It is February 2009, and I am sitting on the patio of a coffee shop upstairs in a mall. The scene would be totally unremarkable except that this mall is in Kigali, Rwanda, and I'm talking about the economics of toilet paper.
It's hard not to gaze out at the vista of Rwanda's famous rolling hills. Half of them are swarmed with favela-like shanty buildings, and the rest are dotted with modern stucco mansions under construction. Kigali is a city in stunningly rapid transition.
Along the sides of the freshly paved streets winding up to this mall are workers in prison jumpsuits digging ditches—a sight that's only ominous when my guide tells me they're imprisoned murderers from the bloody 1994 Rwandan genocide out on a work-release program. It's important to Rwanda's President Paul Kagame that everyone in the country literally and figuratively helps rebuild the war-torn country. Everyone. "Hutu" and "Tutsi" are taboo words these days. "We are all Rwandans" is the country's modern-day mantra. Seeing them holding shovels and other crude, blunt instruments that were not too long ago used to bash in Tutsi skulls is chilling, but I seem to be the only one bothered by it.
Sitting with me is Jean de Dieu Kagabo. He's 28 years old. He lost his parents in the genocide and its aftermath, along with nearly 1 million of his fellow Rwandans. He saw things no one should see. And now, some 15 years later, he's a Central African consumer package goods mogul with several German luxury cars and a summer house on the lake next to President Kagame's.
Talking to Kagabo is as disorienting as looking at those hills that simultaneously show glimpses of Rwanda's past and Rwanda's future. Things are moving so quickly in Rwanda, that it's almost as if there's no such thing as Rwanda's present. Kagabo has what I can only call "Rwandan eyes." There's an otherworldly stillness and depth to them that I'd never seen before, but I see it all across this country—even in the eyes of children. They're eyes that have seen more evil than most of us ever will. Even when Kagabo is laughing, his eyes are not.
We're not talking about these things though. We're talking about toilet paper. Having spent the previous decade of my career parsing business pitches on medical devices, new drug compounds, chipsets, rational databases, super routers, and Web sites, I can't remember the last time I had this un-techy of a conversation.
But here's the remarkable part: Just as those McMansions on the hills could be under construction anywhere in the world, as I sit and talk business with Kagabo, I can't stop thinking about how much he reminds me of an entrepreneur I'd recently interviewed in the United States: Tony Hsieh, CEO of the ecommerce shoe company, Zappos.com. Part of this resemblance is physical: Both men have thin, slight builds, close-cropped hair, and boyish faces. Neither is particularly emotive or talkative. They both answer direct questions, succinctly and without pretense in a soft-spoken tone, more out of shyness than any sort of coldness.
There's also a similarity in what they say, or more to the point, in the way they think. Both men have a knack for looking at a problem and finding a common-sense solution. They are able to tune out every best-practice piece of advice a consultant would give them or every reason a more mature CEO would tell them their idea wouldn't work. Almost like the kid in the story "The Emperor Has No Clothes," for both Kagabo and Hsieh, the obvious answer is the right one, and no one will persuade them otherwise.
Zappos, for instance, was a dot-com survivor that shouldn't have survived. When faced with the concern that shoes were too difficult to purchase online because fit matters and can vary so wildly across brands, Hsieh solved this problem with a common-sense solution. Zappos would pay for the shipping and returns so people could order several different sizes, styles, or colors and just send the rest back. He'd even pay to have a UPS driver come to your house to pick the boxes up. He also gave every customer a surprise upgrade to priority shipping. The hidden truth behind Zappos' nearly $1 billion in gross merchandise sales in 2009 was the fact that some 40 percent were returns—and Hsieh was fine with that.
Of course, some competitors argued that Zappos had killed their business models by setting such expensive customer expectations, but Hsieh's approach solved the customer loyalty problem. That was more important to Hsieh, because Zappos wasn't just selling shoes, it was selling "happiness," in his words.
