vcsqueeze.html
The Venture Capital Squeeze

November 2005In the next few years, venture capital funds will find themselves
squeezed from four directions.  They're already stuck with a seller's
market, because of the huge amounts they raised at the end of the
Bubble and still haven't invested.  This by itself is not the end
of the world.  In fact, it's just a more extreme version of the
norm
in the VC business: too much money chasing too few deals.Unfortunately, those few deals now want less and less money, because
it's getting so cheap to start a startup.  The four causes: open
source, which makes software free; Moore's law, which makes hardware
geometrically closer to free; the Web, which makes promotion free
if you're good; and better languages, which make development a lot
cheaper.When we started our startup in 1995, the first three were our biggest
expenses.  We had to pay $5000 for the Netscape Commerce Server,
the only software that then supported secure http connections.  We
paid $3000 for a server with a 90 MHz processor and 32 meg of
memory.  And we paid a PR firm about $30,000 to promote our launch.Now you could get all three for nothing.  You can get the software
for free; people throw away computers more powerful than our first
server; and if you make something good you can generate ten times
as much traffic by word of mouth online than our first PR firm got
through the print media.And of course another big change for the average startup is that
programming languages have improved-- or rather, the median language has.  At most startups ten years
ago, software development meant ten programmers writing code in
C++.  Now the same work might be done by one or two using Python
or Ruby.During the Bubble, a lot of people predicted that startups would
outsource their development to India.  I think a better model for
the future is <NAME>, who outsourced his development
to a more powerful language instead.  A lot of well-known applications
are now, like BaseCamp, written by just one programmer.  And one
guy is more than 10x cheaper than ten, because (a) he won't waste
any time in meetings, and (b) since he's probably a founder, he can
pay himself nothing.Because starting a startup is so cheap, venture capitalists now
often want to give startups more money than the startups want to
take.  VCs like to invest several million at a time.  But as one
VC told me after a startup he funded would only take about half a
million, "I don't know what we're going to do.  Maybe we'll just
have to give some of it back." Meaning give some of the fund back
to the institutional investors who supplied it, because it wasn't
going to be possible to invest it all.Into this already bad situation comes the third problem: Sarbanes-Oxley.
Sarbanes-Oxley is a law, passed after the Bubble, that drastically
increases the regulatory burden on public companies. And in addition
to the cost of compliance, which is at least two million dollars a
year, the law introduces frightening legal exposure for corporate
officers.  An experienced CFO I know said flatly: "I would not
want to be CFO of a public company now."You might think that responsible corporate governance is an area
where you can't go too far.  But you can go too far in any law, and
this remark convinced me that Sarbanes-Oxley must have.  This CFO
is both the smartest and the most upstanding money guy I know.  If
Sarbanes-Oxley deters people like him from being CFOs of public  
companies, that's proof enough that it's broken.Largely because of Sarbanes-Oxley, few startups go public now.  For
all practical purposes, succeeding now equals getting bought.  Which
means VCs are now in the business of finding promising little 2-3
man startups and pumping them up into companies that cost $100
million to acquire.   They didn't mean to be in this business; it's
just what their business has evolved into.Hence the fourth problem: the acquirers have begun to realize they
can buy wholesale.  Why should they wait for VCs to make the startups
they want more expensive?  Most of what the VCs add, acquirers don't
want anyway.  The acquirers already have brand recognition and HR
departments.  What they really want is the software and the developers,
and that's what the startup is in the early phase: concentrated
software and developers.Google, typically, seems to have been the first to figure this out.
"Bring us your startups early," said Google's speaker at the Startup School.  They're quite
explicit about it: they like to acquire startups at just the point
where they would do a Series A round.  (The Series A round is the
first round of real VC funding; it usually happens in the first
year.) It is a brilliant strategy, and one that other big technology
companies will no doubt try to duplicate.  Unless they want to have 
still more of their lunch eaten by Google.Of course, Google has an advantage in buying startups: a lot of the
people there are rich, or expect to be when their options vest.
Ordinary employees find it very hard to recommend an acquisition;
it's just too annoying to see a bunch of twenty year olds get rich
when you're still working for salary.  Even if it's the right thing   
for your company to do.The Solution(s)Bad as things look now, there is a way for VCs to save themselves.
They need to do two things, one of which won't surprise them, and  
another that will seem an anathema.Let's start with the obvious one: lobby to get Sarbanes-Oxley  
loosened.  This law was created to prevent future Enrons, not to
destroy the IPO market.  Since the IPO market was practically dead
when it passed, few saw what bad effects it would have.  But now 
that technology has recovered from the last bust, we can see clearly
what a bottleneck Sarbanes-Oxley has become.Startups are fragile plants—seedlings, in fact.  These seedlings
are worth protecting, because they grow into the trees of the
economy.  Much of the economy's growth is their growth.  I think
most politicians realize that.  But they don't realize just how   
fragile startups are, and how easily they can become collateral
damage of laws meant to fix some other problem.Still more dangerously, when you destroy startups, they make very
little noise.  If you step on the toes of the coal industry, you'll
hear about it.  But if you inadvertantly squash the startup industry,
all that happens is that the founders of the next Google stay in 
grad school instead of starting a company.My second suggestion will seem shocking to VCs: let founders cash  
out partially in the Series A round.  At the moment, when VCs invest
in a startup, all the stock they get is newly issued and all the 
money goes to the company.  They could buy some stock directly from
the founders as well.Most VCs have an almost religious rule against doing this.  They
don't want founders to get a penny till the company is sold or goes
public.  VCs are obsessed with control, and they worry that they'll
have less leverage over the founders if the founders have any money.This is a dumb plan.  In fact, letting the founders sell a little stock
early would generally be better for the company, because it would
cause the founders' attitudes toward risk to be aligned with the
VCs'.  As things currently work, their attitudes toward risk tend
to be diametrically opposed: the founders, who have nothing, would
prefer a 100% chance of $1 million to a 20% chance of $10 million,
while the VCs can afford to be "rational" and prefer the latter.Whatever they say, the reason founders are selling their companies
early instead of doing Series A rounds is that they get paid up
front.  That first million is just worth so much more than the
subsequent ones.  If founders could sell a little stock early,
they'd be happy to take VC money and bet the rest on a bigger
outcome.So why not let the founders have that first million, or at least
half million?  The VCs would get same number of shares for the   
money.  So what if some of the money would go to the  
founders instead of the company?Some VCs will say this is
unthinkable—that they want all their money to be put to work
growing the company.  But the fact is, the huge size of current VC
investments is dictated by the structure
of VC funds, not the needs of startups.  Often as not these large  
investments go to work destroying the company rather than growing
it.The angel investors who funded our startup let the founders sell
some stock directly to them, and it was a good deal for everyone. 
The angels made a huge return on that investment, so they're happy.
And for us founders it blunted the terrifying all-or-nothingness
of a startup, which in its raw form is more a distraction than a
motivator.If VCs are frightened at the idea of letting founders partially
cash out, let me tell them something still more frightening: you
are now competing directly with Google.
Thanks to <NAME>, <NAME>, <NAME>, and <NAME> for reading drafts of this.Romanian TranslationHebrew TranslationJapanese Translation

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