- http://venturebeat.com
- http://www.techcrunch.com
- http://valleywag.com
- http://www.avc.com
- http://www.pehub.com
- http://marktomarket.typepad.com
- http://broadstuff.com
- http://gigaom.com
The following statements are available for re-print and re-publication with attribution.
“The Canary is Dead†presentation was delivered to a group of Harvard Business School professors to encourage classroom dialogue about better models for venture capital, before students graduate and enter the workforce with bad training.
The Model is Broken
Investing in entrepreneurship has proven to be economically and socially rewarding. However, the venture capital model of providing preferred equity investments in the $1 to $15 MM range is broken for three specific reasons. First, over 90% of companies that require investment in this range do not receive the capital they need, because they are rejected by the model, discouraged by the process or unaware of the rules. Second, the process of raising the capital has anecdotally proven to destroy shareholder value through enormous time commitments, significant legal fees and deteriorated morale. Lastly, the venture investment model, in its current form, does not generate returns for any of the stakeholders when examined in aggregate or on average.
Despite this flawed framework, the venture capital model has resisted change. Larger sums of money has flowed into the venture capital asset class as a result of allocation tables within prospering limited partners, and venture firms continue to receive the same management fees and economic rewards. The bursting of the Internet bubble eight years ago was an obvious time to re-examine the model. After unwinding bad investments from 1999, many VCs began guaranteeing returns by selling new portfolio companies to old ones at a premium. A small percentage of venture firms threw in the towel, and terms like participation were widely adopted to further protect returns, hurting entrepreneurs.
It’s Time for Change
Now, the venture capital industry faces a second major market collapse in eight years without a substantive period of prosperity in between. Limited partners are pulling billions out of the model, are selling positions and may end up rejecting capital calls. Again, this is an obvious time to re-examine the model. It also seems logical that all of the venture capital stakeholders, from entrepreneurs to limited partners, from the media to industry associations, should be involved in the dialog.
What’s Not Working?
Present day venture capital is in the business of finding a needle in the haystack, finding a truly great company from within the many new businesses formed every year. Let’s look at how the model addresses this challenge.
- First, venture capitalists haphazardly select industry sectors and invest en masse into various companies within a short period of time.
- Next, most venture firms select investment prospects from within their direct networks, and many firms don’t take inbound opportunities at all.
- Third, it is common that every partner in a firm, regardless of their experience, must vote unanimously to approve an investment decision in a specific company as well as the investment terms.
- Lastly, the company is put through a difficult due diligence process that can last multiple months before receiving the investment.
This process results in funding 10% of companies that require growth capital. Many start-ups tailor their operations to the present day venture requirements, creating many false positives for the model. Other start-ups fail at the polished presentation requirements, and get overlooked by the model.
Where Do We Go From Here?
The original presentation at Harvard did not include specific recommendations, as the slides were designed to inspire conversation and new ideas. A few recommendations seem obvious and were added to the slides afterwards.
- First, if the venture capital model is neither effective nor efficient at identifying great companies, then the whole selection process needs to be changed. Right now, a small number of highly filtered companies go through a hazing process to get the capital that they need. Why not make the process and the guidelines transparent, providing anyone in any industry of any gender or race with a fair chance to raise capital?
- Second, the fact that the model has been so resistant to change despite overwhelming evidence of failure means that the incentives and governance of the model are poorly structured. Venture firms earn management fees regardless of their portfolio selection or fund performance, encouraging firms to raise larger and larger funds despite the need for less and less capital among entrepreneurs. Additionally, there is no oversight, regulation, or governance on almost all of the venture partnerships. At a minimum, make the management fees contingent on some performance metrics and introduce a board of directors for the firms themselves.
- Lastly, it seems senseless that there are hundreds of undifferentiated firms serving physically small markets, such as the Bay Area, and it seems equally senseless that the purchase of preferred equity in pre-revenue start-ups should cost $25,000, $50,000, or even $100,000 in legal fees.
Now seems like the perfect time for a reality check in venture capital. Let’s start the dialog and fix the model.
I just think it’s funny that there’s a blatant misspelling of the word “Canary” right there on the first slide. Heh.
Good points, Adeo. I have some additional thoughts on the subject at MTM (http://marktomarket.typepad.com/marktomarket/2008/11/the-future-of-private-equity.html)
i tend to agree the model is broken, altho not sure it’s likely to change all that much anytime soon. i imagine there will be a fair amount of shakeout in the VC industry over the next 2-5 years, at least for funds in the $200M+ range.
i do think there are a few big Tier1 funds that will continue to do well (if only because of perceived brand, but perhaps also some value-added)… however, my guess is that smaller funds — let’s say, <$75-100M — will have a much easier time getting decent returns.
imho, it’s the emergence of seed funds ($10-50M) that will provide some welcome innovation to the industry.
i’m not sure that there are necessarily too many VCs, but there are certainly too many BIG VCs who are more significantly incentivized by fees than return.
there are other criticisms (lack of metrics, lack of transparency, poor liquidity, herd behavior, etc), but on face value the size of the funds under mgmt is probably one of the biggest issues to face.
I am seaching for some idea to write in my blog
It sounds like Tier1 is just plain top-heavy (overmanaged).
So long as strong legal documentation of the invesment & expected returns are in place, VC time is better spent on just making the investment & seeing how far it goes, without meddling in the minutia of a Tier1 business.
The simple comparison is that a watched pot takes forever to boil.
How much return do you expect on $1M? = %15, %25, %50, %100, %200. %300? The general odds against return must justify the amount of investment, versus time spent. After all, how much is your time worth to you?
In the hundreds of millions, or billions in operational assets, expenses, and return there is need for large infrastructure like heavy legal & corporate board oversight, but in the $1-15M range?
