One of the concepts we emphasize at Equidam is the inversion of qualitative and quantitative factors in startup valuation, as you go from Seed1 to pre-IPO funding.
The archetypal Seed startup (perhaps just an idea) has nothing to measure. Investors must use their imagination, peer into the future, project a scenario. On the other hand, a startup raising the last round of private capital before an IPO will be weighed and measured almost entirely on financial metrics.
Even as early as Series A you have access to some useful data. Can they actually build the thing? Do customers really want it? Does anyone want to work there? All sources of rich signal to help you make an objective decision about the company.
Seed is different. Success comes down to the quality and consistency of your subjective, independent judgement. In many ways it is a unique discipline within the strategy of venture.
What happens if you try to find a path in the data?
Essentially, it’s a hunt for outliers with no shortcuts and two specific qualifiers for any investment strategy:
Any attempt to pattern-match to past success is going to dramatically limit your pool of opportunity, with no clear upside.
Any constraints built into your investment strategy (sector, region, industry) are essentially a sacrifice of volatility (potential alpha).
Thus, the ideal Seed investor is likely to be a generalist, with no preconceptions about what great founders look like, where they come from, or what they might be building.
Rather than the hubris of a (supposed) rockstar stock-picker, Seed investors will find confidence through constructing solid processes, systematically rewarding good decisions and mitigating bad ones.
Finally, and perhaps most importantly, they’ll have a firm grip on the biases which manifest in all forms of investing. Particularly the curse of overconfidence which erodes the positive influence of success.
In summary, considering all of the above, we should expect Seed investors to present with an idiosyncratic worldview, some robust fundamental skills and an appetite for risk.
Sadly, reality is the opposite: Seed investors are often risk-averse herd animals with little real competence. They have Rick Rubin-esque affectations, pontificating on ‘taste’ and ‘craft’, while copying each other’s homework and hiding deep insecurity.
In the last 15 years we’ve seen the emergence of a Startup Industrial Complex, where a treadmill of capital, services and brand-strength was offered to participating firms and startups. If you wanted quick, reliable markups and easy downstream financing for your portfolio then you hopped on board.
This movement destroyed the institutional contrarianism of Seed investing. Billions of dollars were piled into safe SaaS money-printers when capital was cheap. When the market for safe investments was saturated, investors responded by dumping huge sums of capital into silly ideas (remember NFTs?).
That’s “risk”, right?
This worked during ZIRP, because everything was going up and to the right. Public markets were so cracked-out on COVID and cheap capital that they grabbed anything at IPO. But it was never going to last.
Seed VCs (and their LPs) need to recognise that role is, and always has been, to find breakout companies before they are obvious. Not to compete for deals. Not to seek validation from colleagues. To find those outliers. To be uncomfortably idiosyncratic. That’s it. That’s everything.
Critically, while it may lag by a decade or so, everything else is downstream from Seed.
The entire venture capital strategy depends on Seed investors doing their job properly. The entire premise of venture-backed innovation, and the promise of venture-scale returns, are entirely dependent on the health of Seed.
(image source: “Venice; the Grand Canal from the Palazzo Foscari to the Carità”, by Canaletto)
Show me the incentive and I’ll show you the outcome
Charlie Munger
One of the most thought-provoking articles in venture last year was Jamin Ball’s “Misaligned Incentives“, in which he talked about the difference between 2% firms and 20% firms.
The 2% firms are optimizing for deployment. The 20% are optimizing for large company outcomes. There’s one path where the incentives are aligned.
The article was significantly because it was represented a large allocator acknowledging the issue with incentives in private markets. Not a novel take on the problem, but resounding confirmation.
Ball stopped short of suggesting an alternative incentive structure, which was probably wise given visceral opposition to change. Many influential firms have grown fat and happy in the laissez-faire status quo of venture capital.
Ball — like many people, myself included — framed carried interest as the ‘performance pay’ component of VC compensation. The problem is implicit: we have therefore accepted that fees are not connected to performance.
For decades, we’ve accepted the wisdom that carry = performance, and fees = operational pay. Nobody thought to question that reality.
