Venture Capital’s Goldilocks problem

Finance, at its best, is a form of technology that enables entrepreneurs and businesses to create new value for consumers.

Debt is one kind of financial technology, with Nike as a prominent example of its useful application. For years, conservative Oregon-based banks refused to lend capital to Nike at a rate that matched its potential for demand; it was growing ‘too fast’ and that made these bankers uncomfortable. Once Japanese banks with more tolerance for risk became available to Nike, their capital enabled Nike to grow to meet its customers demands, and the banks (and happy new Nike owners) were well-rewarded. Venture capital is another example of a financial technology that enabled new businesses, albeit far riskier ones. Thankfully for venture capitalists (and successful venture-funded entrepreneurs), returns within a venture portfolio have historically followed a power law which enabled this kind of risk-taking. Venture capital funds could ask the question “how big would this company be if everything went right” and finance large market or technology risks where debt would have been far too conservative.

This made venture capital a good match for companies in which there was a medium-sized upfront investment with unpredictable but potentially very large returns. For predictable but small capital investments (a barber shop), for predictable but large capital investments (a bridge), and for unpredictable but large capital investments(the internet itself) venture capital was not the right financing mechanism.

But venture capital is a bit of a Goldilocks solution for potentially large but unpredictable outcomes. With too much of a capital or expertise requirement, corporate capital is the best funding source (e.g., Amazon, Microsoft, and Google’s data center infrastructure funding today). Too little of a capital requirement and the next great business will be funded off an entrepreneur’s credit card.

What made information technology-based venture capital work (from the 1960s through the 2010s) was a set of platforms and technologies that radically decreased the cost of relatively small teams to build meaningful products quickly, while still having large enough requirements to build a meaningful long-term business.

Are there ‘just right’ opportunities for venture capital today? Here is what is stacked against venture capital: 1) As would be expected in a mature asset class, there are more venture capital dollars chasing opportunities, which raises round price and decreases returns. This is great for consumers, and a mixed blessing for entrepreneurs, who now have to compete against more competitors for customers and employees. 2) Radically decreased cost to begin shipping new products. SaaS, open source, and cloud computing (Gusto, Google Apps, Ruby on Rails, AWS) are breaking apart what were once large blocked fixed costs into incremental costs that scale with the business, decreasing the need for venture capital. 3) We’ve reached Carlotta Perez’s ‘deployment’ phase. The growth of personal computers, the internet, and mobile are all slowing. New winners will likely be smaller, and profitably kept down by similar offerings in un-moatable business categories. The effect of these trends is a commodization of both capital and of companies, which will be tremendous for consumers in the short-term while every last competitive inch is wrung out. The danger for consumers is if the large winners (who already sit within the Fortune 10) begin to stop fearing either each other or startups as competitors. When that is the case, it will likely require an evolution in anti-trust law, that accounts for new data monopolies and retro-active bundling, to restart the awesome powers of capitalist creative destruction. What then for venture capital? 1) Many of today’s venture capital firms will go out of business. 2) Some venture capital firms will move away from the information technology revolution to emerging and speculative categories (biotech, etc.), which may or may not have the return characteristics of software. 3) Other venture capital firms will adjust to smaller exits. What does it mean for venture capital portfolio construction when there are more $300-$500 million exits, but fewer $1b+ exits? 4) Venture capital firms will emerge that have permanent capital bases, and are able to receive and re-invest dividends, and be able to invest in different kinds of companies altogether.

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