How early-stage technology funds really have to look to be successful
It’s a topsy-turvy world: The big private equity guys are berated for being "locusts" and are supposed to be responsible for the capital market crisis, while the early-stage VCs are the “honey bees”. But apparently, the honey isn’t very sweet: Investors are still being drawn to later-stage buyouts and, with a few exceptions, are steering well clear of early- stage VCs. The official response to this situation is diverse – usually involving a petition for the massive reinforcement of the supply side, which often results in liberal "watering can" investments or special seed funds that with their administrative structures tend to be risk-averse.
So what characteristics should optimally structured early-stage VC funds have? To answer that, we first have to take stock of the early-stage technology founder scene in Germany.
Four categories of founders
We can differentiate between the four following types of founders: Internet founders, engineers, inventors and researchers. Manifold Internet founders usually forge ahead without VC funds or can maneuver around the capital market on their own. As a rule, Internet founders need very little capital anyway, because the software is available as an open source product and a lot of personal initiative can be counted on to get a business going. Engineering firms and "independent" inventors are usually too incremental, and for that reason can hardly be scaled as a self-contained business. They often do not stand much chance of survival in any form beyond that of an engineering office. Finally, technology founders who come from universities and research institutes have the greatest potential because their research results usually offer completely new solutions.
Research spin-offs and the players
A representative of a high-ranking research organization recently put it like this: “The last thing professors and their founders want to see are high-gloss bulls*&% presentations by VCs, usually from foreign parent companies, that promise them the moon.”
The reasons are obvious. For one thing, the scientists, who see themselves as intellectuals, are often put off by them, furthermore, the issues surrounding a research spin-off usually have to do with operations and product strategy, for which pure capital market lore will not be very helpful. Unfortunately, during the boom, many VCs left behind a lot of scorched earth so that today they have an image similar to that of bankers whose appearance is accompanied by clichéd expectations: a fully formulated business plan, complete team, 7-digit sales revenues, etc. But that is far from the original meaning of the venture capitalist as it is known in the USA. This role, often intended for business angels as a substitute for VCs, only works in certain circumstances due to the hobby character that many ascribe to their activity and to the fact that there are only very few business angels with truly sufficient capital (that aren’t just looking for a job for themselves). Those for whom it has worked have long since turned themselves into VCs.
What, then, do research spin-offs really need? The immediate benefit of the technology is always apparent, but massive help is needed with commercialization. In the best case, there will be a concept for addressing this issue, but usually it won’t have real answers to the questions of which customer applications the technology will offer a disruptive advantage, how the product based on the technology needs to look, and how the business model must be formulated to sell the product.
To answer these questions, as an experienced entrepreneur with the corresponding specialist expertise the VC must work together with the founders and develop product and marketing visions, but above all to define concrete steps toward their implementation. That is a very creative process that naturally must begin the very first minute the business has started and must be done during the phase when the spin-off is still malleable – by the time the second financing round is reached, it will be too late. Actively guiding this kind of a spin-off process challenges the VC, not only as an entrepreneur but also as a mentor, since the founders must accept the visions as their own and must see the VC as a co-entrepreneur – statements like, “I’m pretty satisfied with my investors, they always left me alone...” are certainly not something one hears (in the positive sense)!
How should early-stage VC funds really look?
The main requirement of early-stage VC funds is that they have to be at least as entrepreneurial as the founders in whom they invest. VC funds that don’t even know what fundraising is, or who call on government aid for it, have already lost – how are people who themselves cannot sell supposed to help a founder formulate a sales strategy? It is equally important that the VC team members make their own investments in the fund. A bonus is one thing, but taking responsibility for one’s own investment is another. That’s why successful early-stage VC funds are private, and the members of the operative team make the investment decisions, not some anonymous committee.
Early-stage VC investment is not a high-volume business. If a partner makes more than one new investment per year and manages more than four, something is not right. Due diligence, business strategy development, assembling the founder team, the first 100 days, three other ongoing investments and deal scouting… and we’re talking about a 60- to 80-hour workweek.
But many participants are not even aware of the baggage associated with the word “seed”. For the founders, it is a sign that a VC is interested in pre-revenue companies; for investors in VC funds, it is a reason to stay away from them. That is why it is high time we return to the original understanding of VC, by which start-ups are built up from the beginning with the entrepreneurial assistance of the VC and are under the pressure of limited means to become successful quickly and creatively. The creation of framework conditions that promote start-ups and VCs, would have a positive effect on the formation of additional private early-stage VCs. Investors in VC funds would no longer feel a need to avoid the functioning VC marketplace that results.
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