The end of the deal flow


26 May 2005

Bill Burnham writes about the changing business landscape for venture capital firms and what that means for their ways of doing business.

For all but a few firms, the dramatic increase in the scope, complexity and competitive intensity of the venture business makes a deal flow-based business model, no matter how good one’s networks or connections, unsustainable because the risk of adverse selection has become so great and in those rare circumstances that a good deal actually makes it into the public domain, intense competition is likely to drive pricing up to a point where the good deal becomes bad because it’s just too expensive. Net, net the cold reality is that the venture business is now clearly and permanently a seller’s market.

While he concedes that there may be a few exceptions, for 99+% of the VC industry the party’s over. The solution is to be proactive about finding your deals

In such a competitive and complex environment the most promising way for VCs to ensure themselves of rising above the tide is to move from a passive deal-flow based approach to a proactive thesis driven investment approach. This approach stresses taking the initiative to develop an investment thesis based on focused expertise and then using that investment thesis as the basis for a directed deal acquisition campaign designed to either ferret out those existing start-ups that fit into this investment thesis or to help create new companies that can take advantage of an identified opportunity.

In this model, VCs do not passively sit back and let deals come to them, but they go and out and “turn over rocks” actively looking for deals that fit their investment thesis in a particular space.

An interesting point is that this new approach favors the new VC firm, or at least levels the playing field for two reasons:

  1. Entrepreneurs respect VCs that understand their market space/business.
  2. Entrepreneurs rarely refuse to talk with VCs that proactively call them and tell them that they are potentially interested in investing in their business.

Required reading for anyone in the industry, but I do wonder how much this applies to the fragments European venture capital industry?