Category: Article

  • Venture Capital’s ‘Knowledge Work’ Problem

    Venture Capital’s ‘Knowledge Work’ Problem

    While GenAI can improve worker efficiency, it can inhibit critical engagement with work and can potentially lead to long-term overreliance on the tool and diminished skill for independent problem-solving. Higher confidence in GenAI’s ability to perform a task is related to less critical thinking effort.

    source: The Impact of Generative AI on Critical Thinking

    This article is broken down into five segments:

    1. Priorities in venture capital
    2. The importance of cycles
    3. Forcing a reset
    4. The ‘knowledge work’ problem
    5. Operating from strength

    Priorities in Venture Capital

    In colder markets, founders just need capital on reasonable terms, and it doesn’t really matter where it comes from. Value-add propositions and brand strength are less important; access to hot companies doesn’t move the needle as much for LPs. Instead they care more about differentiation through strategy.

    In hotter markets, the opposite is true. Investors will be chasing the fastest growing companies in the most attractive categories, out on the thin ice of excess risk. LPs, sold the same dream, care only about how GPs can parlay their way into those deals. How you invest is irrelevant, what matters is your network and your brand.

    Strangely, at the peak things begin to come full circle. In 2021, when there the incredible amount of capital was spread across a record 1,594 firms, there was a horseshoe effect: with such abundant opportunity for investment, LPs and VCs once again saw the opportunity in strategy-driven alpha.

    The Future of Venture Capital Early signs of disruption suggest how the industry may be impacted

    In normal circumstances, the next stage of this cycle is the crash. The firms that leaned the hardest into chasing heat would be the most exposed, with portfolios that are the most obviously out of alignment with value. What’s left are the firms who chose to focus on solid strategy, who can begin harvesting deals in the down market.

    In 2022, this shift was derailed by the emergence of venture banks, designed to escape the typical cycles of venture. The largest firms raised the most capital in subsequent years. Access remained an important part of the story for LPs, especially with the convenient rise of AI.

    In fact, you could argue that this was the second time that cycle was disrupted, as many experienced investors called the top in 2016-2018 only to be thwarted by COVID. Two years of intense, irrational enthusiasm for digital only exacerbated the problem.

    The Importance of Cycles

    Consider how much of the natural world has evolved alongside fire. Wildfires serve an important purpose in preventing ecosystems from choking themselves to death on redundant biomass, and there are even species that have evolved to use fire as a mechanism to spread their seeds.

    Humanities view of fire as a threat, and the goal of suppressing it entirely in the natural environment, has had disastrous consequences. We have seen the emergence of ‘mega-fires‘, where biomass accumulates to the point where spread is fierce and inevitable.

    There are clear parallels here in venture. The extent to which the market is suffering today is proportional to the amount of time it took to hit a correction. What’s worse, for reasons described above we haven’t yet really allowed the full cycle to complete.

    Forcing a Reset

    While venture banks steam off into the distance, and venture capital tries to figure out how to navigate this environment, there are three signs of change.

    • Increasingly, there’s talk of smaller LPs like family offices looking to pursue direct investing strategies. In theory, this affords them a similar level of risk with better economics, but questions remain about their bandwidth to do this properly.
    • There’s been a surprising number of high profile GP departures, both launching their own funds and not. In many cases, this means partners are giving up wharever carry incentive they had. This suggests some discomfort in the status quo.
    • An increasing number of founders talking about bootstrapping or ‘seedstrapping’ (one and done fundrasing), or other strategies to avoid the problems assocaited with getting on the venture capital treadmill and the expectations involved.

    For the GPs that remain, it’s time to consider what the world would look like if the cycle had completed. How would they be forced to act in a truly ‘down market’ environment. Indeed, if you consider that many smaller firms have been priced out of AI, that may already feel like their reallity.

    It is clear that the bar for performance is significantly higher in a cash constrained environment with higher interest rates. While that may not change the reality for venture banks, it is existential for traditional venture capital.

    The ‘Knowledge Work’ Problem

    In hot markets, where investors take a prescriptive approach to investment, there is a huge problem with atrophy. Completely separate to the poor investments that come out of these periods, it’s also worth examining the practices they establish.

    Investors that spend all of their time chasing hot deals based on a number of set criteria have the same basic problem as knowledge workers that rely on Generative AI solutions: they are not using their critical thinking muscles. Executing orders, not problem solving.

    Consider how little actual thinking you have to do about an investment if your process is focused on second-order factors. Is it on an a16z market map, is it on YC’s Request for Startups, are other “tier 1” investors are in the round? Will downstream investors will give you the markups you need, and will LPs will be excited about it?

    This behavior, geared towards capital velocity, is focused on second order information and pattern matching. It is a prescriptive approach that informs what gets investment, displacing the first-order considerations about things like team, opportunity, valuation, market and strategy.

    This dissertation focuses exclusively on moral hazard, which refers to a venture capitalist’s propensity to exert less effort and shirk their fiduciary duties to the investors to maximize their self-interest; specifically, a VC’s propensity to choose subjective selection criteria over more cognitively taxing objective criteria when faced with multiple options and fewer resource restrictions.

    “Venture Capitalists’ Decision-Making Under Changing Resource Availability”, by Noah John Pettit

    While this approach might broadly work for venture banks, with an army of low-impact investors looking to index across new technology trends, it will not deliver the returns required by the traditional venture model.

    Operating from Strength

    The contrary to prescriptive investing is quite literally the hunt for outliers. Backing illegible companies. Being consensus averse. Resisting what have been the loudest models.

    This might sound like cowboy investing. A Rick Rubin-esque vibes based approach to venture capital. It certainly can be, and if you happen to be Rick Rubin it might just work — but why take the risk?

    The way for these investors to operate from a position of strength is to build process alpha. That is, do everything you can to prevent being wrong for predictable reasons (controlling for bias), and to manage the risk of being completely wrong a lot of the time (portfolio construction). Not to overintellectualise investment decisions, but to give yourself the strongest foundation to embrace the risk of uncertainty.

    To take the analogy a bit further, for all that Rick Rubin is a total eccentric, guided by his own taste without the need for external validation, he is not cavalier about it. He pays immense attention to environment and routine in order to help him get the best return on his time.

    There’s never a need for investors to stray from this disciplined mode of operation, it just so happens that most are prey to the cycles of venture capital and the temptation to inflate fees when opportunity arises.

    Discpline is easy when opportunity is limited.

  • Escaping the Cycle

    Escaping the Cycle

    I had a meeting once with Howard Marks, who I had wanted to meet for a long time. He’s a famous bond investor that does a lot of writing. For 15 minutes he asked me questions about the venture industry, a lot of structural questions, and I answered him as best I could. 

    He said, “That’s a really shitty industry”. I said, “Why do you say that, what do you mean?”, and he said “Cyclical collapse is built into the structure.” 

    Bill Gurley on his conversation with Howard Marks, All In Summit, May 2022
    “VC Downturns“, by Ali Afridi of Equal Ventures

    ‘2024’ could have been a short chapter in the history of venture capital. Another post-boom year of declining deal activity, recovering valuations, recaps and shutdowns. We left it with the public markets looking healthy and hope that IPOs might reappear on the horizon. All good reasons to flip the page to 2025. 

    Before you move on from 2024 entirely, consider the boiling frog. Venture capital has been quietly outgrowing traditional definitions over the last 15 years. Last year, as AI drove heat into a cool market, the cracks started to appear. 

    The venture capital industry has historically worked as a relay race where investors at one stage bring in the next stage of investors to fund and support companies as they scale. Right now, it feels like AI investing breaks this model in a few important ways.

    Charles Hudson, Managing Partner at Precursor Ventures

    This isn’t just about inflated valuations, overcapitalisation and ZIRP. It’s about the effort of a few firms to outgrow the boom-and-bust nature of venture capital through a new model for investing. 

    Consider the well documented rivalry between Andreessen Horowitz and Benchmark, with their opposing views on capital abundance in venture. 

    Bill Gurley declined my requests for comment, but he has publicly bemoaned all the money that firms such as a16z are pumping into the system at a time when he and many other V.C.s worry that the tech sector is experiencing another bubble. So many investors from outside the Valley want in on the startup world that valuations have been soaring: last year, thirty-eight U.S. startups received billion-dollar valuations, twenty-three more than in 2013. Many V.C.s have told their companies to raise as much money as possible now, to have a buffer against a crash.