It was a way of constructing a business that no seasoned manager would have ever allowed, but Hsieh saw this clearly and believed that it was the only way to build a billion-dollar ecommerce business for long-term success. He wasn't going to stop at shoes either. Zappos started selling cookware because customers suggested it, and he stated that he could see a scenario where one day Zappos might have its own airline. A decade later, Amazon.com paid $1.2 billion for the company—not because of its margins on shoes, but because of what it meant in consumers' minds and hearts. Hsieh was right.
Kagabo takes a similar, almost childlike approach to his business. He started manufacturing toilet paper when he was 18 because he needed money to feed his family, no one made it locally, and—in good times and bad—everyone needs it. As we sat on this patio, he was telling me about his company, Soft Group's, plans to get into bottled water—a market that's considerably more crowded, with several government-sponsored bottling plants.
His way into this market wasn't by offering better water or cheaper prices. Like Hsieh, it was by solving an important customer problem. Although there's no armed robbery in Rwanda, there is petty theft, and local merchants were seeing pallets of water disappear, leading them to believe employees were pilfering them. These mom-and-pop shops couldn't afford pricey surveillance systems, so the water costs were escalating. Enter Kagabo's common-sense solution: He'd give each store bottles of water with their own labels on them. Consider it a low-tech version of a LoJack®: If the merchants see pallets of water for resale at market days with their brand on it, they can easily figure out where their missing pallets of water went. The thieves were likely to be caught, so petty theft at these stores would decrease.
"Entrepreneur" is a fashionable mantle nearly everyone wraps themselves in these days, but this is what a conversation with a great entrepreneur is like. It's not about technology or features or acronyms—it's a way of thinking and problem solving, coupled with the internal compass to believe in the idea and the confidence and determination to carry it out.
Great entrepreneurs' minds just work differently than other people's. They can see solutions to problems clearly. And while those solutions seem to make obvious sense when explained, few others would have come up with them. You can't describe great entrepreneurs by the kind of companies they are starting, their ages, their backgrounds, or their ethnicity—it's by the way their minds works.
True entrepreneurship can't be taught. It can't be faked. It can't be silenced. You either have it or you don't. And just because we hear the most about U.S. entrepreneurs, that doesn't mean we have a lock on it. Increasingly, even Silicon Valley—the hub of U.S. entrepreneurship—is losing stories like Hsieh and, with it, what made America and the Valley great.
In the 1800s, being an entrepreneur was associated with building something when you had nothing or simply with the luxury of working for yourself. It held the promise of building a nice, profitable business you could pass on to your kids. Every once in a while, a company would come out of it, but that wasn't really the end goal of the early days of U.S. entrepreneurship. There was a focus on lifestyle: making enough income so your children could have more than you did and building something you could own and be proud of. There was no glamour to it, and even if you succeeded, in many parts of the United States you were relegated to disdainful new money status.
Over the 100 years after the first immigrants passed through Ellis Island, the concept of entrepreneurship in America would change pretty dramatically. In 1958, a new law concerning investments in small businesses allowed the formation of a new kind of investing called venture capital. It was pioneered by successful entrepreneurs and restless bankers who were seeking to fill a hole in our finance system—one that had huge risk but potentially lucrative rewards. At the time, public companies could always raise more money to invest in the growth of their business via a secondary stock offering or a bond issue. Private companies could get bank loans. Although some small businesses could get Small Business Administration (SBA) loans, an entrepreneur who had a great idea but no collateral, no business plan, and, in some cases, no product had few options.
When they do their jobs right, venture capitalists take huge risks. They back someone unknown and an idea that seems crazy. In exchange for that risk, they get a huge chunk of ownership in the company, on average 20 percent per funding round. If the idea is good enough, entrepreneurs can use the investment to jumpstart the business, sidestepping the years of lean margins and hard work an old-world entrepreneur might have had to endure building a business out of its own cash flow. If a company can get to hyper-growth, using a combination of a smart entrepreneur's disruptive idea and millions in backing, there's the potential for huge returns for the venture capitalists (VCs) and the entrepreneur. To counter the inevitable—and desired—risk in the asset class, investors pick many bets and hope one turns out to be big enough to pay for the losses of the rest. In a weird way, investors want to see losses. Without them, they probably aren't taking enough risks.
