Wednesday, September 23, 2015

Uncertain Health in an Insecure World – 57

“Cave Dwellers”

When early man emerged from a cave, and used one bone to break another bone, that was new information. But innovation didn’t occur until the prior information gap (i.e., what bone-on-bone could do) was made available to every cave dweller.

The word entrepreneur is derived from the French word for adventurer. New adventurers emerge from their caves in Berkeley and Palo Alto every day.

“Making an investment is like throwing darts in the dark.” – Naval Ravikant, AngelList co-founder.

In early seed and angel venture capital (VC) investing rounds, before gaining market access, by and through their vision & passion, “rock star” entrepreneurs retain great power. In subsequent cycles of market penetration and dissemination, on the pathway to an idea’s mass distribution (i.e., reaching every cave), entrepreneur power is diminished and often financially diluted.

The atmospherics surrounding VC treatment of entrepreneurs matter. Some factors are cosmetic – the reputations of those investing in the fund, both general and limited partners. Other are geographic – the concentration of key elements in an innovation cluster.

In truth, VC’s exploit (i.e., enable the success of) entrepreneurs’ insights, in order to make cold hard cash.

In the 1970’ and 1980’s, the Russ Building on Montgomery Street in San Francisco (above left) was the Sand Hill Road (above right) for VC wealth creators and private equity agglomerators. Kleiner Perkins Caufield & Byers (KPCB) and Sequoia Capital (both established in 1972) represent the founding royalty of VC firms. They have been at the epicenter of the Silicon Valley innovation cluster since the first tremor, backing the “dent makers” through the close scrapes and dark times when bubbles burst and markets crash. 

At the time of idea inception, market receptiveness matters.

In the Silicon Valley, more so than perhaps anywhere else in the world, innovation is often a technological insight that becomes a useful guess as to what is possible. In creating new possibilities, market dislocators move something that works in cave A to cave B. Disruptive innovators (per Harvard Business School’s Clayton Christensen) create a new paradigm in cave A … let’s call it A*. Disruptive innovators are often in conflict with incumbents, who are undercut by bone breaking.

Participants in the VC process often fundamentally change the way that a business is done. This change can be foreseen, or unintended. EBAY ended the classified ad business, and in doing so, destroyed most local community newspapers.

Along this VC trail of new ideas, in fact from its outset, the structure of how one gets paid (the “deal”) influences the behaviors that product the final outcomes (the “exit”).

VC fund down cycles are inevitable. Down cycles attract “road warriors”, the experienced true angels who are unique to the Silicon Valley innovation cluster. Veteran early phase investors have this shared survival experience.

Overvalued tech is the darling of Wall Street.

The impact of stock market malaise in the early to mid-round VC world is worsened by betting on over-valued tech stocks. Recall that average VC fund life is now 11-14 years. Apple (AAPL) is a mature stock with a Sept. 15, 2015 P/E ratio of 13.42. This P/E ratio means that it will take 13.42 years of company operating profits (i.e. earnings) to pay back the present day per share purchase price.

The average current P/E ratio across the tech sector is 20.47!
Most Silicon Valley experts quietly concede that there is a tech stock bubble.

When publicly traded stock markets crash, the window for Newco initial public offerings (IPO’s) slams shut. The critical alignment between entrepreneurial activity & private equity towards cycles of liquidity quickly breaks down. When Wall Street gets the flu, the private equity market goes into the ICU. Why is that?

Wall Street now controls much of private equity VC.
The massing of investment in the existing innovation ecosystem has become concentrated in the corporate VC funds of 20-25 big companies.  IPO valuations have increased dramatically between 2005 and 2015, largely due to the influx of corporate VC from global companies with hefty balance sheets (i.e., General Electric, Siemans, Intel, J&J, Merck, Novartis, etc.). These funds often invest in later VC rounds (series C, D, funds of funds), where “growth" companies are scaling up their commercial products for the mass marketplace. Corporate VC now exceeds private equity VC money in the tech space.

The way of an industrial process is a cultural process.

As the number of emerging cave dwellers grows, the controlling interests in The Valley are fewer, and much BIGGER.

In the Square, we worry that such market concentration is disruptive in all the wrong ways.

No comments:

Post a Comment