The rise of the lean VC

Consumer Internet investing seems to have split off from traditional Venture Capital, and is creating a new category of VC’s: Lean VC’s.  I think you can blame Customer and Agile Development for a small part of it.

Here’s why.

Electron-based Venture Capital
When I first came to Silicon Valley the world of Venture Capital looked pretty simple. VC’s invested in things that ran on electrons: hardware, software and silicon.  While individual VC’s inside venture firms specialized in particular domains (PC’s, peripherals, semiconductors, test equipment, operating systems, applications, etc.,) their investments had roughly the same time horizon and were focused around things that used electrons – primarily computing and computing infrastructure.

The VC business took off with the rapid growth of the semiconductor business. Fairchild Semiconductor became the progenitor of a flood of Silicon Valley chip companies and at the same time the adoption of the limited partnership as the model for Venture Firms gave VC’s their own profitable business model. The personal computer business was built on top of the semiconductor business about the same time that the last of the pieces of Venture Capital were falling into place – the 1979 change in the EISRA “prudent man” rule allowing pension funds to pour billions into Venture Funds.

Here’s what the start of Valley chip business looked like on a genealogy map, tracing most all of its DNA back to the first Silicon Valley chip company, Schockley Semiconductor.

Cell-based Venture Capital – The Birth of Biotech Venture Capital
In 1980 Genentech became the first IPO of a venture funded biotech company. The fact that serious money could be made in companies investing in life sciences wasn’t lost on the venture community.  But the knowledge that VC’s had built investing in electron-based companies didn’t translate to expertise in cell-based or cell-proximate companies.  The technologies were different, the time horizons were different, (2 to 5x longer to take a drug through FDA trials ~14 years,) and the regulatory environment was different (barely any in traditional VC investments compared to FDA trials for drugs and 510K approvals needed for medical devices.) Finally the amount of capital needed to take a drug to FDA trials could be enormously expensive, at least 10x more than startup costs at an electron-based company.

The two watershed events for biotech startups were the Bayh-Dole Act of 1980 and the Orphan Drug Act of 1983. Bayh-Dole allowed for private ownership of government funded intellectual property developed in universities while the Orphan Drug Act created incentives for developing drugs for disorders afflicting fewer than 200,000 Americans.

After a while, the only thing Biotech VC’s had in common with their compatriots who invested in electrons was that they both invest.  (In some Venture Capital firms they may share the same roof and overhead, but no one is confused, they’re in very different businesses.)

The Rise of the “Lean VC’s” – Consumer Internet Gets Funded
For a few reasons, I’ve been struggling to make sense of all the noise happening in what others have called the Super Angel arena. First, my students are confused about who to talk to and how to think about funding their consumer internet startups.  Second, and full disclosure, I’ve invested in a few of these funds; and third my teaching partner Ann Miura-Ko is a partner in one of these funds.

My take is that we are watching an entirely new category of Venture Capital firms emerge.  It is as an important a split as when the biotech guys hung out their shingles.

Consumer Internet startup investors are now their own category.  I call them “Lean VC’s” to emphasize why they’re different.

(In his indomitable way, Dave McClure describes this shift best, but I have to screen-scrape his posts, paste them into Word and clear the formatting to read them.)

One could argue that there’s nothing new here, as Internet distibution models started in 1995. But in reality they only became mainstream ~5-7 years ago. Most of the social and mobile channels (YouTube, Facebook, Twitter, iPhone, Android) have emerged in just the past 3-5 years. But these VC’s aren’t Lean because they fund startups with web-based distribution models. It’s because the startups are doing something very new that make them “Lean” :

• These startups embrace customer and agile development that Eric Ries has been evangelizing.
• They build a minimum feature set.
• Quickly iterate the product in front of customers.
• Drive for a repeatable and scalable business model (revenue in Dave McClure’s investment thesis, “network of scale” in Union Square’s.)
• Their capital needs are low at the front end. The advantage of commodity software stacks drops initial startup costs for Internet Commerce companies. (But scaling customer acquisition may take the same amount of dollars as a traditional software startup.)

Lean VC’s are Different
The skills needed to succeed as a “Lean VC” are different from those needed for traditional software investing. Previous experience of investing in software companies that hire direct sales organizations and take years to build the product using waterfall development doesn’t translate to expertise in Consumer Internet startups. The technologies are different, the speed of execution, iteration and pivots are different and the time horizons for exits are different, (2 to 5x shorter for a consumer Internet company.)

Finally, the “death of the IPO” and the emergence of the “small market M&A” changes Consumer Internet economics. One of the interesting characteristics of these new “Lean VC” funds is that they can be smaller than the traditional multi hundred million dollar VC fund. The small investments necessary to get a consumer internet startup going enables Lean VC’s to make lots of early bets and double-down when early results appear. (And the results do appear years earlier then in a traditional startup.)

(BTW, just like the Biotech VC’s who may share a building with Electron-based VC’s, you may find a Lean Venture Capitalist sitting under the same roof as a traditional VC. Just make sure they get and embrace the Lean VC principles. The test is, ask them how they differ in their investing philosophy from the rest of their firm.)

Lean Angels
Along with Lean VC’s a new class of angel investors has emerged. YCombinator, Techstars, et al, have been described as incubators but in reality they are the new “Lean Angels.”  These angels “get” the sea change happening in Internet Commerce. The difference is that unlike Lean VC’s, these angels help their startups rapidly develop the product, but typically don’t add much help in developing the market/customers. And while they provide the initial investment they rarely follow-on with the Series A dollars needed for scale. They’re a great feeder system for the new class of Lean VC’s.

Lessons Learned

Entrepreneurs in the consumer Internet space should look for funding from Lean Angels or Lean VC’s

Lean VC’s are expert in on-line distribution, Agile and Customer Development

They drive for early results inexpensively, and invest heavily when they see results

Their strategies for their startups differ – some focus on revenue, others build large networks of users

(For more from Steve, visit his blog)

(Be sure to pick up Steve's "must-read" book: "The Four Steps to the Epiphany"

(Image: wikwikit.com)