Venture capital didn’t create the bubble

by Mathew on January 29, 2006 · 31 comments

Dave Winer is a smart guy, and when it comes to Web 2.0 he’s been smart a lot longer than I have — but when it comes to investing and the stock market and venture capital, I think he might be a little out of his depth. I wouldn’t tell Dave how to put together an OPML editor, and by the same token I’m not sure anyone should listen to how he wants to “reform” the venture capital business.

Like a good friend, Robert Scoble is being kind when he says Dave’s post contains “great insight.” I would tend to agree with Paul Kedrosky that his proposed solution is more than a little on the wacky side. Even his description leaves me shaking my head. Here’s part of it:

That’s how Netscape and the dotcommers that followed went through the roof of the stock market. People who traded could see the raw power of the Internet and knew, one way or the other, that this was going to change how everything was done, from business to romance, travel, gambling, everything. So the users of the Internet bid the stock of the Internet up. And up. And up. And so on. So what did the middlemen do exactly? They invested in all kinds of idiotic things.

The point of this seems to be that “people who traded” were the ones who knew what to invest in, while the “middlemen” or VCs threw money at idiotic things like pets.com and boo.com, so we should get the middlemen out of the way and let users run things and decide what to invest in. I’m not sure which bubble Dave was watching, but I remember plenty of supposedly smart “investors” who bought stocks like theglobe.com and others all the way up into the stratosphere. Was that the fault of stupid or venal VCs? Hardly. They were just supplying what the market had already shown that it wanted: Internet-based anything, and right now.

As Nick Carr has pointed out, bubbles are born on the demand side, not the supply side. And yes, it’s true that there are problems with much of what goes on in the venture capital business, as Canadian VC Rick Segal and others have described. I’m interested to see what Rick has in mind — but with all due respect, I hope to God that he doesn’t take Dave’s advice on this one.

For more on the same topic, I think Fraser Kelton has some worthwhile points, and as usual Fred Wilson summarizes things well:

I would suggest one rule and only one. Be the entrepreneur’s partner. Help him or her. Be there for them. Support them. Counsel them. Share the risk with them. Have fun with them. Laugh and cry with them. And make boatloads of money with them. It’s a time tested formula and it will work forever.

Meanwhile, Rick Segal has obviously been thinking about all this as well — as he hinted in an earlier post — and does what I think is a great job of distilling what the “new” startup landscape looks like, and asking the question (my paraphrase): “If you don’t need much money, and you don’t need a lot of hardware or software, and the Web gives you lots of points of contact, what do you need VCs for?” Go read his post for the answer.

Update:

Dave Winer doesn’t think much of my comments, not surprisingly. Fair enough. To answer Dave’s questions (since he doesn’t allow comments on his scripting.com blog), I am not a VC, and whatever investing I do is through mutual funds, so my track record is effectively a blank slate. But I have been writing about investing and the stock market for about 15 years now. I wasn’t saying that I’m more experienced than Dave, just that his argument for reform in venture capital is logically flawed.

Anne Zelenka, who posted some comments here, has written an excellent post on her blog that breaks down — from an Econ 101 standpoint — the elements of Web 2.0 that make it different from Web 1.0, and why the venture capital business just keeps getting harder.

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  • Jacob Levy

    Dave responded to your article, go read that. Anyways, IMHO Dave gets it wrong. Its not that anyone should actively NOT listen to Dave’s ideas, its that you’re questioning WHY anyone should listen to Dave more than to, say, ME :) We’re both not in the VC industry, we’re both exactly the same age, we’re both bald or balding… None of which qualifies us as experts.

  • Mathew

    Thanks, Jacob. I updated the post to reflect Dave’s comments. As I noted there (and would have on Dave’s blog if he allowed comments), it’s not that I think Dave’s ideas should be ignored because he doesn’t have experience in the field, or because he’s a balding non-VC — I think they should be ignored because they don’t make any sense.

  • http://www.annezelenka.com Anne Zelenka

    Mathew – interesting post. Since VCs are in the middle, they influence both supply and demand. One reason there were so many dot-coms in the last bubble was the demand for them created by VCs. What do you think? Does this idea change your analysis at all? I don’t completely follow why you think Dave’s analysis was logically flawed, but hey, I’m no VC.

