Are VCs the new recruitment agencies?

Roughly a month ago I had a lovely brunch with two friends, both currently in the online advertising industry.
Our chat touched on many topics, from crazy Halloween parties to China's media agency.

If you ask yourself "Huh?", the answer is Yes - they are connected in some twisted way.

We finally resolved to talking about the recent burst of small startups, small investments and multiple small exits of companies occurring all around the bay area. Are these signs of a new "tech bubble"?
Some attributes of the current frenzy are similar to previous tech-crazes, but one is unique - the exits are not IPOs but rather many small acquisitions by larger firms, and the investors are not "regular" people doing it through the stock market - they are "sophisticated" angels and acquiring firms.

At one point, I raised my hypothesis that it appears that investors are recently being "exploited " as recruitment agencies by entrepreneurs and acquiring firms.

And it goes like this.

Once upon a time, perhaps 5-10 years ago (or more), founding a startup required significant initial capital. Getting the business to grow and to become profitable, or even with decent traction required on the order of $10M-$20M if not more, except for certain stellar cases.

This caused two phenomena - entrepreneurs had to either raise considerable amounts of money to start a company, or join a large company with a strong financial backing to create their dream products. It was not possible to just "create it and see if it works".

As a result, investors required significant return to let a company be founded, let it grow and then let it be sold. Let's say 5x return would have been considered good. When an acquirer would come, and see that startups spent $10M-$20M, they would know they would be required to shell around $100M to buy the startup to make investors happy.

If you're saying to yourself - "this is not how companies are valued", be aware that sunk cost fallacies are big players in the investor's world, VCs and angels included.

Shelling $100M and upwards is a big deal. Not many companies can do it, and the ones that can really need to justify it to their shareholders, their board, and essentially themselves.

In the last few years, however, it is much easier and cheaper to to start a company. In the Internet business, a founder or two with little or no money can launch a web product. Some very creative ideas have sprung up with an investment of just time, or less than $100k.

This situation is a game changer for two reasons:
1. Talented entrepreneurs (see my post on Talent vs. Business acquisition for the definition of what I call "talented") suddenly have the opportunity to create their dream product without owing almost anything to anyone. Since their passion is many times about the product, and less about building businesses, once the product exists and is a success, it makes sense to be absorbed in a large firm to grow the business.

2. Large firms suddenly found themselves without talented employees. If in the olden days the promise of a big budget and great technology was enough to lure the talented entrepreneurs, today this budget is not necessary, and the technology is easy to create and build. How can you then bring in talented people?

Give them a big "sign-in bonus"! As firms now do not need to compensate investors with large sums for building a product and a business, these sums are transferred as "bonuses" to the startup founders and hopefully a small set of employees.

So why are investors serving as a recruitment agency? The answer is simple - finding which entrepreneur is talented requires to let them (the entrepreneurs) try. Someone needs to cover the cost of this "test", and angels (microfunds, super-angels, anyone) seem to have taken this job upon them.

Their money is used not to build businesses, but to vet future employees. Essentially the smaller investors do not create competition for larger firms, but just strengthen their market position by helping entrepreneurs be acquired early.

They are compensated generously for their investment, but not much value is created through the process - just a lot of trial, error and acquire.