money is falling. Lots has been proven, and the VC has provided key support along the way.

Stage 3
Scale: Making Money

You’ve created a beautiful product, you’ve proven its value and validated the market size. Now is the time to scale. This is the stage when it’s time “to make boatloads of money”. My brief comment from my “LESS & MORE” post sums up this stage nicely:

More Funding Later on. You’ve tested your business plan. You’ve proven your market. Will money ever be less expensive?

This is where the ‘traditional’ VC comes in. They’ve spent the post bubble years raising funds that are atrociously large. They’re looking to make incredibly large investments. They need to – the size of their fund dictates this. These are the people to go to when it’s time to scale.

To scale fast, efficiently, and with the required capital the venture is going to need significant cash. Sounds like a match made in heaven. The cost to the entrepreneur and the early venture capitalists? Very little, thanks to the commercialization stage. With a proven product, value, and market the start-up will find that this is the cheapest stage – equity exchanged for cash – of the process.

And isn’t that what the goal should be? Raise the most cash not only when it’s the most needed, but when it’s the cheapest.

Two of the three stages provide areas where an innovative VC can uniquely offer support to the entrepreneur. And this support helps the start-up out when it reaches the third stage and needs to raise the largest amount of money from the traditional venture capitalists. By offering a diversified support team to the entrepreneur and assisting with the commercialization phase, the VC can disrupt the traditional players and gain a significant competitive advantage.

“there is an opportunity here – disrupt the traditional VC business model”

I wrote those words over a month ago and my mind has been racing ever since. As I dug into the issue a trend started to emerge: older writings said that the VC industry was broken; newer posts have the slant that the VC industry needs to be fixed; and I suspect in the coming weeks, there will be a lot smart people proposing various fixes.

The VC model does need to be fixed, which makes it primed to be disrupted. [For those new to the idea of disruptive innovation, read this.]

Why is it Ready to be Disrupted?

A market is ready to be disrupted when the performance of the product overshoots the requirements of the user. Does this apply to the venture capital industry? Yes. Traditional VC’s have overshot the “needs” of start-ups. It’s interesting that this gap widened, suddenly and significantly, because of large movements in both directions. During the late 90’s venture funds raised too much money and, after the bubble popped, there was too much capital chasing too little opportunity. The performance of the product – available venture capital – snapped upwards and away from the “customers” requirement. The Economist had an interesting article on this in March of 2005 and there was an paper examining this trend released last week.

While this fund raising frenzy was occurring, the “needs” of the customer (start-up companies) fell. The cost of starting a business has collapsed. Advances in technology have had a substantial impact on the cost of starting up. Outsourcing has also had an impact on the cost. Start-ups now outsource work to highly skilled individuals, all over the world, at lower costs. The decrease in the cost of starting a business has caused the needs of start-ups to snap downwards and away from the required performance of the “product”.

These two movements happened suddenly and at approximately the same time, resulting in the equilibrium between VC needs and start-up requirements becoming unbalanced. It’s this unbalance in the market that opens the venture capital industry up to disruption.

There are other reasons that the VC industry is ready to be disrupted, a major one being that the ‘traditional’ VC industry is broken. The VC industry evolved throughout the 80’s and 90’s because of the fantastic returns that could be reaped by investors. New regulations and new trends in how large companies operate have impacted traditional exit strategies. Increased compliance costs, thanks to Sarbanes-Oxley, have reduced the attractiveness of an IPO. There is a decrease in VC exits through this route and until the policy is revised the trend will continue. Another new event that limits the exit strategy of VC’s is the current practice of large companies acquiring start-ups before they’ve grown. It appears that large companies are realizing the attractive deals that can be had by investing in companies, pre VC investment, and are willing to take on the added risk.

Growing venture funds. Falling start-up requirements. Shrinking exit strategies. It sounds like the ‘traditional’ model of venture capital is in trouble. Anyone who thinks the industry is safe because of the traditional barriers to entry better think again.