    “The Mind of Marc Andreessen“, by Tad Friend

    Benchmark has set the standard for “traditional” venture capital, managing small and efficient funds, close relationships with founders, and exemplary returns. In contrast, Andreessen Horowitz represents the era of ‘capital of a competitive advantage’; a confluence of hyper-scalable SaaS, digital growth channels, and historically low interest rates. Not merely a competing venture strategy, but the emergence of a fundamentally new product that trades efficiency for scale.

    The divergence of Andreessen Horowitz (and a few similar firms) from the traditional playbook has created some confusion, as greener GPs attempted to emulate aspects of both. Lacking either the AUM of Andreessen Horowitz or the discipline of Benchmark, they inevitably hit the slippery slope of badly managed risk. This can also be seen in the muddled logic on topics like entry multiples, valuation and concentration, where the ‘common wisdom’ has often made little practical sense. 

    Fortunately, there is light at the end of the tunnel: As this new product is better understood by LPs, GPs and founders, the chaos is better controlled: LPs will have more realistic return expectations, benchmarks and timelines. GPs will be able to identify coherent strategies and compatible advice. Founders will have a clearer choice between traditional venture capital, and the new model of “venture bank”, and the expectations associated with each.

    Too Big to Fail

    In 2009, with the launch of their first fund, Ben Horowitz and Marc Andreessen slipped into the role of VC brilliantly. They had strong opinions about capital efficiency and portfolio structure, a level of sophistication that surpasses many of today’s GPs.

    Despite the success of that first outing, capturing huge outcomes like Skype, the market soon presented a new opportunity. In 2010, rebounding from the GFC, incumbent firms were raising funds in excess of $1B—a throwback to the dotcom exuberance that Benchmark had criticised. Institutional money was once again on the hunt for new opportunities and software had begun ‘eating the world’.

    As entrepreneurs (another contrast to Gurley) Horowitz and Andreessen felt no loyalty to the traditional playbook. They saw an opportunity to innovate; the chance to build a scalable model for venture capital and take a dominant position. So, they invested heavily in media to build a ‘household name’ brand. They sought network effects by launching scouts programs and accelerators. Platform teams were assembled to handle their growing portfolio. Rather than an investment team, they built something more like a sales force. Essentially, they exploited a “boom loop”: raising money to maximise exposure, manufacture category winners, distribute healthy markups and raise more capital. In this environment, venture capital became a cutthroat zero-sum game with very little discipline. 

    Some of the VCs who funded predation succeeded spectacularly, and the basic incentives of venture investing that tempt VCs to employ this strategy persist. The goal of antitrust law is to push businesses away from socially costly anticompetitive behavior and towards developing socially valuable efficiencies and innovations. We think that Silicon Valley could use a nudge in that direction.

    “Venture Predation“, by Matthew T. Wansley & Samuel N. Weinstein

    Jump to mid-2022, and the post-ZIRP hangover experienced by the venture market. Almost everyone had gotten caught-up during the decade of near-zero interest rates capped off by pandemic-driven irrationality (except Gurley, who had stepped back from Benchmark in 2020). The critics of the Andreessen Horowitz model began to emerge, pointing to their inflated check sizes and irrational pursuit of “Web3.0”. Now, like everyone else, Andreessen Horowitz would surely suffer from falling returns and backlash from LPs? 

    It happens that Andreessen Horowitz raised more than $14B in new funds during the first half of 2022, close to the combined total of their funds raised in the preceding three years. They were well prepared for the fundraising winter of 2023, a year which many large firms used to rebalance their portfolios through secondary transactions—playing on the extreme heat around companies like OpenAI, SpaceX and Anduril. 

    In 2024, as the slump continued (down roughly 50% from the funds raised by VCs in 2020 and 2021) Andreessen Horowitz came back and raised another $7B. In fact, the 10 largest venture banks raised more than half of all venture dollars last year. The firms that had contributed most to the collapse were suffering from it the least. How could this be? The outcome frustrated many smaller GPs who had been squeezed out of deals and were having a harder time closing funds. 

    Plans Measured in Decades

    If you want to build a venture bank, you need billions of dollars on a regular basis, and it needs to be truly patient capital. Not high-net-worths, not family offices, perhaps only the largest pension funds and endowments. Most of all, you need sovereign wealth. 

    This transition away from venture capital’s traditional LP base was the central gambit of venture banks. With performance stabilised by the scale of their AUM, the ability to extend into other assets and an internationally recognised brand, they are able to court some of the world’s largest pools of capital. Rather than hunting alpha, they farm ‘innovation beta’—indexing across as much of the fast-growing tech market as possible, with exposure to every hot theme, at every stage, both private, public and tokenised. 

    A lot of the detail is lost when you’re operating at that altitude. Valuation, consensus, discipline, markets… they all matter less if you’ve escaped the typical venture capital fund cycles. Liquidity can be delivered through the secondary market, continuation funds, distributions of public stock or sales of crypto holdings. If it’s a tough market for IPOs, you have the scope to wait it out. When there’s a ‘liquidity window’, like 2021, you can jettison as much as possible—as quickly as possible. 

    If success in venture capital is primarily about being in the right place, at the right time, the proposition of venture banks is to be everywhere, all the time.

    Our results suggest that the early success of VC firms depends almost entirely on having been “in the right place at the right time”—that is, investing in industries and in regions that did particularly well in a given year.

    “The persistent effect of initial success“, by Ramana Nanda, Sampsa Samila and Olav Sorenson

    There is also opportunity in this bifurcation for GPs at traditional firms. While venture banks smother consensus themes, they do so on behalf of this new class of supersized LP. For everyone else, there should be less competition in the traditional LP base—once they recover their enthusiasm for the asset class. 

    The shift obliges smaller firms to focus on non-consensus themes—which they should have been doing all along. Access to ‘hot deals’ is no longer a core proposition for LPs, as it becomes clearer that the juice isn’t worth the squeeze. Instead, GPs should focus on evergreen investing theory. This includes portfolios structured to optimise for outliers and manage risk and a sourcing process that minimises bias, or what Joe Milam calls “Process Alpha”.

    The conventional venture model relied on the power law to rationalize overly concentrated portfolios and “hot deal chasing” when basic portfolio management theory emphasizes (non-systematic) risk management through diversification.

    “How to Construct and Manage Optimized Venture Portfolios“, by Joe Milam

    Essentially, venture capital goes back to being a positive-sum game that effectively finances innovation, and looks less like a ponzi scheme.

    A number of other positive consequences could emerge from this correction: 

    In moving away from consensus themes, VCs will be forced to develop an approach to understanding the value in novel propositions.

    So much funding in the valley has rushed towards the consumer, at the expense of what we would argue are more significant projects.

    Nicholas Zamiska, Office of the CEO, Palantir

    Some of that shift has been cultural, but much is simply that the pervasive practice of pricing with ARR multiples has favoured well-understood segments over the last decade. Deep tech and hardware suffered because VCs simply weren’t sure how to put a price tag on those companies. 

    Calculating or qualifying potential valuation using the simplistic and crude tool of a revenue multiple (also known as the price/revenue or price/sales ratio) was quite trendy back during the Internet bubble of the late 1990s. Perhaps it is not peculiar that our good friend the price/revenue ratio is back in vogue. But investors and analysts beware; this is a remarkably dangerous technique, because all revenues are not created equal.

    Bill Gurley, GP at Benchmark

    As VCs develop a keener and more independent sense for value, the exit pipeline begins to look a lot healthier. Metrics that look at financial health in addition to sheer growth of revenue will more effectively align companies with the expectations of both public market investors and prospective acquirers. Like the old days of venture, much of growth and prosperity will be available for mass market retail participation — which is great for the ‘soft power’ of tech. 

    Some of the world’s most highly valued public tech companies entered the public markets with quite modest valuations, at least by today’s standards. Microsoft, Amazon, Oracle and Cisco all debuted with market caps south of $1 billion. Of those, only Microsoft topped $500 million. This translated to relatively modest gains for their private market investors, compared to the massive value appreciation they have all experienced post-IPO.

    “Who’s reaping the gains from the rise of unicorns?“, by Adley Bowden

    On the other hand, venture banks who have developed monster companies like OpenAI, SpaceX and Anduril, will be able to keep tapping into this expanded pool of private market capital via secondaries. Where companies are strategically sensitive, particularly in the realms of AI or defense, this may be seen as preferable to public company disclosure requirements or the threat from activist shareholders. 

