In an effort to save a lot of pain and suffering for those people who don’t want to read an incredibly long blog post, I have a nice little summary table.  The predictions run the gamut of my personal and professional interests, so they may not be 100% interesting to all people.

• 99% of All Decade Lists That Come This Year Will Be Wrong
• Twitter Will Become A Footnote
• Real Time Has Had It’s Time
• Interest Rates Will Begin To Rise
• Housing Prices Being To Stall And Then Fall
• Jorge Lorenzo Will Win MotoGP World Championship
• Netbook Market Disappears
• Apple’s Disdain For Developers Will Reach A Tipping Point
• ChromeOS Proves To Be Another Of Google’s Failures
• The Final Season Of Lost Will Not Be Seen
• Foundations For The Repeal Of Sarb-Ox
• The Venture Business, As We Know It, Is Dead
• Oil Trading Draws Legislative Scrutiny
• Windows Mobile 7 Will Impress
• Tim Tebow Will Play No Downs That Matter At QB

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One of my favorite VC bloggers, Josh Kopelman, has an interesting piece on the VC math problem as first envisioned by Fred Wilson.  Having gone through the fund raising process, and hearing this nonsense from VCs, I always gnashed my teeth when a VC was setting valuations based on what they needed to own.  Not any intrinsic value of the business, but rather what they felt their ownership percentage needed to be.  This was much more of a problem with the earlier stage VCs, and, interestingly enough, with some of the spray and pray VCs, where you would think they might care less about overall percentage due to the fact that they were investing everywhere.

Josh references a paper by Paul Kedrosky which takes a very detailed research approach to examining this issue.  The paper has been downloaded and will be read tonight.  However, the math that blew my mind was contained in the following section of Josh’s post:

Take a $400M venture fund.  In order to get a 20% return in 6 years, they need to triple the fund — or return $1.2B.  Add in fees/carry and you now have to return $1.5B.  Assuming that the fund owns 20% of their portfolio companies on exit, they need to create $7.5B of market value.  So assume that one VC invested in Skype, Myspace and Youtube in the same fund – they would be just halfway to their goal.

My head just exploded.  Despite my own please for my co-workers to be more intellectually curious with their jobs, I had never done this math.  I am left absolutely shaking my head at the reality that is facing any VC not in the top 5 (as in top 5 VCs, not 5%).  Good luck.  The tactical play for a fund is to invest early and small.  This is at odds with the 2 and 20 model.  I mean how are VCs going to feed their Cayenne Turbos?

Worse, I worry about the companies that the other VCs are funding.  With such a challenging economic model now staring them in the face (hey, at least before they didn’t have to answer to the data which could refute ridiculous forward looking statements about future “internet” or “new economy” fund performance), are they going to just start swinging for the fences?  Will they just pile on the risk and do whatever they can to justify the fees?  Or will they find a way to raise money and do next to nothing, and simply collect their management fees?  I wonder if LPs will now start wanting to have claw-back mechanisms in place when returns fall below a certain threshold.

The really hard problem facing entrepreneurs is that while it costs less and less money to start a company, VCs have more and more money piling up in the form of capital call commitments due to a dearth of deals over the past couple of years.  They want to deploy more capital, and that leads to capital inefficiency within small companies.

The title here might be a bit sesationalistic, but the deal certainly shows how VCs can act in a way that is counter to the wants and needs of the entrepreneurs and management teams.  The news yesterday that Zappos sold to Amazon has been circulating with many emotions.  CEO Tony Hsieh wrote an amazing letter to his employees, which laid out the deal and what it would mean for the company.  Read it if you haven’t already.

Unfortunately, when the press and journos report on a sale, they focus on the topline number, and it is rare that they report much beyond that.  As most of my readers are in the tech industry workers or entrepreneurs, the topic that is of more importance to them is “what did the shareholders who weren’t VCs get?”  That’s a great question, and one that is usually difficult to answer without access to the funding docs of the various rounds.

In the interview that I did with Andrew Warner of Mixergy, I touch on this topic of trying to create a structure that has the interests of both the entrepreneur and the investors aligned.  This morning I was reading the peHUB account of the Zappos deal, and there are a couple of things which pop out at me:

