The existing improprieties in venture capital only exist because we have deployed a piecemeal market model, reminiscent of the Wild West. We can cure its systemic disease, by implementing operating principles to enforce the “capture” of outliers.
I believe it is challenging to build a great company or a sector (that creates sustainable jobs and value) without a high degree of authenticity and integrity. No longer can people, tucked in institutions continue to make false promises or hide behind the skills of others. The merit of the individual will soon start to prevail over the defiance of institutions.
Sex, lies, and videotape
The lies are everywhere in an industry as young and as quickly emerging as technology. Just like the infamous rush for gold during the Wild West, technology has become the breeding ground for more pandemonium than value. On the buy-side and sell-side of technology.
Honesty is a hard nut to crack in California, where the authenticity of silicone boobs is as vigorously defended as the authenticity of silicon valuations. Years of people making good money on riding “the system” yields a formidable defense for its impending change.
The result of the lies in Venture are starting to surface, directly by its performance and indirectly by smart people leaving the “marketplace” and turning the remainder subprime. And just like in any eroding segment a surge of bottom-feeders takes care of the many scraps, making money off of anything that has the hope and desperation to stay alive. With the overhang of a beautiful past, those still in it keep holding on to what once was.
Fuel to the fire
I have been in Venture for more than 15 years (and technology for 30) and personally witnessed from my backyard in Palo Alto how it has destroyed itself, by not being honest, greedy, a lack of discipline or just by not demanding the best. A mediocrity we aim to fix, systemically.
Here is a small collection of what I perceived, based on multiple observations described in one example, as adding fuel to the fire of an already troublesome Venture sector that needs a major overhaul:
Valuations without value
I witnessed a large company acquire a startup for more than $500M, and after doing a post-close deep dive into its financials (ignoring robust political discourse), its actual acquisition value should have been around $100M (at best, using the same multiple). What is disturbing about this is that the malformed exit valuation creates the perception that the initial VC investment in the startup had merit. Its shareholders profited handsomely, have gotten themselves positioned for life, and Venture Capitalists tout their horn – all because the corporate development overlords have not been paying close attention. A good reason why private companies should not be closed concerning how they report earnings. Private should refer only to what type of investors can participate, not its lack of transparency. Examples abound.
I heard from a very reliable source in a company I know well that an acquisition of a $100M-plus startup occurred because the VCs in the deal got nervous, one of the executives at the company described it as “if our last two quarterly numbers were simply flipped, we would not have been forced to sell”. With heavy dilution for the entrepreneurs (not smart enough to protect their turf) and the external board members (with some “top brand” VCs) owning the company, sub-optimal exits are common to save already fragile VC portfolio returns even if it means selling for less than 2x. This is a clear indication of how even the “best” VCs have become subprime.
I also heard from a very reliable source how two large Silicon Valley acquirers called each other and discussed that they did not want to compete with each other on the proposed acquisition price, and one wanted it more than the other. So, they settled on a price (without the appropriate auction battle) together, informing the entrepreneurs at which price and by who the company was going to get acquired. Not only does this process not provide the best value for entrepreneurs, but it also produces a deflated return for Limited Partners (LPs) who rely on high returns to re-commit to Venture.
Spinning wheels with no traction
Many entrepreneurs confuse the pulse of Silicon Valley with what creates value. While it is noteworthy for publications like VentureBeat to record all the innovation and deals that are being done, we need to remember more than 97% of all investments in the last ten years have not led to producing any lasting public value. That, in turn, means that more than 97% of what is described as “hot” is in reality not. And thus new entrepreneurs should not base and bias their ideas on what is described in such publications. They are much better off following their compass and experience. Statistically, entrepreneurs are better off doing the opposite of what is in those publications.
Hundreds of Technology trade-shows like DEMO and the AlwaysOn series (I have been to both once) amplify the problem of institutional VC and “entrepreneurial” group thinking even more. They harvest so-called innovation by technology segment, mimicking the intake criteria of many sub-prime investors. It is precisely for the reason Chris Anderson of TED describes in his introduction video why filling a magazine like Business 2.0 to the size of a telephone book is in no indication of the prosperity or capacity of the industry. TED is so different from the previous conferences because it highlights the outliers of innovation, without categorization, and amplifies its macroeconomic impact and value.
