Why Venture Capitalists Avoid Innovation: They Like Making Money

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Why Venture Capitalists Avoid Innovation: They Like Making Money

 

The following is a guest post from Andy Singleton, the founder of Assemba.  Assembla provides online workspaces for distributed software teams, and helps many startups build their products. 

Any given innovation is much more likely to fail than to succeed.  Innovation as a whole may even be unprofitable for the innovators.  Fortunately, we keep doing it, because in economic terms, innovations are durable (they last forever) and non-rivalrous (anybody can use them), so over the long term, society benefits a lot from the successful innovations.  As a society, we look for ways to get around the fact that innovation is generally unprofitable.  We subsidize innovation.  We honor it.onstartups piggy bank slots

A recent conversation has me wondering anew about the question of whether venture capitalists actually further the process of innovation.  They claim to be in the business of innovation, but they also talk constantly, often in the same paragraph, about how much they want to avoid innovation.

In this latest conversation, the VC said "We look for companies with a product and a proven business model."  This should should sound familiar to you. I wish I could run a video montage of the pictures in my head of VC's saying how much they want to avoid innovation.  Surely you would laugh.  If you ask VC's what they look for, they use words like "traction", "proven business model", "reference customers", and "invest in marketing" or “sales and marketing”.  This in itself is a big step forward from "We invest in teams that have done it before" (Greylock partner, 90's), or "We look for the second time around" (Sigma partner, 90's).  It doesn't take a genius to understand what they are saying.  As much as possible, they want to avoid all innovation (stuff that’s not proven).  It’s risky and unprofitable.

VC behavior subsequent to making an investment is also revealing.  After looking at hundreds of deals, and falling in love with one particular business plan, and persuading other investors and partners that it's great, VC's generally don't support subsequent changes to the business plan.  A self-funded entrepreneur is constantly making major course corrections, to the point of driving his colleagues crazy.  VC's will deny this, but a VC investment is basically a ballistic missile launch, without course corrections.  They are likely to just shut down the funding, or even to continue investing a lot of money in a concept that is clearly not creating the forecast level of excitement.

In my recent conversation, the VC partner went over the top by saying "We want to invest in companies that own code and have protectable IP", and then going on give the example of SpringSource - a service company working with un-owned open source code.
Are these people as idiotic as they sound?  Far from it.  They are some of the smartest, most observant, and most successful business people you will meet.  They have learned the hard way that innovation is more likely to fail than to succeed, and that the best way to make money is to latch on to a product that people already like. Even with this filter, and their cleverness and experience, and funding one in 100 opportunities, they still have a hard time making money in the current environment.  Investors that stray from the established formulas of the VC business (2 and 20 on fees, 5 year fund cycles, "growth capital" for sales and marketing) - are often punished with poor returns.

Note the cruel irony here.  In the VC business, a business that claims (with heartfelt feeling) to be devoted to furthering innovation, innovation is deadly.  It is the least innovative firms that succeed.  Successful firms may excel in a number of areas, but innovation isn't one of them.

So if innovation is actually risky and unprofitable, where does this leave us?  It rolls the clock back 80 years to Joseph Schumpeter's observation that entrepreneurs are driven by "animal spirits" rather than money.  Being a professional economist, he actually said, "Hedonistically, therefore, the conduct which we usually observe in individuals of our type would be irrational."  He also claimed that profit maximizing, utilitarian theory is "unsurpassed in its baldness, shallowness, and its radical lack of understanding for everything that moves man and holds together society."

Limited partners are utilitarians, and they don't invest in irrational animal spirits.

I think that this has some bearing on public policy.  Do we really want to be offering big tax breaks to VC's - the carried interest deduction - if it isn't going to get us the innovation which they have wrapped around themselves like a flag?

It also might have some bearing on the VC business itself.  VC returns in the last decade are negative.  VC partners are making less money now.  Many limited partners are not going to reinvest on the old model going forward.  VC's also have a diminishing reputation in the entrepreneurial community.  They have a strong incentive to get rid of an innovative entrepreneur and just wash out his stock - which they often do.  Suddenly, the old models aren't working for anyone.

