I wrote this essay in December 2013 whilst spending 6 days on the Island of Hainan between events in Guangzhou and Shenzhen.
It retains its relevance today in the context of the so-called Series A crunch and the Unicorn boom.
The original essay
Since early 2011 I have been working with early stage companies through my role at archimedes labs. We have 14 portfolio companies and have been fortunate to work with some wonderful founders. M.dot has been acquired by GoDaddy; Quixey has raised significant rounds of finance, including $50m from Alibaba most recently; Kwicr is revolutionizing bandwidth use and has recently announced significant funding; and more than 90% of the remainder have been funded since we got involved with them. just.me had the privilege of working with Khosla Ventures and True Ventures, Google Ventures, BetaWorks, Crunchfund and others.
I start the story here simply to indicate that what I am about to say — although I feel it quite personally — is not driven by anything other than my observation of the facts.
The Valley today is not the Valley I came to join in 1997. It is certainly different, and that is good. But in one regard it is worse, and significantly so. And we will all pay a price if that does not change. This is a manifesto of the need for that change as much as it is an essay.
There are many who believe that the Valley is as great a place as it has ever been. That the growth in the sheer number of startups and the number of investors, and the more recent trends to create syndicates of investors, establishes a new and viable means of supporting innovation. Much as I welcome these trends, I beg to differ in just one regard. A major part of the ecosystem needed to support true disruption is absent. This is a new phenomena, and a dangerous one. But more of that later, first a little context on myself for those who don’t know me.
What made Silicon Valley unique?
I came to Silicon Valley in 1997, fresh from 3 years as co-founder of EasyNet, Europe’s first consumer ISP (now a B2B company). EasyNet had never raised venture capital, and between 1994 and 1996 David Rowe and myself had built a revenue led company capable of doing an IPO on the UK’s AIM (Alternative Investments Market). We raised no venture capital because in the UK at that time there was none to be had.
My previous 10 years had been spent at cScape (now Clerkswell), operating a cash driven database and networking business. It too never raised venture capital. It was eventually acquired by AIM listed NetB2B2.
When I arrived in Palo Alto, pre bubble, in 1997, I came with an idea — to create one of the world’s first web services — linking ASCII URLs to multi-word and multi-lingual keywords, allowing users to type Keywords in their browser or their search engine, and with no search results, to go directly to the appropriate URL.
This system, called RealNames, was built during 1997 and launched in March 1998. Google adopted it to create “I feel lucky”; Altavista adopted it; Infoseek, MSN and most others. It soon raised financing from Draper, Fisher Jurvetson and Idealab Capital Partners (now Clearstone Ventures). John Fisher and Bill Elkus joined my board.
Soon more money followed. Bob Korzeniewski of Network Solutions, and later Verisign, joined the Board after his company took a 10% stake. Morgan Stanley Ventures led the B round. And then Microsoft took the lead in distributing the web service and got a 20% stake.
By 1999 RealNames was filing for an IPO with the Facebook IPO banker from Morgan Stanley, Michael Grimes, leading the effort and Mary Meeker, now at Kleiner Perkins, as analyst. Hambrecht & Quist was also involved, with Danny Rimer, now at Index Ventures, as analyst.
Before any revenue the company raised $20m. It raised another $110m before becoming profitable. But it transformed the internet into a navigable place for people who spoke non-latin character based languages, It was a big idea in need of major support to work. To this very day, in China,S Korea and Japan users are using Keywords to navigate the web.
Is Silicon Valley still Silicon Valley?
The contrast between Silicon Valley and London was stark for me. The belief in teams and ideas, and the preparedness to take risk in order to execute ideas that if successful could be world-changing, was second to none. It was this determination to fund change that singled the Valley out from the rest of the USA and the rest of the world. It made me want to leave London and be in the Valley in 1997. Today I have 3 children, all boys, all true Americans, and my wife and I love the Valley.
Fast forward to 2013 and the Valley today looks a lot more like my London did in 1996. Of course the scale is still huge. There is enormous amounts of capital available, but a dearth of true risk-taking through the middle stages of the life of a company.
Seed capital is available, and growth capital is available, but in between, the absence of risk-taking Venture Capital is truly staggering.
If we break the stages of investment down into three. Seed, Venture and Growth, then we should acknowledge that the second, Venture Capital, is almost entirely absent, with some notable exceptions (Greylock and Benchmark most strikingly, both are led by former entrepreneurs).