    It seems like some shake-up is going to happen for VCs just because start-ups can get by with so much less money these days and because it’s so much easier to get noticed now without already having the right connections. I think the market will come up with a solution, but I couldn’t predict what it might be.

  • Mathew

    Thanks for the comment, Anne.

    I agree that VCs are in the middle, but I would disagree that they influence both supply and demand. I would argue that VCs only respond to what the market is telling them, and if the market says it wants more profitless dot-coms, then that is what VCs will put their money into. By themselves, they can’t create demand

    The reason I think Dave’s analysis is flawed is that he seems to be proposing a kind of public investment fund, and yet the investing public — including many knowledgeable users and investors — is what caused all the trouble last time around. One of the most dangerous things when it comes to investing is drinking your own bathwater, and I think you could argue that good VCs probably save as many startups from flaming out by going too fast as they do the opposite.

  • http://www.stuartmacdonald.ca Stuart MacDonald

    People are forgetting that The Bubble was our generation’s Gold Rush, with all the giddiness, hope, success, wealth, failure, desperation and heartbreak that went with the *real* Gold Rush. All was possible, basic financial reality was questioned, and there was a real sense that you had to jump in because this was a Once In A Lifetime Thing. You *had* to be in – this was your brass ring, boyo, and don’t you DARE miss out.

    For all its’ seeming frothiness this go around doesn’t feel ike that. Yes, it is minor-league frothy, but there aren’t jillions of dotcom features-masquerading-as-companies, and seemingly pointless-unless-you-squint-really-hard “end-to-end-solutions” to a non-existant problem floating around. I mean let’s cut to the chase: how many of these hot things of the moment *are there*, this time? Not too dang many. Nothing close to the last go around. I mean, it felt like a week didn’t go by without some air-filled whozit going public to breathless acclaim and visions of dollar signs dancing in heads. If that stuff is happening weekly now, I am sure not seeing it.

    The big excitement is not really broad based this time – I mean, for the most part the action is either with GYM+aol or in their immediate orbit. The outfits getting attention are – with serious respect to those who created and drove them (I’ve been there, I get it, you did it, nicely done) – neither numerous, nor huge.

    All this to say that, for VCs, the sandbox in which they are able to play *is* smaller in many respects this go around. That said, anybody who thiks that the role of VCs is off to the dustbin doesn’t get how hard it it to build a profitable, sustainable, matters-to-customers business. It is not easy, and if Big is the desired destination, *rarely* cheap. But good on anybody in VC-land who sees the emerging issue, and is thinking about how to roll with those punches.

    – Stuart

  • Mathew

    I think you’re right, Stuart. Maybe this bubble is Bubble 2.0 — more distributed and less expensive than the original :-)

  • http://www.annezelenka.com Anne Zelenka

    Mathew, yeah, I see your point a bit better now. VCs didn’t create the bubble, I agree with that. However, whether they acted as an accelerant or a modulator… I’m not sure. In a somewhat parallel situation the current real estate bubble has been exacerbated by new types of mortgages like interest-only and 100%, that themselves are available because hedge funds have been buying up mortgage-backed securities sometimes without attention to the risk involved. Did VCs help manage risk, like you propose, or did they make the situation worse because they were playing with other people’s money? I understand other countries don’t have quite extensive a VC industry as we have… I’m wondering how the presence of VCs affected the bubble.

    Anyway, I like looking at it through a supply-and-demand lens… that’s a good thought. I blogged my own economic perspective on the current situation after reading yours.

  • Marina Architect

    Scale out and grow at any consequence was what the VC model predicated for fueling the bubble. No denying it. Get a clue Ingram. Having said that, that approach works in the long run: look at Amazon.com: finally makin’ money every 3 months(cash flow not paper). VC’s are critical in idea development (our US society) but the model is beginning to fade in that software and service needs to be profitable in the near term and not the long-term. This is the difference. But then Skype sold for . . .

  • Mathew

    Anne:

    I would definitely agree that having so many VCs — driven by the hot IPO market — fueled the bubble… no question. I just didn’t think it was fair to say that they created it.

    And thanks for pointing me to your post — you did a nice job of explaining in fundamental economic terms what makes Web 2.0 different from Web 1.0, and that is a valuable thing for all of us to keep in mind.

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  • http://remarkk.com/ Mark Kuznicki

    Better late than never, I’ll add my two cents here.

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