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Summary:

There’s been plenty of debate about whether small VCs are better than large ones, but angel investor Dave McClure says that the big problem isn’t size. He argues that most VCs, big or small, are simply approaching the consumer Internet market in completely the wrong way.

Angel investor and startup advisor Dave McClure

Updated: The latest salvo in the ongoing debate over the health of the technology venture capital industry comes from investor and startup advisor Dave McClure in a blog post entitled “Moneyball For Startups.” One of the big questions that continue to spark heated discussion is whether angel or “super-angel” funds and investors are inherently better than big traditional VCs, a debate that got a boost recently when venture advisor Paul Kedrosky said there was an angel crash looming. But McClure — whose preferred blogging style consists of lengthy rants filled with capital letters, multiple expletives and seemingly random changes in font color — says that the big problem isn’t size. He argues that most VCs, big or small, are simply approaching the consumer Internet market in completely the wrong way.

Most consumer internet investors, large or small, have no g****mn clue what they are doing. They are getting killed on IRR, and most of them should be put down & put out of their misery… NOW. Their investment thesis is suspect, their domain-specific skills are limited or non-existent, and their desire & ability to innovate is minimal. They are simply collecting fees, waiting for their next tee time.

The issue, McClure says, is that VCs of all shapes and sizes have failed to appreciate the kind of revolution that the web and the Internet in general has produced for consumer-focused startups, and how this changes what is required of the venture capital industry. Most VCs, McClure contends, are still stuck in a pre-web mindset where a good investment consisted of building a product — meaning “a variety of expensive things (big iron, disk drives, personal computers, packaged software, computer chips, designer drugs, network routers, browsers, search engines, social networks, etc)” — and then acquiring as many customers as possible and looking for a hundred-million- or billion-dollar exit.

That kind of approach makes no sense in today’s world of ultra-fast, low-cost web startups, McClure argues, since “product” now “typically means a website or service, run on low-/no-cost open source software, hosted in the cloud on low-cost servers, developed in a few months (or a WEEKEND!) by a small team of 1-5 developers, who continuously test & iterate in real-time with online customers.” And where marketing used to be expensive and require a lot of people and processes, he says, it now means “online distribution channels, paid & organic search” and viral and social marketing through Twitter and Facebook — much of which is low-cost or even free, and much more measurable.

There’s a lot more detail in the post, but that’s it in a nutshell. The result of all this is what McClure describes as his central investment thesis, which is to invest in smart entrepreneurs before they have even identified a product or market completely, and then make sure they are testing and checking continually to see if they need to revise or “pivot” to a new product or market. Then, when it becomes obvious they have something and are building a growing customer base, McClure says, it’s time to “double down” (McClure will get a chance to test his thesis with a new $30-million fund he is raising).

It’s sort of like counting cards at the blackjack table while betting low, then when you’re more than halfway thru the deck and you see it’s loaded with face cards & ten, then you start increasing your betting & doubling-down.

So is McClure right that this approach makes more sense than the traditional venture capital process, and that mainstream VCs are simply out to lunch? Some seem to agree wholeheartedly — the legendary Mitch Kapor, founder of Lotus 1-2-3 and the Electronic Frontier Foundation, said that in his post, “Dave McClure gives away every one of my investing secrets.” (Update: Union Square Ventures investor Fred Wilson has also posted some comments in support of McClure’s approach). Others seem more skeptical, however. Keith Rabois, also a venture investor of some note (and like McClure a former staffer at PayPal), said he disagrees with Dave’s take, and pointed to another contrarian response, a blog post by Glenn Kelman at the online real-estate brokerage firm Redfin.

In that post, entitled “It’s Still Expensive to Build a Great Product,” Kelman takes issue with one of McClure’s main assertions, which is that it is substantially cheaper now to start and run a company. Kelman argues that the only thing that has really declined is the cost of software development and hosting, but that it still costs a lot of money to find and keep excellent engineers and designers. And he says that when McClure “argues that his type of investing is the best type of investing, and that the alternative will go the way of the dinosaurs, I just want some data, or even a single example.”

Interested in a follow-up post, Dave?

Related content from GigaOM Pro (sub req’d): What the VC Industry Upheaval Means for Startups

Post and thumbnail photos courtesy of Flickr user technotheory

  1. McClure is way off base, expletives notwithstanding. Anybody who has run a company would have to agree with Kelman and Rabois. The primary assets and expense walks on two legs.