This problem has been well documented over the past 12 to 24 months. Duncan Davidson from Bullpen Capital maintains the following graph:
The graph shows the growing gap between seed fundings and second rounds (called series A here for convenience but includes series B where the seed was an A)And Crunchbase, which has wonderful statistics on a wide range of startup-related events — concurs.
This chart tracks the % of post-seed startups that are subsequently funded after 1, 2, 3, 4 and 5 years from graduating an incubator or seed round. Only 27% were funded after 1 year, and the number barely changes after that.
But we are going too fast. Let’s take a step back. Risk and reward are always correlated. And it makes sense to start by talking about reward. How big are the opportunities for big and long term thinkers today? What is the possible scale of disruption?
A time of great change
We live at a time of enormous change in the computing platforms used by the World’s population. Just as we moved from the mainframe to the PC; and the PC to the networked PC; and the networked PC to the Internet, and then in the Internet era; from portals to web services; and then to social networks; now we are redefining the hardware platforms we all use all over again.
This chart is produced by enders analysis. it shows that the last time there were more PCs and Desktops than smartphones and tablets was 2010. PCs and Desktops will never again be the dominant platform used by human beings for interacting with information or with each other. The implications for software are enormous. If software was written assuming use in a browser on a desktop or laptop, it is closer to its end of life than its birth. this is even true for relatively new software like Google search; Facebook sharing and perhaps LinkedIn networking. That doesn’t mean that these companies will die. it simply means the future is about software written for the new hardware platforms, not software written for a desktop/laptop browser.
The cloud will also change, as its function is increasing to support the data and messaging needs of billions of widely distributed devices that people carry around with them, rather than to support web apps built for the desk and the browser. These devices have powerful CPUs and GPUs and plenty of storage and bandwidth. They need a new cloud that glues them to each other and enables new platforms.Huge new companies are and will emerge on top of the smart phone and tablet platform that is already eclipsing the old laptop and desktop era. These companies simply have to deliver services that meet our needs as users, using these new devices. But in doing that they render obsolete prior services that delivered much the same functions on the desktop and the laptop. They also create entirely new experiences leveraging what is new in the smart phone and tablet dominated world.
The relative decline of Flickr and the dramatic rise of Instagram is a great example of the disruption mobile brings to even relatively recent services, but built for the old platform. The it companies hat were founded on he Cloud based Web 2.0 era — Facebook, Google, Twitter, LinkedIn, Paypal and others — are vulnerable to their world being redefined on smartphones and tablets, simply because new companies can build without the desktop/laptop Web 2.0 legacy.
And of course there are many new opportunities. The emergence of location based apps and services, the growth of messaging, the payments revolution exemplified by Square, Stripe and Braintree, the Internet of things, wearable devices, context driven experiences, and so on.
So, we clearly are living trough a time when massive rewards await the big thinking entrepreneurs who leverage the new to eclipse the old. Both the pace and scale of change are unlikely to let up for many years. Snapchats rumored $3 billion acquisition offer, following hard on the barely sealed Instagram acquisition is testimony to the reality of rewards available for success.
So you would think that this is the very time when risk capital — Venture Capital that is — would be plentiful. Right? Wrong!
Three things that have changed the Valley
The opportunities afforded by times of great change require two things. Big thinking entrepreneurs and capital prepared to back them so they can build teams that can execute.
The legacy of the Web 2.0 era (approximately 2003–2009) has left us with three trends that unintentionally undermine the requirements for truly disruptive leverage of the changes driving human behavior.
Firstly the lean startup movement. Lean startup thinking emerged when companies had to build for a single platform — the Web.
The primary consumption tool for the software was a web browser. In this world it was possible to build a prototype quickly, iterate it, even several times a day, and watch out for what worked and what didn’t. You could launch with a single feature and grow functionality over time, taking each step slowly as you learn from users what they like and do not like.
Lean Startups did not require a lot of cash. The founders, who can be engineers, who do not need to initially pay themselves, and the platforms they need to use — like Amazon’s AWS — come for free, or at least cheaply. Unlike the era prior to Web 2.0, $50,000 or less could be sufficient to build to a proof of concept. The startup no longer needed $5m before launching. There are many examples of this being true.
Secondly, the rise of accelerators and incubators and the retreat of venture capital to later stage. Y Combinator, 500 Startups, AngelPad and even my own archimedes labs have emerged as places founders can go to to build a company.