    Secondary markets also represent an opportunity for traditional venture capital. As managers pick up better standards for valuation, providing greater transparency and explainability, activity is bound to increase. This means more options for liquidity, more consistent buy-sell tension to keep prices under control, and participation from a more diverse base of investors. Finally, it also offers greater cap table flexibility to founders and early investors.

    Let’s be realistic here; you’re better off in the fullness of time if certain players are in your cap table, and not a seed fund. 

    Mike Maples, Jr, Co-Founding Partner at Floodgate

    Clarity Precedes Success

    2025 should mark the end of confusion about venture banks and their role in the ecosystem. After a decade of increasingly confused standards and benchmarks for traditional VC, the two products have been neatly split by the wedge of AI.

    This is an opportunity for rehabilitation, as the confusion around the change has created more issues than the change itself. Both sides are now able to lean into their strengths, consensus vs non-consensus, alpha vs beta, and deliver the commensurate returns to LPs with matched expectations. 

    Make no mistake, 2025 will be a crucible for venture capital. The divergence of exits from public market performance is worse than ever, and confidence is low. Despite this, there seems to be a resurgence of smaller firms raising capital—matching historical patterns where incumbents lead the rest of the market by a year. 

    Critically, how will smaller GPs execute in the new environment? Will they learn the lessons from the last five years and play to their strengths? Or will they keep trying to span the chasm of small fund risk tolerance and large fund risk appetite? 

  • Venture Banks

    Venture Banks

    In venture capital circles, the most widely discussed trend of 2024 (outside of AI) has been the concentration of capital into “venture banks” like Andreessen Horowitz, General Catalyst and Thrive Capital. The household names of venture capital have had a blockbuster year, while others carefully ration the tail-end of their last fund. 

    The first quarter opened with Andreessen Horowitz and General Catalyst scooping up 44% of the available capital. 2024 is closing on a similar note, with 9 firms having captured more than half of all funds raised so far. The 30 most capitalized firms this year collectively represent three quarters of the pool raised by at least 380 funds. 

    However, the real anomaly is not how much the large funds have raised, but rather how poorly everyone else has done. Why has the bottom fallen out of the market for smaller funds, if the giant firms are still able to vacuum up capital? 

    There are a range of opinions on this question: Consider the insights shared by Sam Lessin, in The Venture Capital Regatta; Yoni Rechtman in Return, Bifurcation or Megafund Dominance; or Charles Hudson, in Three Future States of the Early-Stage VC Ecosystem. Both are respected investors with valuable perspectives but a slightly different set of base assumptions, so triangulating on objectivity is difficult. 

    Ask a hundred GPs or LPs where they draw the line between small funds and large funds, or how they define multi-stage and multi-sector strategies, and you will get a hundred different answers. The lack of standard definitions and common understandings has dramatically hindered productive discourse about venture capital over the years. 

    Importantly, it has obscured the manner in which multi-stage venture capital has diverged from the rest of the market. Today, it operates a novel model for startup investment, targeting a new class of LPs with a very different premise.

    A Rapacious Playbook

    In 2011, Jay Levy of Zelkova Ventures wrote an article about the conflicting interests involved in insider pricing. His point was simple: when investors led rounds for existing portfolio companies, their desire for greater ownership would be outweighed by their need to show performance. 

    Two things are striking about this article:

    1. Jay’s concern probably seems alien or overly-dramatic to anyone who entered venture capital within the last decade. Today, it’s just the game on the table. 
    1. It is also likely to be the single largest contributing factor to the pricing bubble that grew during ZIRP and exploded in 2022, if you follow the incentives created. 

    In a rational market, where VCs are all stage-specific, each round of investment has a different lead investor. That means, at regular intervals in the company’s development, it will be valued by a neutral third-party. Outside investors that want to maximize ownership will go up against founders that want to limit dilution. From that tension, we expect a generally fair outcome to emerge. 

    Venture capital relies on this tension, and the increasing financial savvy of investors as the investment moves downstream, stewarding companies toward exits. From qualitative analysis at the earliest stages to the quality of cash flow at maturity; you move the dial from founder strength to financial performance as you go from pre-seed to IPO, and so the expertise of investors evolves in parallel.

    Multi-stage firms have a different (and fairly rapacious) view on this process. Instead of inviting scrutiny of the value of their portfolio companies, their strategy is to keep that in-house, or within a network of associated firms. Rather than rational pricing through the tension of buyer and seller, they have embraced the jagged edge of what Jay Levy described: why worry about valuation if pricing can be a competitive advantage? 

    Want 3-4x markups on investments to show LPs? Just do subsequent rounds at 3-4x and get them rubber-stamped by networked investors. With “performance” taken care of, it’s easier to raise more capital to feed portfolio companies, fuelling aggressive growth to grow into those markups. It’s putting the cart before the horse, compared to conventional venture thinking, but it has a certain brutal charm.

    So, we’re beginning to see that the ‘capital as a competitive advantage’ playbook didn’t expire with ZIRP. A decade of cheap capital was what it took to prove the model, and today it just needs a different class of LP to back it. Indeed, multi-stage GPs appear to have spent 2023 with their heads down, consolidating around the best-looking secondary opportunities (SpaceX, OpenAI, Anthropic, Anduril) ahead of a grand tour in the Middle East. Sovereign wealth, with giant pools of capital and no great pressure on liquidity, are complementary to the traditional large institutional LPs for this strategy. 

    Exploiting Venture Capital’s Flaws

    As multi-stage firms have expanded their funds under management, they’ve had to similarly scale their ability to capture market share. This has been solved through a fairly innovative list of features, each of which exploits a different dynamic of venture markets: 

    Platform Teams: Leaning into size as an advantage, multi-stage VCs have built platform teams with the advertised intent to offer support and resources to portfolio companies. In reality, portfolio teams are the serfs of the venture world, managing the burden of a large portfolio for a relatively small team of partners while generally adding little value for founders. 

    Signalling Risk: VCs are wildly vulnerable to herd behavior. An example of this is “signalling risk”: concern about the signal of how other investors respond to a startup. Despite being obviously silly, this essentially means “tier 1” firms get prima nocta on every founder they touch, so they scoop them up en masse with scout programs and EIR initiatives. 

    Backing GPs: While the rest of the market struggles, multi-stage funds can raise additional vehicles through which they become LPs in emerging managers. They look like the good guys, supporting the underdogs, broadening the market and encouraging competition. In fact, they are entrenching centralized positions in the relationship model of venture capital.

    Operator Investors: In the last decade, there has been an ideological shift towards the idea of ‘operator investors’. Former founders are seen as the ideal archetype for venture capital, having first-hand experience building companies. As it turns out, they don’t really make for better investors, they’re just extremely well networked and have credibility with founders.

    Procyclical Pricing: A huge amount of valuation wisdom has been discarded over the last decade, as the industry as a whole adapted to deal velocity with cruder pricing models—e.g. revenue multiples, raise/ownership, etc. These common practices lack critical specificity and amplify volatility in the market, a problem for venture firms that rely on rational pricing.

    The Value of Venture Beta

    The product of this multi-stage approach to startup investment is “venture beta”: returns will broadly track the market, while they expand in network, assets, and market share. For the largest institutional LPs, like sovereign wealth, this is fine: acceptable returns with minimal volatility, and they can brag about funding innovation with the support of the most prestigious firms.

    Further out, this model’s success depends on whether it can produce companies that are attractive to public market investors or private market acquirers. Up to now, large infusions of capital with crude pricing have produced sloppy, undisciplined businesses. The IPO market is still reeling from being force-fed companies with poor financial health in 2021. Whether this misalignment can be fixed, or is inherent to the strategy, has yet to be seen.  

    Some early stage VCs have commented that multi-stage VCs still rely on small, contrarian firms to identify opportunities before they are ‘legible’. It seems more accurate to say that small firms are just another source of signal about new market opportunities for the mutli-stage strategy, rather than a crucial part of the chain. Scout programs, hackathons and accelerators all create redundancy for the competence of small firms in this capacity. 

    For Those Seeking Alpha

    While historical patterns would indicate that the funding will bounce back for everyone else next year, it is worth some urgent reflection on how the growing share of multi-stage capital influences the market. 

    In the short term, multi-stage firms tapping into a new LP base shouldn’t have a huge impact on smaller funds, although many of their usual LPs will be spooked by the shift. GPs should have a good answer for how they adapt to this reality. How can they compete against the capital, network and brand strength of multi-stage firms in future? With increasing skepticism about the “value add” from venture capitalists, what do they offer founders that the multi-stage firms can’t?

