Monday, October 09, 2006

Poison the Well

Throughout history, retreating armies have poisoned wells, burned crops, and otherwise left the victors with barren lands. Which brings me to Sevin Rosen.

Not simply content to quietly shut down after nine funds and several decades of very succesful and significant investments, the firm announced the industry broken and incapable of creating value for its limited partners. In articles in the NYTimes and interviews on CNBC, Steve Dow is making his case for an industry in decline doomed to poor investment returns.

I must say that I find it remarkable that a set of investors whose professional existence is predicated on funding disruption and innovation are publicly advocating that an end-state in the venture capital industry has been reached; that no viable models exist, no innovations exist, no disruptions exist that will allow people to rewrite the venture rule book and add value.

There are no end-states, but rather constantly changing constraints that demand adaptation to ensure survival in the brave new world.

In June 2005, Howard Anderson, a co-founder of Battery Ventures, wrote an article titled Goodbye to Venture Capital in which he lamented how too much money and companies combined with stagnant tech spending had slayed the golden goose. It has, frankly, become cliche to discuss structural challenges and to see nothing but poor risk adjusted returns on the horizon.

Strategies, however, reflect the context facing any given business. The context today is quite clear - and commented on by me here - surplus capital, relatively poor IPO market, and too many venture firms/people.

In the face of stark constraints, the challenge is to define an intellectually credible strategy for creating value that incorporates today's realities rather than ignores them. At Hummer Winblad, we focus on capital efficient software companies priced to reflect the reality that the median IT exit is sub $100m. In the ROIC ratio, the denominator is fixed by the investor and entrepreneur. If the market is fixing the numerator (iemedian exit<$100m), then the maximum amount of money invested must take the exit as a given and be as low as possible.

Business models, use of proceeds, total capital required to reach profitability, and the weighted-average post-money valuation must all reflect the new reality. Steve Dow argues that, "Maybe we have to look only at deals that are going to take a limited amont of capital." I would argue that is logically consistent with simple math: exit/investment = return on invested capital.

Adam Smith famously stated that specialization is a function of market size. Venture capital is a massive market with significant specialization. There is no, accordingly, single model of venture investing and therefore no way to comment on the model failing. Certain firms and certain strategies that do not reflect the empirical constraints of the industry and adapt and innovate will certainly underperform.

My read is that firms will need to go earlier to avoid the ugly exit realities, or they will go abroad to leverage growth markets. Mid to late stage US investing will be a real challenge. The US will see smaller funds that are economically viable in the current market.

Life is disruptive and all business people - operators and investors - need to constantly question their strategies and demand an intellectually credible answer to how to best compete given the exogenous variables at work in any given industry.

VC is no different and it is too large and specialized an industry to extrapolate industry malaise from the hardships of a few funds. While I have great respect for Sevin Rosen's track record, I am not quite sure why going on CNBC to discuss the "broken" industry is a good idea.

No comments:

Post a Comment