This phenomenon fitted well into the lean-startup philosophy that complemented the Web 2.0 phase of tech innovation. A small amount of money — typically under $20,000 — and 3 months of effort — would suffice to produce a strong prototype or proof of concept, or maybe even a first version launched service. the low capital requirements and rapid development philosophy, combined with a DEMO day launch, led many to conclude that venture capital was no longer required for early stage investing.
Over time, most venture firms abandoned early stage investing. The tiny capital requirements and the onerous oversight from Limited Partners that had proceeded from the 2000 Internet bubble burst made investing at this stage irrational. Besides, why not wait to see who did well and selectively invest only in the winners. if Angels were prepared to fund the early days, so be it.
Since 2006 the rise of accelerators and Incubators has been dramatic and only eclipsed by the growth in the number of companies funded through them, as this CrunchBase graph shows.
And the phenomena shows no signs of slowing down, except in the USA. As I have travelled in 2013 I have experienced this huge growth in incubation in Tokyo; Jordan; Moscow; London; Shanghai and Guangzhou. It is truly everywhere.
Thirdly, the growing attractiveness of growth stage investing. Dating from the time Yuri Milner’s DST invested in Facebook the venture capital firms began to jealously look at the returns delivered by later stage, growth, investing. Whereas venture returns for many firms were turning negative, the growth investors were seeing large scale absolute returns by betting very large sums on later rounds in companies where most of the risk had gone. Twitter, Instagram, SnapChat, Groupon, Pinterest and others have all been beneficiaries of this trend.
Ernst & Young in its Venture Capital survey of 2013 — looking back at 2012 — said this:
As the naughties ended and we saw 2010, these three trends were all hard baked, resulting in a structural break in the normally balanced Silicon Valley funding ecosystem.
On a recent flight to Moscow, where I was due to speak at the US Embassy to an invited audience of venture capitalists and others, I drew the sketch below to illustrate the break in the former balance.
The sketch is not a work of art by any means, and there are certainly exceptions to its message. However it does portray the reality. Today more startups are chasing more seed dollars than at any time in history.
They emerge from incubation seeking second round funding, after perhaps three months building their product. For the most part they fail as investors ask questions about “traction”. The second round crunch (a better name than the series A crunch, because it is often a B round) is faced by more than 90% of startups today and even by 73% of incubated startups.
At that point many are encouraged to agree to be hired by one of the large Web 2.0 companies — an Acqui-hire. If the team is hirable, and agrees, the talent goes to the big.co. The consequence is a brain drain from early stage innovation to big company product development.
Good companies and teams die, along with the bad ones, and their talent ends up out of the innovation pool — at Google, Apple, Facebook, Yahoo or other places via an Acqui-hire.
Acqui-hires are the enemy of innovation, although often the savior of investors.
For many even this outcome is not available and their company simply dies. They either take a job, or live to fight another day by seeking another startup opportunity and seed funding — the Blood Bath in the drawing.
The second point of the sketch is to show that on the other side of the Valley there is another pile of cash for companies that get the elusive “traction”. The Valley is great at these two stages, and betters anywhere in the world. Break out successes can raise tens or even hundreds of millions of dollars without massive dilution.
The problem lays in between these two investment phases.
Second Rounds are scarce
The primary way a founder hears that their second round is unlikely to happen is when they hear the question about their traction. Startup founders will be very familiar with the question — they are asked it over and over. “What is your traction?”
And on the face of it the question is reasonable. Are you successful?
The timing of this question is also moving earlier in the life of the startup. It is increasingly common for Angels to ask this question too. Indeed, one of the questions a startup that is making an Angel List profile is asked is to give metrics for traction.
The problem is that this question is being asked much too early for most companies. Had Pinterest or Groupon or Snapchat or Whisper been asked this question during the first 2 years of their life the answer would have been negative.
But we founders are like circus animals in one regard. If the world we live in imposes a set of rules, no matter how wrong, we will perform according to the rules in order to take home the prize. The very asking of the question early in the life of a company changes the kind of entrepreneurs the Valley produces.
There are two unintended consequences of this.
Entrepreneurs are trained to think too small
Small thinking has always been a problem. But at a time of great change it is almost a crime to be encouraging the belief that a company can build something meaningful in 3 months and hope to get to traction soon after. By definition these founders will not be focused on the big problems and therefore the big opportunities of the day.