Unfortuantely, for many firms (and certainly the majority of venture capital dollars under management), carry is a mirage. It exists so investors can pretend that performance is a meaningful component of their compensation while they continue optimising for scale.
European Waterfall vs. American Waterfall
European waterfall is a whole-fund approach to carry, whereby GPs don’t receive carried interest until LPs have had 1x of the fund (plus a hurdle) returned to them. American waterfall operates on a deal-by-deal approach, with a clawback provision if the fund isn’t returned (plus a hurdle).
We know the american waterfall model (while imperfect) has historically outperformed, and yet the european waterfall has become standard. Venture capital has biased towards the ‘LP friendly’ approach to carried interest, even though it reduces their carry income, because it enables more easily scaling funds.
We find strong evidence that GP-friendly contracts are associated with better performance on both a gross- and net-of-fee basis. The public market equivalent (PME) is around 0.82 for fund-as-a-whole (LP-friendly) contracts but is over 1.24 for deal-by-deal (GP-friendly) contracts.
In summary, the problem is not that VCs have picked fees over carry as the more attractive incentive, it’s that carry has been used as a smokescreen for the exploitation of fees.
Consider these few points, from the perspective of a seed GP:
If you charge a fee to manage the fund, you should not raise a successor fund without a serious step-down in those fees. Otherwise, what are you being paid for?
You should not charge management fees on investments you’re no longer truly managing. If you have no meaningful influence over a company in your portfolio, what are you being paid to do with it?
Indeed, if you’re no longer truly managing those investments, it’s incumbent on you to sell enough of your stake to lock-in a reasonable return when the opportunity is available.
If you raise a larger subsequent fund, you should be able to explain how that strategy allows you to extract a similar level of performance from a larger pool of capital. Otherwise, how can you rationally justify a larger total fee income?
Everybody knows that markups are bullshit. If you want to raise a second fund, get at least 2x back to your LPs through secondaries first. DPI is the only proof that there’s value in your investments.
None of this should be surprising or even unintuitive, and yet…
Successor fund step-downs are remarkably uncommon.
Most US funds still do fees on total comitted capital, not even fees on invested capital, never mind fees on actively managed investments.
Few GPs have a sophisticated view on early returns, with most still focusing on MOIC rather than IRR and assuming late-stage price inflation will continue.
VCs expect founders to present a coherent pitch covering growth strategy and the implicit capital requirements. The LP-GP relationship is far cruder.
The whole venture ecosystem knows markups are barely worth the paper they are written on — and yet these incremental metrics continue to drive fundraising activity.
Over the past 15 years, LPs have become so preoccupied with getting into the hottest name-brand funds that there has been little scrutiny given to the fundamental logic of terms.
In an entirely fee-based environment, without carry as a smokescreen for bad actors, fees would likely be more clearly connected to performance — addressing the concerns laid out above.
This has the benefit of being a more predictable approach to compensation, likely attracting more responsible fiduciaries and level-headed investors. Less swinging for the fences, and more methodical investing and steady DPI.
However, it would also mean losing an important minority of brilliant investors who are genuinely motivated by carry.1
Ending the AUM game; 100% carry
In a scenario where investors only ‘eat what they kill’, performance would matter so much — across so many dimensions — that VCs would have to very quickly develop better practices on portfolio management and liquidity.
Of course, the downside is that compensation would be heavily backloaded, with no compensation for the early years of deploying capital and developing exits. A deeply unhealthy barrier to entry for emerging managers.
What’s interesting about these two edge-cases, on opposite ends of the spectrum, is that both produce the same outcome: a greater level of professionalism, with a more sophisticated view on portfolio management and liquidity than we see today.
Clearly, neither extreme is a good option and the ideal is somewhere in the middle — with both fees and carry in the mix. However, central to incentivising better outcomes is an end the fee exploitation game, with two key realisations for LPs:
Fees must be connected to performance, in that a GP should not be able to raise another fund if they have not yet demonstrated concrete performance.
The only meaningful demonstration of performance is DPI. Fortunately, as the market embraces secondaries, it’s possible to generate meaningful DPI much sooner.
