April 21, 2008

VCs have a self-destruction gene, let's tweak it

Adam asks why there aren't more Paul Grahams, who asks why there aren't more Googles. When I actually read the post, I was somewhat confused, because he provided the evidence for Adam's question. The guy is rich, doesn't that make him wise? He's definitely thrown the holy handgrenade of confusion amongst the faithful knights, this time.

The headline question is, why aren't their more Googles:

Google's founders were willing to sell early on. They just wanted more than acquirers were willing to pay. It was the same with Facebook. They would have sold, but Yahoo blew it by offering too little.

OK, that statement is fine, true, a non-controversial statement (albeit, it doesn't actually address the headline question one iota). Now put your coffee mug down, take a deep breath and read this:

Tip for acquirers: when a startup turns you down, consider raising your offer, because there's a good chance the outrageous price they want will later seem a bargain.

Is this a test? Is Paul Graham hoping that people will read this and say, ha ha, I spotted your little joke? Or does he seriously believe that the current crop of acquirers are so stupid as to allow their self-destruction gene to run rampant and clean out the field a little?

On the off-chance that the above is not completely transparent, let's work it through. (As this is a blog that is read by few people, we run little risk of spoiling his fun.) The first thing to realise is that startup founders are always totally convinced that their offer is worth more. That's part of their makeup. As Paul Graham points out, this uncanny, reality-defying total belief is essential to getting the startup to where it is now.

So, it is a given that when you go to a startup, they will believe that they are worth more than you offer. If they don't believe that, then you possibly should take that as a sign, as perhaps Paul Graham suggests. However, when it comes to takeovers, this will quickly become a self-fulfilling rejection, so you need to somehow inject some pragmatics into the equation. If there are no pragmatics, there is no sale, period, and we aren't having this conversation. There's a lot of that going around these days....

So, somehow, pragmatics is inserted into the brain of the founder to fight the self-fulfilling fantasy gene of demi-god status. How this is done is totally random of course, by simple game theory; if we knew how this was done, we'd use it against him, and his demi-god capabilities would immediately destroy our tactics, so it can't be possible, before the fact, to know how. Capice?! As this is impossible to predict (is there a smart financier behind the founder? A mother? Is he actually ready for a takeover? Is he in fact smart and the bravo is a facade?) it is not really plausible to derive much info from any offer he rejects or accepts.

Given that, let's then turn to the advice: offer more money. OK, that's fine if this is a one round game. But what happens in round two? Well, clearly, all the startups hear about all the VCs who have followed the advice of the sage, and they all reject the first offers.

By induction over the basic model we can quickly determine that (a) we started from no useful information, and (b) each successive round takes us further from no information, and (c) each round that concludes with a successful "higher price" sale sucks more money out of the VCs, so (d) this strategy is guaranteed to kill more VCs and fund less startups than any government subsidy could possible do.

Round n+1: everyone goes broke.

In fact, this is simply how trade works, and economists and greengrocers alike learn it at an early age. In the trade it is called haggling, and the advice to haggle is no more useful than advice like "listen to your mother when she's right."

To repeat the comment I made on Adam's blog: VCs are about hard work. Just like the rest of life, there is no easy money. And circus tricks like the above are fine for the marketing and webpage ... "we know when to double our offer" ... but they won't give you any insight into how the VC world really works.

The rest of the post asks some good questions:

The most surprising thing I've learned is how conservative they are. VC firms present an image of boldly encouraging innovation. Only a handful actually do, and even they are more conservative in reality than you'd guess from reading their sites.

I used to think of VCs as piratical: bold but unscrupulous. On closer acquaintance they turn out to be more like bureaucrats. They're more upstanding than I used to think (the good ones, at least), but less bold.

Right. VCs are very very conventional. Very very bureaucratic. But the facade is outrageous, daring, all flash and bang. Why is this? Why can't a VC have an image that looks conservative?

I met some guys who do exactly that. Conservative. Not only do they pick a strong investment strategy that targets particular groups, they clearly explain their investment strategy on their site. And they do OK. I wish I could have done a deal with them, but their strategy and mine weren't aligned.

So, why do VCs believe they need this false front? Is it because you cannot attract a steady series of crazy offers across the desk without appearing to be crazy? You can't date a teenager without ... dressing like one? You can't be a VC without pretending to have a nose ring?

Plus most of them are money guys rather than technical guys, so they don't understand what the startups they're investing in do.

