In my last blog article, I framed the current state of the venture industry and pointed out several issues that are clearly causing the industry problems. In this blog, I suggest the type of VC that I think is going to be the market leader over the next decade and what kind of value must be provided to drastically shift the success record for these firms.
I believe that a new type of venture firm is emerging and this is going to be very good for venture capital firms, the angels, and the entrepreneur. This new type of venture firm, I call them the "Efficient Frontier" venture firm, will be positioned on the following elements:
First, as I said in my last post, 97% of all acquisitions happen below $50M and the entire industry is optimized around the 1% of exits that happen above $200M. That is insane. The Efficient Frontier firm will optimize their portfolio around the 97%, rather than the 1%. What that means is smaller funds and smaller investments. It means that a fund should be $60M to $100M, not $300M to $1B. It means that the total investment should be more like $5-$7M, not $20-$25M. And it means the exits will be in 4 to 6 years, not 12-15. That means a good $35M for a company that received $5M in venture funding for 1/3 of the company would break down something like this: 1X preference is $5M, 1/3 of the balance is another $10M or a total return to the VC of $15M, the employees would get $6M, and the founders $14M. That would be a good party for everyone! There is probably less than 10% of the current firms that make anywhere close to this return.
Second, the Efficient Frontier firm will also change the industry's underlying strategy of portfolio theory. Instead and trying to get 100% of the return from 20% of the exits, the objective would be to get "everyone on base". That means the financing should come in tranches of about $1M. Most companies can get a base product to market for something around $1M. That's the first tranche and until the base product is done, the team should keep development as the focus. Then, the second $1M comes in and the entire focus should be establish a "repeatable model". Get the pricing done right, determine the sales cycle, and identify the support requirements. Because of the current VC strategy, many companies are forced to hit it hard and start repeating a non-repeatable model. That is a great way to increase the burn and go out of business fast. Once you have the repeatable model firmly established, bring in the third tranche and hit the gas. The company should keep the "pedal to the metal" as long as four factors are in sync: they are making happy customers, they are working the team hard but not burning them out, the product is growing smartly, and they have time to leverage important partnerships. If any of those factors start to rattle, let up on the gas. Companies on this trajectory should be doing $8-$12M in revenue in their third year of sales and reaching profitability.
Third, the Efficient Frontier firm will provide as much value in the form of "brain power" than they are in cash. That means most of them will be ex-CEOs and will have a lot of experience running companies. A lot of VCs that are ex-investment bankers or straight out of B-School think that by watching a company grow from a board seat they are experts in how to run a business. That is a little like think that because you watch Monday Night Football every week you are going to be a great football player. I was really lucky when I came out to Silicon Valley in that my company was invested in by Mayfield and Venrock. My partners were Yogen Dalal and Terry Garnet, both very experienced CEOs. I can't tell you how valuable their leadership and guidance was as I was building out my company. I think this will often take the form of some kind of accelerator, similar to Y-Combinator or Techstars. The key is that new entrepreneurs are greatly helped by the mentoring of a seasoned CEO, as the face many issues that are simply not intuitive.
Next week I am going to go into detail about the company milestones these Efficient Frontier VCs will focus on with their investments.