When Investing Too Early Isn’t “Wrong”

I recently had a twitter exchange with early stage venture investor Mark Suster over the issue of being “too early” as a venture capitalist and what that means in the current climate. While I genuinely like and admire Mark and am not one to publicize my disagreements (or would that be disa-tweetments?) with other investors over what are primarily philosophical matters, I thought the content in the exchange was valuable and supported some re-examination.

Mark made what I would consider a somewhat sweeping statement–namely, that investing too early was the same as being wrong. I responded that this entirely depended on the perspective being considered. Let me explain.

There scarcely exists a technology sector that became vibrant and consequential that did not experience a great deal of stops, starts and stalls early in its evolution. Most of the early “failures” in a space — i.e., companies that had a piece of the solution figured out but perhaps not the entire solution — were venture-backed companies. Many of the same venture investors in those early failures learned from the experience and went on to back later entrants that became juggernauts in that given sector. Were those investors wrong? Would those investors have developed the insights, market knowledge and ecosystems critical to their becoming investors in the eventual market leaders without those early experiences? Would the sector have developed as it did without the flame-outs?

My answer to those rhetorical questions is emphatically “no.” As has been evident  across technology markets for decades, technology advancement occurs in waves of innovation that beget other waves of innovation, and so on. The early failures provide formative experiences for the investors that were involved and for future entrepreneurs behind new entrants in that sector that can plainly see what worked and what didn’t for the previous class of market entrants.

Take, for example, the notion of Pattern Recognition among venture investors. Much has been written about the concept, including an earlier piece in this forum. Tangential to pattern recognition is the idea that a venture investor’s early forays into a sector provide a great education — wanted or unwanted — about what will ultimately be successful in the space and what simply doesn’t work. It also provides the investor a great deal of market knowledge and an ecosystem of supporting companies and entrepreneurs that will serve that investor well for years to come in his or her chosen area of investment, and even in other areas. This is called active cross-pollination and it is critical for long-term success as a venture investor.

To pull on that thread a bit further, venture investing is not a discrete, narrow vertical exercise. Good investors are constantly influenced by outside factors, parallel markets, advancements in technologies that appear unrelated until an epiphany occurs and interesting combinations can result. From the embers of a previous failed investment can come a dormant technology or a seasoned manager that can be re-potted into a new venture and can enable that venture to become enormously successful. The point I make in raising this is that the future success would not have likely occurred without the early mis-step. I have several examples of this in my own career.

There is an oft-told piece of black humor among attorneys about a veteran attorney counseling a young protegé. The senior attorney remarks, “When I was a young attorney like you I lost a lot of cases that I should have won. Now, with my years of experience, I win a lot of cases that I should probably lose.” No one is suggesting that venture investors new to a sector should message to entrepreneurs that they are “learning” on their deals. That said, to maintain that experiences on early investments do not positively inform decisions made on later ones is simply folly.

So, can one be “wrong” by investing too early in a sector, as Mark suggests? Most definitely. This occurs when an investor develops an investment thesis, makes an investment in a company against that thesis, leaves the sector after that company fails to never invest again in the space and never leverage the lessons learned from that experience into other investments. Hopefully, this does not occur very often among professional venture investors. The mere statement that anyone invested “too early” in a sector implies that the given sector did ultimately develop into something substantial. With any luck, the earlier investors that helped shape the sector with early bets were able to prosper by participating in the eventual winners. Historical venture returns seem to bear that out.

The Seed/Micro-VC Trend: A Boom, Not A Bubble

The current debate among VC practitioners and others in the community over what to make of the current boomlet in seed stage dealmaking has yielded some interesting insights into the past, future and overall health of the greater venture industry.

The seed “boom vs. bubble” discussion is a healthy one, in my view. As in any debate over an emerging trend, one of the factors that bears close examination is whether or not the underlying issues are fleeting and cyclical or whether there are deep and structural changes afoot that would support a wholesale shift in how an industry functions. I, for one, am in this latter camp.

That a sea change in venture capital is underway is hardly news. Versions of this argument have been made with regularity for at least the last couple years. What might surprise some, however, is that the underpinnings for this shift took root almost a decade ago in the wake of tremendous overcapacity in a variety of technology sectors during the internet bubble years of 1996-2000. More recently, outspoken VCs, entrepreneurs and market observers such as Mark Suster, Dave McClure, Chris Dixon and Paul Kedrosky have all weighed in on this debate with intelligent, well-reasoned arguments for their respective positions. All their pieces are well worth reading. While there exists a good deal of overlap on the key points behind these arguments, let me weigh in with a few bullet-points that offer support for my view that the seed/Micro-VC trend we are seeing — particularly in the consumer internet and broad web applications space — is indeed a boom that will continue to reshape the venture industry for some time to come as opposed to a precarious bubble that will inevitably pop, with devastating results.

