Venture capital (VC) funds like to invest in disruptive change, but what they really love is the stable, change-resistant nature of their own business. That is about to change. “Bits of destruction” spare no one. (The term bits of destruction was coined by Fred Wilson, of Union Square Ventures, a top-tier venture capitalist who has not been afraid to criticize his own industry and who always innovates.)

Risk capital, of which VC is sometimes a part, is critical to innovation, which is critical to healthy economies. Therefore, this does matter to all of us. In this part 1 of a series, we will look at the four big secular waves of change hitting the VC business.

Two Things to Understand About VC

This post does assume some basic knowledge of how VC funds work. For those who need an ultra-fast primer, here are the two main things you need to know:

1. VCs are intermediaries.
   They take money from Limited Partners (LPs) and invest it in ventures run by entrepreneurs. The principals in the deal are LPs and entrepreneurs, but they never get to meet. Entrepreneurs meet the intermediary, the General Partner (GP), who runs the fund on behalf of the LPs.
2. VCs, the GPs, typically get paid on a “2 and 20″ formula.
   The 2 is 2% of funds under management. So, for a $500 million fund, the partners have to live on $10 million to pay their salaries, keep the office running, etc. Yep, nice work if you can get it! On top of that, they get 20% of the “carry,” which is industry jargon for the profit that the fund makes when a venture is sold.

Stop Moaning About Normal Business Cycles and Other Excuses

VCs know the difference between cyclical change (short-term economic cycles that you deal with tactically) and secular change (long-term fundamental change that you deal with strategically). This is key to their investment strategy. They invest in ventures that can exploit major secular changes. However, many VCs are, at least publicly, in denial about the secular changes impacting their business. The talk by the VC establishment is all about recessionary economic conditions, lack of good investment bankers to take ventures public, Sarbanes Oxley as a brake on IPOs and other cyclical, tactical-level issues.

These are lousy excuses for non-performance. To take each in turn:

• Recession.
  First, recessions come and go within the typical five-year venture time horizon. This is business as usual. Secondly, recessions give upstarts a way to draw the attention of customers to their disruptive value proposition.
• Lack of good investment bankers to take ventures public.
  “My goodness! You mean that if you had a fast-growing, profitable business, you wouldn’t be able to find a bunch of smart suits to take it public in exchange for a fat fee? Could you use a few good introductions?” The problem is more likely a lack of great fast-growing profitable ventures.
• Running a public company in the shadow of Sarbanes Oxley is too hard.
  Seriously, folks. Can’t you find a CFO who can put some decent accounting systems in place? Worst case scenario: let’s say this increases general and administrative expenses by a couple of percentage points. You can’t work around that?

4 Secular Forces of Change

The elephant in the room—what a lot of VCs don't like to talk about—is the fact that the big secular forces of change are not a problem for entrepreneurs; they are a problem for VCs. In fact, so much change is happening that entrepreneurs have more opportunity than ever before. The folks running old established businesses are the ones having a tough time today. And that includes the old established VC funds. The big secular forces of change are threatening their hugely profitable businesses.

Here are the four big secular forces of change impacting the VC business. Each on its own is significant. Together, they amplify each other and could create a fundamental shift in the business:

1. Online transparency,
2. Declining value of the Rolodex,
3. Change to tax on carry,
4. Globalization.

Online Transparency

It used to be that VCs were like the Wizard of Oz at the end of the yellow brick road: not as impressive in the flesh on Sand Hill Road as their expensive PR legend had you believe. That is changing, thanks to three trends:

1. VC blogging and tweeting.
   This is a very positive trend for both parties. VCs get to engage in conversations that drive high-quality deal flow. Entrepreneurs can gauge the quality of their thinking. It is good for all, and empty suits are more easily exposed.
2. A willingness to criticize VCs publicly.
   Historically, anyone who has criticized VCs has been labeled a sore loser who couldn’t raise money. The Funded may be controversial, but VCs have grudgingly come to accept that they can be rated just as restaurants and plumbers can be rated on Yelp. Georges van Hoegaerden is mercilessly analytical in his criticism of the VC industry. Entrepreneurs with a proven track record are willing to go on record. A few VCs are willing to join the critiquing, pointing out that they don’t want to be tarred with the same brush applied to some of their peers.
3. Transparency in deal data.
   The data on which VCs actually base their deals is much easier to find. This makes it harder for a “zombie VC” (i.e. a VC with an impressive name and site but that no longer actively invests) to hide. This has to go much further. It would be great to see real data about exit valuations and returns, so that we can see which VCs are doing well. VCs generally don’t like this transparency (though many of their LPs do). VCs claim that making this confidential information public would harm their portfolio companies. But this is not a valid argument for companies that have exited and are no longer in their portfolios.

This trend towards online transparency looks unstoppable. It will level the playing field somewhat between entrepreneur and VC. It may also cause some commoditization as we get accustomed to rating VCs by hard numbers.

Declining Value of the Rolodex

VCs offer three things:

1. Cash,
2. Contacts,
3. Advice.

Cash is a fungible commodity, so VCs like to emphasize their added value (i.e. numbers 2 and 3). Advice is hard to quantify, and you may prefer to get it from your Uncle Charlie or the Dalai Lama.

So, the VC secret sauce has been their golden Rolodex. You had to pretend to love number 3 in order to get 1 and 2.

In the days of the face-to-face enterprise, selling that Rolodex was critical—actually, more critical than the cash.

But no one funds those deals any more. Ventures now get traction online, one click at a time. Many ventures don’t even list their investors anymore.

Contacts are always useful, even for consumer Internet ventures, but entrepreneurs can now tap LinkedIn, Facebook, Twitter and other sites to avoid the dreaded cold call.

Did Twitter and Facebook scale so quickly because their top-tier VCs made some great introductions?