Venture capital needs to evolve alongside more distant exit horizons by making better use of secondary liquidity, more cleanly dividing the market into early and late stage strategies — which can each then better play to their strengths:
We were able to take a 1x or a 2x of the entire fund off [the table] and still be very long in that company. That locks in a legacy, locks in a return, and shortens the time to payback.
For funds like [mine], selling stock of private startups to other investors will be “75% to 80% of the dollars that [limited partners] get back in the next five years.
You sell at the B, and you actually — for us, with the way our math worked — could have a north of 3x fund. But I also wouldn’t want to give up the future upside. We actually ran that through the C and the D. The big ‘Aha’ for me was that selling at the Series B, a little bit, was actually very prudent for a couple of reasons.
With all of this in mind, it no longer unreasonable for LPs expect something like a 2x return on their capital by year 6, and for VCs to raise new funds based on hitting that 2x target. Ensuring a decent return (on an IRR basis) for their LPs while companies are still within their orbit of influence.2
Unsurprisingly, proposals to fix fee income are unpopular, and not only with those who profit from the status quo. There is a lack of systems thinking which would allow participants to grasp the interconnected factors which shape outcomes, and see the opportunity for change.3
secondaries aren’t a good market ➝ because they’re only used to sell poor quality assets ➝ so they’re not a good market
returns in venture come from a few giant outcomes ➝ so we hold to IPO ➝ so more value accrues to a few survivors ➝ so most of the returns come from a few giant outcomes
you can’t get liquidity on markups➝ because they’re optimised for fees not liquidity ➝ so markups aren’t liquid
In essence, power law and illiquidity are both absolutely realities of the venture strategy, but both have also been used to excuse and entrench suboptimal practices.
The Opportunity of Secondaries
A common misconception: the value of investments increases consistently (even exponentially) over time, so GPs should always hold to maturity. This idea has played a significant part in slowing down the use of secondary transactions. It’s not really true.
Investments often don’t increase in value. Quite often, they fail outright. Failure rate does reduce over time (39% at seed, 13% at series D), but it remains significant throughout.
Typically, you think of a series A startup as less risky than a seed startup, and a series D startup as less risky than a series A startup. This is often true, but because VC dollars both add and remove risk, the move down the risk curve is less linear.
This is especially true for ‘the biggest winners’ who are often absorbing huge amounts of capital from the ‘venture banks’:
But in recent years, this picture has been skewed even more, especially if the capital raised comes from a mega VC fund. At each funding round, there is a significant re-risking of the startup, to the point that you are not moving meaningfully down the risk curve for a long long time. And even at a late stage, a mega funding round can bring you right back up to the point of maximum risk.
These rounds are also often highly dilutive; particularly with the proclivity of large firms to ignore pro-rata and cram-down early investors.
So, in an absolute sense, there is a sustained risk of failure which slowly concentrates portfolio returns into fewer companies over time, which will decelerate TVPI growth (or even turn it negative).
On top of that, there are often terms included in later rounds which mean that shares held by early investors become relatively overvalued. Particularly, IPO ratchet clauses and automatic conversion vetos. Thus, even if the theoretical TVPI of a seed fund remains flat, in reality it may be falling:
“In November 2015, Square went public at $9 per share with a pre-IPO value of $2.66 billion, substantially less than its $6 billion post–money valuation in October 2014. The Series E preferred shareholders were given $93 million worth of extra shares because of their IPO ratchet clause. This reinforces the idea that these shares were much more valuable than common shares and that Square was highly overvalued.”
Looking at AngelList data, the best time for a fund to sell (on an IRR basis, and ignoring the clauses above) would be year 8 — with value concentrating (but not really net expanding) in years 9 through 12.
That means the typical investment (assuming a 3 year deployment period) would be best positioned for a (partial) sale in years 5-7. Considering this, it’s difficult to make the case that GPs should be holding 100% for the ultimate outcome, every time. If they do, they are concentrating their risk without necessarily improving the portfolio outcome.
To take this a step further, we could assume in a more rational market, less dominated by hype (more secondary activity driving more pricing tension, fewer bullshit markups), the illustrated TVPI would flatten out more gradually — so less of an obvious time to sell.
