Theories on Why Venture Capital Doesn't Scale

We continue to drift in the middle of a chaotic venture capital market that many say is "broken." I have been thinking about this and I am trying to understand the factors that add up to this "broken" state. To me, "broken" means that as an asset class venture capital is not performing well relative to the risks taken and the performance of other asset classes given their risk profile. (By asset class I mean the venture industry taken as a whole.) This industry's turmoil reveals itself in many ways but its root cause started as too much cash and now seems to be too little cash. Cash comes from several places including raising new funds or decreasing investment rates and operating expenses.

Raising new funds is not all that easy because the industry's recent track record is not exactly stellar. Decreasing our investment rates has been easy to manage and we cut operating expenses where we can. At the end of the day...the only true source of oxygen is "the next fund."

There are different reasons new funds are not so easy to raise for so many firms. One principal reason is that funds in the late 1990s and early 2000's were ambitiously large. By this I mean that firms used these funds to substantially expand their operations and investing scope. We saw many funds triple in size over the predecessor funds. Now if a new fund was three times as large as any predecessor fund...it had to likely have thrice as many "hits" as its predecessors in order to perform at least as well. In order to generate three times as many hits, venture funds recruited additional players en masse. This is really where the problem starts.

In my opinion, venture capital is much more artful than it is scientific. The best venture capitalist can not simply codify his instincts and experiences in such a way that they are highly transferable to other humans. The best venture capitalists are simply instructors who provide tools to a school of students some of which prosper many of which do not. There are good schools and there are not-so-good schools. Good schools take time to develop. As a result, it is very difficult to scale this business. No matter how many students Roger Federer enrolls in his tennis academy it is unlikely to produce the next Roger Federer. The odds against it are great.

A good venture capital firm probably has at any one time three or four natural athletes. Each firm can talk about this process and that process and proprietary secret investment formulas but I don't consider those plausible ingredients for achieving scale. It is marketing lingo for "it's ok to give us right now 3x more money than we can handle." The core team can put to work only so much capital and watch it effectively in a way to achieve results consistent with the risks undertaken. The school takes time to develop. Nonetheless...our current tendency is to continue trying to raise gargantuan amounts of capital well beyond any plausible management scale. This is, in effect, investors making the bet that a successful venture capitalist can transfer his skills with an efficacy that results in two Roger Federer's by the end of next year.

The other issue is this: there are only going to be so many big winners per period. By winner I mean investments that generate a lot of return. Since late 2001, the number of winners seems to have dwindled but the number of venture capitalists has sky rocketed. This means that a large body of professionals has really not had close contact with winners in such a way that they can understand what happened, why it happened and imbibe enough experience of success to plausibly create another success. This is not one of those life experiences where the only learning comes from failure..

There are many exceptions to this perspective..but there are many more points of proof than there are exceptions.

In Search of "Now"

I am observing the current, rocket-like ascent of "Twitter". Twitter is, among other things, a one-to-many text messaging system. The "one" is you or me. The "many" can range between a limited size, private group such as your friends or a universally large, public audience such as CNN viewership. In its smaller setting, group members use the system to keep others informed of daily activities...(sort of a never ceasing human exchange). In the more public setting, Twitter is a real-time news reporting tool.

The meteoric climb of Twitter is based, in my opinion, on its popularity as a medium for the "never-ending human exchange". I have seen this previously in many other electronic forms. Despite their visual differences each of these sort of does the same thing. Here are some examples:

• Facebook: An organizational tool for building a personal profile that may be shared with a few or many.
• Youtube: A publishing tool for letting all comers have a visual understanding of you...who your are...what you can do...etc.
• MySpace: Same as "Facebook".
• Twitter: See above.

I remember for awhile...when YouTube was racing upward as a platform for gaining celebrity. YouTube was a hotspot for coming out of nowhere into fame. It seemed to me YouTube was almost as famous as the fame it created for others. YouTube is still there...where is all the star-generating power? Separately, I read today that MySpace is laying off 30% of its workforce...huh? Wasn't it valued at something like $400 grillion...a lot of smart people got behind this thing..what happened?

The popularity of these mediums reminds me closely of the fashion industry. Each year designers are required to create new themes and visuals that satisfy the eye and offer a slightly vanguard way to humans for expressing themselves. The great design houses can completely change the user experience from season to season. The designers know the user experience needs to change because the old experience ceases to satisfy the user as an expression of the self.

The whole concept is a derivative form of something called "attachment" whereby we humans entrust things external to our selves with the power to determine whether or not we are happy or sad. Do I have enough money..I want more chocolate cake...if I just had a bigger house....etc...because none of these things individually brings peace to the soul we find ourselves hopping from one hope-filled attachment to another.

Now the difference between any of the human-exchange mediums described above and the fashion industry is: a designer clothing brand can change its feel sufficiently to accommodate the endless human journey of self-expression ( cloth is a medium capable of a very wide range)...a piece of software, in general, can not change enough to help here. As a result....social software gigs seem to pop up and then slide down (they sell the same dress year after year).

If I step back from these platforms and am honest with myself...I believe they are promising me some upside...a differently perceived future me...I can be a YouTube star. As a result, my mind is stuck in a YouTube/Facebook/Myspace/Twitter future. It is this very thing that many human philosophers and at least one eastern religion say is the source of human unhappiness. Not being in the present. I am still looking for the social networking site that puts me in the Now..this will be a big thing.