Thursday, April 30, 2009

Why Venture Capital Is Limited In Scale

Fred Wilson has posted a very thought-provoking piece, arguing that the VC industry is raising too much money. His essential argument is that VCs are raising so much money that the total number and amount of exits cannot possibly deliver a good industry-wide IRR.

I agree with Fred's analysis, but wanted to go a little deeper. This post originally appeared as a comment on Fred's blog.

As an asset class, VC has become terribly overinvested. While the dot com bubble was partially to blame, the hidden cause was the massive rush into VC by endowments and pension funds.

All the major institutional investors were jealous of David Swensen's returns at Yale, and concluded that the reason Swensen outperformed was that he invested in illiquid asset classes like VC.

As a result, the VC industry ballooned to its $25 billion/year size. It was simply a matter of supply and demand.

And at $25 billion/year, VC is simply too big to deliver good returns. True, there are only so many exits, but that too is a symptom and not a cause.

VC companies tend to play in the specific fields of technology and biotech. Both those markets are a certain size; simply pumping more money into company formation doesn't change the fact that the major technology buyers such as Wall Street aren't going to increase their spending more than 5-10% per year.

In the end, all company value comes from the net present value of future cash flows. And cash flows come from customers. And customer spending fundamentally scales with global GDP.

When VC was a small asset class, it had plenty of headroom to grow. But the larger it gets, to closer its returns will get to the overall equity return, with the added negative of illiquidity and volatility.

Sunday, April 26, 2009

Education Is Destiny: Educated Poor Do As Well As The Lazy Rich

If you're born into the poorest quintile, and don't get a college degree, you have a 32% chance of making it into the middle class or above (top 3 quintiles). That rises to 62% if you get a college degree. Getting a college degree doubles your chance of having a successful life (if having a successful life is defined as rising to the economic middle class). You have an 84% chance of doing better than your parents.

If you're born into the top quintile and get a college degree, you have a 54% chance of doing as well as your parents, and an 89% chance of making it into the middle class or above. That drops down to 64% if you don't get a college degree.

In other words, you're almost as well off being born poor, but getting a college degree, than being born rich, but not going to college.

If the American dream is about being able to work hard and become successful, then it appears that the American dream is still alive and well--if you're able to earn a college degree.

The Zero-sum Fallacy Of Socialism

This paragraph from Warren over at Coyote Blog may well be the best paragraph I read all week:

"For socialists, wealth is not created by man’s mind and his effort — it is a spring in the desert with a fixed flow rate. It just exists to be taken or fought over. The wealthy, by this theory, have not earned their wealth, they are just the piggy ones who crowd to the front of the line and take more than their share from the spring. Unfortunately, socialists have never been able to explain why the spring, which flowed so constantly (and so slowly) for thousands of years, suddenly burst forth with a veritable torrent in lockstep with the growth of capitalism in the west. And why it seems to dry up in countries that adopt socialism."

The fallacy of treating the world as static, rather than as a dynamic system, is a common one; it affects not only socialists, but every person (including many entrepreneurs) who don't seem to realize that Newton's Third Law is almost universally applicable.

The Best Time For Change Is When People Are Forced To Choose

I like Seth Godin's work, but I think he's overrated.

It's not Seth's fault; he keeps doing great work. But the Internet hype machine has saddled him with ridiculously high expectations and a worshipful aurora of groupies, which makes it difficult to evaluate his work properly.

Nonetheless, his recent post, "Pick Anything -- The Calculus of Change" is a keeper:

"Do nothing is the choice of people who are afraid. Do nothing is what you do if too many people have to agree. Do nothing is what happens if one person with no upside has to accept downside responsibility for a change. What's in it for them to do anything? So they do nothing.

The key moment for an insurgent, then, is the time of "pick anything." That's why these are such good times for iPhone apps. That's why the beginning of an administration is a good time to lobby. When people have to pick, they have to confront some of the fear and organizational barriers that lead to the status quo."

Those who have worked with me know that one of my most important marketing principles is that your competitors are rarely your most important competition. Doing nothing is always your toughest "competitor."

As Seth points out, if you can find a moment in time where the status quo is vulnerable, that's the ideal time for the savvy entrepreneur to strike.