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Venture capital isn't over — it's trifurcating!

TechCrunch Disrupt SF 2011 - Day 3

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Venture capitalists and founders at a recent TechCrunch Disrupt conference. Are the those who disrupt about to get disrupted?

Scott Anthony, who runs venture investing for Innosight — a consulting firm founded by the founder of "disruptive innovation," Clayton Christensen — has applied the master's lessons to the venture capital space at Harvard Business Review's blog. Like a lot of folks, myself included, he takes a recent Kauffman Foundation report as his starting point. 

And then he effectively deploys Christensen's best-known concept to explain why venture capital — and particularly big VC funds — isn't performing as well as an investment class as it has in the past. The way disruptive innovation works is that in an established industry, a new player will enter at the low end and wind up disrupting the major players.

A good example might be Japanese carmakers attacking first small motorcycles and later small cars, then moving up the food chain to make plenty of trouble for Ford and General Motors. More recently, you could argue that Instagram did this to Facebook by creating a lightweight mobile photo-sharing app that was so easy to use that it acquired 50 million users practically overnight. 

In VC, something similar appears to be at work:

Christensen likes to describe how, in the early stage of theory development, people make predictions based on observed correlations. For example, people observed that things that flew had feathers. So people hoping to fly created large feathered wings. More advanced theories pinpoint causal mechanisms. For flight, that was Bernoulli's Principle, a theory that explained the concept of lift and why modern aircraft are not covered in feathers.

Much of the venture capital industry seems stuck in the feathers-and-wings stage of theory development. Many successful venture capitalists observe directional patterns. "Every time I have succeeded," they might think, "I've backed an 'A team,' that has targeted a hot market space." There's no doubt that's true, but that is a statement of correlation, not causality. Even worse, the narrative fallacy means that people are likely to construct stories about the past that might not have been precisely true, making future predictions even more dubious.

He goes on to discuss how this doesn't mean that venture capital should close up shop, but rather get acquainted with what he calls "trifurcation." There will be big VC firms, the well-known names from Silicon Valley and perhaps a few in other regions that have established startup economies.

There will be data-driven operations like Google Ventures, which among other things is crunching numbers on whether failure is worth investing in (failure is often taken as a hard-earned and much-desired battle scar in the tech startup world). And there will be incubators that can bust out startups in a hurry, to try to catch lightning in a bottle in the new fast-paced innovation paradigm.

It's interesting to think that an industry (of sorts) that prides itself on being the innovation expert is being exposed to Christensenian disruption. But it shouldn't be surprising. VC has been around for decades. It has undoubtedly funded great companies that have inculcated entrepreneurship and created substantial market value. 

But like everything else, VC isn't immune to "creative destruction" — the famous and famously misunderstood process, identified by economist Joseph Schumpeter, by which old economic structures are displaced by new ones. Venture capital exists in capitalism — and exists because of capitalism — and what we may be witnessing is the leading edge of a major change in how it's organized. 

One issue is that industries aren't supposed to be able to disrupt themselves. Outside players need to come in at the bottom of the market. This suggests that if a trifurcated VC model doesn't succeed, something different — something faster and cheaper — may arrive that funds companies in wholly new and unexpected ways.

Follow Matthew DeBord and the DeBord Report on Twitter. And ask Matt questions at Quora.

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