Venture capital started in Boston, but the combination of that method of investing and the burgeoning high-tech industry really lead to venture capital's explosion. And Silicon Valley dominated technology and ushered in a remaking of what it meant to be an entrepreneur.
By the late 1990s, Silicon Valley was a well-oiled machine. There was fluid interaction between Stanford University, nearby Sand Hill Road where dozens of VC firms were located, and a burgeoning working class of techies who embraced the risk of leaving an established job to go work for a new hotshot with a great idea. People in the Valley bonded because they were all immigrants and outcasts, somewhere on the spectrum between visionary and delusional. For every early Valley entrepreneur, there was a wife or mother somewhere sobbing and pleading with them to come to their senses. But over several decades, people saw the model work, watched as everyday people become millionaires, and believed in a place where smarts were all that mattered—a place where anyone could be the next great robber baron.
Unlike in Boston, there was a sense of openness in Silicon Valley. Competitors were also friends. Employees freely jumped between companies, sharing knowledge and ideas. VCs and angels invested in multiple companies, and they helped build bridges between potential partners and even helped orchestrate acquisitions. Even when someone's company gets bought, the non-compete clauses only last a few years. Companies in the Valley want to stay on top because they're the best, not through contracts, intimidation, and legislation. After the March 2000 NASDAQ crash, no Valley companies were asking for bailouts.
Despite its core of invention, the Valley loathes patent lawsuits, because usually they're waged by a so-called patent troll squatting on an idea that he or she never worked to turn into a business. Great entrepreneurs know an idea is just that. It's the execution, the sleepless nights, the years living on the edge that create a billion-dollar business. And unlike more rigid East Coast societies, there was no stigma to new money. Rather, new money meant you'd earned your wealth, and that gained you not only respect but also fame and adoration.
Within the United States, a pilgrimage started to take place from the Midwest, the South, and even the former center of innovation and finance—the Northeast. Globally, it was more pronounced than ever. In the 1980s and 1990s, more than 50 percent of Silicon Valley startups had one or more immigrants as a key founder, according to Duke University researcher Vivek Wadhwa. For immigrants like Andy Grove of Intel, Vinod Khosla of Sun Microsystems, Max Levchin of PayPal, and Sergey Brin of Google, Silicon Valley was the epicenter of the American dream.
The Internet took the sleepy town and stealthy industry of Silicon Valley and turbocharged it, displaying it to the world. The Valley had long had a core of enthusiasm, hubris, creativity, and greed, but now it was everywhere you turned, from north of the Golden Gate Bridge to the ho-hum depths of the East Bay to the once-sleepy orchards of the South Bay, and even down to the hippy beaches of Santa Cruz. You didn't even have to be that smart to do well, whether you were building a business amid the expensive and technical rollout of fiber optics and data centers, or you were selling computers and routers to every household now that the Internet made computers cool, or you were building the wonky behind-the-scenes software like databases that ran the whole thing. The Internet was such a concentrated, yet ever-reaching land grab of opportunity that nearly every business decision seemed insane and yet insane-to-pass-up at the same time.
It was in the great 1990s Internet bubble that Silicon Valley—the entrepreneurs behind it and the investors who fed money into the system—became famous. The idea of entrepreneurship morphed into something glitzy and glamorous, associated more with greed and ambition than pride and a nice lifestyle. While the word entrepreneurship merely took on new connotations, the phrase small business wouldn't do; instead, the Valley coined the term startup. Inherent in the phrase small business is the idea that it won't grow; inherent in the term startup is the idea that it will grow fast, get bought, or die. Small businesses were what old-world entrepreneurs started; modern entrepreneurs created startups. Silicon Valley exalted and transformed what it meant to be an entrepreneur in the United States, in the way that Hollywood exalted and transformed what it meant to be an actor. Silicon Valley was the place where modern entrepreneurs made it.