And, maybe innovation is coming.  There has been a burst of micro-venture initiatives that invest small amount of money at the earliest stage.  That's a dangerous place for an investor (angel investors are incredibly brave) because one of the tenents of the old rigid VC model is that follow-on investors will usually try to squeeze out the early investors.  Maybe this indicates that innovation is happening throughout the investor chain. I also recall a conversation with a partner at General Catalyst, one of the more successful new VC firms, about their practice of "home cooking", or creating their own companies.  The speaker dismissed the appeal as "zero pre" (translation: our interest is purely economic, in that we get a better deal if we pay a $0 pre-money valuation) but I think something deeper is going on.

Is it possible that, once in a while, the VC business should look to innovation, for real?

 

Posted by Dharmesh Shah on Thu, Feb 18, 2010

COMMENTS

For the past 18 months I have been working hard to build a company. In this time we have kept one aspect of our core idea. The "Major change" is in my eyes doing what is required to make money now as the investors (You know who you are) have not given me help of any kind.  
 
Investors in general wasted time and energy that could have far better results in your core business. Even when presented with a "proven business model" and a "team with experience" they are not likely to invest.  
 
Lately they have come out. Why? because now development is nearing the end, and traction is starting and we have a lot of interest. We now need money to expand our core competencies and increase our sales force.  
 
The most interesting thing to note about these investors is that they are the same sort we have discussed things with for the past 18 months. Secondly is that the offers they want now we would have gladly taken 6-9 months ago but today are next to insulting. 
 
One must keep in mind that the Business Angel is not all that different then the VC in general. They want to invest as little as possible for as much as possible. Many VC's are far more honest then business angels as well. 
 
My advice to anyone seeking investment (as we are still doing) is to look for the "right people" and don't even discuss the money needed. If they like your idea, ask them what they think it is worth. NEVER tell them what you want. After 18 months I have heard every excuse possible and in the end we are gaining traction. We could still use money, but we are now looking at what the angels and VC's have to offer us outside the money. Money is important, but value added is worth far more. 
 
As an entrepreneur I see my ability and idiocy to keep dreaming and changing course as the largest asset in the company. Finding way to make a profit, keep my core competencies (People with skills) and please our customers. We are seeking to make our customers our financial partners. In the end, it is them that will make the company succeed more then any investor and the rewards for our efforts will benefit both of our groups. 
 
Thanks for another good article guys. for 18 months you have helped me in ways I can not even begin to explain. Keep it up please.

posted on Thursday, February 18, 2010 at 1:27 PM by Wayne


When I started MediPurpose ten years ago, I assumed that the VC firms I approached would understand the risks associated with a new startup and had business models that could analyze and evaluate the risks in an objective manner. I was sadly disappointed to learn otherwise. 
 
When I had finished developing my medical device prototype at my own cost, I approached my first VC. I was told to get it manufactured so I had a product to sell. After getting my medical product ready, I was told I needed a customer. After getting my first customers, I was told that I needed to get real sales traction. After doing that, I was told that I needed to start making profits ... 
 
The truth was revealed when I asked a friend in one of these VCs why they invested in untested dotcom startups without any paying customers, sales or profits (this was the dotcom boom days). He replied that the market wanted to invest in dotcom companies and all they were doing was to get the startup into the market so that they could flip their "investment" to the unsuspecting public for a quick return. 
 
I'm sure there are VCs who really look at new innovations and try to evaluate the risks versus the return but many of them just follow the "herd".

posted on Thursday, February 18, 2010 at 1:39 PM by Patrick Yi


Hi Wayne your story sounds familiar. I was looking for funding and got the same message!  
 
But then I realised that I didn't actually require them. So I made some little business and got the ball rolling. 
 
