Blame the VCs

The doom and gloom that has hit the subprime startup market has a lot of people pointing fingers at the VCs who bought up equity in overvalued companies apparently thinking that the value of profitless Web 2.0 “businesses” could only go up.

Not surprisingly, VCs are taking about as much responsibility as Dick Fuld. In other words, it’s not their fault.

A couple of weeks, Michael Arrington, himself an angel investor with an impressive portfolio that includes stakes in Web 2.0 powerhouses like Seesmic and DanceJam, explained why the VCs aren’t to blame.

Arrington starts off:

The criticism is coming from people who don’t understand that the world has changed in the last week and that companies need to change with it.

He goes on to explain the business of venture capital:

First, the downturn has nothing to do with the venture capitalists (in fact, it has nothing to do with Silicon Valley, this time). They have one job: generate the best return they legally can from their investors’ money. In boom times deals get competitive and VCs make independent decisions on what deals to bid for. Companies also have to pay more for people, resources, office space and advertising in boom times, which means they spend more money and have to raise more money. If you think venture capitalists are being irresponsible (or worse, evil) by investing money in those companies that they think are good bets, you’re just not getting how the whole system works.

And then he goes on to explain away the argument that “VCs should have told companies to conserve cash all along”:

Just like a bear in the woods (I imagine) has to slow its activity in the Winter as food supplies dwindle, startups need to go into cash conservation mode to increase their chances of survival when the market slows. They need to be prepared for a hit in revenue, and they know they can’t necessarily go to the capital markets to get money to stay in business.

But to argue that a company should always cut costs to the bare minimum is the same thing as asking that bear to act like it’s Winter in the Spring, just because someday Winter is definitely going to happen. All you end up with is a dead bear.

Any further questions?

Unfortunately, Arrington is wrong.

Irrational Argument #1: The World Changed A Few Weeks Ago

The world did not change a few weeks ago. The word “recession” started popping up last year and half-decent traders took note when the Dow gave a short signal in January 2008. I reflected on the impact recession would have on startups back on January 2 and pointed out that startups not looking at the macroeconomic landscape were taking a big risk.

But wait – “very few people saw something of this order of magnitude happening.” Those are words recently uttered by venture capitalist Fred Wilson. And to that, I say: bullshit.

Lots of people saw this coming. Perhaps Wilson should refer to Chapters 24-26 of G. Edward Griffin’s book, The Creature from Jekyll Island. They’re entitled Doomsday Mechanisms, A Pessimistic Scenario and A Realistic Scenario, respectively. The first edition of The Creature from Jekyll Island was published in 1994.

I accept that Arrington and Wilson have been ignorant to the problems inherent with fractional reserve banking, the Federal Reserve, the Bank for International Settlements, fiat currency, Bretton Woods II, etc., but they should not assume that their ignorance is shared by everyone else.

Bottom line: the world didn’t suddenly change a few weeks ago. Ignorant people were forced to see it for what it is.

Irrational Argument #2: This Meltdown Has Nothing to Do with VCs

While this global economic meltdown itself was certainly not caused by venture capitalists, it’s disingenuous to argue that the pain that will be felt in Silicon Valley isn’t, in part, due to their behavior over the past several years.

Here’s why: the same ponzi scheme that fueled Wall Street helped fuel VCs.

Note to Arrington: the tens of billions of dollars that have flowed to Sand Hill Road didn’t come from nowhere (well actually they did but that’s a matter we can discuss when you read The Creature from Jekyll Island).

As The Deal recently pointed out, “Many of those same LPs that fattened venture funds are the same pension funds, endowments and other institutions that levered up, piled into hedge and private equity funds, and otherwise made a big problem even bigger.”

What were VCs to do with the glut of capital cruising for some action? Raise it and spend it! But that’s easier said than done. After all, when you have an oversize fund, economics dictate that you spend it in larger chunks. If you’re a top-tier firm, a small stake in a hot Web 2.0 like Facebook should do the trick! If you’re not a top-tier firm, providing a $3 million Series A to a YouTube wannabe isn’t such a bad “bet.”