Ain't that the truth! The biggest problem I've seen with VCs is that they have next to no technical ability. So they have no ability to sort the technically sound from the technical fantasy. And this rhymes with my comments on CSOs from a while back: Strong technical people get that way by studying lots of tech. Strong money people get that way by studying lots of money. A rare bird indeed is one who naturally finds themselves in both camps.

Top tip: look for a strong technical player who has an MBA. This guarantees that, even if they aren't good at the money, they at least have the language and the culture injection enough to be able to understand and communicate.

(insert routine self-important blah blah disclosure here!)

Finally, he asks:

I've tried to explain this to VC firms. Instead of making one $2 million investment, make five $400k investments.

OK, sure, this is the phenomena that appeared in the mid 90s with several incubator investors and the Spring Street market. Basically, investment became technically a whole lot cheaper and more opportunities sprung up, creating a hole, a new opportunity in the market.

The failing is that the due diligence doesn't get any cheaper. The trick is to find a way to reduce the cost of the due diligence. There are ways to do it, but you aren't going to find them in VC firms, which is why angels exist.

( Hint: pay me like a VC and I'll tell you how to do it. 2nd Hint: if you pay me like a VC, it will be just as expensive. 3rd Hint: obviously, the trick is to not pay me like a VC. 4th and 5th hints will cost real VC money ... are you getting it yet? )

(As I recall, I analysed Spring Street and realised that they understood the flaw in the idea, and instead simply used the exposure to bootstrap up from the little boys' idea to the big boys' market.)

Posted by iang at April 21, 2008 06:35 AM | TrackBack

during the internet bubble, the VCs weren't interested in owning a company ... they were looking at how fast they could flip their investment via an IPO. It was get a percentage of something really lame-brain, unload it on the public, it goes belly-up ... and then repeat with the next one (since there was still a need for a solution ... jokes in the period about no interest in start-ups that actually showed positive cash flow).

So there is counter argument ... why bother with somebody that actually thinks they have something valuable and successful ... they just want something lame-brain but with enuf of a facade that doesn't go belly-up until after they unload on the public.

As an aside, there are "angel" investors that actually look for several hundred thousand. These tend to be in it for the longer term.

Frequently the 2-10mil were looking for something that they had control and was within 24months of IPO. Once they got the investment/control ... the whole focus was the packaging of the IPO (how fast and how much)

Now for real topic drift. The large corporate CSOs use to come out of gov. service having dealt with physical security issues. Not too long out of school ... I got paired with one such brand new corporate CSO (recently of gov. service) and got to run around talking about electronic/computer related assurance/integrity on and off for several months (i didn't view it particularly security specific ... it just was part of industrial strength, business critical data processing)

10-15yrs later ... when computer security was becoming more fashionable and they needed people to fill newly created "security" positions ... they tended to be the people that weren't needed/wanted for doing anything else.

Posted by: Lynn Wheeler at April 22, 2008 09:54 AM

there is some temptation to draw comparison between packaging of startups for IPOs during the internet bubble to the packaging of subprime mortgages as CDOs.

I've used the analogy of CDOs as subverting the "observe" in boyd's OODA-loop. past posts mentioning Boyd &/or OODA-loop

Milken had used CDOs two decades ago during the S&L crisis to obfuscate the mortgage values. Long winded decade old post also mentioning need for greater visibility into underlying value in CDO-like instruments

Mortgage originators used to have some interest in the quality of mortgages ... since there revenue came from mortgage performance. Along came CDOs, and they could unload the mortgages w/o regard to the quality. Their only interest became how fast they could originate mortgages (w/o regard to quality) ... and their revenue purely became how fast they could they originate mortgages and unload as CDOs.

a couple recent references:
http://www.garlic.com/~lynn/2008g.html#4 CDOs subverting Boyd's OODA-loop
http://www.garlic.com/~lynn/aadsm28.htm#61 Is Basel 2 out...Basel 3 in?
http://www.garlic.com/~lynn/aadsm28.htm#66 Would the Basel Committee's announced enhancement of Basel II Framework and other steps have prevented the current global financial crisis had they been implemented years ago?
http://www.garlic.com/~lynn/aadsm28.htm#67 Would the Basel Committee's announced enhancement of Basel II Framework and other steps have prevented the current global financial crisis had they been implemented years ago?

Posted by: Lynn Wheeler at April 22, 2008 10:49 AM
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