New Funding Models
This is the first part of a two part series analyzing the current venture capital model and how it can be made more successful for small early-stage investors: angels, small family offices and high net worth individuals.
The Problem
The Silicon Valley model of 2-3 unicorns making up for 30 other failures has survived because of a cheap capital environment and because success begets success – the earliest firms with the best returns attract the best companies. The model really does not make sense outside that select group of funds. By tagging onto this model, lesser VC firms have grown fat off management fees – and fee-focused firms are mis-aligned with LPs. A series of funds that ensure 10+ years of management fees do not incentivize focused and effective discovery and diligence. Finally, investor examples outside venture, such as private equity funds and value investors like Berkshire Hathaway have much higher success rates because of their greater involvement and fidelity to standards.
To summarize:
A 95% failure rate ensures low ROI outside of the top firms
The current model misaligns lesser VC firms and LPs
At odds with successful investor strategies in other alternative classes
Excessively High Failure Rate
A 95% failure rate is, perversely, a mark of pride in the venture community. The upside of a single investment can be enormous, particularly for the funds that invest early and are able to protect their stake over multiple rounds. This does not describe most funds, in particular funds that have not been in the game in a more expensive money era. And the downside generally means a 0% return. Venture investing has thrived in a cheap money era where alternative high-yield investments are necessary for institutional investors to make their projected long-term returns. For large well-connected institutions, investing with the Sequoia Capitals of the world, this risk is mitigated. But the central fact is that there is a huge difference in returns between successful VC firms and the rest, specifically a 33% differential between the median and highest VC returns, double that of the 16.5% differential for all alternative asset investments.
Moreover, a model based on a 95% failure rate is self-perpetuating, because it disincentivizes prudent behavior on the part of VC partners. Due diligence becomes “follow the leader” and thus it is not properly performed. FOMO becomes endemic – why develop your own pipeline when you can just see where the money is going and follow it. Why concentrate your time on founders? Deeply engaging with founders, spending the time understanding them and their business, mentoring them intensively, is hard work and requires patience, diligence, and lots and lots of face time. Most venture capitalists these days have followed a path from Ivies to Wall Street, and have analytical and fundraising skills, not people skills that allow them real insight into founders and their companies.
Misaligned Incentives
So if a 95% failure rate is not financially rewarding for smaller investors like high net worth individuals, family offices, and angel groups, how is it VC firms are able to raise billions in fund after fund? For VCs, this is not a bug, but a structural feature of the system. The revenue model of a typical fund is known as 2/20 – 2% management fee for every year in the life of the fund and a 20% “carry” or 20% of the return of the fund after LPs have been reimbursed. A fund raising $100 million collects $2 million a year for at least ten years, regardless of investment success. Since startups generally take 5-7 years for an exit, and the cycle has firms raising funds every three years, a firm will raise three funds before lack of success becomes apparent.
This lack of success can be opaque. Often a fund will invest in a later round of a startup heading for exit or IPO, at a time when the return on investment is far less risky, but with correspondingly smaller rewards. So their track record seems to be successful, even when their return on investment is low. A fund can only achieve a high ROI by finding and investing in startups at the earlier stages. Large, successful firms do this by investing in “scout” funds that do the legwork to understand the market and the culture and forge relationships with great founders. The best small conventional VC funds often end up with scout relationships with the big firms. And there are great small firms doing this for themselves.
But most fund managers do the math. It is far cheaper and easier to focus on the fees without doing the work to ensure the portfolio investments will be successful. This is easy to justify in a model with a 95% failure rate. New venture capitalists used to be immersed in the culture of the Valley and networked deeply, with domain expertise and often startup experience. While there are many new VCs who were successful founders, most VCs these days come from Wall Street, having climbed the greasy pole of Ivy League matriculation and made it to a top Wall Street firm before leaping to the Valley. They are not the heirs of the great venture capitalists who built the Valley.
Smaller investors may not see the misaligned incentives and are thus unable to properly evaluate the risk/reward ratio. Data about the returns of VC firms is not accessible and opaque when released. Looking at a track record that merely lists the portfolio companies in which it has invested does not give real clarity into the actual outcome of the firm’s strategy, insight, relationships, or quality. But, as the managers selling you on the fund will try to convince you, the portfolio companies may give the impression the firm has had the requisite success to justify an initial, as well as follow-on, investment. But the only real metric is return on investment, which rarely is clear until the seventh year of the fund. And by then the firm has raised three funds, and the investor is hooked and only realizes the mistake when they have already lost money on their fund investments.
Ignoring Potentially Beneficial Strategies
Venture investing is different. However, it is not so different that strategies from private equity and value investing that they can’t be sources of knowledge for discovery, founder and startup management and fund planning. Because of their more successful outcomes, other asset classes attract far more capital (startup venture capital represents only 2.3% of all alternative assets).
The culture of venture capital follows the startup mantra of “move fast, and break things”. This has been a viable strategy with capital cheap and the ability to fund indefinitely until market capture. But in a more expensive capital environment, and particularly in a market where companies need to get to break-even more rapidly, temperance and discernment should be more valued by fund managers. While there is a considerable information deficit at the early stages, the market, risk factors and quality of the team are easier to evaluate. So applying the basics of value investing and private equity can be powerful tools in venture investing as well.
Private equity firms and value investors both share one simple strategy – find companies that are undervalued by the market and capture that unappreciated value. Private equity captures it by acquiring the company, focusing on the fundamentals, selling off unhelpful assets, installing productive management and selling the company at a premium over the acquisition price.
Value investors invest in companies that: can be easily analyzed, that have management that is focused on building the business and rewarding shareholders, transparency (particularly around the true profits and cash flow of the business), innovation, differentiation and the existence of a moat, and a focus on long-term returns.
Both private equity and value investor strategies can be successfully applied to venture investing, and can help improve returns for smaller investors outside of the older, bigger, and more consistently successful firms. Particularly when combined in a model with market knowledge, strong founder connections, and clarity about the interplay between industry/vertical and geography.