Steven Chu, Nobel Prize winner and Energy Secretary designate, gave a fascinating interview at UC Berkeley recently. There is a particular section that I found to be deeply insightful and relevant to the Venture Capital business. I quote from this section beginning at about minute 48:
“The lesson I learned is that you don’t even have to be brilliant if you are the first to look at something with a new tool… What are the new tools…? Let’s figure out something to do with it…
If you use an old tool to tackle a problem you’ve got to be really smarter than the rest of the folks because everybody has this tool. If you are the first to look with something new it’s like starting a new world. You just look around and everything you see is going to be new.”
He goes on to explain how he applied some new science to develop some very powerful solutions to important problems. He explains that it does little good to start with the problem. Without a new tool you only have conventional and well travelled paths to address it. It may not be obvious what problem exists and can be solved but starting with a new tool gives you a chance to create something truly disruptive.
The history of innovation is replete with examples of the primacy of the new tool. It probably begins with fire. The printing press, the water wheel, the steam engine, the internal combustion engine, the assembly line, electricity, the electric motor etc. etc. Each of these fundamental inventions gave rise to an era of new inventions addressing applications which could not have been conceived before the technology. Who would have ever considered the automobile before the existence of the engine? Wiring of the world to power light bulbs provided the foundation for thousands of electrical appliances that surround us every day of our lives.
Institutional Venture Capital
Venture capital with a small c has been a part of the world for hundreds of years. Queen Isabella provided the seed capital that got Columbus onto the water.
Venture Capital as an industry began in the 1960s. This was a magical time. The post war economic recovery was in full swing. The transistor was the first seed of this reality and integrated circuits were just emerging. The earliest computers were providing a clumsy but very useful model for applying electronic computation and “software” to solve difficult problems. The transistor, the integrated circuit, the minicomputer, the PC, the hard disk, Ethernet, wireless telephony and networking, the internet emerged in a continuous stream. Each of these fundamental new tools created a “new world” of opportunities to create disruptive solutions. As the tools matured and grew more powerful the solutions they enabled became more and more pervasive. As Steven Chu observed, “You don’t have to be brilliant if you are the first to look at something with a new tool”. The breadth and depth of the new field of opportunities opened up by these tools was probably unique in history. Tens of thousands of entrepreneurs started tens of thousands of startups, fueled by a rapidly growing Venture Capital industry. These startups turned into Microsoft, Google, Cisco, Amazon, Apple etc. etc. Countless smaller companies also participated and became part of the wave of technology that has inundated our daily lives. Technology grew from essentially zero to represent nearly 35% of the US GDP. Billions of dollars were invested and billions were returned to smart and lucky investors. The golden years!
Hitting the wall
The San Jose Mercury published a graph of venture backed IPO recently:
The decade from 1991 to 2000 produced nearly 500 IPOs. The decade from 2001 to present has produced 88. 2008 produced 1 IPO and 2009 doesn’t look much better. What has happened? I do not have data on hand for venture capital returns but I would bet that overall returns since 2000 have been very strongly negative.
Some folks blame the economy or other transitory exogenous factors. I believe that there is a much more fundamental and intrinsic factor at work.
The Sudden Absence of New Tools
The waterfall of new tools that started with the transistor in the 1960s has slowed to a trickle. The technology industry is, as a result, consolidating with a handful of monster players controlling the path to market for almost all technologies. Refining the old tools has become a business requiring massive injections of capital and long incubation periods. A new startup “has to be really smarter than the rest of the folks because everyone has this tool”. There are a few of these but nowhere near enough to support the massive scale that the Venture Capital industry has achieved. As a result there are billions of dollars chasing a small and declining base of quality deals.
Why has the emergence of new technologies declined so significantly? My guess is that it is a macro level systems phenomenon. Stephen Jay Gould developed the now standard evolutionary theory of “Punctuated Equilibrium”.
In essence he observed that evolution was not a smooth and continuous series of gradual changes. Instead it was marked by long periods of near complete stability, punctuated by brief periods of rapid and fundamental change. I suspect that many systems follow this same model, including innovation. The burst of invention and commercial success which was initiated by the invention of the transistor has run its course. The changes are not over but the rate of change has slowed dramatically and the difficulty faced by a “new species” in the resulting ecology is dramatically greater (survival rate is far lower). The rapid evolution of new tools is over and will not resume until and unless there is another fundamental technology innovation comparable to the transistor.
An Industry in Denial
I know of no example of an industry which conducted an orderly and systematic downsizing when the opportunity it addressed disappeared or radically changed. We can look around at the auto and recording industries for recent tragedies. The Venture Capital industry is no exception. Instead of recognizing the hand writing on the wall, VCs are inventing new places to put money and trumpeting the “opportunity” they represent.
The Clean-Tech Mirage
One of the most outrageous of these is “Clean-tech”. Is there a market for Clean-tech? Probably. Will there be a few companies created which succeed. Probably. Is there a fundamentally new tool that creates the dynamic required for a large scale venture capital industry to thrive and provide good returns? NO!!
Without a new tool you struggle with Steven Chu’s dilemma. You have to be “smarter than the rest of the folks”. A few may leap over that hurdle but the folks running Exxon, Shell, General Electric and other majors have the same tools, by and large and they are just as smart, they are far more nimble than they were 30 years ago, they have access to far greater resources and they have far broader market reach. According to the Mercury News the Venture Capital industry invested $6 Billion in 2007 and $8 billion in 2008 in Clean-tech. My guess is that the returns will be a very small fraction of that amount.
There is still a market for venture capital with a small c. Innovation is not dead. Smaller new tools emerge around the fringe of the market every day. A few of the big C investments will work but the Venture Capital industry as a whole will destroy billions and billions of dollars of investor’s capital in the post 2000 meltdown. I guess the good news is that, however big the capital destruction is, it will be a drop in the bucket compared to that recently achieved by the real masters of the universe, the Wall Street bankers.
If and when venture capital returns to its roots it will recover its business value. The new "micro-venture" model is: to start a very small fund (perhaps a separate fund for each separate investment); to include a significant amount of the general partner's own money; to make small investments in capital efficient businesses which can become profitable early and with no more than a couple of million dollars; and to pay the general partner exclusively with carried interest after the principal have been returned to the investors. Small startup opportunities exist and are ignored by the big-fund coupon clippers. If you can find (or start) a micro-venture fund, with good solid partners, you can still make an (admitedly smaller) investment in the venture capital sector with a reasonable expectation of an appropriate return.