In short, the story here is not about opportunistic secondaries to drive better IRR. The real case to be made is for a comprehensive secondaries strategy, and opportunistic holding. For too long, there has been ideological friction around secondaries which has held back venture performance and enabled some very bad habits. It’s time to change that.
If there’s a chance to wipe the slate clean for venture capital, for LPs and GPs to return to first principles on compensation, incentives and ideal outcomes — to begin aligning venture capital with a high-performing meritocracy — it’s here, today.
Ironically, innovations in venture capital haven’t kept pace with the companies we serve. Our industry is still beholden to a rigid 10-year fund cycle pioneered in the 1970s. As chips shrank and software flew to the cloud, venture capital kept operating on the business equivalent of floppy disks. Once upon a time the 10-year fund cycle made sense. But the assumptions it’s based on no longer hold true, curtailing meaningful relationships prematurely and misaligning companies and their investment partners.
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?
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:
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.
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:
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.
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.
VCs taking public money (pensions, sovereigns, etc) must publicly disclose all deals, terms, marks and position changes.
LPs managing public money must publicly disclose all fund positions and cash returns.
Tax treatment for anything up to ~series A should be extremely advantageous to small managers.
No passing public money through multiple layers (e.g. VCs acting as LPs to EMs).
LPs managing public money should not offer bonuses to their allocators based on short-term performance.
LPs managing public money should have something similar to polical rules around disclosing gifts, travel, hospitality, etc.
This is just a start. The highest level changes that should be made to correct some of the perverse incentives in venture capital today, providing adequate accountability for public capital.
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:
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.
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:
It shortens the feedback window for VC performance, and disincentivises pouring capital into hot deals for inflated TVPI.
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:
Whether the basic 2/20 fee structure ought to change in this scenario, and whether it should be significantly different between the two?
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?
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)
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.
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.
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:
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.
Track records for evaluating VC's are an overused crutch.
LPs are programmed to use past track record as the primary driver in making a decision on whether to invest in a new fund (A recent study showed historical persistence of VC is that 70% chance a fund performs above…
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.
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.
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.
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.”
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.
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.
Remember FTX was a $32bn company with no board, no accountant, no HR & no detailed due diligence prior to investment.
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.
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.
Obvious Second Order Effect
Guess what happened once Founders realized that VCs were valuing startups using revenue multiples?
They started playing a game of Hungy Hungry Hippo with the goal of accumulating as much revenue as they could!
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.
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?
VC doesn’t do real diligence because investors possess pseudo mystical beliefs about value creation in the asset that are nearly completely unmoored to data or scientific validity. You did a fair job demonstrating this via your post.
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.
The success of AI is existential for venture capital
Imagine entering VC in 2020, full of enthusiasm about a the unstoppable wave of technology. Your peers are impressed; it’s a prestigious industry that is perceived as commanding a lot of power through capital.
You have to put aside your personal thesis in favour of the firm’s strategy on crypto, micromobility, rapid delivery, creator economy, and web3. Each of those sectors are benefitting from venture capital enthusiasm and weaponised capital, driving prices through the roof. It’s an exciting time, though you’re not feeling as involved as you would like to be.
In fact, you’d quite like to make the case for investment in other industries; overlooked opportunities which offer larger ownership stakes and cleaner cap tables. It’s difficult to justify the change of strategy when the biggest markups are all coming from a few hot sectors, so you avoid the friction.
Capital is flowing into the asset class from LPs at an unprecedented rate. Rather than pressure to justify and properly diligence investments, you are pressed to ensure capital is deployed and opportunities aren’t missed. Access to hot deals and co-investment with the tier-1 firms is how you stay relevant to LPs. Success is now largely dependent on your relationships across the industry.
It creeps up on you that your colleagues have stopped talking about exits. TVPI looks phenomenal. There’s no rush for any portfolio to go public. Now the conversation is about pricing and the appetite of downstream investors. Beyond that, it’s someone else’s problem.
For the first time, your spidey-senses start to tingle.
Early in 2022, concern ripples across the industry. Worries of recession, interest rates on the rise, and a weak public market that has lost interest in recent VC-backed IPOs. In simpler times, you would have papered over the cracks by highlighting fund resilience. Now, the idea fills you with dread. None of your portcos are growing much and auditors are on your tail to correct markups.