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  2. Until the mid 80’s most solutions were proprietary and very expensive to design, engineer, develop, sell and support. There were therefore relatively few choices and few methods to disseminate information about them (trade shows, trade rags, sales forces, etc.) This began to change with the introduction and use of open standards (SUN/Unix). So prior to then it was difficult to build a product but relatively easy to market it.

    The advent of the web and the proliferation of open standards and openware in the late 90’s, brought different challenges to creating a successful company. With the web, there are now countless ways to get information about a solution or offering. The challenge to a new company is identifying the audience they need to reach and then finding the correct messaging and medium to reach them. Additionally, there are exponentially more solutions available now than there were 20 years ago. Prospective buyers are bombarded with messaging from literally hundreds of vendors. It is challenging just to get though all of the noise. Many great products/services/solutions die on the vine because they can’t get through the noise and to their audience.

    The result is that the capital investment it takes to create a successful enterprise has shifted from engineering and development to sales and marketing. The challenge here is that while this may be conceptually true it has not occurred in fact. Most B2B companies underfund and do an extremely poor job of marketing.

    Why?

    1) The best marketing people go to B2C companies where there are huge budgets and lots of ‘interesting’ things to do. B2B companies tend to scrimp on marketing budgets – what really good marketer wants to work with that?
    2) Typical career paths for VPs of Marketing in B2B companies are System Engineer-to-Product Manager-to-Product Marketing Manager-to-VP of Marketing. Generally speaking, the people performing marketing in B2B companies have zero customer empathy and are not qualified and regardless, are not funded sufficiently to successfully accomplish their missions. You want a good B2B marketing guy? Find one that came up through the ranks in sales.

    In the current technology climate there needs to be a fundamental shift in how capital is allocated to build a company. It needs to shift from development (which is now relatively easy) to marketing (which is relatively complex.

    Go ahead and get in my face and debate me over this: I love a good argument. And If like you, I may even give you some tips and clues and how to get through the noise and get meaningful time with C-Execs in highly qualified accounts.

    “Going to Market is Like Going to War”

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    1. Some good points, Bill — thanks for the comment.

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  3. Discovery-driven Planning and Agile Market Research – An Antidote to Doubling Down Prematurely?

    Dave McClure correctly points out how investors (and I would add, entrepreneurs) can be blind-sided, although he fails to mention some important solutions. Ian MacMillan (Wharton) and Rita McGrath (Columbia) have examined these issues in discussions of innovation, uncertainty and investment. MacMillan puts it succinctly when he recommends “spending imagination before you spend your money and… engineering the risk out of uncertain projects…” In a nutshell, the process he and McGrath advocate involves 1) creating tests to probe and reduce the uncertainty ahead of investment; 2) staging the investment tranches, contingent on intermediate outcomes; 3) postponing investment until (some of the) uncertainties are resolved.

    Useful sources on their perspectives include notes from a conference last month at Wharton http://bit.ly/aIihsF; a video in which MacMillan and McGrath explain the rationale and benefits of the approach, which they call “Discovery Driven Growth,” at http://bit.ly/dxJdwi; their book http://amzn.to/cZeLIW; and McGrath’s blog at http://bit.ly/cL1AG8. Several readers have pointed out the parallels between their perspectives (developed over the last 10 years or so) and the “lean startup” notions of Eric Ries (http://bit.ly/hSVtd) – these complementary perspectives are crucial to avoid the pitfalls identified by McClure.

    Another important and useful resource is what we call Agile Market Research. Assumptions and hypotheses embedded in business plans – especially re: how consumers will respond to very new products, pricing, even branding – can be tested in advance of significant investment and commitments. While “listening to customers” and “build it and see if they will come” can be informative, Agile Market Research (often using virtual prototypes) allows us to model and predict market response and is recommended when opportunity costs, investment and/or uncertainty are high. Compared to market tests, building a predictive model is (i) faster, (ii) less expensive and (iii) allows one to test many different configurations, price points and business models. An important caveat – predicting how consumers will respond to products they’ve never experienced (e.g., iPad; Twitter; etc.) is fraught with challenges, but it’s not impossible (for further discussion, see http://bit.ly/9kJ1tZ).

    Dr. Phil Hendrix, immr and GigaOm Pro analyst

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    1. Thanks a lot for that, Phil.

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  4. We call it “Venture Operating”, because venture investors are increasingly funding operating costs, not capital expenditures like they used to. There is no way they’ll get 20%+ IRRs on their portfolios doing this.