    For GPs with high domain expertise in hard sciences, there is enough evidence of outperformance to differentiate them from large generalists. For everyone else, the burden of proof is going to be higher than ever, and will require becoming disciples of venture theory: Read everything there is about portfolio construction, historical performance, decision making, biases and strategy, and build a rock-solid case for LPs that you deliver on the two critical fronts:

    1. The potential to deliver excellent returns, in contrast to the mediocre performance of the largest firms. Not by swinging for the fences on every hit, but with properly optimized portfolio, price discipline, and solid understanding of the underlying theory. 
    1. Backing the best founders with the most important ideas. However good a multi-stage fund gets at identifying early stage opportunities, their model will always bias towards consensus themes and capital-intensive ideas. It is a limitation. 

    Essentially, GPs of smaller funds need to meet divergence with divergence, and embrace the strengths of their size and strategy: contrarianism and discipline, which amount to a form of value investing for early stage companies. Finding the easily overlooked. The alpha. 

    The Fork in the Road

    Multi-stage GPs spent the last decade cosplaying as VCs, despite their practices being opposed to the conventional rationale of venture capital. You can’t make good judgements about price vs value or question consensus themes if your existence is predicated on assigning arbitrary markups and chasing the hottest companies.

    Over the last decade, many VCs have sought to emulate “tier 1” multi-stage behavior, acting out what they believe LPs and peers expect to see despite the fundamentally incompatible models. This herding around identity and behavior reflects the extreme level of insecurity in venture capital, a product of the long feedback cycles and futility of trying to reproduce success in a world of exceptions. It has also produced some extremely poor practices, and bad attitudes.

    The more VCs study the history, theory and current reality of private market activity, the more conviction they can develop about their own mindset as investors. The more confidence they have, the better they will fare as individuals in a discipline where peer-validation is poison and the herd is always wrong.

    If that’s not for you, then there is a lucrative future to be had working at a venture bank. 

    But you need to decide which path to take. 

  • Venture Capital Abandoned Deep Tech and Is Paying the Price

    Venture Capital Abandoned Deep Tech and Is Paying the Price

    The venture capital industry, once lauded for its role in fostering innovation and technological breakthroughs, has lost its way. The pursuit of hyperscalable software companies, fueled by incentives tied to management fees and opaque valuation practices, has led VCs to prioritize short-term gains over long-term value creation.

    This shift has effectively sidelined deep tech startups in favor of software ventures that, while initially promising high margins, often end up as structurally unsustainable and unattractive in the eyes of public markets and acquirers.

    The liquidity crisis and the collapse of valuations post-2022 are, to a large extent, the result of this myopic focus.

    Markups, Management Fees, and Misaligned Incentives

    The core problem lies in how venture capital funds are structured. Many VCs earn their income primarily through management fees, which are a percentage of the assets under management (AUM). In this framework, VCs are incentivized to raise as much capital as possible and deploy it rapidly, not necessarily into companies with the strongest long-term potential, but into those that will generate high markups quickly. The logic is simple: markups create the illusion of success, which can then be showcased to Limited Partners (LPs) as evidence of strong fund performance, enabling VCs to raise subsequent funds and further increase their management fees.

    However, the criteria for these markups are alarmingly arbitrary. Without standardized metrics for valuing private companies or clear data collection methods, VCs have significant leeway to set valuations that align with their own interests. The result is an ecosystem that disproportionately rewards companies that raise as much capital as possible, at the highest valuation they can achieve, regardless of their underlying business fundamentals.

    This creates a vicious cycle where capital-intensive, rapidly scaling software startups are favored over deep tech ventures. The latter, which often require years of research and development before reaching commercial viability, do not fit neatly into this model. They lack the frequent fundraising rounds that VCs rely on for quick markups and cannot be easily measured using ARR multiples which have become the venture capital industry’s (moronic) North Star.

    A Crisis of Venture Capital’s Own Making

    The 2022 downturn in venture-backed company valuations, especially in the SaaS sector, was a long time coming. For years, VCs funneled billions into software companies with the promise of high margins, rapid user growth, and scalable business models. But as these companies matured, the flaws in this strategy became apparent. Many of these SaaS businesses, initially rewarded for their revenue growth, began to reveal cracks in their unit economics and competitive moats.

    In the public markets, where profitability, defensibility, and cash flow become the ultimate measures of value, these companies failed to meet expectations. The high-growth software playbook that worked so well in the private markets could not withstand the scrutiny of IPOs or M&A, leading to today’s slowdown in both exits and later stage valuations.

    The outcome? VCs are now sitting on portfolios filled with overvalued, underperforming software companies. The lack of attractive exit opportunities has created a liquidity crisis, trapping capital in companies that may never deliver the returns expected.

    The Opportunity Cost

    Amidst this frenzy for rapid scaling and quick markups, deep tech has been left behind. Yet, ironically, it is these deep tech companies—whether in biotech, space tech, or hardware—that have the potential to deliver outsized returns and societal impact. Unlike SaaS companies that can be replicated with relative ease, deep tech ventures are built on defensible intellectual property, technological breakthroughs, and years of research. Their competitive moats, while difficult to establish, are significantly harder to erode.

    Deep tech is fundamentally misaligned with the current VC incentive structure.1 These startups will take much longer to mature. They may not need to raise subsequent rounds until they have proven their solution, which may mean lengthy R&D cycles without easily measurable increase in value. This means fewer markups, less frequent fundraising, and, consequently, less “performance” to show to LPs.

    The paradox is that while deep tech may not deliver immediate returns, its potential for outsized impact—both in terms of financial returns and societal benefits—is far greater than the current crop of SaaS investments. If successful, deep tech companies can redefine industries, create entirely new markets, and generate returns that are an order of magnitude higher than those seen in the overfunded software space.

    The Return to Venture Capital’s Roots

    The original mission of venture capital was to take on the risk of funding transformative technologies that traditional finance would not touch. Semiconductors, biotech, and early internet technologies were all enabled by patient capital willing to bet on the future. However, over the past decade, this ethos has been replaced by a focus on capital velocity, management fees, and the illusion of quick wins.

    The solution to the current crisis is not simply more capital or better timing. It requires a fundamental realignment of venture capital with its original purpose. This means rethinking how funds are structured, how incentives are aligned, and how performance is measured. VCs need to shift away from the obsession with ARR multiples and markups toward a focus on genuine value creation, technological defensibility, and long-term impact.

    In essence, the liquidity crunch facing the VC industry today is self-inflicted. By prioritizing short-term returns over sustainable value, VCs have created portfolios filled with fragile businesses ill-equipped for the demands of public markets. A return to deep tech, with its focus on defensible, transformative technologies, offers a path forward—not just for the VC industry but for the broader economy.

    The future of venture capital should not be in chasing the next SaaS unicorn but in rediscovering the roots that built the industry: funding the innovations that will shape the next century. The hard pivot toward deep tech is not just a strategic necessity—it is a return to the true purpose of venture capital.

    1. While there are welcome signs of a hard tech rennaisance in places like El Segundo, it remains an uphill battle and is largely misaligned with venture capital incentives. Indeed, the fact that companies like SpaceX and Anduril had to be started by billionaires is evidence of venture capital’s failure. [↩]
  • Why venture capital should embrace divergence

    Why venture capital should embrace divergence

    In the last post, I talked about the hunt for liquidity in VC and the role that transparency has in building a healthy secondary market.

    To take that further, we should look more carefully at the structure of venture capital, the direction the asset class is moving, and lay out a direction which can address the question of stronger secondaries and access to liquidity.

    Venture capital spent the last decade pulling itself in two. The vast amount of capital resulted in the expansion of early investing while also keeping companies private for much longer. The role of a GP is now more specialised, with a greater focus either on the qualitative metrics at early stage, or the quantaitive metrics at later stage.

    This divergence is new enough that it still causes significant confusion; it’s easy to find people talking at cross purposes because they exist at opposite ends of the market. The differences are so fundamental that they are practically separate asset classes.

    It is in these differences that the future of venture capital lies: the value unlocked by embracing the divergent strengths of early and late stage managers — with the former selling significant stakes from their portfolio to the latter.