1. Angels & Seed Funds More Sophisticated Now Than Ever. The current and active angel investor appears quite a bit different from what we saw during the ’96-’00 period. In short, fewer non-tech high-net worth individuals who made their fortunes in shopping centers or tanning salons and more investors that came from the tech world as early employees or founders in some of the biggest names in the tech community, investing either individually or in dedicated vehicles. Google and PayPal alums alone account for an entire ecosystem of seed investors that are almost ubiquitous in today’s seed stage community. This deeper operations bench strength and greater familiarity with the tech community among today’s seed investors provides more stability in some respects. While it is still early days, some observers believe that today’s more seasoned angel is more likely to add greater value to a portfolio company as well as not exhibit the skittishness apparent among less sophisticated angels a decade ago when companies hit inevitable speed bumps.

2. The Institutionalization of Seed Funding. Yes, there are still many individual angels that invest for their own account, in their own deals, with some syndication with other high-net worth angels, but what is most notable in the current market is the trend of dedicated vehicles that look and feel like a venture fund while leveraging the nimbleness and informality of an angel group. Some of these vehicles are traditional “blind pool” funds while others adopt a more fluid Pledge Fund model, described in one of my earlier Adventure Capitalist posts, The Rise Of The Pledge Fund.

These approaches are well-suited to the current venture environment, in my view. Unlike individual angels that invest their own capital on a deal-by-deal basis, dedicated seed funds provide less informality, more structure, a clearer strategy, better process around how (and if) to do follow-on investments, and how to network with the institutional venture class. Additionally, creating a seed stage vehicle means, in most cases, making a multi-year commitment with limited partners. This is positive market signalling to both venture firms — that would like to know whether the seed funds are going to be around long and, hence, whether to bother getting to know them — and for the entrepreneurs themselves who would like to have the comfort to know that the seed stage fund’s committment to the company will be based upon that company’s performance and viability, and not upon some fickle decision by an individual angel.

3. Capital Efficiency Re-shaping the Financing Landscape. As everyone has heard, the cost to develop, build and launch a technology startup has fallen dramatically over the past decade. By some estimates, the cost to produce (design, develop, test, launch, scale) a basic e-commerce application has fallen by 50% every two years since 1995. This is significant and is not reserved for only internet and software companies.

The impact from a financing perspective is equally dramatic. A decade ago it might have required five to ten million dollars in investment capital to take a company to the point that it can be today with less than 1/10th that amount. As a venture fund, we regularly see companies present to us that have a product, customers, traction in the marketplace, legitimate mindshare and brandshare in the community, and are even cash-flow-positive in some cases — all without raising a nickel of outside capital. This would have been almost unthinkable a decade ago. While the obvious consequence of this is that it takes less capital to launch a start-up, in many cases it also takes less capital to sustain one — at least for a period of time. The current trend of capital efficiency means start-ups get farther with less capital—eschewing big raises that large established funds typically need to justify their fund sizes and post sufficient returns for their limited partners.

4. Business Model Innovation Also Altering Financing Landscape. While much has been made of the issue of cost and development time compression at many of today’s start-up companies, another powerful driver affecting the current financing market and the emergence of new Micro-VC investor groups is the role of business model innovation in creating entirely new industries and delivery models (i.e. Software-as-a-Service) and better monetization, tracking, reporting and distribution tools that start-ups can avail themselves of — in real time and very cost-effectively. The impact? Not only can many of today’s emerging companies build and launch their products and services quickly and cheaply, they can also market, distribute, sell and collect on those products and services without massive sales and marketing spend as had been the norm in the recent past. This, again, can negate the requirement of raising a significant amount of outside financing before getting the company to a point where it can realize a significant M&A exit. 

5. Succeed or Fail – Quickly and Cheaply. Former Benchmark Capital partner Andy Rachleff liked to say that start-ups needed to “fail fast and cheap.” His point was to emphasize that start-ups will make numerous mistakes in their development but to make those mistakes quickly, as cheaply as possible, and to pivot to another approach or product or market that has a better chance of being successful. Failure is tough enough; a long, drawn-out and expensive failure is excruciating. It should be noted that this perspective is equally relevant for venture investors. In the current environment, new ideas test cycle more rapidly now. Time compression means shorter time to market, time to revenue, time to exit. Shrewd seed and Micro-VC investors are well-positioned for this and realize that they can back many different companies, with minimal investment at risk, and be able in a matter of months, not years, to get a good sense about whether the original hypothesis for the company is unfolding as had been hoped or not.

