Will the Downturn Reinvent Venture Capital?

Excellent post by our friend Alan Patricof in the NY Times DealBook about the changing paradigm of venture capital. There has been a lot of discussion lately about the reinvention of the venture industry, and it is a subject near and dear to our hearts at True. We think about it, and act on it, every day. As Alan details in his post, the paradigm for VC has changed due the disappearance of the IPO exit option and the structural change that fund size growth has wrought upon the venture capital model. In our opinion, the emergence of extreme capital efficiency from new web infrastructures and evolving software architectures has also been critical to this shift. The bottom line is that the venture industry is out of alignment with the needs of early stage entrepreneurs, and it is early stage entrepreneurs who are vital to pulling the US (and rest of world) out of the current economic situation.

In this time of macro-economic crisis, companies large and small are cutting back on resources and investments in R&D. Microsoft, Yahoo, Ebay have lost incredibly talented people over the past months, and mature startups are struggling for survival. Google today laid off engineers; Pfizer recently announced plans to lay off researchers.

Innovation is at risk in America, but it is badly needed for our future. Startups funded today will fulfill a massive need for innovation and growth over the next 5-10 years for our country, but the venture capital industry (as formed today) seems poorly designed to foster the risk taking necessary to seize this opportunity. Ironically, though we invest in innovation, venture as a business has (so far) failed to innovate in a meaningful way to address the changing landscapes of our underlying markets and the changing needs of our customer (the entrepreneur).

We started True in 2005 because we felt that the existing venture capital model didn’t work anymore for the needs of the earliest stage entrepreneur. Large funds, big checks, pursuit of the ever elusive “billion dollar” exit, partnership dynamics that strive for risk reduction, and an industry aversion to failure/loss have all contributed to the capital flight away from the earliest investment stage.

This was occurring at the worst possible time for investors because starting in 2004, we witnessed significantly higher capital efficiency across the startup spectrum. Just as VCs were systematically and structurally moving away from early stage, the early stage risk equation was getting dramatically better for investors and entrepreneurs alike. You could start a company with $500K (or less) and demonstrate substantial progress and customer need. You could likely build significant revenues for much less than $2mm. Great entrepreneurs quickly realized that you didn’t need a $5mm check for an A round, and they also realized that if they raised less, they could own more of their company. Smart and savvy angels quickly noticed this as well, but there were few institutionally-backed options.

We started True to reinvent one small segment of venture capital: the very early stage. We scrapped the playbook for mainstream venture and decided instead to design everything around one simple idea: the customer is the early stage entrepreneur. Our primary objective is to back great people in great markets. We seek to maximize timing, product and market risk. We believe these are the surest paths to out-sized returns and opportunities. We try to minimize people and capital risk by working with folks known to our team or network. We limit capital risk by investing very small dollars early-on. Bigger dollars come with success or proof, and, because our funds are fairly large for what we do, we can support a company for the long term. This is critical, because innovation and success are rarely straight lines.

None of this means we aren’t faced with tough decisions (we are) or failures (we are), but it does mean that we’ve designed our firm and product set around the opportunity we see in the market, not the other way around.

In order to innovate, we VCs need to think like our entrepreneurs and be flexible, creative, do more with less, access parts of the markets that are uncomfortable, and swim out of the mainstream. LPs would be wise to encourage these risks, whether in the form of new models or new platforms (admittedly a self-serving statement). Innovation is a tremendous force for change in the world, and it is a constant. Great industries will be built during these tough times, but most of them will start small.