    This could represent a major positive development for venture capital, for a number of good reasons:

    • Shortening liquidity horizons to ~6 years1
    • Reduce the dilution required in a startup’s lifetime.
    • Shortening the feedback horizons for LPs who cannot rely on incremental metrics like TVPI/IRR
    • Better optimised for a firm’s specialisation on go-to-market or growth problems
    • Reducing the risk exposure associated with downstream capital and later stage competitive pressure
    • Limiting capital waste by introducing sell/buy tension at an earlier point in the startup’s life cycle, encouraging more rational pricing
    • Preventing momentum investing from large funds distorting investment selection at early stages

    In practice, this results in a division of the venture asset class into two main categories. While there will inevitably be some overlap in the middle, and some exceptions, it seems worth separating the two disciplines and their specific attributes:

    Early VC: Pre-Seed – Series B/C

    Smaller, thesis-driven firms that are focused on finding outliers. Founder friendly, research heavy, experimental, eccentric. Carrying a relatively smaller burden in terms of dilligence and transparency.

    • Fund size: < $500M
    • LPs: Accredited Investors/HNWs/FOs/Smaller Institutions
    • Liquidity: Primarily secondaries 

    Late VC: Series B/C – Exit

    Larger, metrics-driven firms that source strong performers directly from the early stage firms. Looking at proven businesses with high growth potential through a more standardised lens. Transparent about both deployments and LPs.  

    • Fund size: > $500M
    • LPs: MFOs/Larger Institutions/Sovereign Funds
    • Liquidity: IPO, PE secondaries, M&A

    This bifurcation has two important additonal benefits:

    1. It shortens the feedback window for VC performance, and disincentivises pouring capital into hot deals for inflated TVPI.
    2. It provides clear deliniation for introducing major institutional capital and the enhanced regualtory scrutiny that should imply.

    These two points reflect the goals of creating a more favourable environment for LPs, a more robust fundraising ecosystem that is less prone to bubbles and crashes, and an approach to enhancing transaprency without hampering the smaller early stage firms.

    There are three hanging questions about the economics of this change:

    1. Whether the basic 2/20 fee structure ought to change in this scenario, and whether it should be significantly different between the two?
    2. The degree to which a rational market will change venture capital returns. How much have expectations been warped by the history of dumping overheated companies at IPO? Can we expect a more stable growth in value through the life of a company?
    3. What is different for firms like Lightspeed which may be using a continuation fund to buy their own secondaries?

    In both of these cases, I think the solution is to let the market experiment and work this out — especially with added transparency and scrutiny on practices — I have more faith in positive outcomes. Even for Lightspeed, the performance of both units will be under seperate scrutiny, so the incentives should still work.

    Why now?

    What has changed in the last two years which makes this proposition attractive? Well, the IPO window closed. The strategy (as discussed in my previous article) of dumping companies with inflated valuations on public market investors came to an end.

    An underestimated effect of that strategy, which dominated VC for the previous decade or so, was that it meant a disproportionate amount of value was unlocked at IPO — and VCs didn’t necessarily believe in the value of companies on the way there.2

    Consequently, nobody wanted to offload their shares in a winning company until it went public. That’s when the big payout was. Clearly LPs liked the outsized returns for as long as they lasted, but now that era is over we are firmly back to looking at the timeline on returns.

    In a market with a more rational perspective on value and pricing, you can make sense of a transaction at any point. Secondaries become much more appealing. Again, this is all covered in more detail in the previous article.

    Certainly we appear to be at a point in history where every stakeholder in venture, from founders to LPs, should be interested in finding a better way forward.

    This is just one proposal for what that might look like.

    (top image: The Choice of Hercules, by Annibale Carracci)

    1. Maybe longer in today’s market, but I expect that to contract again [↩]
    2. This is where the frankly obnoxious view of valuation as an arbitrary milestone comes from. [↩]
  • VC has trust issues, not a liquidity problem

    VC has trust issues, not a liquidity problem

    In a strange twist for an asset class built on patient capital and outsized returns, finding liquidity for investors has become a matter of urgency for VCs.

    On the surface, this is a story about venture capital’s evolution and fund managers adopting more sophisticated liquidity strategies. Pry a little deeper, and you’ll find LPs reneging on capital commitments, pushing VCs to secondary markets and expressing disappointment with activity over the last few years. Now, some just want to cash out. 

    Gradually, and then suddenly

    The average age of private companies exiting through an IPO has advanced from 7.5 years in the 1980s to 11 years in the 2010s, as both regulatory and macroeconomic factors have brought more capital into private markets.

    The cash-rich environment allowed companies to grow into loftier valuations with relatively little scrutiny, while benefiting from the scrutiny of their public peers. For many this seemed like a winning strategy, with projected outcomes that were often jaw-dropping, and some VCs began talking about 15 year liquidity horizons. Significantly, there was no outcry from LPs; distant horizons were the name of the game, and the theoretical scale of returns bought a lot of patience.

    Large private firms are thriving in part by freeriding on public company information and stock prices. Such firms’ astonishing ability to attract cheap capital may last only so long as public companies continue to yield vast, high-quality information covering a broad range of companies.

    Elisabeth de Fontenay, Duke Law: The Deregulation of Private Capital and the Decline of the Public Company

    So why the sudden pivot to seeking liquidity in the last two years? Why are investors now so concentrated on returning capital? Is there more to this story than interest rates?

    Overheating the market

    The basic proposition of venture capital is that LPs commit a certain amount of capital to a VC fund and are returned some multiple of that over the following decade.

    There are two unique considerations for potential investors in venture capital:

    1. VC firms will typically deliver weaker returns over subsequent funds, with many top performers being emerging managers with smaller funds. 
    2. The asset class lacks a meaningful standard for measuring current fund performance, with firms ‘marking their own homework’ to some extent. 
    Pitchbook: Private market fund performance

    This combination makes it challenging to identify promising VC funds; track record is unreliable and performance is opaque. What remains for LPs is networks and trust, explaining why so much focus is put on relationships. These relationships, and over a decade of ultra-low interest rates, have allowed VCs to get away with longer periods of illiquidity and slipping rates of return. 

    The assurance offered, in place of returns, centred on the mounting theoretical value of venture portfolios. Venture-backed companies were raising vast sums from investors who thought of valuation as an ‘arbitrary milestone’ in the process. As long as the number kept going up with each new round, the investment looked good. This approach allowed VCs to raise ever-larger funds, extract more in fees, deploy more capital to inflate valuations further… and the wheel kept turning.

    In theory, LPs were set for historic returns, as soon as those companies hit an exit. 

    The venture funding freeze 

    How many poorly-performing tech IPOs does it take to put public market interest on ice? In 2022, we found out. 

    While some point the finger at interest rates for spooking investors towards the end of 2021, the evidence of a correction was there from earlier in the year as many high-profile tech IPOs saw a rapid collapse in share price. There was a clear disconnect between tech valuations and a public market which no longer had faith in what they were being presented. 

    Crunchbase: The Biggest IPOs Of 2021 Have Shed 60% Of Their Value

    This was the consequence of venture capital’s exuberance. Shifting the focus to crude measures of current value had corrupted pricing discipline to the extent that exits were no longer viable. Any path to liquidity required coming to terms with huge markdowns, backtracking on the promised returns and damaging the trust of LPs.

    To say that, in hindsight, it would have been a good idea to sell more stock in 2021 is to ignore the underlying irrationality. Had VCs been inclined to sell, valuations wouldn’t have been so high to begin with. 

    It was not that the strategy was bad, it was that there wasn’t one. 

    The path ahead for venture capital

    VCs created this liquidity squeeze by exploiting an opaque market and increasingly divorcing price from value. This is precisely what needs to change in order to foster a healthy secondary market: greater transparency, discipline on valuation.

    Specifically, a secondary market will only work if it is perceived to be where VCs sell their winners at a reasonable price, to account for shifts in risk profile outside of their portfolio focus. In this scenario, the incentives are built on transparency. Conversely, if the perception is that secondaries are for firms to offload companies that investors have lost faith in, then the incentives are built on obscuring or misrepresenting performance. That asymmetry leads to adverse selection and the slow death of any market it touches. 

    The future of venture capital has to involve greater transparency and stronger standards, to rebuild relationships with LPs, enhance market efficiency and access to liquidity. That vision requires the careful consideration of incentives, built on a fair and rational approach to understanding the value of venture investments. It means eliminating trust from the equation. 

  • The failure of due diligence (in Fintech)

    The failure of due diligence (in Fintech)

    For as long as there has been business, there has been fraud, and ‘cooking the books’ is about as old as it gets. In recent years, the extreme focus on revenue has produced dangerous incentives for founders and investors to cut corners. Those chickens are now coming home to roost.