With surprising speed, the tables turn. An era of unprecedented growth and optimism comes to an end. Y Combinator writes the eulogy with an open letter to their portfolio companies. Venture-backed hypergrowth is shelved in favour of finding a path to profitability. The red-hot sectors which had promised game-changing returns are quietly scrubbed from websites and bios.
By Mid-2023, venture capital feels like a fever-dream. Many of the most exciting investments from 2020 and 2021 have imploded or recapitalised. Layoffs are the norm, even for many VC firms. Nobody in the arena wants to talk about why.
Fortunately, nobody has to dwell on the cause of the downturn for too long: exciting new tech from companies like OpenAI and Midjourney provides the perfect source of distraction. A whole new gold rush to sell to LPs.
The incredible possibilities offered by powerful, accessible AI models will spawn companies with growth potential not seen since the early years of Google and Amazon. It promises to easily turn-around a few years of poor performance for the venture asset class.
Of course, there are nay-sayers. Not the doomers who speak of an AI-driven apocalypse, at least they buy into the incredible scope of the technology. They are believers. The real problem are the cynics.
The cynic’s claim is that today’s “AI” is just an evolution of decades-long work on machine learning, neural networks and natural language processing. Yes, the hardware is a lot better, processing at scale is much easier, but fundamentally not a huge amount has changed. Models will be commoditised and commercial applications will favour incumbents who have data and distribution. It’s not the generational game-changer that venture capitalists claim.
Those who believe the hype (or those whose career depends on it) preach the gospel of salvation for an entire generation of managers. The narrative battleground is shifted to the conflict between these two groups, the doomers and the boomers, away from the cynics who offer nothing but grim reality.
Evangelism reaches new heights. Marc Andreessen who led the charge on the 2011 – 2022 bull run with his essay, “Why Software Is Eating the World“, proclaims even greater optimism with the publication of “Why AI Will Save the World“.
It gnaws at you. Do you really believe? Do the numbers make sense, or is venture capital back at its usual bullshit? Is it your responsibility to just blindly support this as an insider?
Worse, what if this fails too? The consequences for the venture asset class are difficult to contemplate.
At some point, you are sure the music is going to stop.
Until then, the only path you can see is to continue following your peers. As long as you are all doing the same thing, no failure can be pinned on you.
…Right?
Each day you scramble to find the hottest AI deals in your network and secure allocation. You keep making the same promises and assurances.
You lean into the identity, blend into the herd. Any sense of irony in wearing the uniform disappears. You begin to believe.
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.
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.
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.
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.
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.
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.
Not to mention the patagonia vest, vacations in Mykonos, or how many times they can squeeze ‘grok’ or ‘rubric’ into a conversation. [↩]
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. [↩]
The moonshot factory, not the social media platform [↩]
We also discussed this during a recent episode of the Equidam podcast. [↩]
This is a question I saw on Reddit’s often-comical /r/venturecapital, which I thought was interesting enough to write out a decent response to. It hits at the root of a few major problems in the asset class which are always worth addressing.
A 409A valuation, named after Section 409A of the United States Internal Revenue Code (IRC), refers to the process of determining the fair market value of a privately held company’s common stock. It is often conducted to comply with the tax rules governing non-qualified deferred compensation plans, such as stock options, stock appreciation rights (SARs), and other equity-based compensation arrangements.
A lovely summary fromChatGPT
First thing’s first: Generally speaking, VCs don’t care about valuation, and especially not ‘fair value’.
Fair is irrelevant. Only market clearing numbers matter…😉
…and that’s quite reasonable. VCs have their own investment strategy, their own approach to calculating risk vs potential, and if it works for them (and their LPs) then great. More power to them.
What’s important here is that while we often use the word valuation in reference to deal terms and portfolio performance, what we really should say 99% of the time is price.
In venture capital, price factors in a number of things, including the advantages of preferred stock over common stock, but most significantly it is geared at reflecting what the market would be likely to pay for that startup at the time. This is why VCs focus so much on comparable deals when pricing rounds, even if it ends up being a bit circular, with everyone copying everyone elses homework.1
So that is the status quo. But why are VCs interested in preferred stock in the first place?