Forget about fundamentals. Forget about valuation. Risk is the name of the game according to Arrington, who writes that “if VCs ignored the economy and always invested super conservatively so that no one could accuse them of being irresponsible, they’d go out of business after their first fund failed to return capital to investors.”

Risk is (obviously) a complicated subject but let’s make it clear: you don’t need to be “irresponsible” to make lots of money.

As a trader, I would point out that the opposite is actually true. My profit depends on risk management: I make trades only when I think/know that the probabilities favor me, I set stops to minimize my losses when I’m wrong, I employ strict money management so that I’m not risking more money on a single trade than I am willing to lose and much of the time, I employ a variety of options strategies to hedge my positions (and to increase profits) in volatile markets.

Don’t let anyone fool you: those who believe that you have to risk more to make more are usually the ones who go broke. Just ask the friendly folks who used to work for Bear Stearns.

I wouldn’t argue that VCs need to be “ultra-conservative” (the VC “asset class” is inherently “risky”), but it doesn’t take a now-unemployed former Lehman Brothers quant to intuitively tell you that investing $28.7 million in a profitless circle jerk at a valuation rumored to be greater than the prices potential buyers have already walked away from probably isn’t a good “bet” when you need an exit of 3-5x that amount to leave the party with a happy ending.

Bottom line: taking risks doesn’t mean that you throw the concept of risk management out of the equation. That’s exactly what many VCs did by overinvesting in markets saturated with companies that had nowhere to go.

Irrational Argument #3: Different Economic Situations Require Different Strategies

Arrington’s brilliant “bear in the woods” metaphor implies that companies reasonably operate differently when times are good than they do when times are bad. I don’t generally disagree with this but I think he’s being disingenuous in this specific instance.

Here’s why.

Many, if not most, of the Web 2.0 startups that are going to feel the most pain (and go out of business) were not just spending “a little too much.” They were overcapitalized, overstaffed and putting drunken sailors to shame. To most, the only exit strategy was “get bought out.” Business models, revenue streams, value and prudent management were all foreign concepts.

Hipster 20-something CEOs who have never managed anything (except maybe their own blogs), who have never balanced a checkbook and who don’t understand the concept of “fiduciary duty” were left in charge of companies whose investors believed them to be worth tens and hundreds of millions of dollars (and in the case of Facebook, billions of dollars).

I certainly hope Arrington is smart enough to see the problem with this.

This bear wasn’t even hunting in spring – it had found its way into a campsite and was raiding the food stash. Beer included. Big difference.

Conclusion

I don’t like blaming people. I believe in few things as strongly as I believe in the concept of personal responsibility. When things don’t work out the way I hoped they would, I try to accept responsibility for whatever mistakes I made that contributed to the outcome. I move on from there, hopefully avoiding those same mistakes in the future.

Individuals in Silicon Valley who are being laid off (or who will be laid off) by companies that aren’t performing need to take responsibility for their choices. Most of these individuals probably didn’t complain much about their employers’ shortcomings when times were good and, of course, there are never any guarantees when working at a startup anyway.

That said, it’s inane to argue that VCs have no responsibility for funding hundreds (if not thousands) of startups that many observers, myself included, knew had major weaknesses and that were being run improperly. The writing was on the wall when I started posting my cynical concepts on TechCrunch in 2006.

While VCs are in a “risky business,” they are first and foremost stewards of their limited partners’ capital.

Make no mistake about it: VCs who invested in startups that were the Silicon Valley’s equivalent of a toxic CDO dropped the ball and lost sight of what they were supposed to be doing – investing in great startups that have the potential to create incredible value by becoming great businesses.

Instead, they invested in flavor-of-the-month, hype-over-substance, build-and-flip bullshit startups in a fashion that mirrors the same reckless “get rich quick” ponzi scheme that has decimated Wall Street. They somehow believed that a media revolution could be unmonetized.

And while the pain these reckless VCs have contributed heavily to will be orders of magnitude lower than the pain reckless investment bankers and central bankers have already caused around the world, that’s only because the McKinsey-types on Sand Hill Road never had the intellectual capabilities required to destroy a global economy. If they did, they would have.

Thank god for little things, right?