Financial Innovation in VC-Land

This is probably the last post of 2007 you'll read on my blog. I may write a post tomorrow morning, but whether anyone will be in the office reading it is debatable.


For this post, I want to comment on a WSJ article in yesterday's weekend edition on smaller-scale venture capital operators. Peter Thiel, a former CEO of PayPal, runs Founders Fund, a small VC group. For a half million dollar investment in Facebook, he earned a 50 multiple return. According to the article,


"Mr. Thiel, the former CEO of online-payment company PayPal, is making waves in Silicon Valley with an investment strategy that differs significantly from the traditional approach. His company invests only modest amounts of money, sometimes just a few hundred thousand dollars, and focuses on entrepreneurs Mr. Thiel and his partners often know personally. He also takes an uncharacteristically hands-off approach to company management.

Already, the gambit has yielded several potential winners like Facebook."

Could larger, more stolid VC outfits be seeing the end of their days?

The Journal piece further notes,

"The venture-capital world "definitely needs to be shaken up," says the 40-year-old Mr. Thiel, an avowed libertarian who helped bankroll the movie "Thank You for Smoking," a satire about improving the reputation of cigarettes.

His company also reflects how a new type of venture capitalist is emerging, as start-up costs for Internet companies decline sharply. Many start-ups now need a bankroll of no more than a few hundred thousand dollars to get rolling, compared with the millions of dollars required a few years ago."

This sort of development seems to me to demonstrate new product development and evolution in the largely-unchanged VC world of the past few decades. Someone has developed a way to make good returns on VC investments, but leave the companies in the hands, and control, of the founders. Which doubtless is very attractive to the latter, as they seek funding.

As the Journal article reminds us,

"Most traditional VC companies want to invest larger sums, several million dollars, say, for large stakes in start-ups and then exert control over the companies' operations. Some demand "liquidation preferences," or guaranteed returns if companies are sold.

Venture capitalists often can be too quick to fire start-up founders and replace them with professional managers, Mr. Thiel says. He blames a cultural divide: Many VCs "have these very cushy jobs, they get paid a lot," and often can't relate to founders, he says.

With so much money chasing deals in Silicon Valley these days, start-ups can afford to be choosy in picking their financial backers. They are increasingly turning to companies like his that offer less of a "command and control" model, he says.

Mr. Thiel, who based Founders Fund in San Francisco rather than the traditional VC hotspot of Sand Hill Road in suburban Menlo Park, Calif., is structuring deals differently from how traditional venture capitalists do. Significantly, the fund often buys only a 5% or 10% stake in a company and sets up a special class of stock that start-up founders can sell while they are building their companies -- and before venture-capital investors see profits. That way, the thinking goes, the company founders can reap some financial reward and stay motivated to build the company before an IPO or company sale, which can take years."

It sounds like Thiel had found an edge over his longer-lived competitors. By identifying with his target market, he and his colleagues seem to have discovered a non-price competitive advantage. According to the article, other firms are beginning to follow Thiel's lead, albeit slowly.

On the negative side, though, the article reports,

"Mr. Thiel acknowledges his company faced resistance from blue-chip investors when it set out to raise money for its latest, $220 million venture-capital fund. One large institutional investor, who declined to be named, said he was put off by Founders Fund's anti-establishment pitch. Others wonder whether Founders Fund could soon tap out its close-knit network of entrepreneurs and run out of companies to fund."

Still, what matters most is whether Thiel's approach begins to turn a generation of startups in his direction, and simply take them off of the table for larger, more conventional VC groups.

Then, the 'large institutional investors' may not have the luxury of refusing to play ball with Thiel.

With Larry Ellison's dutch auction IPO last week, and Peter Thiel's novel VC approaches, there are signs that even the clubby worlds of investment banking and venture capital might, over time, be shaken up...and down to their core.