New Funding Models – Part 2
This is the second 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.
Increasing the Success Rate
If there is an unacceptably high failure rate in traditional venture investing, the goal should be to increase the success rate of portfolio companies. This presents four challenges:
Building a pipeline of high quality startups
Invest at better valuations and at an early stage
Mentor and shape the company for better returns
Avoid devaluation at the later stages
A combination of traditional venture strategies combined with strategies from private equity and value investing can meaningfully increase the number of successful portfolio companies and return on investment. This is a model that is more suitable to diverse ecosystems in a post-Silicon Valley future.
Pipeline
The first challenge is discovery. Discovery is pretty easy if you are in the Bay Area or one of the established ecosystems. Even then you will need to be pretty connected to actually be invited to invest in the best deals. But if you are outside the Valley, your chances of getting into those lucrative deals is very low. Just doing the research is a time-consuming and specialized process, requiring a deep network to find, evaluate and successfully filter the thousands of startups in single geographical region. And the cost and effort of filtering and curating those startups for individuals and small family offices on one’s own are rarely worth the benefits.
A successful firm must establish strong relationships with ecosystem builders and startups in specific geographical regions. One must be on the ground doing initial discovery, meeting with and evaluating startups, and working with local investors to divine as much information about the market, founders, and companies as possible. Understanding the industries and verticals best suited to the particular regional market and curating companies based on their ability to capture that market and expand into international markets are also crucial skills.
One advantage is to have an understanding of how culture ordains resources and constraints that shape the business environment for specific verticals. Additionally, it shapes the attitudes and strengths of founders. Value in an early-stage company is found in understanding and identifying the verticals best suited to a particular geography. It is no accident Facebook started in the U.S., and WeChat in China. And that there is not a single successful social media company founded in Europe. Facebook was an extension on U.S. university culture, and WeChat a response to the lack of social, commercial and financial tools existing in post-Mao China. They couldn’t have started anywhere else.
And since culture is so powerful, focusing on that in evaluating the strengths of a team in tackling a specific regional market in a particular market is a powerful curation tool. Most U.S. and even foreign VCs emulate what works in the Bay Area and project it locally. But Germany is not San Francisco, and the companies that will thrive there may not have anything to do with startups that might thrive in the atmosphere of the Bay Area. And successful founders in Southeast Asia might look very different from successful founders in the U.S.
Invest Early at Better Valuations
More importantly, there are better valuations outside the Bay Area and the major US ecosystems. Value investors are clear about the pitfalls of a hothouse environment. Charlie Munger is infamously negative on venture and its various fad investments. And he is correct, investing for value is far superior to FOMO and following trends. As the rapid exit of funds from crypto, blockchain, NFTs and Web3 attest, investing in fads works pretty much like a Ponzi scheme. Early money gets huge returns, and late money is lost. Inevitably, the amount of money piling in causes FOMO, lax diligence, and lax oversight, and when the overall economic environment changes the house of cards collapses. Even Sequoia got burned by FTX.
If instead an early-stage fund focuses on value, risk is mitigated, and not at the expense of ROI. The first cardinal principle in finding value is to not over-invest. One must invest in markets and industries/verticals that are not hot, but instead are well-suited to differentiation and growth and, most importantly, at the early stages are outside the interest of US-based VCs. These startups in our targeted geographic markets generally are not able to tap established VC funds, keeping valuations low and prices reasonable. One can benefit from lower valuations due to a lack of competition from other VCs as the investment has greater value – less costly to invest for a comparable return. Why compete to fund companies that are faddishly hot, generating FOMO and costing more for no greater return?
Mentor and Shape to Increase Returns
Here is where lessons from private equity can have a meaningful impact. Once great companies are found, firms should get involved early and mentor and shape the company for success. Mentoring should focus on the crucial elements of success: corporate and team building, revenue models, and market expansion.
Like private equity, the goal should be to focus companies on the fundamentals of their market and their best revenue potential. Funds should work with founders on short, medium, and long-term goals, encouraging productive management that is focused on executing on the KPIs we set with them to compete successfully in their market and drive revenue. Trust them to execute, but plan crucial corporate infrastructure early to quickly assemble corporate structure when rapid growth starts in order to avoid overwhelming the team.
Avoid Devaluation
Building relationships with teams enables a fund to avoid devaluation by continual investment up to the priced rounds, ensuring the investment has outsized returns. Most importantly, term sheets need to ensure the ability to pro-rata invest in subsequent rounds. If one invests starting at the pre-seed stage, through the seed stage, and finally in a priced Series A stage, a fund can maintain and increase pro-rata shares of the best companies, all the while curating the companies with the best chance of a lucrative exit. This is the only way investors can actually see a meaningful return.
Moreover, the 90%+ failure rate of the traditional Silicon Valley model is untenable in a post-Silicon Valley world. A better objective would be a 50% success rate combined with focusing on early exits to maximize ROI. This may be seen as highly optimistic. However, as outlined above, by re-evaluating the existing model, picking out the best aspects, and combining them with lessons from private equity and value investing, this is an achievable goal. By picking companies with an eye to value, managing them intensively, focusing on crucial KPIs, and building structure early, one can break out of the 90%+ failure rate rut. This is truly avoiding devaluation, the devaluation of an LP investment that is squandered on FOMO-selected, unsupported, over-priced, failed startups.
Align Incentives with Investors
Firms need to take their investor responsibility seriously. The evolution of the traditional VC model has opened a gap between the interests of LPs and the fund managers. The best firms are still focused on the fundamentals and work to find the best companies and bring them to exit, earning their fees and making huge returns for their investors. But the lure of high management fees and the income and lifestyle they enable, for extended periods of time due to the time it takes for a successful exit, provides poor incentives for fund managers, incentives that too many succumb to.
A new model in the post-Silicon Valley world would have better alignment between managers and LPs. Specifically, de-emphasizing fees in favor of manager compensation via exit returns should be the objective. Rather than the general partner/limited partner structure that is conventional, firms would be better served by emulating Sequoia and its Sequoia Capital Fund. Rather than working from discrete funds, misaligning incentives for fund managers, expenses and compensation can be paid from an incorporated entity rather than requiring high management fees over a 10-year period. There are other benefits as well, since their is no need to organize multiple special purpose vehicles for each fund, and the incorporated entity can raise capital independently, and spin off individual funds as it sees fit.
But the main purpose is to re-align LP and manager incentives, giving LPs more confidence a fund investment will result in a better return.
Change
While keeping the framework of the conventional VC model, a post-Silicon Valley fund, particularly one investing globally, needs to reflect the local culture better, and re-learn how to properly align LP and manager incentives. Building pipeline, focusing on value, avoid devaluation, and, most importantly, exploring novel legal structures that focus more on building ROI through increased success rates are ways a modern fund can accelerate success.