Of course, there was a problem with this. All that money flowing around the Valley and all the opportunity essentially derisked an economy that got its start and thrived particularly because it was so risky. That meant as more money flowed into the venture capital system, returns got worse, which drove investors into the arms of emerging markets. But before we talk about that shift, let's look at why returns fell after the 2000-era boom.
Because venture capital was so little written about before the Internet boom, many people don't realize how inflated it became. In 1996 the industry was investing a collective $12 billion, and by 2000 that ballooned to $106 billion. Single firms were raising $1 billion or more at a time, more than double the average just a few years earlier. After the dot-com crash, many firms voluntarily lowered their fund sizes from $1 billion each to $400 million or so, but more money kept flowing into the industry. The assets of institutional investors like pension funds and endowments were swelling with appreciation in real estate and other assets, and many of them were upping the allocations for private equity. The crash notwithstanding, there was exponentially more demand to invest in venture capital firms than ever before.
Many in the industry warned against the ramifications of this approach. Influential firms like Sequoia Capital refused to raise more than they thought they could feasibly invest, leaving hundreds of millions on the table. In a 2003 keynote in San Francisco to other limited partners, Fred Giuffrida of fund-of-funds Horsley Bridge Partners delivered a fire-and-brimstone speech warning of the excess funds pouring into the industry. During a presentation, Giuffrida showed a slide depicting a huge elephant trying to fit into a tiny box. His point was that far too many limited partners were shoving an unsustainable amount of money into venture capital. This elephant represented $1 trillion wedging its way into an asset class that had only returned $88 billion from 1990 to 1997. The math just didn't work, he argued, pleading with firms to lower their allocations, but few did.
Institutional investors were sick of Ivy League endowments like Yale and Harvard hogging all those fat venture returns and getting credit for being investing geniuses. Meanwhile, venture capitalists found it difficult to turn down money when they got a healthy 2 percent to 3 percent of assets under management to run the business. Whereas in earlier years that 2 percent to 3 percent was barely enough to pay rents and keep the lights on, in the post-1990s, the funds were so big that venture capitalists could live like kings whether they had a hit or not.
Everyone in the ecosystem knew the odds: 2 percent of startups funded since the 1980s made up some 98 percent of the returns, and only 5 percent of the VCs investing made more than 90 percent of those same returns. The institutions that invest in VCs just believed (or deluded themselves) that they were investing in that 2 percent to 10 percent that would win big. And if not? Well, it was still only 10 percent of their portfolios, at most.
This deluge of available money meant more than just a greater number of losses. It led to a systemic culture where no one had any skin in the game. VCs weren't dependent on returns to make millions, and when there was this much money looking to fund any good idea, there was no reason for entrepreneurs to invest their own money and no expectation for companies to bootstrap themselves the way they had in the past. Founders could easily get funding, get a nice salary, and in subsequent rounds cash out some of their equity far before there was an IPO or acquisition—something that was unheard of in the early days of venture capital.
To be fair, many entrepreneurs did bootstrap their companies anyway and would refuse large salaries. Unfortunately for investors, these were the better entrepreneurs. They were the ones who had made money already, and they knew the dangers of taking too much venture capital too soon. They wanted to retain control and wanted to make the biggest share of the returns when they hit it big. Because the cost of starting a Web or software company had plummeted some 90 percent since the late 1990s, it was a lot easier to bootstrap something than in the past. So in essence, there was adverse selection, and VCs got stakes in the worst startups, the unproven kids, and the entrepreneurs looking for a flip or quick money acquisition.
Similarly, there are a lot of reasons why it makes sense for a founder to take some capital off the table by cashing in shares. It makes the founder more likely to hold out for a big exit than to sell on the cheap early. But there's no doubt—it made being an entrepreneur more of a rational job than an unexplainable passion. It couldn't help but make the Valley more mercenary and more mainstream. The venture business became less about finding those elusive home runs and more about doing slightly better than break-even on each deal. It was an antirisk trap. With each big hit like YouTube that a VC firm missed, the more the partners had to play it safe, because they couldn't risk big losses.