Not with the current value of today’s dollar (1/2 gallon of gas) or yesterdays’ (1/4 gallon per 1). Ten years ago that was 1 for 1, and twenty years before that nearly 3 gallons to the dollar.
Back then a million bucks was a million bucks. Now it’s about two bits! …Shave & a haircut, indeed!
Still, when times are calling for pennies from Heaven again, an enthusiastice enterpreneur with a good idea, and wide open niche market can put Tier1 VC to good use.
However, at those levels either the enterpreneur can guarantee a specific return on failure, or promise a higher rate on success.
Heavy legal, managment, coersion, or reportage (the VC who calls 4 times a day, 6 days a week) are just as necessary, effective, or efficient as painting flowers on bullets.
Often at Tier1 levels, the actual return per dollar invested is much higher, without excessive managment overhead & oversight.
Any effort to micro-manage enterpreneurs at levels below the Tier1 cap ($15M), just limits creativity and stifles effort. As they become successful, THERE is where higher levels of scrutiny belong.
Then by our original example; once you’re running the whole kitchen, then the Chef must be aware of everything from soup to nuts.
You hit the nail on the head (although people seem to be saying the same thing ad nauseum without effect). I’m trying to start a new app and am stuck in the awkward position of looking for less than $500k. I’ve been able to put in $15-$20k by cycling some consulting gigs and from savings but there’s a tough spot at around $100k where it’s not realistic to invest money one’s self but there isn’t enough equity at stake for an Angel/VC to get involved. Everybody wants to see friends and family investing but what if the entrepreneur is the one paying for his mom’s bills? What if the entrepreneur’s parents were teachers and the extended family are farmers and mechanics?
It’s not really about equality though. The real issue is that getting financing is difficult AND INEFFICIENT FOR THE INVESTOR. I’m having to create a whole slew of personal relationships, networking, etc… – just to get small amounts of money. While I like being social and getting out there, it’s slow. We need a WalMart model for ‘common’ money (i.e. under $500k using a typical business model). The real issue is that many people could be funded so much more efficiently, with better returns, if the industry was more transparent.
1. Come up with standard best practices and legal documents that follow a ‘wizard’ format so that everybody is following the same methodology. If they don’t want to follow that methodology, than they have to pay the $50k in legal fees. A smart VC could create a wizard for this process and get massive buy-in from the community for less than $100k. If they controlled the levers of what is ’standard’, that would be worth alot more than $100k.
2. VCs and Angels should release into the public domain all business plans and presentations where there isn’t an overriding need for privacy – in which case the document should be redacted but still released. For $20k, a VC or Angel group could do this and gain massive exposure to the entrepreneur community.
Both 1 and 2 are options that actually make sense for an individual firm to do even if the rest of the industry stands still.
Adeo-
These are interesting suggestions but who are they directed at? The current venture model is broken, I agree – but there are a very small handful of firms consistently in the top-decile that make phenomenal returns for their investors, invest in game-changing companies like Google, Ebay, Intel, Skype, etc etc. But the vast majority of venture firms will not – they’ll muddle along with the odd winner but at a portfolio level, their returns will suck given the illiquidity and risk profile of the asset class.
But here’s the rub. LPs continue to fund them. Fund after Fund after Fund. LPs drive fund terms as well – the management fee and carry structure, the clawback provisions, the fund size – nearly everything is negotiated with the LPs at every new fund raising. Yes, there are standards 2 and 20- for instance – but 2 and 20 makes no sense when your last three funds have failed to return capital. Yet, those funds – typically with golden brand names – continue to get funded. Why? Because it’s easier for an LP to invest with a storied, brand name Valley fund that hasn’t had a winning fund in decades- than it is to take a hard look at the asset class as whole and say this makes no sense. Better returns are achievable – far more easily – in lower middle market buy-out funds and with a LOT less risk/volatility.
But I also guarantee you that if big LPs, the Calpers, Harvards, Abu Dahbi Investment Authorities of the world stop investing in VC funds, everyone will be crying “FOUL! No one will fund innovation!”
The combination – ie: generating sufficient returns while funding ‘innovation’ is a very, very, very subtle alchemy. It does work – but only for a handful of funds. The rest blow themselves up in the process.
By the way, an interesting side note: Stanford, at the white hot center of VC and, arguably the biggest beneficiary (at least among Universities) of the venture model – no longer invests in new or even existing venture funds. Why? They did a study a few years back looking at all of the Funds they’ve invested in over 20+ years. And the # was like 300+ fund investments. The vast, vast, vast majority of their venture returns came from just six groups – and of those six, two accounted for more than 1/2 of the those returns. KP and Sequoia. But now, even though they certainly have allocations to both funds, it’s almost not worth the bother. If Stanford invests $10M or $20M into KP’s next fund and KP does a 3X on the fund – extraordinary by almost any measure (not 3X on a deal but on the entire fund), it barely registers into Stanford’s overall return since they’re managing about $17B in total assets.
And hence the real problem. If Stanford leaves KP, there will be 100 LPs lined up to take their place. 1 might get in. The other 99 need to fill up their Venture allocation ‘bucket” and will seek the next best and the next best and the next best after that. They’ll commit to a brand fund of KPs generation but which has rested on it’s laurels for many funds. Or they’ll fund new funds. In short, demand far outstrips supply for quality venture. So until LPs wake up and start demanding budget based mgmt fees, right-sized funds, bigger GP commitments, etc – this broken model will persist. But it will take awhile. With 10 year fund lives, the feedback loop is sufficiently long as to interrupt critical thinking at the LP level.
Alas. Hate to be a pessimist but I’ve seen it all up close.
BRR