As can be surmised I am a steadfast critic of the role of Venture Capital, having turned predominantly subprime. So, it would be easy for me to align with The Funded in its attempts to rate VCs. And while The Funded is an exciting attempt to start making VCs a little bit more accountable and it has succeeded in erasing the worst of blatant VC misconduct, The Funded is really like a photography site where the ratings of who likes a photograph are in no way in correlation to how well a picture sells. So, the portrayed VC transparency (to unsuspecting onlookers and participants) and the rating is not just a little more transparent; it is wrong. Even more wrong because deal performance is no indication of the viability of producing real success down the road (see how dating doesn’t produce a healthy child) or the health of the sector, especially not when the majority of VCs have become sub-prime, and so have the entrepreneurs who glowingly fall into their trap.
Venture Capitalists that are not
I have written about the lack of relevant entrepreneurial experience of VCs, many of whom have never crossed any chasm in their own lives to be in a position to help their portfolio companies calculate the risk of doing the same. While the previous is debilitating in its own right, many VCs are also poor economists who cannot even articulate the fundamentals of free-market principles. That matters because it means VCs cannot see and evaluate macro-economics adequately (which supplies most of its disruptive value), nor establish the proper funding requirements of a company that depends on it, as the funding requirements of a startup company driving a free-market model is so fundamentally different from those pursuing a proprietary market strategy. So, again, to quote Einstein, “the quality of your theorem defines what you observe,” and what VCs have observed and produced the last ten years is, therefore, challenging their theorem.
Angels that are not
I have done angel deals (as well as VC) and applaud them for taking the extraordinary risk of not only being an active investor but being their LP at the same time. It gives them more credence but not necessarily more merit. Many of them made their money when turkeys could fly, or side winds blew in their favor. Very few earned their money the way a startup intends to, by having an outlandish vision and doing all the hard work yourself to turn it into success. Groups of angels are springing up every quarter now, nobly compensating for the lack-luster investment pace of VC, yet turning technology Venture even faster in a more fragmented sub-prime business than it already has become. Because of the lack of seamless runway support and deflation and fragmentation of risk, more technologies will be built that yield even fewer companies with even less macroeconomic relevance.
The experts that are not
Better hindsight does not translate to better foresight. Especially not in disruptive innovation, where hindsight is considered toxic waste. Time and time again do I see the people with a crafty description of how the world works today, quickly become the heralded experts of how it should work. Forgetting that a better understanding of the way the world works today, especially in Venture, is no indication of how it should and eroding the opportunity for groundbreaking innovation. That valuations are no indication of the health of our sector, and that the number of deals done is not, nor the number of VCs, nor the number of startups. The only thing that matters is a fruitful alpha (portfolio return) for LPs, who supply their asset (money) to the VC. A journalist who takes the reports from Thomson and dissects it earlier than others is not an expert in Venture because of it. A General Partner who is part of a brand name VC firm, and created the problem in VC, to begin with, hanging on to a rambling attachment of external factors should not be crowned the expert in fixing it. With the sector in the dump, it is time to look for solutions elsewhere.
The need for alpha to produce alpha
Now all these aspects seem as impossible to overcome as a dog biting and barking at everyone and everything, but it is not. A dog needs an alpha-model to submit to, in the same way, Venture requires the discipline of a new financial system to keep sane. For the last 20 years, LPs have let VCs run around like wild dogs, and their performance now dictates that they need to be reigned in.
The real improprieties in Venture only exist because we have deployed a piecemeal market model, reminiscent of the Wild West above. Most problems in Venture will be resolved by curing its systemic disease, and by implementing a new free-market system that does not exist in Venture today.
The financial system we propose implements free-market principles that facilitate the removal of bottom-level diversification, the deployment of responsible risk and the reliance on marketplace transparency to all marketplace participants to (re)define merit of innovation.
Only alpha-model discipline can produce the alphas LPs are looking to generate. Venture is not too big to fail, yet without new discipline, it will to the detriment of us all.