Dharmesh, great article once again. Good job!

posted on Thursday, February 18, 2010 at 1:42 PM by William


If VC money is used to boost growth after product market-fit, they really don't help innovation in-itself. They do, however, help sustain a proven innovation through the rough patch of the first few years. 
Was this always the case? The amount of capital required to start a startup is shrinking. This allows idea-evolution to work even before the VCs put the money in, so they can afford not taking the risk and still having their pick.

posted on Thursday, February 18, 2010 at 1:55 PM by Omer Gertel


I don't buy this argument at all. Let's look at: Apple, Google, Cisco, Digital, Akamai, and Amazon. Each of these companies is WILDLY innovative and NONE of them would have ever been possible without strong and committed VCs behind them since the start. 
 
What I think you are pointing out is that there are a lot of lemmings in VC who don't have the balls to have an original thought or bet on their own thesis. This is just not true about all VCs. 
 
Honestly, I think that Silicon Valley is one of the greatest treasures in the US and there is zero way that it would have been possible without a vibrant and bold VC community that was going aggressively after innovation.

posted on Thursday, February 18, 2010 at 2:08 PM by Antonio Rodriguez


Right on target. The VC is really waiting on the business to make it - they are become late investor rather than early.  
 
That might have a good side to it - forces new companies to be lean and aggressive and runs off those people who thing a VC investment is income. (I was part of a deal where some of those on the board thought we succeeded the more VC we got.)  
 
The only really sad side is I see people who waste their entire business time trying to raise $ as opposed to selling a product. This kills a lot of good ideas because people EXPECT VCs to act like - well - VCs.

posted on Thursday, February 18, 2010 at 2:28 PM by Dale Callahan


Andy, 
Your thesis reinforces a deep-set belief of mine that VC interests and Entrepreneur interests are fundamentally misaligned, at least at the earliest, most innovative stages of a company. In fact, I wrote a blog post about why VC money isn't right for my early-stage SaaS business. At a later stage (e.g. "growth," "Expansion," or a similar term), investment capital may make more sense. 

posted on Thursday, February 18, 2010 at 2:34 PM by Richard Wilner


Assemba. Hehehe... 
 
First line, the link is correct but not the name.

posted on Thursday, February 18, 2010 at 5:52 PM by RN


I think my boss put it best when he said: 
 
"Venture Capitalists are neither" 
 
They manage money and their investors expect a return. Innovation, as several people have mentioned, is risky and it takes forever. 
 
The truly innovative companies find other ways besides venture capital to get their ideas to market. It's a painful process.  
 
You are always behind, always understaffed and always running out of money but in the end, you some how figure out how to make it happen. Then, venture will step in and fund your expansion.

posted on Thursday, February 18, 2010 at 6:57 PM by Jarie Bolander


The open source code you mentioned in relation to SpringSource is not un-owned, far from it. SpringSource holds the copyright for all the source code and it employs greater than 95% of the people who work on that code. Also, any contributions to a project in the Spring family requires the author to sign over ownership to SpringSource.

posted on Thursday, February 18, 2010 at 7:00 PM by Brian


You've taken a good point and pushed it into straw-man land to get readers, ruining it.

posted on Thursday, February 18, 2010 at 8:20 PM by Greg


In a global economy as fast moving, dynamic and with accelerating complexity it's probably a mistake: 
- To look to any idea or set of ideas to represent much anymore. Contradictions are likely better than having "the answer." 
- To see business models as anything other than increasingly perishable. Likely opportunities increase as well. 
 
"Bad actor" arguments are easy for our brains to process but largely a myth and symptom of deeper complexity. Those are NOT easy for our brains to process!

posted on Thursday, February 18, 2010 at 8:44 PM by Rich and Co.


