How Venture Capitalists Destroy Innovation

The IT infrastructure market in particular has been hit by an innovation drought since the IPO markets dried up around 2000.

A venture capitalist has one single job: to invest in companies that will become more valuable over time and return profits to investors in their funds, and then to themselves. They do that job best -- with the greatest profits -- when they fund the next big thing and turn the status quo on its head.

That sort of next-big-thing innovation either steals value (as in money) from the status quo (think Amazon vs. retail) or creates net new value where none previously existed (think Google, which created a whole new industry).

For a VC, the investment cycle is completed with an exit: the VC-funded company is sold or goes public. The big exits historically have occurred when a company uses its VC funds to foster innovation and then competes to either crush the existing incumbent at its own game or create whole new games to be played.

But in the technology industry, we haven't seen much of those grand VC investment cycles over the last 15 years. VCs are playing small ball. Most particularly in the area of IT infrastructure, they've stopped building companies that innovate toward the next big thing, and instead have been building companies that merely plug holes in the big incumbents' portfolios. The big incumbents aren't crushed; they're just ruffled a bit, and then they buy up the new company that has a small-scale innovation, and the status quo lives on. I don't blame the VCs for this change in priorities. When the public market dried up in about 2000, the only viable exit left was to sell the VC-funded company to one of the big, deep-pockets guys in the same market. And if a VC is going to have a place in life other than being a role model for blue blazers in the workplace, he has to create returns for his investors (and perhaps more importantly, himself).

For a long while, the IPO exit was pretty much dead. It became clear to VCs that it was a gross waste of time to try to build a company that had better stuff than EMC or Cisco or IBM or whoever. The innovative little startup that you funded might actually be able to pull that off, but then what? Where was the exit? So companies were funded not to become the next Apple, but to become the proverbial "finger in the dike" for a big buyer. Innovation stopped occurring for the market at large and started occurring to plug holes for specific companies. And a lot of times the outcome has been that the startup that was acquired had its innovations shelved so that they couldn't interfere with their buyer's ability to keep collecting money for non-innovative stuff.

This is what has been happening. Just about all of the VC-funded innovation out there has been sucked up by the incumbents. EMC has acquired over 30 companies in the last few years. Cisco has acquired well over 100 since 1999.

There have been exceptions, but they have been few and far between. 3Par and Data Domain come to mind. They had truly innovative stuff and defied the terrible IPO markets to create exits. And in the end, they were acquired, too. At least it didn't happen until after their IPOs and their chance to leave their mark on the world.

This state of affairs won't last forever. But it won't be going away anytime soon, either. The IPO market has just started coming back at long last. But it's going to take a while for VCs to adapt. Recent large-scale innovative successes will certainly get VCs' attention (you know they sat up and took notice last week when Twitter went out at $25 billion). But when it comes to tech infrastructure, how long will it take for truly innovative companies to emerge that can change the way we operate as an IT society? It could be many more years.

Steve Duplessie is the founder of Enterprise Strategy Group, where he is a senior analyst. You can contact him at steved@esg-global.com, and read his blog at thebiggertruth.com.

Read more about management in Computerworld's Management Topic Center.

This story, "How Venture Capitalists Destroy Innovation" was originally published by Computerworld.

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