I try to read Stu Phillips’ Soaring on Ridgelift whenever he posts. He’s a venture capitalist. He’s also, judging from his posts on the blog, a smart person, thoughtful about business, a good writer. And his latest–about the future of venture capital–is important.
He acknowledges a lot of talk about venture capital being broken, but disagrees.

Like any “system” that has been “enhanced” over decades, the architecture of the venture capital business isn’t broken but has fundamental issues that slow or even limit its ability to adapt to new market requirements.

Instead, he says, venture capital is caught in “an architectural transition.” He cites four factors:

  1. Too much capital. Interesting, no? You wouldn’t think that would be a problem, but it turns out that it is.

    The supply of capital into venture funds isn’t balanced by the market exit potential (IPO, M&A) to generate an acceptable rate of return.

  2. Too little expertise. Also very interesting, but a bit unnerving, too, because the VCs I’ve dealt with in my career were always at the pinnacle of the startup business. Stu says there are “a lot of smart people with very little operating experience.” Consider this thought:

    You wouldn’t want a medical procedure to be performed by someone who had been trained but was about to conduct their third or fourth procedure–on YOU. Yet in the VC world, this happened with new VCs sitting on the boards of private companies and dispensing guidance and business advice. The rapid growth exceeded the capacity of the experienced VCs to mentor the new folks coming into the business.

  3. The Internet effect. This is my personal favorite. Fascinating. He calls it a “little-known side effect” of better information flow and decreased latency.

    But this same improvement means that ideas, concepts, description of problems, etc. quickly spread to be known by many people. The time advantage of knowledge has been reduced and places an ever larger premium on being the first mover and flawless execution.

  4. Technology markets are mature.

So where does this take us? He has an interesting view of declining searches for startups and venture capital. He says venture capital 1.0 was the birth of Silicon Valley (my summary, not his words) and 2.0 was the internet boom.

And what’s 3.0? Still to be determined. AndPhillips doesn’t venture a guess. But his conclusion about either fire or water is worth repeating:

Big problems or unmet needs create a fire–big pain and urgent need. If you decide to play with fire, you must execute with perfection and precision. You won’t get a second chance, and VC investors should quit funding the moment execution becomes flawed or someone else does a better job.

Difficult problems or emerging trends benefit from an approach like the erosion of water. Relentless and slow like a river or getting into the cracks and freezing to break down the problem faster, like ice. Build entry barriers with fundamental IP, good execution and careful deployment of capital–together with deep and meaningful strategic relationships with established companies that realize they need your help.

Pick one!

Tim BerryTim Berry

Tim Berry is the founder and chairman of Palo Alto Software and Bplans.com. Follow him on Twitter @Timberry.