Thursday, October 11, 2007

New VC Model For Small Scale Financing

There is a great meme circulating about how the VC industry needs to adapt to a world with massively lower barriers to entry.

Paul Graham - from YCombinator - who is leading this change more than anybody has the definitive post. Its worth a careful read. Fred Wilson, from a more traditional but still very innovative VC (Union Square Ventures) agrees with the general trend and is well positioned to play by the emerging new rules.

There is a wonderfully entertaining rant by Dave McCLure about how VCs had better get with the program or else. He hits a very serious point about standardisation of deal terms and online closing process being essential. Here is another clearly heartfelt post that would probably be echoed by a lot of entrepreneurs.

When I first heard about YCombinator, I thought “incubator” and even worse “drive by VC”, both late cycle excesses in the Web 1.0 boom that led to a lot of capital destruction (in small chunks of course). As is so often the case, when history repeats itself, it does so with a surprising twist. Which now makes me think that this might be a sustainable new model.

The model clearly has almost nothing to do with traditional VC. The big “VC aristocrats” (aka “Tier 1″) with their $multi-billion funds and huge success stories behind them will almost all say that it is classic late stage bubble excess. At some level they have to think this as they certainly cannot play in the new rules where $300k might be a Series A.

Many of the Tier 1 players, who made their fortunes in IT, are also generally thinking, along with Nick Carr, that IT Does Not Matter. They believe that the big wave of opportunity has moved onto frontiers such as CleanTech and personalized medicine.

The A&R model from the music industry offers some interesting parallels for this new world of lots of small web start-ups. A&R (Artist & Repertoire) defined by Wikiepdia as:

“In the music industry, Artists and Repertoire (A&R) is the division of a record label company that is responsible for scouting and artist development. It is the link between the recording artist/act and the record label, generally to help with the artistic and commercial development of the label’s artists. An A&R person is often required to handle contractual negotiations, find songwriters and record producers for the act, and schedule recording sessions.”

In this new world the A&R function - scouting and entrepreneur development - is done by new style VCs such as YCombinator, angels and angel networks. They are independent of the “record label”, which we can now think of as the big platform acquirers (GYM and the newly energized AOL and maybe soon Facebook - making a rather unpronouncable GYMAF), but they have good connections with these platform companies when it comes time to exit.

The A&R guy would hang out in the Clubs checking out new bands. Years of experience gave them great intuition to make quick judgement calls, essential when a bit of dithering might mean you went down in history as “Decca Records turning down the Beatles”. The most fundamental skill however was a well tuned ear for the “clapometer”, seeing the enthusiasm of the audience at first hand in a tiny basement and extrapolating from there to Shea Stadium.

Like any analogy it cannot be stretched that far, but it does fit some recent trends, particuarly the trend to younger entrepreneurs. Fred Wilson kicked up a storm a few months ago when he simply observed that they were seeing a lot more young entrepreneurs. Young people obviously know better what appeals to other young people.

More fundamentally, the music business and this new start-up model have fundamentally different power laws to traditional VC. “Classic VC” worked on a portfolio with say 10 deals, 1 could be a megastar, 3 reasonable returns, 3 make their money back and 3 bomb totally - or some variant on that theme. The new model might have 100, but still only 1 megastar. There is only one top of the charts or only one Google/Facebook/eBay. That sounds like a bad deal but it is not because the returns to the megastars are massive, many will make a reasonable income (derided by VC as “lifestyle businesses”) and even the weak ones can get sold to at least recoup the money.

The maturity of “pay as you go infrastructure” changes the financing rules dramatically. You don’t need to use precious equity to finance capital expenditure. You use a small amount to build the service and get some traction. By the time you need to scale the risk profile is dramatically different. This is where quasi-debt structures are likely to evolve (i.e. with some Warrants so the debt provider gets a small equity (”kicker”). It is like the record company saying “wow the kids love this, crank up the presses”.

This new model also dramatically changes what the entrepreneur needs from their VC in addition to cash. In Enterprise IT, the VC’s “golden Rolodex” and reputation was worth more than the cash; it signalled “survivability” to a CIO burnt by doing deals with start-ups. In the new era many sites don’t even bother with About Us, as the decisions are taken one click at a time based solely on the value of the service.

The new VC may show some additional value by advising on how to scale and maximizing valuation on exit. These are valuable but not mission critical.

The sustainability of this new model is based on three fundamentals:

1. The continued evolution of mature web standards so that new services can easily be “plugged and played” in the acquirers platform. This trend looks pretty solid. It should be a key financing criteria.

2. The continued growth of online advertising. The gap between time spent online and $$ spent online is still “big enough to drive a truck through” so this should be OK. There is still a lot of innovation needed to generate engagement and to demonstrate measurability - but that will probably happen and “is another story”.

3. GYMAF and other large companies continue to fail to meet the emerging trends with internal R&D and therefore will always be willing to pay a premium to acquire from outside. This trend looks solid. It has been true for decades and is even more true when the next “hit” is completely outside the normal range and is so dependent on fickle consumer taste. Record companies that tried creating their own bands ended up with The Monkees (and that was the success story!).

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