Is Venture Capital Broken?

Adeo Ressi, founder of the very interesting TheFunded.com has posted slides from a talk he delivered at HBS on the venture model.  This is a great contribution and hopefully the start of a healthy and public dialogue.  The slides are not easy to digest on a standalone basis, but if you take the time you will learn some interesting things.

1.  The IPO market has been really poor for 8 years.  The venture industry appears to still be coasting on the dotcom craziness from 98/99 and has struggled and will struggle to come anywhere near that level of success.  Reminder: Sarbanes-Oxley is a big reason for the 05-07 issues.

2.  There are 4800 firms (perhaps nationally, but maybe globally).  Sometimes the world feels like it’s Sequoia, KPCB, and Benchmark, but there are many, many firms.  Of course, this creates huge inefficiencies.

Adeo’s background slides don’t do justice to his very good reccomendations.  He has a firm grasp of industry challenges and he knows current process often retards startup momentum.  His solutions:

1.  Fewer Funds to eliminate the chaff that raised capital

2.  Standard terms to yield more efficiency and reduced legal fees.

3.  More investments in many more companies.

4.  Restructured management incentives.

Here are my 3 observations though I could write about this for a week:

1.  More investments means more work.  Venture capitalists believe they add huge value (more than their money) and therefore won’t spread themselves too thin.  In general Venture capitalists work hard, but it’s not investment banking or management consulting.  They don’t work 75 hour weeks.  Usually, VCs are older, wealthier and their pace is different.  Unless Adeo wants the 1000 great firms to hire more professionals, fewer firms will result in fewer investments.

2.  Venture investing is a very lucrative profession once you reach a critical mass of capital in a fund.  A firm that manages $100mm is collecting $2mm just to run itself and that’s only from one fund.  Most firms manage at least two funds over a 10 year period with maybe 4 or 5 years of overlap.  These firms have few professionals and very little support staff.  Salaries are high.  Carried interest pays them very well — if they succeed.  Obviously, if the fund returns are poor, then the partners will have to find new employment, but that’s years and years later.    Adeo wants them to change their incentives and there may be a window for that during this recession.  But this will depend on how limited partners deploy their power.  Will lps force vcs to change?  I hope so, but have not seen that during my career to date.

3.  I don’t think fewer funds are the answer.  Diversified investing approaches are far, far more important.  The groupthink issue really plagues the industry. How many video startups raised money during the YouTube phenomenon?  Highland Capital and General Cataylst, once revered Boston firms invested in Going.com so they could have a social network in the portfolio.   It’s astonishing how fads get followed.  Paul Graham writes about this subject better than anybody.  VCs are not known for their creativity.  Now there are exceptions and a younger generation is far more experimental.  You can see Fred Wilson,  Brad Feld and Raj Kapoor to  a little think differently and try to free themselves from the groupthink.     But these are the exceptions more than the rules.

Josh Kopelman, the most creative VC/Entrepreneur I have met,  wrote an interesting post about how venture firms can really differentiate by creating “structural advantages.” In First Round’s case, there might be hope, but for the most part firms struggle to do this well.  I’ve been to a half-dozen firmwide meetings that were excellent networking events, but did not benefit my startups.    I think TheFunded should explore structural advantage as  litmus test for funds.

Adeo is onto something big with his presentation.  Venture investing will change over the next 20 years.  When and how will be the subject of many posts to come on YallaGuy.

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4 Responses

  1. I think standard terms is the wrong focus; the argument that legal fees are too high and add too much friction to early stage investing is a canard – i’ve done dozens of deals fast and cheap. The market is non-standard for a reason – private companies with illiquid stock – there are no real industry standards (nor should there be).

    I think the best firms do have structural advantages – FR, USV, Spark – I and think those are the ones that orient themselves to real actionable, measurable ways to assist portfolio companies

  2. Andy, I disagree. Standards are very helpful at decreasing friction. I’ve seen a real difference in philosophies on east and west coast on standards. Also, having standards in term sheets is very different than standards in deal documents. When it comes time to do Series A, fees go up because law firms argue over minutiae. I think it’s fine for standards to exist in illiquid markets. Look at Yossi Vardi, he has a standard: it’s 20% for 100k and it’s all common. Everybody gets the same deal, fees are low and friction is low. He also uses it as a litmus test to see who will work with him. Yossi describes himself as “spray and pray” investor so I realize it’s not a standard offer.

    There are also standards for equity packages for non-founding CEOs, and other executives. There are many “standards” in our industry and I think they are useful starting points.

    There are times when standards hinder innovation. I’m thinking of the 2/20 structure of venture firms and how that limits Limited Partner money from finding alternatives to venture firms such as betaworks or seedcamp etc. These kinds of “venture investors” are not well understood by investors who have only known one standard.

  3. […] shares a few thoughts and anecdotes about a lot of the discussion flying around the web about the VC model being broken. James D. Robinson […]

  4. Yes it is – and I’m so glad that we we are working to make some serious changes in this field with Grow VC. http://www.growvc.com will be more than current VC or Angel business model on steroids.

    Grow VC will break the mold and restructure a new better working model for new international start-up ventures. It will change the way new ventures will be funded – forever…

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