    Now a regular feature in tech media, we’ve seen a growing number of cases in which startups have been caught fabricating revenue (and associated metrics like accounts, deposits, transactions, etc). Given the focus on financial performance for venture backed businesses, it has left the impression that you might escape scrutiny if your numbers look good at a glance. 

    The most recent examples include Banking as a Service (BaaS) up-and-comer, Solid; financial aid startup, Frank; notorious cryptocurrency exchange, FTX; and mobile money interoperability provider, Dash. It’s not deliberate that all of these examples are Fintech companies, though it does appear that Fintech is the sector most commonly associated with revenue fraud.   

    (source: Contextual Solutions)

    Is this a consequence of the fundraising environment? Is there a deeper problem in Fintech?

    The pressure of hypergrowth

    While venture capital has taken a much more moderate tone towards growth in 2023, with mentions of ‘quality revenue’ and ‘sustainability’, this wasn’t always the case. Up until early 2022 the strategy du jour was raising huge amounts of capital at inflated valuations in order to fund aggressive growth to try and justify said valuations.

    Companies are taking on huge burn rates to justify spending the capital they are raising in these enormous financings, putting their long-term viability in jeopardy. Late-stage investors, desperately afraid of missing out on acquiring shareholding positions in possible “unicorn” companies, have essentially abandoned their traditional risk analysis.”

    Bill Gurley, GP at Benchmark

    Nowhere has this been felt more keenly than in the Fintech industry, a darling of the venture capital industry since the post-financial crisis wave of evolution kicked off around 2010.

    (source: Pitchbook)

    The startup-led digitalisation of financial products, including the ability to scale at a rate far surpassing incumbents by using a different playbook (see how Revolut has scaled internationally by adhering to just the regulatory minimums), has driven incredible revenue growth for Fintech in recent years. 

    After achieving more than 500% growth in 2021, the juggernaut Fintech growth finally began to stall in November. We can speculate on the reasons, but the chief suspects are the impact of COVID’s Omicron variant on business confidence, the beginning of the current surge in inflation, as well as growing fears of deeper economic woes spurred by the pandemic. 

    None of those factors will be much comfort to founders who will continue to try and live up to the expectations of the extreme growth demonstrated in 2021. For many investors, the benchmark has been set and the goal is to return to it, for the sake of their fund performance.

    Smoke and mirrors 

    Even at the best of times you will see a range of behaviours, from subtle manipulation to outright fraud, in startup financials. With so much on the line, and relatively little accountability, there’s a clear incentive to cut corners.

    Combine that with the heights of ZIRP-drunk behaviour in 2021 and you will see real problems – even unintentional. An example of this would be PayPal’s admission that 4.5M fake accounts had been created to abuse their sign-up bonus schemes at the time. This admission was shortly followed by revised revenue projections, as they realised the huge outlay of capital was not going to yield the returns they had hoped.  

    (source: PayPal quarterly reports via American Banker)

    Consider also how startup investments have been priced in recent years, with revenue multiples becoming the easy shorthand for valuation. In a 30x industry, as Fintech was at the peak, $1M in revenue became $30M in value – and due diligence wasn’t keeping up. Revenue was poorly scrutinized to begin with, and now it was having an outsized impact on fundraising.

    The magnification of value produced a powerful incentive for founders to exaggerate revenue with any trick imaginable…  of which there are many: ‘round tripping’, reporting gross revenue rather than net, sketchy definitions of ‘booked revenue’, or treating discounts and refunds as expenses rather than contra-revenue events. For many, it became common practice to fudge revenue reporting (to varying degrees) in order to inflate performance and exaggerate potential.

    When I joined Flexport as co-CEO in September 2022, I found a company lacking process and financial discipline, including numerous customer-facing issues that resulted in significant lost customers and a revenue forecasting model that was consistently providing overly optimistic outputs.

    Dave Clark, former co-CEO of Flexport

    Unfortunately, conditions only worsened when the ZIRP-hangover began. After the leg-sweep of funding early in 2022, investors were briefly forgiving about slowed growth in the new environment but it didn’t last long. Today, founders are expected to live up to the kind of growth they had previously promised investors, without necessarily having the available venture capital dollars to afford it, all while angling more aggressively towards profit. 

    The crunch is real, and it will lead many founders to make bad decisions. 

    Challenges for investment due-diligence 

    A much discussed side-effect of the ZIRP-era coming to an end, with the collective tightening of belts in venture capital, is the resumed focus on proper due diligence with startup investments. This will include things like debt, leases and contracts, as well as the startup’s current and projected revenue. 

    This may already be catching out the lies from startups that exaggerate revenue to bump their valuation in a previous fundraising round, but it’s not always as clear cut. For this, we can look at the sordid history of GoMechanic, a startup caught in a revenue-faking scandal despite previously having sign-off on its accounts from Big Four accountants PwC and KPMG. The third time was the charm when EY finally managed to nail down where things were going wrong, including all kinds of accounting chicanery in a partially cash-based business. 

    This begs the question: how realistic is it for investors to catch-out revenue fraud for private companies, when there is so little in the way of enforced standards? Public companies are expected to adhere to GAAP (Generally Accepted Accounting Practices), but no such obligation exists for private companies. ASC 606 and IFRS 15 exist as revenue recognition standards for both private and public companies, but will continue to be ignored by startups for as long as they aren’t required by investors or properly scrutinised by board members. 

    For Fintech investors especially, this prompts the old debate about whether investors need to be experts in the industry in which they invest. If you are a partner at a financial services company (venture capital is really just a peculiar financing product), investing in financial services startups. should you not therefore have at least a minimum of financial literacy? 

    To go deeper down the rabbit-hole: there are questions about how much investors knew about some of these cases, before they were brought to light. When is it of interest to an investor to intervene, and go through the messy process of righting the ship, even when it may mean revising value downward for other investors, founders and employees? What if they just kept quiet, and let it be someone else’s problem?

    Diligence isn’t cool; do it anyway

    Increasingly, issues appear in the world of private company investment (and are amplified in the high risk/reward world of startups) which relate to a stark lack of transparency, accountability and regularity. 

    If venture capital firms invest in startups with the expectation that they will one day exit via IPO (and thus adhere to GAAP), why do they not require prospective investments and  portfolio companies adhere to those standards from day one?

    Startups are volatile in performance and unconventional by nature, making it impossible to standardise much about how they operate. In fact, I’d go so far as to say that conventional business wisdom is a plague on founders. However, much can be standardised about the ‘unsexy’ aspects of the fiduciary duty between founders and investors. 

    Founders are probably not jumping at the chance to apply accounting standards to their business. It is far easier, unless obliged otherwise, to sketch out an income statement with a  degree of improvisation. A certain amount of poetic licence goes a long way for VCs, too.

    However, it’s clear we are entering a new era for startups, with fresh scrutiny across the board – especially for Fintech. The world of startup investment is, slowly and painfully, moving towards greater levels of accountability. 

    We should also think carefully about the operating system of startup fundraising, and whether it really incentivises the best behavior and the best outcomes. I am a ‘techno-optimist’ in that I believe in the power of efficiently allocating capital to innovation… but that means real innovation, not monkey jpgs.

  • Adverse selection and venture capital

    Adverse selection and venture capital

    There’s a weird phenomenon among VCs where the less successful they are, the more evil they become to founders to squeeze more money out of their best startups out of necessity which then becomes a vicious cycle of adverse selection.

    Garry Tan, President & CEO of Y Combinator

    Including the above, criticism of venture capital often applies a fairly broad-brush, which might feel unfair. 

    If you look a little closer, you’ll see it’s actually a problem of venture capital’s own making. An identity has emerged over the last decade which feels like an attempt to homogenise the asset class. This has been characterised by gatekeeping, consensus seeking, exclusionary behaviour, protectionism of networks and relationships, determining the ‘in-group’ and then restricting access to it.1

    This identity appears at the core of venture capital, thanks to the gravitational effect of extreme insecurity: with so little in the way of transparent standards, particularly on measuring performance, most managers look for implicit validation from their peer group. They adopt the same attitude, use the same jargon, invest in the same categories, and follow the same practices.2 

    Toxicity seems to be compensation for insecurity in our industry. It’s not good.

    Eric Bahn, Co-Founder & GP at Hustle Fund

    Unfortunately, that group is clearly a negative force, having a chokehold on the public image of the asset class and an unfortunate influence on the overall returns.