This lack of having to make a big return to stay employed for founders and stay in business for VCs trickled down through the Valley ecosystem. Given that even profitable public technology companies were regularly laying off employees as a way to meet quarterly earnings, there was suddenly less risk in working at a startup than at the types of companies once considered stable and safe. Employees at startups got an equivalent salary, stock options that may or may not be worth something one day, and generally a more flexible work environment.
But this was the curse of the Valley's great company-formation, money-making machine becoming common knowledge. It was no longer just the believers and risk takers who played a part in it. In a bid to become the place where there was zero stigma against risk or failure, the Valley eradicated the things that are good about having a fear of failure. Namely, the rush, commitment, and passion that comes with having skin in the game.
Part of all that me-too investing was the fault of limited partners who put way too much money in the hands of VCs, part of it was the fault of VCs, and part of it was just the by-product of a lull in the technology industry. The great Silicon Valley cycle that had begun with the semiconductor and rippled through computers and software and laptops and telecom to end with the Internet had just run its course. By 2006, excitement was building in the Valley again with a new lot of Web companies—dubbed Web 2.0—but most of these were really closer to media companies. The hard work was no longer technical, which had always been the Valley's forte; it was amassing large audiences and innovating new advertising models to sustain them.
Many people hoped that cleantech could be the new computer, and indeed Barack Obama talked this up in his 2008 Presidential debates as a way to fix the economy. There were plenty of opportunities to change the way we use and generate electricity, and done correctly it could be a huge market. But cleantech represented two things venture capitalists hate: investing in so-called science fair projects where hundreds of millions could be spent before you'd even know if you had a product, and having to be dependent on the government. There was inevitably going to be a few decades where the costs of remaking our electrical lives would be prohibitive for most consumers, and hence would have to be subsidized by something like tax incentives. A lot of VCs talked a good game about cleantech, but most of the investments were lower-capital plays that only nibbled at the core problems, like a software system for better routing electricity around large retail chains.
A glaring exception was Elon Musk, one of the founders of PayPal and an immigrant from South Africa. While his fellow PayPal alums plowed their money back into the Web 2.0 world—funding or starting companies like Facebook, LinkedIn, YouTube, Slide, and Yelp—Musk built a rocket company called SpaceX, a solar panel company called SolarCity, and an electric car company called Tesla. He invested more than $180 million of his own money in these ventures, and much of the world thought he was stark raving mad.
Indeed, calling Musk eccentric is an understatement. He's got a laugh like a James Bond villain and a flaring temper to match, and he's wildly unpredictable. Just after eBay bought PayPal for $1.5 billion, he reportedly wrecked a brand-new McLaren S-1 on Silicon Valley's windy highway 280. He doubled over in laughter by the side of the road. Why? He hadn't yet bought insurance on the car. He stands out all the more because this kind of entrepreneur is so unique in the Valley right now.
I asked Musk once if he was crazy. How could he think that he—a computer guy—could build an electric car company when General Motors had invested $1 billion on the EV1 only to kill it off? "I didn't really approach this thinking it would be the best rank-order return on investment," he said. "If I thought that I'd be pretty crazy. I just thought it was pretty important for the future of the world." Meanwhile, in Silicon Valley, VCs hem and haw over investing in a company like Facebook at too high of a valuation, because they can't immediately determine how they'll double their money. This is the curse of short-term thinking. It's not risk-based investing if you can see an exit before you do the deal. Or as legendary venture capitalist Vinod Khosla sums up his industry's sad evolution: "There's too much capital and not enough venture."
