Why Venture Capitalists Avoid Innovation: They Like Making Money | Hacker News Reader

Why Venture Capitalists Avoid Innovation: They Like Making Money

onstartups.com

24 pointsjohns24 comments

I think this article is expecting VCs to do something that angels and founders do: take a chance on a crazy idea in exchange for owning a BIG chunk of the upside.

A VC is a later-stage beast. They want less risk, and are willing to accept less reward (and ownership).

There's a spectrum of risk and reward and not everybody is in the same position.

A lot of innovation happens in the shadows before metrics evolve that help VC's determine probability of success. It's only when the VC's can judge among a number of opportunites, that they will invest in any of them. Even with quite a number of players, there is still plenty of upside.

Innovators think, "I'm the only one doing this and it's going to change the world." Innovators think VC's want in on the ground floor to maximize returns on capital. Innovators think their ideas are sure things. But they aren't.

It's good innovators think that, because if they didn't, they wouldn't waste their time on their silly ideas that never go anywhere... but sometimes do.

The author contrasts "VCs want Innovation" with "VCs want a product and a standard business model". They then claim that these statements contradict.

For example, Gridspy is making an innovative product, which is proven and already has several customers. However our business model is totally standard. 1) Sell units for profit. 2) Residual monthly fees for profit.

You can make innovative products and companies with boring old business models. VCs are right to be cautious around "We have a great idea but no possible way to monetise it."

Then again, I agree with pg that you don't need to have a business plan to have a great product. Companies such as twitter can turn into the most exciting startups.

I really liked "VC's generally don't support subsequent changes to the business plan. A self-funded entrepreneur is constantly making major course corrections, to the point of driving his colleagues crazy. VC's will deny this, but a VC investment is basically a ballistic missile launch, without course corrections."

That's a dangerous place for an investor (angel investors are incredibly brave) because one of the tenents of the old rigid VC model is that follow-on investors will usually try to squeeze out the early investors.

I've heard this in several places before? Can someone explain how this is done? How can early investors be diluted without also diluting the founders?

From my limited knowledge, one of two ways:

1) The founders also get squeezed out

2) The founders have some sort of preferred shares.

What exactly does #2 mean? Whenever new shares are issued, the founders get some more shares free?

There are lots of ways to do it.

For example, the company could be set up so 10% of the company is owned by folks who have type A stock and 90% by owners of type B. The company can issue additional type B stock without issuing more of type A stock. That dilutes the value of each type B share without affecting the value of type A shares.

The reason I am confused is this: they still end up with something, sometimes, at least. Otherwise noone would do it. The question is then, why doesn't this become a reduced to absurdity example where past investors are always left with nothing. If they can be wiped out, why aren't they always wiped out?

The VCs who did that would get a bad name.

Also, it is in everyone's best interest that the angel investor network is healthy.

You can dilute the founders, then vote to grant them more shares.

In real life, both founders and earlier investors get diluted.

The meager extra stock options given to the founders don't even come close of compensating from dilution for subsequent rounds.

Well obviously everyone gets diluted as more money is invested. That makes sense.

But, founders do still end up with substantial stock.

A tidbit of advice I got from a startup lawyer is that you want to provide value throughout the company's life. Apparently a lot of angels get screwed down the road (post VC) because they are no longer playing a big role. The founders, however, are often still playing an important role and get additional grants (especially if the founders are already fully vested after 3 or 4 years).

Investments in innovation are very risky, but the payoffs match the risk. Basically as an investor you need to understand this and to decide how much risk you're willing to take. If you invest in a proven technology and a proven team you're more likely to make a smaller profit, but investments in new technology and often unproved teams can provide obscene paybacks but carry considerably more risk. Google comes to mind as an example.

I don't think it's that simple. First of all, risk cannot be measured, so the fact that a person takes as much risk as they can bear is incorrect, it's all an illusion. I think it's easy to look back at let's say, Facebook, and say that they were a risky bet with a huge potential for growth. But the fact is that this kind of disruption cannot be predicted, in other words, no one in their right mind would have predicted Facebook to grow this big.

What I am trying to say, is that there is no point on investing in a company simply because they are risky/unpredictable and hope that they happen to be at the upper end of the tail and give back huge returns-- that would be a terrible strategy.

Facebook is a great example of a very risky bet that paid off bigtime. As you say, noone in their right mind would have predicted that facebook would grow this big - but the VC's that did and took a huge risk got an enormous paycheck out of it. The same Vc's probably invested in a lot of other companies that turned out to be losses.

Basically my premise is that risk x potential payout is a fixed number. Invest in a McDonalds franchise on your local highstreet and you will have a high probability of a low return. Invest in crazy stuff like facebook abd you have a low probability of a high return.

As you say, it's a simplicfication but I think it holds true in general.

Oh please, facebook already had 1/2 the Ivy league signed up and were growing at a fantastic exponential rate before they received an initial investment of 500k in June of 04. A real 'venture' move would have been to fund Zuckerberg _before_ he had a giant user base.

I think a better argument is VC are only willing to bet on small amount of innovation at a time. (However, the article is worth reading he does ask some interesting questions.)

For example Zappos didn't innovate how you sell shoes. Others were already selling shoes online. They simply innovated how you treat the customer and your employees. Thats a small innovation that VCs are willing to bet on.

VCs, despite what they might claim, are not about innovation or even venture. They function merely as a bank that buys equity, this is identical to the type of banking setup that would finance railroads in the 1800s.

I propose a start-up test, if a VC is willing to fund you, you do not need them, you are better off taking debt financing, you are already a sure thing.

isn't this the purpose of patents?

... prepare for grotesque oversimplification ...

NewCo creates some innovation and spends a bazillion dollars creating a new market for it (and fails because creating new markets is expensive).

NewCo ultimately runs out of money and dies. VCs retain the assets (including the patents).

LaterCo comes along a few years later with new funding and taps into the market NewCo created with a similar product. LaterCo succeeds.

NewCo's VCs send in their lawyers and LaterCo pays up.

Perhaps the article should be about why VCs have quit taking long term bets.

My version of events:

NewCo comes up with a reasonable extension on existing technology that anyone in the field who thought for 6 months could have come up with. However they fail to take it to market.

LaterCo is never formed because its founders discover the patents. An exciting new technology never reaches the market.

Most investment banking analysts aren't doing the job for the pay (which is mediocre when the hours are considered) but the exit options, one of which is VC. Investment bankers are, on the whole, mediocrities if not outright idiots; the analyst position enables the talentless to trade in their health and well-being in order to have career options that would otherwise be way out of their league. Thus, many venture capitalists are former investment bankers.

Anyone see the problem here?

People do become analysts for the pay (in addition to the exit opportunities). Despite the per-hour rates, there's definitely something alluring about the idea of making more (even if only marginally so) than your peers right out of college. Starting pay at VC's for analysts coming from banking is low relative to other options (especially private equity, which is generally the top choice). The bankers who come to VC either aren't good enough for better options or are genuinely interested in being involved with innovation, or at least the illusion of it.

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