Historically (as in last month), entrepreneurs have had to put up with ‘traditional’ VCs because the barriers to entry limited competition. Start-ups needed the help of VCs to scale for two reasons: (1) “He who has the gold, rules”; and, (2) the value of the VC’s network. Lately, the barriers have started to fall. With lots of money raised and less money needed (money is becoming a commodity in the venture world) it’s no longer “he who has the gold, rules”, but instead “he who has the gold… competes with everyone else”. Networks, while still very important, are becoming easier to grow and develop. Fred Wilson accurately summarizes the findings of a new study, with an aptly titled post called “No Duh”, with the following statement: “The Internet is the most amazing social networking tool ever invented”. The ease and ability to network through the internet is being used extensively by start-ups to help build and develop their company — putting less emphasis on the benefit of the VC’s network. (Note: this is not to say that their network isn’t needed, it’s simply to say that it’s becoming less crucial).

The barriers are falling. So what? It means that the market is going to become competitive. Once this happens (it already is) the entrepreneur will no longer be shoehorned into dealing with a VC who fits the VC stereotype. There is lots of chatter about the VC stereotype (Google returns 62,500 results for “VCs suck”). The barriers of entry will decrease the need to put up with the stereotypical VC’s, and until they correct their ways, there is an opportunity to compete with the entrenched players.

My final thought on why the market is ready for disruption is focuses on my frustration that I shared in my original post: “VCs lose 36% on the median investment”. The VC industry is a ‘hit’ industry – the investors raise a fund, invest in a number of companies, have a median loss on the investments, but rely on a single hit to yield an incredible return. The world has significantly changed over the past 10 years and these changes have had a huge impact on ‘hit’ industries. Chris Anderson documented this impact in a revolutionary article, The Long Tail:

The theory of the Long Tail is that our culture and economy is increasingly shifting away from a focus on a relatively small number of “hits” (mainstream products and markets) at the head of the demand curve and toward a huge number of niches in the tail.

The VC industry is currently a ‘hit’ industry, but we’re going to see a change in this. Like the music or movie industries there will still be a market for hits (“the next Google!”) and many VC’s will be happy to wrestle for the hits and maintain a negative median return. There will also be many VC’s who are happy to play in the “long tail” of the industry – a number of smaller investments, with smaller returns, with a positive median investment.

How to Disrupt the Market? (or: “How to Fix the Venture Capital Industry”)

Simple. By meeting the requirements of the start-up at a lower cost, getting a foothold, and then expanding upwards. The important question is how to “meet the requirements… at a lower cost”? The answer, as in most disruptive cases, is simple.

To meet the requirements at a lower cost, and successfully disrupt the VC industry, there are five non-traditional practices to embrace.

Customer Service. Competition is entering the market, money is a commodity, and ideas are numerous. People are the scarce commodity. The stereotype of the VC is that they treat founders poorly. The VC who is regarded throughout industry as “a great guy” will have a definite competitive advantage over the others. Founders will seek out VC’s who are more human and less VC-like.

Already, there are VC’s who are embracing good customer service. Fred Wilson talks about the idea of the entrepreneur as the VC’s customer. And Rick Segal, a Canadian venture capitalist, trumpets the importance of customer service in the venture capital industry (it must be a Canadian thing, eh).

Competing on customer service happens in every other maturing business market, and it’s going to happen in the VC industry. The VC’s who embrace this the quickest will have a competitive advantage.

Partial Founder Buyout. By letting the founders cash out early, VC’s can align attitudes towards risk between the founders and themselves. Paul Graham has an excellent essay on this. Eric Olson takes a central idea of Graham’s essay, allowing the founders to cash out, and provides a simplified explanation of the argument. The argument boils down to this: a founder would rather have a smaller return that’s guaranteed over a larger return that’s risky.

By aligning attitudes towards risks the VC will be able to invest in companies that otherwise may agree to an early-stage sale. There have been a number of small companies with huge potential that have been sold recently by the founders. If the company had been given time to grow the founders may have reaped the reward of the huge potential. However, because of the amount of risk involved, they had the incentive to sell the company early on, for a guaranteed return.