In the entertainment business, the saying goes: "You will never get an agent until you no longer need one." Same applies for a lot of startups.

posted on Friday, February 19, 2010 at 8:16 AM by Peter Alberti


I think the model you are arguing for would multiple the failures and desroy the economy. Innovation is by definition an improvement. Innovation occurs only after a new product idea is accepted by the market. Other wise its a product idea that is believed to be an innovation and may actually be backwards in practical application. Developing a new product or service in of itself is not an innovation its a part of the process of innovation. A VCs job is to remove risk of all the failures and considering all the possible ideas to try one should believe that most ideas are not in practical application innovative and so a filter needs to be applied. VCs of course are not a market and so will make a great deal of mistakes so no arguing against this filter of ideas. I think your article is really around the frustration around getting capital to fund the business. I'm not a VC but I'm in business school getting my MBA and really the number of ideas that go flat is astounding of 200 ideas from engineers/developers of products with a history of a proven track record only 2 will be successful. (don't quote me it probably is even greater in discrepency I'm just writing it from memory so it could be off by a factro of 10 or more).

posted on Friday, February 19, 2010 at 1:40 PM by John


You have excellant insights. I just wished you would post more often or at least on a regular schedule.( Once a day,week or month)

posted on Saturday, February 20, 2010 at 12:46 AM by Bill McNeely


It'd be nice if they look at innovation, but that aint gunna happen soon. it seems like.

posted on Saturday, February 20, 2010 at 4:10 AM by Startup Advice


Interesting post. However, I disagree with a lot of your conclusions. I think you are mistaking innovation with risk. VCs look for ways to mitigate risks of all sorts, including fundamental technical risk. It takes true innovation (beyond technology) to come up with a plan that sufficiently mitigates risk yet provides enough upside to justify an investment. 
 
 
 
More of my response here: http://www.thefeinline.com/blog1/2010/02/technology_risk_innovation.html

posted on Monday, February 22, 2010 at 11:47 AM by Michael Feinstein


How meaningful is an Innovation that cannot be monetized - even to an entrepreneur? 
 
If a dozen entrepreneurs work on ideas in the same domain (social n/w, mobile advertising, affiliate n/w to name a few) with relatively minor differences, do we get really get any innovation?  
 
Not to side with the VCs, but they do seem to moderate or tune this outcome.

posted on Thursday, February 25, 2010 at 5:33 PM by SS


We got approached by some VCs. They were not interested in investing in our business unless we were making X. But at X we'd be so profitable we wouldn't need them anyway. Seemed to me they wanted a 100% bet and zero risk. Nothing VC about that at all. 
 
 
 
Dharmesh there are 3 spam posts in this thread: 
 
 
 
o One is advertising a educational establishment in India.  
 
o Two are advertising a gambling site - an activity that will ruin the lives of 7% (on average) of all males that take part in it.  
 

posted on Saturday, February 27, 2010 at 7:02 AM by Stephen Kellett


Can you please expand on the "established formulas of the VC business"?

posted on Monday, March 08, 2010 at 1:34 AM by Clinton


This post really surfaces the core problem in venture capital - that the current financial service business model that is venture capital is now out of step with the need of innovation and entrepreneurs. This is the primary reason why venture badly lags other types of investment class - particularly on a risk adjusted basis. Frankly, this isn't good for anyone as it also points to an underlying mis-allocation of capital for start-up companies.  
 
The reason for this can be traced to the changes in entrepreneurship toward much more capital efficient models during the "discovery" or "pre-proof of concept" stage. 
 
This shift has created a systemic change in the competitive dynamic for start-up ideas - one not in favor of current VC business models. 
 
In the past, when table-stakes for getting through proof of concept were $2-5MM the VCs basically held a monopoly on what and what didn't get funded - capital was the barrier to entry that made ideas secondary to execution. That advantage is gone - never to return. 
 
So its not surprising that VCs are sliding toward later lower risk investments - they have to. 
 
You also point to new models emerging around micro-funding - the fundamental challenge that all of these ideas face is a.) how do you reconcile the non-scalable aspect of investment evaluation with a business model that can generate returns for investors commensurate with risk and still have money left for the professionals making investment decisions.  
 
Its a tough challenge but doable - and innovation and technology are the key. 
 

posted on Wednesday, March 17, 2010 at 10:21 PM by Mark Langner


Aşk Sitesi 
 
I see a lot of interesting posts here. Bookmarked for future referrence.

posted on Saturday, April 17, 2010 at 10:30 PM by Aşk


You have excellant insights.  
Thank you admin

posted on Sunday, April 18, 2010 at 9:15 PM by Evli


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