Money Makes You Stupid. Innovation Makes You Money!

In 2005 I was asked to write an article for ACG (the Association for Corporate Growth) in Philadelphia. I came across my notes from that article over the weekend. While the article was interesting, some of the research I did for it was even more so. The article I wrote was about picking a private equity fund and the barriers to performance that many had. As I reviewed the various articles and research reports I drew from for the article it began to dawn on me that the alternative asset sector (VC’s, and PE’s), was no different than any of the sectors it invested in…it requires innovation to deliver outsized returns.

The guys with the money are supposed to be the smart ones. They are the ones sitting quietly on the other side of the table that suddenly spring to life, asking razor sharp questions about your business model or customer acquisition plan. But why has this very group been so slow to innovate. Probably because when you make up the rules (and the fee structure) you are happy to play the same game as long as you can.

A Quick History
The 80’s brought us perhaps the last true innovation for the money boys, the leveraged buy out. With this gun in the holster raiders were born delivering outsized returns for investors. The 90’s brought us the coming out party for venture capital. A pre-existing segment of investment that gained public prominence when combined with the emerging tech sector. The S-curve and portfolio theory became an excuse for “acceptable loses”. While the early practitioners were skilled and disciplined, the gold rush that preceded the tech bubble collapse exposed the “me too” attitude of many VC’s and investors suffered. The 00’s (still not sure what we call these years) saw a surge in private equity. Part corporate raider, part VC gambler, the PE guys raised huge funds and with a 2% management fee the bigger the better.

I was there for much of it. First, for the VC arm of Zurich Scudder Investments, then as a private equity fund manager. So it is from this viewpoint that I ask. “Where is the innovation?”. Since the first use of the LBO or the first decision to place a bet early, recognizing that the steep part of the value curve occurs in a company’s adolescence. Where is it? And why haven’t investors demanded it? Even into late 2000 demand for access to VC funds was thunderous. At the time of my ACG article the PE tide was still coming in with billions to be raised (much by first time funds) even while there was an enormous overhang (previously raised funds yet to be invested).

Innovation or Investor Revenge?
Lean Start-ups are the next iteration for the money guys but this time things have changed. The numbers aren’t big enough to create a cushy fee and the balance of power is not widely lopsided. This alone should keep the “me too” crowd on the sidelines for a bit. Also the process itself is both fast and amorphous. A problem for the slow and safe 3 year pro forma crowd. The truly smart ones will see it as a huge opportunity, treating lean start-up investments like a farm team for their big league funds. The others, unclear on how to make money on anything other than performance (like their investors!), will be forced to sit on the sidelines and serve as useful exits for the lean investors and entrepreneurs.

The answer to the title of this section, by the way, is both and here is why. The concepts behind lean start ups are not new but they have been adapted for the times and available tools (think old school Deming after 3 Red Bulls). The investment amounts are low, 5K-15K, and the deal documents are open sourced (you should of course have a lawyer review blah, blah, blah). All combined the lean start up movement actually disintermediates the money guys. Good news for both the entrepreneur and the investor.

A study that I found in the research for my ACG article was entitled, “How Venture Capital Thwarts Innovation”. It analyzed how much innovation actually came from VC backed companies for the period 1992 to 2002. The result was little. Throwing money at an idea doesn’t make it better. Staying close to your customer and focusing on your business model does. Maybe the money guys should think about that for a bit.

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