Chang
e to Tax on Carry

Will the VCs’ 20% carry be treated as income tax or capital gains tax? The 2% is clearly taxed as income. The debate rages on, but there is a strong chance that it would be treated as income tax. Their own capital is not at risk. The politics indicate that it will move that way.

Why does this change the game? Because it will eliminate a big motivation to run a fund. Let’s say that your cash and experience allow you to (A) start a venture using your own seed capital, thereby putting you in control of your own destiny; (B) invest in other ventures directly; and (C) raise money from other people and start a VC fund. Now, look at that decision when A and B are taxed at a capital gains tax rate of 15% (or 0% in some countries) and C is taxed at a marginal rate of 40% or more. Would A and B give you more satisfaction and kudos?

Will the VC option attract only risk-averse financial types who don’t have the confidence to do A or B? Would you want to invest your money with someone like that?

Tax policy does affect behavior. It is designed to do that.

Globalization Hits Lack of Scalability

When entrepreneurs had to establish their business close enough to Sand Hill Road so that the VC could get there on one tank of gas in his Ferrari, a small coterie of insiders could run the business.

Those days are long gone. Regionally in the US, New York now rivals the Valley. Globally, the big growth is in Asia, and European VCs and entrepreneurs are growing in confidence and capability every day.

VC funds have to decide between being local (i.e. being a small firm of partners who can meet face to face every Monday in their office) and going global. The problem is that a VC fund is not a naturally scalable business. If you bring in more partners, you cannot maintain a situation in which all partners agree on every deal. That creates way too much overhead and friction. The need for fast decision-making overrides the standard layers of corporate management approval.

On the other hand, if local partners make the investment decisions, what value would they get from being part of a big global fund (in which the folks way over at head office take a big chunk of their profit)? Is branding really that important? Smart entrepreneurs know that a fund’s name (i.e. brand) is much less important than the individual partner who they deal with.

This is a strategic dilemma for big funds.

We Will Always Have, Need and Reward Risk Capital

This is not to suggest that everyone should bootstrap their business. Some ventures are perfectly suited to bootstrapping, and some need external capital. Risk capital is critical to the innovation economy. We will always have, need and reward risk capital.

At issue is the model for funneling that risk capital to innovative ventures. That is changing.

In part 2, we will look at major criticisms of the current model.

Stuck in a cubicle all day? Hit a brick wall on that project? Not sure what to do next with your life? You need some inspiration, and you’re in luck because the web is full of inspiring stories captured on video. Video is the perfect vehicle for an inspiring story because it can make the story come alive like no other medium.

Below is a list of 7 of the most of the inspiring videos on the web, embedded so you can watch them here. Each video, which range in length from 3 to 20 minutes, has an inspirational message to impart. If you know of any other inspiring videos, please share them in the comments.

1. William Kamkwamba: Harnessing the Wind

William Kamkwamba was 14 when he built a windmill from scrap parts in order to provide enough electricity to power 4 lightbulbs and 2 radios in his home in his tiny village in Malawi. Kamkwamba’s story first came into the global spotlight when he spoke at the TED conference. He recently did a followup TED talk.

Kwakwamba’s inspiring story teaches us to dream big.

2. Jason McElwain: Autistic Basketball Player

Autistic basketball player Jason McElwain spent most of his high school career cheering his team on from the bench as team manager – until the final 4 minutes of his final game as a senior. McElwain didn’t waste any of his opportunity to get in the game, pouring in 7 shots and finishing the game as high scorer.

McElwain, who never complained about being left off the roster, shows us that attitude is everything.

3. Cat Lainé: Empowering Local Communities

Cat Lainé, who is the Deputy Director at the Appropriate Infrastructure Development Group, talked at the BIF-4 conference last year about how she and her colleagues empower communities in developing nations to change from within. Lainé believes in using human capital already within local economies to solve problems and develop solutions that work locally.

Lainé teaches that solutions are often right in front of your nose.

4. Blake Mycoski: Creating Sustainable Charity

Blake Mycoski didn’t just want to start a charity to put shoes on the feet of children who needed them – he wanted to do something more sustainable, something that didn’t rely on asking for donations. So Mycoski started TOMS Shoes, a for-profit company that gives one pair of shoes to a child in need for every pair they sell.

Mycoski’s inspiring message is about the necessity of innovative thinking.

5. Geoffrey Canada: Closing the Achievement Gap

According to Geoffrey Canada the American school system is broken when it comes to teaching children in inner-city schools, and most people wouldn’t disagree with him. But Canada’s inspiring approach to fixing the problem is something that no one before him had tried – a complete overhaul of the social infrastructure. Canada created a “conveyor belt” in a Harlem neighborhood that touches the lives of children and their families from birth through college.

Canada shows us that sometimes you have to take a radical approach.

6. Ben Underwood: Seeing While Blind

Ben Underwood was blind, but while he was alive, he got around almost as well as people who can see, and even played video games with his friends. That’s because he had done something that’s very unusual: Ben Underwood taught himself how to echolocate. Underwood trained his ears to listen for the echoes that tongue-clicking sounds that he produced made as they bounced back off of objects. He then processed that information to figure out where physical objects lie around him.

Though Underwood sadly passed away earlier this year, his inspirational story proves that no obstacle is insurmountable.

7. Lewis Gordon Pugh: Utilizing Extremes

Lewis Gordon Pugh has swum in every ocean in the world, and was the first person to swim at the North Pole, where the waters are below zero degrees centigrade (which is the freezing point for fresh water). Pugh uses his extreme swimming feats to shed light on issues of worldwide importance such as global warming.

Pugh teaches us that you should strive to push yourself to your limits.

See also: Top 7 Places to Watch Great Minds in Action

Image courtesy of iStockphoto, cmisje.