The real question for venture capital isn’t if change is coming, but how change will impact the start-up world. So, let’s pull out a dusty tool from the management consulting toolkit and breakdown both the “as-is” and “to-be” VC model.
Venture capitalists are pioneers of the finance industry, and let’s remember that VCs are the group jumped in to serve entrepreneurs when the rest of the finance industry wouldn’t touch high-risk markets with a ten-foot pole. Banking counterparts refused to innovate or fund start-ups, largely because bankers were too busy making money performing traditional services like debt, underwriting, issuing securities, and executing mergers and acquisitions. But the pioneers of venture capital ventured into the unknown and put their necks on the line to help entrepreneurs, particularly as the world of scalable tech businesses formed. Working hand-in-hand with entrepreneurs, venture capitalists helped legitimize the start-up world.
So, let’s move away from the notion that venture capitalists are crusty old men with money and no innovation. That’s oversimplified at best and borderline divisive; all innovation is not coming from entrepreneurs. Venture capitalists, without a doubt, are innovators in their industry.
But just as we need to move away from thinking VCs are old and stogy, we also need to be honest about the fact that venture capitalists evolved from bankers. Bankers – the analytical, risk-averse, and meticulous types – are clearly smart…but they are not creators, they are service providers. In other words, venture capitalists are the most innovative and risk loving of the generally non-innovative and risk-averse banking world. Think of VCs as the most sober people at fraternity parties; sober in a relative sense, not in a breathalyzer test.
Dave McClure, self-admitted venture capitalist and founder of 500 Start-ups, a successful tech accelerator, shared his thoughts on the industry:
We tell them [entrepreneurs] what they should be doing in order to build BIG, SCALABLE companies that can (hopefully) make us lots of money. And yet, MOST venture capitalists SUCK at building BIG, SCALABLE venture capital firms… well, at least MOST of us, anyway.
So let’s build on Dave’s thoughts & summarize how MOST venture capital firms do & do not add value to entrepreneurs today:
Most venture capitalists aren’t operators and when venture capitalists try to get involved in operating companies, this creates risks for entrepreneurs.
When venture capitalists give entrepreneurs operating advice, they are giving advice to help create a home run – which creates more company-risk than pursing a single, double, or triple. In the VC world, one home run trumps five singles. Start-ups aint baseball and entrepreneurs needs to be fully aware of this when they seek VC financing. Investors swinging for the fences is not a bad thing at all – just a reality of the industry.
Venture capitalists, in large part, make investments based on the presentation skills of the entrepreneur. A polished pitch deck and a charismatic founder are tough to turn down. The problem with this approach? The skills needed to be persuasive during a pitch aren’t the same skills required to run a team.
Venture capitalists are generally functional experts, not industry experts. Tech expertise – like expertise in law or accounting – is a function that’s important across all industries. But don’t confuse functional expertise with industry expertise. Functional knowledge helps develop product. Industry connections help close deals.
To scale businesses through venture capital, entrepreneurs must shift focus away from building a business and towards the pursuit of funding. Here’s the way fundraising typically works: entrepreneurs generate a business idea, develop a viable version of the product, and establish (hopefully) growing traction with customers. At this point, one of the founders changes focus from product & customer and instead almost exclusively focuses on a new unrelated task: raising capital. This has always flummoxed me, much like the word flummox.
Venture capital firms recognize the problems with today’s industry and aren’t standing still. They are wisely continually changing their model to increase the odds of company success and enhance returns.
So how will venture capital look different in the coming years?
1) More Meaningful Industry Expertise
Say goodbye to the days where bankers morph into venture capitalists and say hello to a new model where industry experts evolve into venture capitalists. Deep industry focus forces tight investment theses and allows the investor to offer truly tangible value than a counterpart whose core expertise is “having an eye” for deals.
Perhaps the biggest advantage of investors with deep industry expertise is their ability to open. There’s no substitute for personal relationships and all industries are relationship-based industries. And what if your investors actually owned well-respected businesses that could serve as your first customer? Welcome to the new world of venture capital.
Fraser-McCombs Capital, a Boulder-based VC specializes in sales and marketing tech in the automotive dealership space. Their model delivers industry expertise in a way that illustrates the future of venture capital. The firm is a partnership between Chase Fraser, an experienced automotive digital marketer who has sold multiple companies, and Red McCombs, owner of the largest automotive group in Texas. By combining deep industry knowledge with entrepreneurial deal-making experience, the Fraser-McCombs model decreases start-up risk by ensuring a strong set of first customers, accelerating growth by opening industry doors, and streamlining operations by reducing the number of non-core activities for entrepreneurs.
2) Entrepreneurs as Specialists
As the start-up world continues to mature, expect to see ongoing specialization of entrepreneurs. Great start-up leaders at Day One aren’t necessarily great once the business hits $10mm in revenue. Marketers with great expertise acquiring the first 1,000 customers aren’t necessarily great at getting customer number 100,000. This specialization will become more common and VCs will become more comfortable plugging in experienced entrepreneurs at different stages, much like a baseball manager makes decisions about pitchers throughout all 9 innings.
3) Venture Capital as a Start-Up Factory
Get ready to see more and more venture capital firms starting companies themselves. That’s right – it will be commonplace for venture capital firms to partner with seasoned entrepreneurs and start brand new companies rather than waiting for entrepreneurs to start companies and bring deals to the VC.
Deep industry expertise means a thorough understanding of industry warts and as venture capitalists become industry experts, don’t expect them to sit back and wait for deal flow. Instead, look for venture capitalists to create deal flow the old fashion way: identify industry problems and start new companies based on the solution.
To keep this simple, here’s what the new world looks like:
VCs identify industry problems and potential solutions
VCs hire specialized early-stage entrepreneurs and have them lead the charge with a meaningful equity stake in tow. Expect these founders to collect solid salaries during the early years thanks to their proven track record of success.
The fundraising process is skipped since the VC making the investment is the one starting the company
Entrepreneurs exclusively focus on building the business…and move even faster thanks to the gift of industry connections & early adopter
4) Say Goodbye to Living In Two Worlds
In the future, we’ll see more venture capital firms starting companies with hired gun entrepreneurs. As part of this, the start-up version of the engineer’s dilemma will be solved and we’ll see a sharp decline in the number of entrepreneurs that must choose between running a company and raising venture capital. Sit back, smile, and imagine a world where entrepreneurs can build product, pitch customers, and lead teams rather than craft a perfect investor pitch.