6. Emerging Cachet of New Seed/Micro-Funds. One clear shift I have sensed recently is how the new crop of seed stage investment firms are being perceived in the marketplace — and, most tellingly, by the founders and management teams at promising young companies. A couple of years ago I began to notice that the fellow venture investors that I would “bump into in the hallway” when visiting promising young start-ups at their offices or even at technology conferences were becoming less frequently the recognized, established firms and more often were funds that were fairly new to the landscape. In the time since, some of the most talked-about tech companies of recent note received their financial support from these newer investor groups.  The entrepreneurial community has taken notice. At a recent breakfast meeting, I asked a young founder of a buzz-worthy consumer internet company about the firms with which he was hoping to meet to discuss funding. He rattled off a list of names of angels, seed stage funds and early stage firms but not one well-known Sand Hill Road VC fund. I found this startling and somewhat ominous. His perspective, echoed by other entrepreneurs I have since consulted, was that the newer crop of seed stage funds and angels were believed to be “hipper”, more entrepreneur-friendly, and more aligned with the needs and interests of founders and management teams. Whether that perception is accurate or even fair to many storied Sand Hill Road firms — personally, I don’t believe it is — is really beside the point. Clearly, for many emerging companies in the broad web 2.0 sphere, being aligned with a younger firm is becoming highly prized and is being supported by anecdotes of sought-after start-ups eschewing the most august names in the venture community for up-and-coming firms more renown for seed investing in the broad consumer internet space.

7. Many Storied Firms Need to Re-evaluate/Re-Brand to Be Relevant in Early Stage. The points made above are by no means de-facto evidence that storied Sand Hill Road firms are losing their luster or are not garnering their share of buzzed-about companies — they are; but it might be a proverbial shot-across-the-bow and an indication that some healthy re-evaluation and re-appraisal about the value of “brand” in the venture community might be in order. Seed investors like the outspoken and always colorful Dave McClure might be ready to ring the death knell for the traditional venture fund, but I will borrow a phrase from Oscar Wilde and insist that reports of the demise of Sand Hill Road venture firms are wildly exaggerated. That said, Dave makes some valid criticisms. I have some of my own. A quick ecosystem map of the most active venture firms in the broad web 2.0 space illustrates that the consumer internet/mobile apps/digital media community is being dominated by firms that did not even exist five years ago. That is dramatic and says a lot about the state of today’s venture industry.

8. Large Venture Firms Won’t Go Away. Yes, the industry is shrinking. Nothing earth shattering there. There will be a net reduction in the number of active venture firms and, on balance, assets under management (AUM) will decline. This is part of a natural winnowing cycle that, as indicated earlier, has been going on for almost a decade. Start-ups usually fail quickly; venture firms are 10-year vehicles so things are not so brisk. Moreover, one or two well-timed exits can turn things around for a venture firm that looked doomed. So, apart from fee income, there are several other strong motivations for a GP to stick it out in a dormant fund and hope for better days.

My strongest criticism for those so quick to call for the end of the traditional venture fund model is that such a prediction is quite myopic and too heavily skewed via a Web 2.0 prism. The fact is that building significant businesses of sustainable value takes capital, takes real expertise, and takes time. Moreover, while development costs have collapsed in a number of technology areas, others sectors of technology have not seen quite the same advantages. There still exist many attractive areas of investment that require a lot of capital – semiconductors, life sciences, biotechnology, and clean tech, to name just a few — in order to build significant businesses. Seed and Micro-VC alone can’t support those investments on their own. It takes a deep ecosystem of complementary investors with deep pockets and deep relationships in the business community as well as in government, universities, research labs, the military, and the international community. In short, it takes a village.

In summation, there are fundamental changes at work in the venture industry which give significant and lasting advantages to seed and Micro-VC funds that can exploit this market opportunity. This “boom” in seed and Micro-VC activity is not so much a boom as it is a seismic shift in how technology companies will be founded and funded for the foreseeable future. Similarly, capital efficiency and business model innovation are not trends that will go away or be supplanted by something else. As we all know, today’s technology architectures build on those of the past, reducing costs over time and commoditizing things that once required huge budgets and thousands of man-hours to develop. Seed stage investors will be with us for a while and the continued “institutionalization” of that segment of the asset class will bring more order and structure to things that were somewhat fluid in the past. Whether these investor group will remain small, focused and independent or whether legacy funds will seek to add that capability to their organizations is something to be determined. My sense is that there will be a bit of both as standalone seed stage firms and larger established groups can add specific and complementary capabilities to a portfolio company in the current environment.