    VC used to be for high fixed cost/low variable cost industries, but is now being used to cover variable costs, like sales commissions. Few banks would ever finance a startup’s fab, but they will gladly fund the hiring of a few more salespeople for a good company. Moreover, the bankers generally need a single digit return, not a monstrous IRR to justify the investment. They also don’t go crazy with liquidation preferences and the cost of capital is much lower.

    Venture “Capital” is increasingly a biotech phenomenon, but even there the IRRs suffer from the very long time lags to liquidity events. Green investments are doing atrociously, as wind/solar get cheaper by getting bigger, like traditional manufactured goods, not by getting smaller like semis.

    The VC model that’s existed for 40 years is clearly not working anymore, which is reflected in the re-allocation of pension/endowment/institution assets into other categories. Don’t know if McClure’s got the right answer, but the risk of venture investing is very hard to justify when the return comes not from financing high margin software licenses or chips, but from funding the expansion of the marketing department.

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  5. I think there’s too much fuss about right or wrong VC approaches. What matters the most is what entrepreneurs do.

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  6. McClure has it about 90% right. Particularly, where a start-up needs to allocate a bunch of time/money to marketing after they’ve hit a certain point, not keep spending it on tech. Developers hate that thinking, they want more money spent on the tech side; but, Start Ups that are a blend of Business and Developer Teams may succeed if they balance and shift their spending at various phases.

    The only item McClure failed to address is that age-old conundrum of focusing investment in Silicon Valley/Bay Area, where (other than commercial rents), the cost of living remains close to the highest in N.A. — So, you have to raise far more money just to barely get by, and all that money goes to insurance companies, landlords and mediocre restaurants and groceries that charge 2x what you’d pay elsewhere. Forget being a start-up under this model if you have any business experience and might have a family — you can’t afford to launch in the Bay Area without much larger funding rounds.

    Solution to that? Look to Salt Lake City, Portland, Albuquerque, Omaha, etc. – only in those locations can businesses actually operate under the terms McClure lays out.

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    1. your logic is as flawed as mcclure’s. what makes the bayarea special is the liquid talent pool, not the underperforming grocery chains or restaurants.

      you should operate in albuquerque only if you dont need the talent….

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      1. @les madras — Not sure of your logic or reasoning at all?

        There is no reference to “under performing” grocers that I see; only the fact that the cost of living in the Bay Area is exceedingly high.

        The Bay Area has a large Talent pool because it’s where the money has been. If the money were in Wilmington, DE, the Talent would be there.

        The issue is how do you finance the new lean McClure model in the Bay Area due to cost of living? You get into a Catch-22 pretty quickly, or you limit yourself to only doing deals with 20-something garage bands; likely where you have no experienced marketing/business Founders, even though that’s where you need to do part of your spend?

        I have yet to see anyone ask McClure how he gets around this? Since, the rest of his reasoning does seem sound. BTW, there’s a lot of Talent in places like Albuquerque and they even get AT&T reception.

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      2. @melr
        the so-called new lean Mcclure model of startup is about building penny-ante companies that get their traffic from google and their money from google adsense. its a useless endeavor that should not exist anywhere. not even albuquerque.

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      3. +1

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  7. There is one group that needs to run away and die: The non-entrepreneur & non-operator experience version of a vc.

    Sorry, but you have no reason to live!

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  8. It’s funny. This isn’t my first kick at the cat but each time I always found it strange the push to take more than you needed and then ramp the numbers to justify it. There was an “apparent” process designed to inject greater sums to achieve bigger “bang” which seemed more heat than light.

    My current gig is designed around spending as little as possible period. Less money needed = less dilution and more flexibility. Especially in the formative stage, money is a curse, so to speak. Marketing and sales gobble cash worse than zombies and the expected results never align (rarely if ever). It’s the internet age, if you cant pull customers from Google organically, you aren’t very good at SEO (hire someone) or your product doesn’t have a market (wow, that’s a problem money can’t fix). If you can’t get followers, your product isn’t very good. Unless your product is aimed at people over 50, marketing on TV, Radio and print is pointless or merely self-gratifying (IMHO). PPC is for getting $ sales, so should pay for itself.

    If you can’t live on a shoestring before VC money, god help you. You should even have to live on a shoestring every day after that. Cash in the bank is a temptation for:

    Office space, Staffing, Lunch, Dinner, Toys, Vacations, “Culture” , team-building and “branding” and “extending features”.

    If a $ doesn’t make your product better or get more sales, it’s a pointless dollar and one you’re better not taking in the first place.

    Just a thought.

    Rob

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