Good Venture Capital Can Turn Bad, Too


Good Venture Capital Can Turn Bad, Too

Those working to build disruptive growth businesses within established corporations sometimes look longingly at the green grass on the other side of the corporate fence, where innovators who build independent start-ups not only can avoid the encumbrances of corporate bureaucracy but also have the freedom to fund their ideas with venture capital. The belief that venture capitalists can fund start-ups much more effectively than corporate capitalists is so pervasive, in fact, that the venture capital investment arms of many corporations refuse to participate in a deal unless an independent venture capital firm will co-invest.

We would argue, however, that the corporate-versus-venture distinction isn’t nearly as important as the willingness or inability to be patient for growth. Just like Honda, most successful venture capital firms had precious little capital to invest at the outset. The lack of money conferred on their ventures a superior capability in the emergent strategy process. When venture capitalists become burdened with lots of money, however, many of them seem to behave as corporate capitalists do in stages 3, 4, and 5 of the growth-gap spiral.

In the late 1990s venture investors plowed huge sums of capital into very early-stage companies, conferring extraordinary valuations upon them. Why would people with so much experience have done something so foolish as to invest all of that money in companies before they had products and customers? The answer is that they had to make investments of this size. Their small, early-stage investments had been so successful in the past that investors had shoveled massive amounts of capital into their new funds, expecting that they would be able to earn comparable rates of return on much larger amounts of money. The venture firms had not increased their number of partners in proportion to the increase in the assets that they were committed to invest. As a consequence, the partners simply could not be bothered with making little $2 million to $5 million early-stage investments of the very sort that had led to their initial success. Their values had changed. They had to demand that the ventures they invested in must become very big, very fast, just like their corporate counterparts.[22]

And just like their corporate counterparts, these funds then went through steps 3, 4, and 5 that were described at the beginning of this chapter. These venture funds weren’t victims of the bubble—the collapse in valuations that occurred between 2000 and 2002. In many ways they were the cause of it. They had moved up-market into the magnitudes of investment that normally are meted out in later deliberate strategy stages, but the early-stage companies in which they continued to invest were in a circumstance that needed a different type of capital and a different process of strategy.[23] The paucity of early-stage capital that continues to prevent many entrepreneurs with great disruptive growth ideas from getting funding as of the writing of this book is in many ways the result of so many venture capital funds being in their equivalent of step 5 of the death spiral—retrenching and focusing all of their money and attention to fix prior businesses.

We often have been asked whether it is a good idea or bad idea for corporations to set up corporate venture capital groups to fund the creation of new growth businesses. We answer that this is the wrong question: They have their categories wrong. Few corporate venture funds have been successful or long-lived; but the reason is not that they are “corporate” or that they are “venture.” When these funds fail to foster successful growth businesses, it is most often because they invested in sustaining rather than disruptive innovations or in modular solutions when interdependence was required. And very often, the investments fail because the corporate context from which the capital came was impatient for growth and perversely patient for profitability.

The experience and wisdom of the men and women who invest in and then oversee the building of a growth business are always important, in every situation. Beyond that, however, the context from which the capital is invested has a powerful influence on whether the start-up capital that they provide is good or bad for growth. Whether they are corporate capitalists or venture capitalists, when their investing context shifts to one that demands that their ventures become very big very fast, the probability that the venture can succeed falls markedly. And when capitalists of either sort follow sound theory—whether consciously or by intuition or happenstance—they are much more likely to succeed.

The central message of this chapter for those who invest and receive investment can be summed up in a single aphorism: Be patient for growth, not for profit. Because of the perverse dynamics of the death spiral from inadequate growth, achieving growth requires an almost Zen-like ability to pursue growth when it is not necessary. The key to finding disruptive footholds is to connect with a job in what initially will be small, nonobvious market segments—ideally, market segments characterized by nonconsumption.

Pressure for early profit keeps investors willing to invest the cash needed to fuel the growth in a venture’s asset base. Demanding early profitability is not only good discipline, it is critical to continued success. It ensures that you have truly connected with a job in markets that potential competitors are happy to ignore. As you seek out the early sustaining innovations that realize your growth potential, staying profitable requires that you stay connected with that job. This profitability ensures that you will maintain the support and enthusiasm of the board and shareholders. Internally, continued profitability earns you the continued support and enthusiasm of senior management who have staked their reputation, and the employees who have staked their careers, on your success. There is no substitute. Ventures that are allowed to defer profitability typically never get there.

[22]Professor William Sahlman of the Harvard Business School has studied the phenomenon of venture capital “bubble” investing for two decades. He observes that when many venture investors conclude that they need to have strong investment positions in a “category,” investors develop “capital market myopia”—a view that does not consider the impact that other firms’ investments will have on the probability that their individual investment will succeed. When massive amounts of available venture capital are focused on an industry where investors perceive steep scale economies and strong network effects, the funds and the companies in which they invest are compelled to engage in “racing” behavior. Firms seek to dramatically outspend the competition, because it is a company’s relative spending rate and its relative execution capability that drive success. Sahlman notes that once a race like this has started, venture funds have no option but to engage in that behavior if they want to participate in that investment category. Sahlman has observed that between the mid-1980s and the early 1990s—the period following the first of these investment bubbles—the returns to venture capital were zero. We have seen a similar decline in venture returns in the years following the dot-com and telecommunications investment bubble in the late 1990s.

[23]Big-ticket investing of money that is impatient for profit and growth is very appropriate in later stages of step 1 of the spiral, when the company needs to focus deliberately on a winning strategy that has become clear. Interestingly, Bain Capital, which has been one of the most successful investment firms over the past decade, made this transition very effectively. Bain started out making rather small venture investments. It provided the start-up funding for Staples, the office superstore, for example. It was so successful with its first fund that investors simply poured as much money into subsequent funds as Bain would let them. This meant that the firm’s values changed, and it could no longer prioritize small investments. In contrast to the behavior of the venture funds in the bubble, however, Bain stopped making early-stage investments as it got bigger. It became a later-stage private equity investor, and continued to perform magnificently. In the parlance of the model of theory building we presented in the introduction, as these investment funds grow, they find themselves in different circumstances. The strategies that led to success in one circumstance can lead to disaster in another. Bain Capital changed strategy as its circumstances changed. Many of the venture capital funds did not.