I am pleased to publish this column in partnership with my friends at the MENA Private Equity and Venture Capital Association, as part of their efforts to stimulate an emerging VC ecosystem in the Middle East & North Africa. The first half of this column was published a couple months ago; I am publishing the complete column below.
Why should that be so? Why are free markets not so free? And what are the lessons for new regions trying to create their own venture capital?
Governments around the U.S. and the world have invested billions of dollars in attempts to foster their own vibrant, sustainable VC industries. They have almost all failed. The geographical imbalance is stark. According to the recent PWC/NVCA MoneyTree report, about 40% of all VC in the U.S. is concentrated in Silicon Valley. And according to Ernst & Young, about 2/3 of all VC in the world is concentrated in the U.S.
The uneven distribution of venture capital might seem like an academic question, but its implications are real. I am convinced that thousands of companies with potentially world-changing innovations – whether life-saving drugs, alternative energies, or countless other new ways to solve big problems – fail each year because of their inability to access capital. If money is just money, then it should flow efficiently, and great entrepreneurs with great companies should always find it. However, in the real world that’s not the case. The capital markets may look free, but they don’t work freely.
So, where do we look for possible answers? We know that venture capital is not just a result of writing smaller checks (that is, portfolio allocation). Lots of people have tried that and failed. And we know it’s not just a matter of picking winners and losers in order to buy low and sell high, like one would in a stock market (that is, arbitraging). That has been tried, too. So the answer must be something else. And it must be something unusual, outside of the usual mental model of finance.
I believe we can find answers in the history of Silicon Valley. There, we can ask the question: what was venture capital before venture capital? And when we do that, we discover that the answer is simple. It was people.
The people who helped build the Silicon Valley VC industry were like entrepreneurs themselves. After all, they had to create an industry from scratch. They had more than a bit of cowboy in them. They had a sense of adventure, they had a passion for the companies they were building, and their community was small enough that they all had to rely on one another to survive. Moreover, they were not bound by traditional structures of finance – they organized money in whatever shape, manner, and structure were needed at the time.
A recent documentary – Something Ventured (2011) – interviews many of the founders of the venture capital industry, letting them tell their stories. I highly recommend this movie. It captures a critical piece of history that is fading away quickly. To me, what is most striking is that every single one of the interviewees – including legends like Don Valentine, Tom Perkins, and Arthur Rock, among many others – has an unmistakable, mischievous gleam in their eyes as they talk about their work. These dudes were not your usual, run-of-the-mill asset managers or financial engineers. They were taking on the world, and loving it.
Based on the lessons of Silicon Valley, how does one build a venture capital industry from scratch? Here are five rules to start with:
1. Venture capitalists are not mere asset managers.
A skilled financial manager does not a great venture capitalist make. I’ve noticed that many governments or other institutions seeking to build their own venture capital industries often hire bankers or financial analysts to run early-stage funds. It’s seemingly a safe choice on paper; they seem like competent managers of money. But in reality, they often know little about how to create new enterprise value, nor have the necessary personal qualities to partner with entrepreneurs. Instead, look for people with some “cowboy” in them, who care deeply about growing companies, who are bold enough to rewrite the rules of finance if they need to, and who know how to navigate companies through the tortuous, serendipitous path that is to come.
2. Focus on human behavior, not fund structures.
Don’t copy fund structures simply because they worked elsewhere. You can’t just take the limited partnership model that worked in the U.S., cut-and-paste it like a manufactured product into a new market, and expect it to work in the same way. Instead, focus on what you are trying to accomplish, and then design a fund structure for that purpose. Are you trying to incentivize win-win or zero-sum behavior? Do you want to grow companies that make local headlines, or become globally viable competitors? Do you want fund managers who collaborate well with other players over the long run, or maximize their own returns in the short run? All these factors can be designed into the DNA of a fund, even an entire VC industry. Here’s an example of how my firm helped design the first national venture fund of Armenia following this approach.
3. Empathy for entrepreneurs.
For my book on innovation ecosystems, The Rainforest, I interviewed venture capitalist Brian Dovey of Domain Associates. He gave this gem of wisdom:
Good VCs can come from most every walk of life. In my late 40s, when I was becoming a venture capitalist, I went around to many VCs and asked them to give me advice on how to do it. Every one of them had a different answer―the answer that played to their own backgrounds. But there was one thing they had in common. All of them had empathy for the entrepreneur [italics added]. They knew how difficult it was. They were in sync with the entrepreneur. The entrepreneur was not the enemy, not someone to be pushed hard or beaten, but someone to be respected, even forgiven for some things that would go wrong.
Startups are hard to build, easy to ruin. Good VCs know how to facilitate the entrepreneurial process, not create unnecessary distractions or burdens.
4. Passion for growing amazing companies.
Venture capital is an active sport, not a passive one. Great VCs don’t just wait for things to fall into their laps. The movie Something Ventured describes how venture capitalist Bob Swanson of Kleiner Perkins had to spend a couple weeks to convince scientist Herb Boyer to start Genentech, the company that launched the biotechnology industry. Startups are too difficult, too unpredictable, and too heart-wringing to take on unless VCs have a deep motivation for what they are building. We often think of entrepreneurs as the passionate ones, not VCs. But VCs who are trying to create new funds in new markets are pioneers, too, and they need some of that same passion.
5. Loyalty to the ecosystem.
Align the incentives of venture capitalists with the rest of the ecosystem. If VCs are incentivized to squeeze every last penny out of their companies, many of them will. While that might increase the return on a single deal, it won’t build a sustainable VC industry. VCs should not be measured against a simplistic notion of fiduciary responsibility, where their only obligation is to direct shareholders. VCs are also responsible to the broader ecosystem that helps generate the value they harvest. That ecosystem imposes its own obligations, like an unwritten code of conduct. A great example is the story of why Andreessen Horowitz did not maximize its stake in Instagram. In a successful venture ecosystem, actions are not isolated. Actions matter to the broader community.
To understand what venture capital can be in the future, we should look at what it was in the past. The outward forms are not sacred, untouchable objects. They can be shaped to fit the needs of the environment. Regions that are creating their own venture ecosystems should start from first principles. The history of Silicon Valley shows that venture capital, when done right, is always about people first, structures second.
Victor W. Hwang is a venture capitalist and entrepreneur in Silicon Valley. He is primary co-author of The Rainforest: The Secret to Building the Next Silicon Valley. His firm, T2 Venture Creation, grows startups and designs innovative ecosystems for companies, communities, and countries. Victor is Executive Director of the Global Innovation Summit + Week, a major conference on growing innovation ecosystems on February 17-21, 2014, with participants from nearly 50 countries. Follow Victor on Twitter and Facebook.