In the early days of venture capital, VCs were nothing more than a collection of ex-entrepreneurs and frustrated bankers who made bets on intuition and relationships. They didn't have to see a market to invest; they didn't even have to see a product. "They were willing to bank on intuition and trust, combining patience with an understanding that it might take five to seven years for them to see a return," writes ex-Valley entrepreneur Judy Estrin.[9] This went hand-in-hand with government spending on long-term, high-risk research—the kind of research that helped create the Internet. The government funded the development of the Internet for a stunning 24 years. If the Advanced Research Projects Agency (ARPA) network and government research was as robust now as it was in earlier decades, the United States would be a leader in cleantech, and private and public market returns would have followed.[10]
This is a direct trickle down from Wall Street and the result of large pension funds, fund-of-funds, and endowments becoming the backers of VCs, not wealthy individuals and believers in the long-term benefits of true innovation. Wall Street lives its life quarter to quarter, and the ability to closely track stocks and funds online, on CNBC, and even on your smart phone encourages this. There are a few public-company CEOs who have the credibility and confidence to stand up to this pressure, among them Steve Jobs of Apple, Jeff Bezos of Amazon, and Larry Ellison of Oracle, but the list is short. If startups continue to act like public companies, Silicon Valley is in big trouble.
Publicly held tech companies talk a good game about their investments in R&D, or research and development, and indeed the investment in company-based R&D has soared. In the 1970s, it surpassed government-sponsored research for the first time, leading the government to think private enterprise didn't need groups like ARPA anymore. But the reality is that most of the company-led research is mostly "D" and barely any "R."[11] That may help the balance sheet and stock price in the short term, but it robs the company long term. Google gets high marks for requiring that its engineers spend 20 percent of their time on new projects. Unfortunately, many engineers at Google will tell you that math is based on them having 120 percent time.
By contrast, Estrin describes the glory days of Bell Labs, a division of AT&T that helped discover revelations in the field of chips and transistors—the Petri-dish elements that would eventually drive decades of high-tech growth in the United States. The scientists at Bell Labs worked on whatever they wanted. The incentives to invent weren't based on how commercial they could be, but rather they were based on how much scientific acclaim the scientists got from peers.[12]
Indeed, the more big, publicly traded tech companies have talked about innovation, the more they've just bought it rather than invented it. Cisco Systems, Microsoft, Google, Yahoo!, eBay, and Oracle all nailed one core product that made them tech giants and then bought their way into secondary products in order to continue to show Wall Street growth. Contrast that to Apple, which followed up its iMac success with the iPod and the iPhone, or Amazon, which leveraged its success in ecommerce to become a cloud computing vendor and consumer electronics company with the Kindle book reader.
This is the flip side of the great wave of tech initial public offerings (IPOs) in the late 1990s. Their natural growth has run its course, and a Wall Street dominated by activist hedge funds and short-term investors expects more—now! Developing products and new markets from the ground up doesn't deliver that. What does? A big acquisition that can send the stock soaring and blur year-over-year organic growth rates.
There are a lot of dangerous ripple effects from this approach for the Valley's startup ecosystem. When you have a cast of willing buyers, it incentivizes entrepreneurs and VCs to build products—not companies—that can be flipped early and often. Worse still, it rarely helps customers. While companies talk about buying innovation, they have a shoddy track record of incorporating and investing in what they buy. In some cases, the deal is less about buying a good product and more about taking a potentially disruptive competitor out at a cheap price. Either way, entrepreneurs usually wait out their vesting period, after which they are free to leave and start something new. That cycle, in turn, hurts the Valley ecosystem, because you have fewer entrepreneurs who are experienced at really building and running a business.
Some structural problems have also forced the Valley to become more mercenary and short-term focused. After the 2000 bust, the U.S. government passed something called the Sarbanes-Oxley Act, which created a host of new rules for public companies. The goal was greater transparency and accountability, and it included things like deeper audits and forcing CEOs and some board members to personally sign documents that earnings and other announcements were legitimate, to avoid their passing the buck in the case of another Enron-like situation of outright fraud.
Like most reactionary legislation, however, Sarbanes-Oxley had a host of unintended consequences. For one thing, some of the most qualified people no longer wanted to serve on public company boards because of the new personal liability involved. Even worse was the costs entailed in Sarbox compliance. Suddenly, being a public company cost millions more, which dramatically froze the ability for fast-growing but cash-strapped companies to go public. The only real beneficiaries were accountants, insurance salespeople, and lawyers.