    Adverse Selection

    If you follow finance and economics, you will be familiar with the problem of adverse selection. For those that aren’t, here a rough summary of the explanation from Nobel winning economist, George Akerlof, and his famous paper, “The market for lemons”:

    Buyers in the used car market aren’t typically mechanics, so struggle to judge whether their potential purchase is in good shape or a bucket of rust with a new paint-job.

    This imbalance of information between buyers and sellers creates a reluctance to ever pay full price – until eventually everyone selling good cars is driven out of the market.

    To apply this to venture capital: you have a category of managers who deal with their performance anxiety by blending into the herd – aiming for consensus, not excellence. The ones who smirk when managers set ambitious targets, despite that being the name of the game.

    These managers are the buyers in this analogy, hedging their bets out of uncertainty in their own ability, benchmarking against averages, and ultimately degrading the whole asset class. 

    Feedback Loops

    I’ve written at length about why standards for measuring performance in VC are important, and how that could be addressed. But why does it matter, and what do we mean when we refer to insecurity amongst managers?

    For this, there’s no better analogy than The Monkey Problem, which I believe is credited to Astro Teller, Captain of Moonshots at X:3

    Imagine you tell 100 people that their goal is to have a monkey on a pedestal reciting Shakespeare, 100 days from now. They know that you might check up on them along the way, and are concerned about demonstrating their progress.

    The first thing everyone is going to spend time on is finding or making the most impressive pedestal, because that is the most attainable and demonstrable sign of progress – even if it is trivial compared to teaching the monkey. 

    In venture capital, the pedestal equivalent is the logo hunting, where managers will seek to invest in hot deals, or invest alongside ‘tier 1’ firms, in order to have those logos on their LP updates. It’s a superficial sign of “progress”, and has no direct relation to the real goal of generating returns. They don’t really know how well they are performing on those terms, and they can’t really compare themselves to their peers.4

    Turns out, when you’re building a venture firm truly from scratch (limited track record, no Ivy, didn’t work in venture prior, etc.), logos + investing alongside name brands matter far more than anything else.

    Eric Tarczynski, Founder and Managing Partner at Contrary

    Monkeys and Lemons 

    To join the two together: the monkey problem creates the information asymmetry (inability to understand fund performance) which results in the lemon problem (the drift towards measuring manager performance via relationships and how well they fit the stereotype).

    As a result, there’s increasing gravity around that ‘in-group’ network of VCs, and fitting into those patterns of behaviour and identity. It’s that group which becomes the subject of so much (often deserved) criticism, and the target of parody. 

    Managers who do not identify with this group are de facto not the target of that criticism. They are secure enough in their ability to not need to adopt the superficial signals of competence. Through their implicit understanding that venture capital is precisely not about fitting a pattern, they are likely to outperform those that follow the herd. Unfortunately they often face an up-hill struggle when raising successive funds. 

    This has a deeply concerning impact on the performance of venture capital, and the quality of ventures they back, as well as the diversity of founders and ideas that will be funded.

    VCs may subconsciously be looking for founders who share similarities with themselves and may not be able to effectively assess founders who have exceptional but different qualities.

    Nnamdi Okike and Aaron Holiday, of 645 Ventures

    The solution to this, going back to the root of this problem, is to focus on the monkey.

    Every stakeholder in the process, from founders to LPs, need to be clear that their responsibility is generating returns. There needs to be a real shift towards making and measuring returns, rather than assigning value to relationships and hype.

    Specifically, for an informative approach with practical feedback windows (quarterly or annual, rather than decennial), that requires making TVPI a meaningful metric through standardised methodologies and transparent reporting.

    This is never going to happen without some kind of broad industry consensus, which in turn is unlikely to happen while the ‘in-group’ VCs dominate the narrative and control what success looks like to protect their own necks.

    For those who are holding on to the belief that venture capitalists are the last bastion of smart money, it is time to let go. While there are a few exceptions, venture capitalists for the most part are traders on steroids, riding the momentum train, and being ridden over by it, when it turns. 

    Professor Aswath Damodaran, Wall Street’s “Dean of Valuation”
    1. Not to mention the patagonia vest, vacations in Mykonos, or how many times they can squeeze ‘grok’ or ‘rubric’ into a conversation. [↩]
    2. Once-upon-a-time it was popularly characterised by ‘VC Twitter’, though that weird ecosystem has become more self-aware and at least partially a self-parody. [↩]
    3. The moonshot factory, not the social media platform [↩]
    4. We also discussed this during a recent episode of the Equidam podcast. [↩]
  • Larian’s unfair advantage

    Larian’s unfair advantage

    This post was inspired by two things I saw recently:

    • Jonny Price of WeFunder, sharing their newly designed raise page, featuring some giants of tech like Substack, Mercury and Levels.
    • Xalavier Nelson Jr. of Strange Scaffold, commenting on the seemingly extreme success of Larian Studios, with the upcoming release of Baldur’s Gate, and imporing consumers that it not “raise the standard”.

    The connection between these two items is not obvious, but it is interesting.

    The lemon problem

    WeFunder, for the uninitiated, is a crowdfunding platform for (primarily) technology companies. It allows community-oriented startups to sell a small % of ownership to their users and supporters.

    Unfortunately, crowdfunding faces a stigma which some refer to as ‘the lemon problem’. Essentially, “why are you raising from unsophisticated retail investors when you could get backing from a top tier venture capital firm?”

    This signalling issue then discourages the best startups from pursuing crowdfunding, which (in theory) lowers the overall quality available there, reenforcing that crowdfunding is a negative signal.

    The problem with that concept is that it is dumb, and built on a decade of putting venture capital on a pedestal.1

    Crowdfunding, or ‘community rounds’ as Jonny would prefer, offers a path for users and supporters to become advocates with ownership and incentives aligned with your own. You can offer them perks, you can treat them as your Customer Advisory Board, and you can usually rely on them to help disseminate your message.

    Unfair advantages

    So where does this connect with Xalavier, and Larian?

    We’ll begin at the end, with Xalavier’s comment:

    Like a lot of people, I’m deeply excited about what the lovely folks at Larian accomplished with Baldur’s Gate 3, but I want to gently, pre-emptively push back against players taking that excitement and using it to apply criticism or a “raised standard” to RPGs going forward.

    Xalavier Nelson Jr. on the expectations set by Baldur’s Gate 3

    He goes on to cite a number of reasons why Larian has been advantaged in the development of Baldur’s Gate. Particularly, their experience with this style of game, and the importance of the IP they have secured from Wizards of the Coast.

    He’s right on all counts. Larian is – today – in an unparalleled position as a developer of RPG games. They have great experience, multiple studios, a supportive community, and a huge IP.

    You could, if you were a peer of Larian’s, a fellow game developer, feel a bit like they are operating in a league above you. That there’s an unfair advantage, and any comparison between their work and yours would be unfair. Punching down.

    Unfortunately, Xalavier stopped there. He didn’t finish the thought. He never asked why Larian has this advantage, to determine whether or not it is unfair.

    Kickstarting a dream

    Back in 2013, Larian was a relatively small games studio. They did ‘mercenary’ work for other studios to help pay their bills while developing their own string of medium-budget RPG titles.

    Their work was quality, but they couldn’t compete in the big leagues. Studios like Bethesda, Obsidian and Bioware were effectively household names, and threw resources into pushing the envelope of what RPGs were offering.2

    Larian were ambitious, though. Swen Vincke, the studio head, had been an RPG fanatic all the way back to Ultima 7, and he wasn’t done trying to carve a path in the genre. As they began developing their next title, Divinity: Original Sin, they ran into a problem: it was more game than they could afford to make, but they couldn’t afford to make any less. They needed a break.

    Funding for games is notoriously difficult. All of the costs come before you make a penny in revenue, and there are usually few indications that you’ve made something players want until release. Many games flop, and many studios fold. It’s not an attractive area for institutional investors. So Larian turned elsewhere, to their community, and the wider community of RPG fans.

    In 2013 they launched a Kickstarter campaign for Divinity: Original Sin. They aimed to raise between $400,000 and $1,000,000 to support development, by offering everything from ‘gratitude’ to an invitation to the launch party depending on how much was contributed. They clearly laid out what each benchmark in funding would mean for the game, and the player’s experience.

    They didn’t quite hit the $1,000,000 mark, but they did raise $944,282 from close to 20,000 individuals. An average contribution of almost $50 each, from a vast but not cash-rich audience, into the dream of a great RPG.

