Lots of people are asking this question: Is the VC model broken?

It’s an important question, regardless of what you believe, because it creates debate and change. Few things ever stay the same, and the VC model is no different. And without a doubt, I believe the VC model and startup investment in general will undergo significant change in the next 5+ years. We’re just at the early stages of it. The focus shouldn’t really be on whether the venture capital model is broken, but on how venture capital is going to work in the future; because I think most people agree that change is afoot.

So what will that change look like? And beyond venture capital, how will the entire industry and approach for raising capital evolve?

The Funding Gap

I like Paul Graham’s recent assessment and essay, Why There Aren’t More Googles. Specific to raising capital, he argues that there’s a funding gap between the Y Combinator style incubators and traditional venture capital. Think: between $250-$500k. Incubators rarely put in that kind of initial money and VCs will almost always put in more. The gap is filled in part by angels, but Graham posits that we’ll see a new type of venture capital fund emerge that is designed for making those types of low cost / high risk investments. And we’ll see these funds make more bets – i.e. make smaller but more frequent investments.

I agree with Graham that there is a gap between incubators and early stage, individual angel investors and venture capital. And there are some funds coming out to solve that. Montreal Startup is a good example of that (disclaimer: they’re an investor in Standout Jobs. I also think we’ll see more angels form into defined groups that work aggressively to find, evaluate and make deals. The New York Angels are a good example of an active angel group (again, they’re an investor in us.) Other groups that I’ve seen in action include the Maple Leaf Angels.

An early stage startup can go a long way on $250,000-$500,000. Sometimes it’s not far enough, but at least they’re given a solid shot at executing on their ideas and building up early, but measurable market traction. And that’s what venture capitalists need to step in and make a more sizable investment.

Wade Roush at Xconomy shares Graham’s opinion of a funding gap but also notes the high number of angel groups in the United States.

The VC Model is Just Fine, Thank You Very Much

Lots of people are on this side of the fence. Peter Yip at Crosslink Capital recently wrote a post entitled, The Coming Venture Capital Boom. And no, “boom” isn’t a typo for “bust” – Peter means it. He ends his post with this:

As the fire continues to rage in financial markets, it is hard to imagine when Opportunity will reappear. But the truth is when everyone sees Opportunity; they are only seeing the reflection. True Opportunity appears at the market bottom, not at the top. It’s times like these that test what you believe in, and I believe in the Business Cycle, Human Creativity, and the stimulative effect of massive Government spending. 2009 and 2010 will be great times to invest to reap the benefits in 2012-2014, for those who can judge both business risk and liquidity risk, and have the courage of their convictions.

Georges van Hoegaerden, Managing Director at The Venture Company recently wrote that the VC model is not broken. He starts the post off beautifully:

It continues to amaze me how VCs point to the economic downturn as a reason for sluggish investing. We all know that at this point they should do exactly the opposite (and a few good ones do).

The VC Model is F-cked, Run For the Hills!

Without repeating everyone’s argument on this side of the fence, there are plenty of people who believe the VC model is truly broken. The debate really took off with Adeo Ressi’s presentation, The Canarie is Dead. Adeo is the founder of The Funded, a site for startup entrepreneurs to go and “rant” about investors (it’s entertaining…) A host of people agreed with Adeo including Alan Frazier and Sevin Rosen.

Basil Peters has a great post based on a recent study done on the results of VC investments into angel-backed companies. (Incidentally, if you’re raising money or thinking about it, read Basil’s blog.)

As Basil points out, “…there is no free lunch. This data shows that after a VC invests your chances of failing completely also increase significantly.”

What’s This All Mean for the Entrepreneur

For entrepreneurs the entire debate amounts to a ton of noise. Some of it is good, but a lot of it can be extremely distracting. What does matter is that entrepreneurs need to plan for the turbulence and expect the craziness to last for quite some time.

No one needs to tell you that times are tough, and raising money is hard. The reality for a lot of startups is challenging. Valuations are dropping and startup fundraising will most likely be one of your biggest frustrations.

But I still believe in opportunity amongst chaos. And if I was running a VC fund or involved in an angel group, I would be actively pursuing new investments. For entrepreneurs, I would recommend that you go into the process of raising capital with actionable plans that vary depending on how much you can raise. For example, you might have a strategy ready to roll if you raise $250,000, and a slightly more aggressive strategy if you raise $500,000. And so on. You shouldn’t lock yourself into one plan and one fixed amount of money you absolutely must raise. That’s a dangerous approach. I can’t speak for any VCs in particular, but I think they appreciate this more open approach, whereby you’ve clearly thought through different scenarios. It should provide added confidence that you’ve thought things through, can execute based on the different scenarios and fundraising variables.

And, you probably should have a plan in place if you raise $0 too…