Wall Street banks, too, developed new rules and policies that chilled small cap IPOs. Stricter lines were drawn between analyst research and banking. Again, the intentions were good: In the late 1990s, favorable analyst coverage was frequently traded for the rights to take a company public. But by untethering the two, research began to focus only on the large cap names that the greatest number of customers and traders would care about. Suddenly, smaller companies were completely uncovered, which dramatically decreased investor interest in their stocks. Without trading volume, a public company might as well still be private. Insiders and investors couldn't sell off shares without buyers, making returns just as elusive. Companies couldn't use that stock currency for acquisitions, nor could they tap the market again for more stock or bond money to grow their businesses.
Finally, there were no boutique banks left to champion these smaller deals. In the early formative decades of Silicon Valley, there were four boutique firms known for ferreting out hot companies, taking them public, and making outsized returns for their investors. They were Alex. Brown, Robertson Stephens, Montgomery Securities, and Hambrecht & Quist. During the IPO bubble of the 1990s, each of them was acquired by a bulge-bracket Wall Street firm. When the Valley crashed, Wall Street fired a lot of those local San Francisco deal makers. A few boutiques tried to start up again—some even lead by the same guys who started those four early firms—but with the new structural problems curtailing the smaller IPOs that had built their earlier empires, they didn't have the same success.
Because much of NASDAQ appreciation in past decades had come from new, disruptive companies, curtailing the ability for them to go public also hurt the overall appreciation of the market. Put another way, if everyone's retirement is locked up in the same large cap companies like Microsoft and Google, there's not a lot of room to beat the market and make money. Without public-market investing, the goings-on in Silicon Valley are just that. One could argue that these changes on Wall Street are at the root of many of the problems with risk-taking and short-term thinking in the Valley. Simply put: Taking big risks doesn't work when there's no reward. If the only reasonable exits are acquisitions, then why should investors or entrepreneurs invest the time and money to build a big business?
In 2009, Grant Thornton released a study called "A Wake-up Call for America"[13] aimed at calling attention to these structural problems with the public market. Researchers emphasized that the only way to make money today was by using sophisticated high-frequency trading. That's just what we need: a market already wrecked by a fixation with the short-term becoming even more short-term obsessed. "Our one-size-fits-all market structure has added liquidity to large cap stocks, but has created a black hole for small cap listed companies," said David Weild, former vice chairman of NASDAQ and capital markets advisor at Grant Thornton. He continued: "Wall Street's very nature has been substantially transformed."
Because those IPO returns helped create the Valley in the first place, the Valley was substantially transformed along with it. The number of U.S. listed companies has declined more than 22 percent since 1991. The study argued that the United States needs 360 new listings per year just to replace the listed companies that go away every year, whether through acquisition, going private, or bankruptcy. Wall Street hasn't seen numbers like those since 2000.
Pascal Levensohn, an investor with Levensohn Venture Partners and board member of the National Venture Capital Association, doesn't sugarcoat the implications for U.S. entrepreneurship. He said at the time of the report, "(This) inhibits job creation and hurts American entrepreneurs more than any other group. If we can't repair the bridge into public markets, the next generation of innovative private enterprises—starved for long-term risk capital in the U.S.—will continue to move to non-U.S. emerging innovation hotspots, where startups are nurtured through attractive capital incentives."
Venture capitalist Bob Ackerman puts things more bluntly, "We're dismantling the reward side of the equation. This isn't about VCs having sour grapes. We'll be just fine. I can invest in India and China. Talent and capital are the two most mobile assets in the world. They'll go to where they are welcomed and rewarded. This is about the decay of U.S. innovation."