The lean startup movement is not to blame for this, neither are the incubators and accelerators. They are doing great work enabling rapid development and a growth of the number of startups and entrepreneurs. No, the blame lays elsewhere.
Having said that, it is true that the lean model needs to be modified for a mobile world where a company needs to build for Android, iOS, the web and possibly wearables. The cost of labor has not declined. It is still approximately $150,000 per person per year to sustain a Silicon Valley team.
Lean is of course a relative concept. And a startup today can benefit from many things which make leaner approaches more possible. Infrastructure is cheap for example. However, Labor is not cheap, and neither should it be. A 20 person company with an idea that requires 12 months of infrastructure to be able to deploy client side apps will still cost $3m in the 12 months. There are many ideas that need 20 or more people to execute to traction, and may take more than 12 months. Not all of them can be broken down into micro chunks that are fundable on a smaller basis.
$20,000 or $50,000 cannot begin to address the big opportunities. Indeed even $5m may be insufficient for some of them to get to measurable traction.
But the real problem is different
Abandonment of Risk by post-seed, pre-traction investors.
The real problem is the abandonment of post-seed risk investing by the Venture capital community. The search for the winning app, and proof of “traction”, at a point too premature for big ideas to emerge, is killing big and long term thinking.
The requirement for “Traction” is another way of saying that risk is bad or unwelcome. This is a reasonable belief for a private equity investor. But it is the antithesis of Venture capital.
By definition low risk is only available early to bootstrapped smaller companies; or later to growth capital candidates. Early companies pursuing big ideas almost never have traction at the time of their greatest needs. They especially do not have the kind of traction investors are looking for in today’s Valley.
Syndicates will help, but are insufficient
Partially in recognition of this, angel syndicates are now forming. They are yet to be proven, but want to be able to bring larger investments in the $millions to post-incubated, pre-growth companies. The reason this is happening is because nobody else is stepping in to that role.
But until the hole is filled, companies are faced with either building small traction-able ideas, or praying for miracles as they hope to be one of the few break-outs who can get to growth stage investors before they run out of seed cash. Anywhere else in the company-building process they will almost certainly die.
In practice it means that big established companies are the only ones able to think big and long term. This is not unlike the situation outside of Silicon Valley in London, Berlin, Beijing, Shanghai, Guangzhou, Moscow and Tel Aviv. Silicon Valley will no longer be “Silicon Valley” should this situation persist. It will, in almost every way, simply be another version of what exists elsewhere. Its uniqueness will be reduced to the scale of early and late stage investing, and the acqui-hire possibilities. Not to the availability of risk-taking Venture Capital that made it what it is today.
The opportunity: Rebirth of Venture — Second Round Capital
It makes no sense to observe these trends and throw our hands up. Just as Yuri Milner’s DST transformed Venture investing into growth investing, it is entirely possible to transform Silicon Valley into a balanced ecosystem again. All that is needed is to deploy capital into the risk-laden middle stage of a company’s life.
This does not mean saving all of the companies that die. But it does mean saving those that should live from going down the Acqui-hire route.
This involves those age-old skills of team and company picking. It is full of both risk and full of reward. It is traditional Venture Capital.
There is no argument that the Angel movement can be part of the solution here. And if syndicates turn out to be large and available, maybe even a big part of the solution. But it is also true that large sums of capital are needed soon, before we have mis-trained an entire generation of entrepreneurs to think only in 3 month windows.
A fund of at least $200m, and preferably larger, is a minimum to make an impact on the upcoming class of Silicon Valley entrepreneurs.
If such a fund existed — I call it 2nd Round Capital — then it would be good for all parts of the ecosystem.
- It would be good for the Seed investors, Incubators and Accelerators because a larger number of graduating teams would be funded.
- It would be good for growth investors, because more candidates would emerge that could be candidates for growth capital.
- It would be great for entrepreneurs who want to take on the big opportunities afforded by the mobile platform. They would be empowered to think big and long and not need to play the short term traction game.
- But above all else it would be great for humanity, because big and long term thinking — like that evoked by Elon Musk in rethinking high speed travel recently — can only serve humanity well. And the absence of it can only slow down progress.
In 2014 we in the Valley need again to focus on Venture Capital, big ideas and long term thinking. This is a necessary complement to Seed and Growth capital. Where others retreat is where the brave should venture to go.