Most individuals are risk averse, and the level of aversion only increases as dollar figures rise. By partially buying out the founders, a VC can lower the amount of risk involved for the founder and access deals that other VCs can’t.

Focus on a Niche. By focusing on a small niche market, the VC can exploit the long tail of venture investing and enjoy a positive median return. The venture capitalist may have to give up on the ‘hit’, but they should be okay with that. They’re leveraging their expertise in the niche market to make a number of smaller investments, that will yield a positive median return.

A venture capitalist who doesn’t rely on landing a hit to prop up their other investments, and instead aims for a number of smaller returns that yield a positive median return, will be able to compete against entrenched VC firms. By going long tail, and being happy with it, the venture capitalist develops yet another competitive advantage.

Don’t Be An ATM. A disruptive VC aligns risk attitudes as soon as they invest, but they shouldn’t simply be an ATM. The VC should provide the young company with as much assistance as possible in the early stages so that the start-up has the greatest chance to succeed. The VC has invested in their niche area and should provide the start-up with industry expertise, guidance and advice. And not just at the quarterly board meetings. They should provide valuable assistance and share their expertise on a regular basis.

There are times when a start-up would benefit from having an expert assume a role within the company for a temporary amount of time. Unfortunately they can rarely afford to do this. The VC team should include members who can parachute into certain roles, for brief periods, to support the company (as in a legal counsel, a CFO-like individual, …). This tool would add incredible value to a growing company.

The disruptive VC should also have a basic set of tools that they can supply the start-up with. Should a start-up spend time searching for a good payroll company, branding company, law firm, accounting firm, …? No. The VC team should find a way to assist with these tasks, and not just by handling the introductions. By freeing time from tedious activities, the VC allows the start-up to focus on the tasks that will add the most value: developing and launching incredible new products/services.

Raise Less. Invest Less. Companies are able to start with less money. VC’s have funds that are too large. VC’s are valuing companies higher than they should be, allowing them to invest enough money in the company to make the investment worthwhile. Artificially increasing the valuation is not a good thing. Clarence Wooten does an excellent job explaining why:

Increased capital is always accompanied by expectations of increased return, which translates to increased time to liquidity and increased market risk. Unfortunately for the entrepreneur, additional capital seldom equals additional return. If the company is going to be sold, the acquisition price has to be significantly higher than it would be had the entrepreneur taken less venture capital to begin with. If it isn’t significantly higher, the entrepreneur stands to lose out on all or a substantial portion of their return.

Raising less money means that the VC can invest less money, making it easier to achieve a great return. Being able to invest less money means two things: (1) the VC doesn’t need to artificially increase the valuation, keeping more exit options open; and, (2) the VC can invest in the company at an earlier stage. This allows the VC to help guide and develop the company in a roll similar to a co-founder.

The disruptive VC is investing in a niche where they have industry expertise – enabling them to add a lot of value to a young company. They also aren’t just an ATM, and the earlier they invest, the earlier they can support the start-up with their toolbox of valuable start-up services.

Raising less money allows the VC to get involved earlier, adding great value through their other disruptive practices at a very early stage.

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It looks like there are already venture capital firms practicing some of these techniques within select market segments. I’ll discuss those segments, and the firms, in a future post. It’s an exciting time in the venture capital industry. It’s obviously in need of a fix, and that means a disruptive firm can enter the market, establish a foothold, and grow. This is great news for entrepreneurs and terrible news for entrenched (stereotypical) VCs.

Based on the number of posts of “Venture Capital is broken”, and “Venture Capital needs to be fixed” I’m excited to read the posts that will soon be written on “How to fix Venture Capital”. If you’ve made it this far in the post, I’d also be interested in hearing your comments on my thoughts.