Even President Obama broke from the traditional America-is-the-best-country-on-earth rhetoric in his January 2010 State of the Union speech to address the fact that complacency was holding the United States back. He stated, "China's not waiting to revamp its economy; Germany's not waiting; India's not waiting. These nations, they're not standing still. These nations aren't playing for second place. They're putting more emphasis on math and science. They're rebuilding their infrastructure. They're making serious investments in clean energy because they want those jobs."
Estrin echos with this statement: "Great companies often fail when they take their success for granted. And so, too, can great societies."[14]
It bears noting that this topic of entrepreneurs and investors increasingly playing it safe gets a lot of intense debate at the senior levels of power in the Valley. But the debate isn't whether or not this derisking and move to smaller, more certain outcomes is happening. The debate is whether it's necessarily a bad thing. Many entrepreneurs see nothing wrong with aiming to build a $100 million business or designing a product that can be flipped for $20 million. Not everyone, they argue, wants to or needs to build a huge public company, especially given how unpleasant running one has become.
Being an entrepreneur is about following your dreams, and if your dream isn't to build the next Google, by all means, don't. But don't expect to raise venture capital or get on the cover of magazines either. And don't expect to change the world.
If Silicon Valley were a stock, it would be Microsoft. Just as Microsoft is still the world's largest software company, so too is Silicon Valley still the largest hub of this breed of modern entrepreneurship and venture capital—and neither shows signs of that dominance changing overnight. Microsoft could fail in Web advertising, mobile phone operating systems, entertainment and video games, and its core businesses would still funnel some $60 billion in revenues into its coffers every year.
But if Microsoft's dominance hasn't been challenged, it is slowly but surely eroding in terms of influence. On platforms like the Web and mobile devices, the war isn't between Microsoft and anyone, it's between Google and Apple. Even with its dominant products, percentage points of market share here or there are increasingly going to competitors, be they Google, Salesforce.com, or Firefox. It's not the cash Microsoft is still raking in that matters, it's that shift in momentum. Customers don't get excited by a Microsoft launch anymore, many top employees have long since left to work for companies like Google and Facebook, and the stock is essentially where it was 10 years ago.
Like Microsoft, Silicon Valley won't lose in sheer numbers of startups or dollars spent, and it will probably still continue to give birth to most of the billion-dollar companies for the next decade. But, like with Microsoft, the momentum is shifting. No one stays on top forever in technology, especially in the Internet age. As the home to Davids continually toppling Goliaths, the Valley should know this better than anyplace. In short, the modern entrepreneur movement worked too well for Silicon Valley. Success transformed it from a place that was all about upsetting the status quo to a place that wanted the status quo—the bulk of the money, the best talent, and attention—to continue. Silicon Valley suddenly has everything to lose.
VCs are already shifting where they invest. Ten years ago, the most powerful VCs in the Valley refused to invest outside a 30-minute drive or one-hour flight radius of the Valley. The world had to come to them. Now, with nearly every firm in the Valley investing in Israel, India, or China, that's changed dramatically. Almost to a firm, the most senior and powerful partners are spending many weeks a year traveling the emerging world and looking for deals. It's the only way the Valley's Sand Hill Road will continue to stay at the epicenter of financing innovation—by going to markets that are actually growing and thriving. VCs aren't all investing geniuses, but when the so-called life blood of a region starts to leave, that says something.
Investing in emerging markets hasn't been easy for an industry that's always been about local deal making and clubby relationships. Firms can't rely on their sterling reputations or networks of contacts to get the best deals. They have to fight for them. And smart entrepreneurs like Rwanda's Jean de Dieu Kagabo have the home-field advantage. Many of them have the option of taking Western money, taking local money, or just continuing to bootstrap their companies—options that the first generation of American entrepreneurs never had. As a result, entrepreneurs like Kagabo are a mixture of this old-world entrepreneur and the modern Valley entrepreneur they read about online or hear about when VCs come courting.
Emerging market growth aside, if returns were still strong in the Valley and the United States, most VCs would stay put. But with their industry facing 10-year returns at or below the broader markets for the first time in its history, it's time for them to take the kinds of risks they used to demand of their entrepreneurs. It's time to find a new greenfield.