Venture capital is all about power law, right? The idea is to invest in many startups, expect to lose money on 80%, and make a varying amount of money back from the remaining 20%.
Venture Capital ‘Backable’? 💡
I’ve reviewed over 3000 African startup pitch decks in the last 4 years. The most important question I ask myself each time is.. ⬇
So why do they care so much about downside protection, rather than maximising that upside?
When you add a liquidation preference to a deal, the implied value of the equity increases, meaning you get a smaller % for your capital. Lower returns at exit. That kind of trade-off flies in the face of power law, so why is it of interest?
Liquidation preferences insulate VC firms from losses, so they can delay markdowns until after they raise another fund. VC returns follow a J-curve, therefore losses come much earlier than returns. Liquidation preferences can serve as valid reasons to not mark-down investments as companies begin to miss milestones or don’t receive an exciting Series A valuation bump.
William Rice, “Slugging Percentage vs. Batting Average: How Loss Aversion Hurts Seed Investors”
Liquidation preferences are mostly an irratational response from loss-averse VCs, some of whom may be trying to shield themselves against reporting poor performance to LPs. Maybe that’s overly cynical; I’m all ears if anyone has a better explanation.
The core assertion here is that in a more rational and healthy market, liquidation preferences probably wouldn’t exist and VCs would just buy common stock.
An industry with few standards
Now that we have some understanding of how equity is priced and why preferences exist, let’s return to the original proposition: that VC investments could be marked up or down based on 409a valuations.
In some cases, VCs do set marks with 409a valuations, but not all. Unfortunately – as with much of VC – there are no real standards.2
Some VCs will only set marks based on fundraising activity, some will also consider 409a updates, some will factor new SAFE caps. Some will ignore downrounds, some won’t.
The way VCs price rounds is subjective and non-standardised, and therefore way they track the value of those investments is also subjective and non-standardised.
It might be going too far to say that this was all designed to obscure performance and protect charlatans, but this is probably how I would design VC if that was my intention.
Performance > relationships
Putting aside deal pricing for now: a VC firm could use any framework that provides a systematic read on fair value, such as this one from Equidam, and apply that to tracking portfolio company performance.
This would represent a huge shift in how VCs operate, and how they manage relationships with LPs. It’s also something that I’ve written about at some length before.
The horizon for useful feedback could be annual (or even quarterly) rather than 5-10 years.
LPs could hold fund managers accountable for performance, and we may see that many household names (which attrract the lion’s share of capital and startup attention) are actually dramatically underperforming. They could more confidently back emerging managers, who could provide more meaningful metrics of success.
VCs would be able to follow portco growth more precisely and learn much more quickly about what works and what doesn’t. Good managers would be able to fundraise much more easily.
Crucially, it would make VC an industry based on performance rather than relationships and hype chasing as it is today. It would make VC better at backing innovation, which is what the whole asset class was built around.
The flawed idea that VC is all about relationships (who you know rather than what you know) is too often taken as biblical truth. A mountain of research, however, shows that in VC, personal relationships destroy economic value. Closer ties = worse performance. pic.twitter.com/BQUxF9UIEB
Startups are volatile, but capital should be stable
Finally, if VCs were also to price deals based at least partially on fair value, we’d avoid momentum-driven valuation rollercoasters like we’ve seen in the last two years. Much less risk of valuation bubbles and crashes, more stability for LPs and VC funds, more consistent access to capital for founders, and – again – an asset class that could better serve innovation.3
A more objective and independent perspective on startup potential, better suited to investment in the innovative outliers that venture capital was created to support.
I’ve spoken to a number of people – LPs, VCs and founders – about this topic. There’s a near universal acceptance that a standard for private company valuation would be of huge benefit to the whole venture ecosystem.
Unfortunately, none of them are particularly incentivised to make a stand on it.
Some may benefit from the status quo, and the rest are keen to maintain their relationships by not making waves.
If anyone has any data on this, I’d love to see it. [↩]
There are also huge second-order effects, like how it would make venture capital fairer by removing more of the bias found in less structured approaches to valuation – but that’s for another post. [↩]
