Dave Winer wrote a post today called “How to Reform the VC Industry” Robert Scoble and John Roberts of CNET follow up with their own thoughts.

I agree with the premise – that venture capital is broken (at least as it applies to new web startups), but I diverge from the line of thinking on why, and what to do about it.

Dave’s arguments in my words:

1. venture capital is broken because they are middlemen and they make bad decisions (lots of online pet companies in the nineties)
2. and people really need less capital now to start companies, and they need it later in the cycle
2. so companies should go right to the users, who often have money
3. but Dave ends his essay by saying that some companies will still need capital, and suggests forming a publicly held venture fund to supply this capital

Scoble generally agrees, and points out that venture capital is tight exactly when companies need it the most: in tight economies.

John Roberts main point is that ideas are easier than execution (I think he’s right that execution is really, really hard).

I agree with a lot of what Dave writes, but not the key parts. And Dave takes the time to say that VCs don’t add enough value as middlemen, but his solution is to create a…venture fund. The only difference is that it will be publicly held instead of privately held. Presumably this is to get “users” directly into the investment flow. But it seems to me that Dave is suggesting the insertion of a new middleman to take the place of the old.

Publicly held venture funds have already been tried, by the way. There’s 3i in the UK, and DFJ tried a similar experiment called MeVC back in the bubble that ended up a complete mess. In general, publicly held venture funds don’t work because they don’t provide the predictability of earnings, the visibility and the liquidity that the public markets require. Furthermore there is the whole issue of disclosure regarding companies in a VC portfolio that would be very damaging. That’s why endowments and retirement funds that decided to disclose VC returns are being being kicked out of their allocation, even when long term relationships existed. So not only does the idea of a public venture fund not really work, private funds don’t even want publicly held investors to participate in their funds. (Thanks to Jeff Clavier for discussing this with me and filling in gaps in my memory).

In my opinion, venture firms provide a valuable service. They are asked to make investment decisions very early in a company’s cycle – often before launch and almost always before it’s clear that the risk of user adoption has been overcome. That’s hard to do – and the hyper-competive vc market, flush with cash, ensures that only the best survive.

So what do I think is wrong with funds today? Many of them are too big. They need to make big investments to justify fund size and the associated management fees. But companies can create a lot with much less in the way of resources compared to a few years ago. They don’t need as much money. But they take it anyway…and this may be a reason that valuations have risen. Clarence Wooten, who’s starting a venture fund with this in mind, wrote about this late last year and put it perfectly:

The average venture capital fund size currently stands at $280 million, which presents a problem for VCs focused on investing in early-stage software companies. Generally speaking, the larger the fund, the more money it must invest on a deal-by-deal basis in order to justify the time commitment by the fund. But significant venture funding is not what today’s capital-efficient, Web 2.0 startups need—especially those that leverage the LAMP -stack, open-source frameworks and blog-fueled promotion. The old style of venture capital just doesn’t work for the type of company generally seen profiled on TechCrunch.

Instead of VCs changing their model to invest smaller amounts, we are seeing an increase in Series A valuations. It’s not that startups have suddenly becoming more valuable, it’s that funds need to deploy larger amounts of capital. Considering the movement towards less capital and competition by the likes of Google, VC’s are increasing the valuations of young companies. The valuation increase enables the fund to deploy enough capital to make the investment worth their time.

Entrepreneurs giddy that their company has just been valued at a significant multiple often take the bait and raise more capital then they need.

The way to fix this: boutique firms are already being formed that will invest smaller amounts in web 2.0 startups. Angel investors (Dave’s “users”) also fill in the gaps (and always have). Let the big firms focus on more capital intensive ventures. In the end, people with lots of money want professionals to make investment decisions for them.