Update: After reading this I go and check out tech.memeorandum.com and there is a post from Doc Searls titled “Disrupting the VC Business and Exploring the Because Effect“. It’s great to see that others are thinking along the same lines as I am (especially wrt disruption).

It looks like Rick Segal (who I reference in this post) is giving a lot of thought to this idea as well. I can’t wait to read what he has to say.

One major lesson on team building was drilled home by Wayne McVicker in his excellent book, Starting Something. Throughout the book, McVicker shared a valuable lesson: that hiring for fit is far more important than hiring based on the strength of a resume.

He drills this point home with example after example from his time growing Neoforma during the late 90’s. McVicker believes that the culture of a young company is crucial to its success and that hiring for fit preserves the culture, ensuring that the team continues to push forward. This is one reason why entrepreneurs should spend more time building the right team.

In the early days the team is going to make or break the organization. A start-up sin is to hire a body because a seat is empty. This should never happen. Instead, until a great match can be found that seat should remain empty. Growth should be delayed. And the right person should be found.

You’re trading short-term growth for long-term sustainability. There is nothing more disruptive to a well working team than introducing a new member to the team who just doesn’t… fit.

The team is the most valuable resource of a young company and hiring anything but the right person; therefore, puts the company at great risk.

[Note: this is a continuing post, in follow up to my "Less AND More" post. You can find the first two continuing posts here: More Wild Guesses & Less Opportunity.]

People who know me know that I love reading. I figure sharing my $0.02 on business books will help people avoid the crap that I sometimes come across. I’m not going to highlight the business books that suck, there are just too many of them . Instead, I’ll highlight the best business books that I’ve read. I’m going to make you a guarantee: if you read a review here then you’ll like the book.

The first book I want to recommend is Starting Somethingby Wayne McVicker.

The book is non-fiction and was entertaining, educational, and a pleasure to read. McVicker started a medical web company, Neoforma, in 1996 and he documents on a monthly basis the ups and downs of starting and growing a company. The book is exciting for a number of reasons. First, the lessons an entrepreneur can gain from reading McVicker’s story are priceless. Second, the company was formed pre-bubble and gives a great example what it was like to have a hot company in Silicon Valley during the late ’90′s. Third, the book is filled with so many characters and interesting stories that I found it more entertaining than many works of fiction.

This is a definite read for any entrepreneur. (Thanks to my brother for discovering the book and giving it to my for my birthday).

But really, don’t take my word for it. All of the reviews for this book on Amazon received 5 stars.

My post on “Less & More – The Entrepreneurs Toolbox” has been a popular one and my first in-depth follow up on Forecasting has been popular too. I eventually will discuss all of the less and mores in depth and in this post I’m going to share my thoughts on opportunity.

Less Opportunity. You’ve niched yourself. You’ve built the team. Don’t drown in the opportunities that you’ll come across

When it comes to opportunity many entrepreneurs remind me of my dog, Dodger. When I take him for a walk I’m convinced that his thought stream goes something like this: “I have to go pee. Hey, there’s a good tree to pee on. No wait, look at that tree over there! Woah, that tree looks even better. Is that an Oak?”

Entrepreneurs are smart, motivated, and driven. Those traits don’t generally lend themselves well to focusing on a single opportunity. And that’s not good. While other opportunities may present tempting alternatives, the entrepreneur would be best served to focus on the original opportunity and work hard towards achieving it.

It isn’t good to run from one opportunity to the next in an excited frenzy. A start-up has limited resources and as they’re spread thinner over more opportunities, each one has less of a chance to succeed.

You started your company because of an incredible opportunity and you won’t be able to capitalize on it if you’re constantly distracted. Stay focused on the (occasionally tedious) tasks at hand, don’t be tempted by distracting opportunities, and enjoy the rewards when you reach your goal. At that point you’re ready to start exploring the other opportunities.

[Note: this isn't to say that the entrepreneur should go forward blindly. It's important to always be aware of, but not distracted by, other potential opportunities. If you come to the realization that the original opportunity isn't going to be what you thought it was, it's good to know what else is out there.]