1. Zappos management didn’t want the deal – the management team wanted to remain independent.  It’s a well reported meme that Zappos has a culture which is very unique, but has generated a booming repeat customer business, and one that has grown quite nicely, even in these tougher economic times.  Being part of Amazon will certainly change that.
2. The sale was forced – it appears from the reporting that the investors were able to force the sale of the business.  That’s their right if they own more than 50% of the business, but it could also be their right if they had what’s called a protection right in the security in which they invested.  These provisions allow for a great many things, including the ability to force a sale at a valuation of X times the value of the round invested.  That takes the decision out of management’s hands, and clearly not always in their best interest.
3. Not all liquidity events are created equal – the total investment in Zappos, according to peHUB, was $49.1 million.  Most casual observers would think that this is all that must get repaid before the employees/entrepreneurs start seeing money.  This is not the case, as it would depend on whether or not the different rounds of investment were made as common stock, convertible preferred stock, or, worse, participating preferred.
4. VCs will screw you – the most interesting line of the whole article is the peHUB quote attributed to a shareholder about Sequoia: “…came in at a high valuation, but he countered that with a very high liquidation preference.”  The high valuation is meant to give the entrepreneur the sense of relief associated with keeping more of their baby, but that liquidation preference (3 or 3.5X!!) is meant to ensure that no matter what, Sequoia actually gets a guaranteed return.  I would love the opportunity to invest is a repeat successful entrepreneur with a 300% return guarantee.

The liquidation preference issue is moot depending on if the security was a convertible preferred and if the valuation of the round at which the money was invested would be low enough such that the shares converted.  Regardless, this serves as a great example point of how investors can create situations where the entrepreneurs are not being looked after, nor are the interests of management and investors aligned.

Tony is a super succesful entrepreneur, with one exit in the late 90s for almost $300 million, as well as successful investments out of his own fund.  If Sequoia took him to the woodshed like this with the liquidation preference, and the forced sale, imagine what they would do to the unseasoned entrepreneur.  As an entrepreneur today, you can do so much more with so much less.  See what you can get done before taking money from the large fund investors who “need liquidity” rather than what’s best for you.  If you take money from a VC, caveat emptor.

UPDATE: I got an email from Dianne at Kel & Partners (presumably Zappos’s PR firm) explaining to me that the story is false and that she cannot say anything else for legal reasons (which is true).  Unfortunately she called me Brian, which is not going to endear me to you.  The email was pretty impersonal (probably a form letter) and leads me to believe that this meme has upset someone and the PR firm is in damage control mode.  Whatever the actual reason for selling, I am happy for the Zappos management team if this is the exit they indeed wanted.

Apparently (apparently!), I have said something that hit a nerve.  When I posted my thoughts on the whole issues as to whether or not the VC model was broken, I had no idea that it would be the most popular post I have ever written (and it’s not even noon on day 2).  Crazy.

Predictably, some of my VC friends showed up to the conversation to point out that 1) am angry, and 2) that the “good” VCs don’t have associates.  First, I am not angry.  It’s easy for the VCs and their ilk to cast those aspersions, but the reality is that they have a fantastic business model, and they are going to fight to the death to protect it.  Second, the venture firm that completely blew me up at my last company has no associates.  One day I will tell that story, but even firms with only partners can behave badly.

I certainly don’t want to over-generalize an entire industry, but I can say that the vast majority of VCs are either neutral to the value of your business or in fact do actual harm.  I would go so far as to say that 10% of VCs are net positive, 70% are neutral, and 20% actively destroy value in the firms in which the invest.  As I quipped on Hacker News, partners in VC firms tend to practice what I call seagull management: the fly in, make a lot of noise, crap all over everything, and leave.

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There’s an interesting article over that The Funded which discusses the state of affairs in the VC market.  The post itself is a response to the Fred Wilson post about the current state of affairs in the VC market.  Fred’s claim is that the VC model is not broken.  He’s right.  Sort of.  Being broken would imply that it was fixed or working correctly at one point in time.  I would in fact argue that the model was flawed from inception, and was based on the imbalance of supply and demand for risk capital.

I am about to go on a bit of a (LONG) rant here, but my point of view is one of someone who has worked in a private equity firm, sat on boards, invested privately, worked in multiple startups, founded a company, been a CEO, and raised money from angels and VCs, including securing term sheets from some of the most well known names on Sand Hill Road.  I am an entrepreneur first, and someone who has been smacked around by the VC community as a seeker of funds.

Let’s start with the venture funding process.  The Funded rightly points out that the junior folks at these VC firms are all business school guys who have no depth of experience from which to draw on when they are deciding which deals to pursue.  That is mostly correct, though there are a few I have met in my travels who at least had some real operational experience before going to a venture firm.

The trouble isn’t so much that the associates don’t know what actually constitutes a good business, it’s that they believe that they are uniquely qualified to make that determination.  Further, they actually believe that their few years of business school entitles them to an opinion as to whether or not a leadership team is going to get the job done.  This is particularly pronounced and troubling when the management team has 20+ years of experience, but the associate doesn’t think is “cool.”  If the associate doesn’t like you, you don’t get through them as a gate keeper.

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