    It gave Larian the cash they needed to get Divinity: Original Sin out of the door, and it was everything they had hoped for: a landmark RPG which put the studio on the map, and laid the groundwork for everything they would do in future. Ultimately, their work inspired sufficient confidence from Wizards of the Coast to give Larian the rights to develop the Baldur’s Gate franchise with this hotly anticipated sequel.

    Community driven growth

    Over the next few years, covering the eventual launch of Divinity: Original Sin in 2015, the even-more-succesful sequel in 2017, and up until the imminent release of Baldur’s Gate 3 today, Larian has experienced the benfit of that crowdfunding round.

    More than any other factor, raising money from an audience of customers (and potential future customers) has meant that Larian has never had to compromise. They were not at the mercy of institutional investors or publishers to hit hasty development milestones or add supplementary revenue streams. They could build the game as they wished, by a group of RPG enthusiasts; for an audience of RPG enthusiasts. They are self-sufficient, and happily so.

    We’d tried multiple times with third parties and we listened to them every single time, and we had to learn that it was important that we took our own fate in our own hands. And since then, things have been going on the upside for us.

    Swen Vincke on developing Divinity: Original Sin

    This alignment of incentives between product and customer is fundamental. It’s how companies should work at the best of times, but the need for external capital can often complicate the relationship. Larian went right to the source.

    And that is their ‘unfair advantage’, that they were able to focus entirely on their vision to build a fantastic product.3 Exactly as every company should, in theory.

    Equity in the equation

    Larian’s crowdfunding success was built purely on the promise of what their product could offer to customers, and how additional capital would strengthen that proposition.

    In the world of startup financing, equity crowdfunding takes this concept and injects it with steroids. Revolut’s crowdfunding round in 2016 has since created more than 100 millionaires, and the company has attracted more than 4,000 retail investors to date.

    These may not necessarily all be users of Revolut, but they are individuals who believe in the future of the company, will recommend it to others, and will contribute to the future growth of the company.

    This is why I’ve long been enthusiastic about crowdfunding as a source of capital for startups. And while that includes the obvious consumer companies with network effects and tangible investor perks, it also includes many successful raises from business-facing deeptech companies who are producing radical innovation.4

    Be like Larian. Make community your unfair advantage.

    1. How is that going, by the way? [↩]
    2. And each had, in their own way, at a previous point in time, earned that place in the ‘big leages’. [↩]
    3. It has also allowed them, more recently, to build this supportive community into their development pipeline. Early access for Baldur’s Gate 3 will have lasted for an unprecedented three years before official release, during which time they have relied on that community for feedback and vital testing capacity. [↩]
    4. Why VCs are failing that sector is another subject, but if you’ve read many of my recent articles you may be able to piece that together yourself. [↩]
  • It’s all about identifying outliers

    It’s all about identifying outliers

    What startup investors can learn from sports betting

    Early stage investing is a complex and relatively new practice, which makes it fertile ground for analogies which can help explain the more abstract concepts to both newcomers and veterans alike. 

    In this particular case, grappling with the intrinsic value of pre-revenue startups, there’s an interesting parallel to sports betting. Fundamentally, both involve looking at the strength of a team and the competitive landscape and making a judgement on future potential.

    What we’re considering here is the idea that a startup – even a pre-revenue startup – has a determinable value even before that value has been tested in the form of a market transaction. This is also what you might call a ‘fair market’ valuation, which is what we aim for at Equidam. 

    MOIC vs. betting odds

    In early stage investing, investors will look to benchmark potential returns using a metric called the multiple of invested capital (MOIC). MOIC is calculated by taking the total potential return on an investment and dividing it by the amount of money invested. For example, with an investment of $100,000 in a company with an expected MOIC of 10, the company should have the potential to return $1M.

    In sports betting, participants measure their potential returns using the odds of winning, which represents the probability of success. For example, if the odds of a team winning a basketball game are 9:1, it means the team is assumed to have a 10% chance of winning and the return would be a multiple of 10. 

    Rewarding the earliest participants

    In both examples, the earliest (successful) participants receive the most lucrative returns. In investing, this is because early investors are able to get a lower share price than later investors. In sports betting, this is because early participants are able to secure better odds.

    In both cases, this is for the same reason: At the very beginning there is the least available evidence to indicate an assumed outcome, thus a greater level of perceived risk associated with the choice. This is true both in terms of signals from other participants (other bets or investments made) as well as actual progress in terms of milestones achieved, such as games won or revenue secured. 

    Qualitative and quantitative measures

    In early stage investing, investors use a variety of qualitative and quantitative measures to judge the potential of a company. Qualitative measures might include the management team, strategic relationships, and the competitive environment. Quantitative measures include things like the company’s projected financial performance, market growth and associated risk. This is reflected in the form of the valuation, which ultimately informs the potential return on investment.

    In sports betting, participants use similar measures to judge the potential of a team. That might include the team’s roster, their experience together, track record of the coach, and the threat posed by other teams. This is reflected in the form of a perspective on what the betting odds should be to provide appropriate upside for that level of risk.  

    What this means for early stage investors

    According to some, a startup does not have a valuation until it has been priced in an equity transaction. To an extent (in a strict and formal sense) that is correct. It does not itself have a valuation, because value is not an objective concept. Like beauty, it lies in the eye of the beholder. However, we shouldn’t pretend that an equity transaction represents an ‘objective’ read on value either; it’s also just the opinion of an investor.

    What this analogy illustrates is that you, as an early stage investor, should have your own personal read on valuation as a reflection of future potential. You need to understand the qualitative and quantitative factors involved, and determine a practical framework to run your own analysis. It’s the best way to sharpen your judgement on future potential, take an informed perspective on risk vs return, and put your money to better use.

    If you are investing your own money, it’s not crucial that your valuation framework be seen as objective or fair. Many investors look at valuation primarily in terms of market context and what other investors are doing. Others use simple heuristics like national averages adjusted with a few qualitative measures, even if that screens out some deals. Whatever approach you use, if it allows you to reach your desired level of returns then it is clearly working. 

    When being objective is important 

    Imagine it’s January 2023, and a friend is looking to place a bet on the upcoming NBA championship, and you – being wise and well informed – recommend putting money on the Denver Nuggets. This is a team which hasn’t won a championship in its 47 year history, and a year ago they lost in the first round, so the odds are great (in terms of MOIC) but your friend will take some convincing. 

    It’s in explaining this opportunity to another person that objectivity becomes important; your rationale must survive without the support of your own biases and perceptions. What are the data points which conclude that the Denver Nuggets have been overlooked or undervalued by the market? What is it about their 2023 roster and the wider competitive environment which indicates for success? How do you piece that into a compelling story for your friend? 

    This is, again, mirrored in the world of early stage investment. If you are looking for input on the potential of a startup – which has not yet been rubber-stamped in a market transaction – you will want to see it in a transparent, objective format which covers all of the key indicators. This is applicable in a range of cases, whether that is determining a valuation for the first round of a company, proposing a valuation to a group of angel investors, or reporting updated valuations to your LPs.

    This is where we finally arrive closer to assigning a ‘fair valuation’ to a startup, rather than the individual perspectives on valuation. Not a number determined by the combination of gut-feel and Excel-gymnastics designed to pattern-match past success, but something scrutable, explainable and repeatable. 

    Crucially, valuation can be incredibly useful even when it’s not associated with a market transaction. In fact, the single perspective of a lead investor on the value of a company is potentially less valid, and less reliable, than a more objective framework.1

    Backing outliers is the whole ballgame

    Early stage investment pivots around uncertainty and valuation is always a tricky exercise in assessing the tangible and the intangible. Reaching 100% efficiency in the risk/reward is never going to happen. 

    Similarly, your friend doesn’t have to buy every data point in your recommendation, they just have to understand what you are looking at, the conclusions drawn, and appreciate that it was a rational process with an outcome they can challenge or disregard as they wish. 

    Had they made their bet based on the odds at the start of the season, following the favourite as indicated by the market, they’d have lost their money. Had they waited a few months to see how each team performed in order to inform their judgement, they would have increased their chance to pick the right team, but with much lower potential returns.

    And that’s the argument in a nutshell. In order to understand an opportunity while the terms are most favourable, or to explain that opportunity to others, you need to think about practical and objective measures of future potential. Early stage investing is all about identifying outliers, like the Nuggets, which is precisely why we approach valuation from this perspective. 

    1. Especially given the extreme proclivity of investors to pass the buck, and base their pricing on other market transactions. [↩]