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.
Venture capital is a seriously long-term game, with investments taking somewhere between 8 and 16 years to return liquidity.
The distance to that horizon creates a lot of eccentricity.
For example, VC does not reward following patterns or navigating market movements, neither of which is relevant to decade-long cycles. Consensus of pretty much any kind is toxic, as the more people agree with something the less profitable it becomes. Investment experience is like comfortable entropy, slowly eating-away at your ability to remain objective.
In a sense, success itself is antimemetic: the better the outcome of an investment, the more likely you are to try and repeat it through pattern matching ā destroying the calibration which allowed you to find it in the first place.
Can you imagine how maddening that is?
This is why the best GPs are oddballs. They live with the paradox that being a āgood investorā is a process of constant discovery, and the more lost you feel the better you are probably doing.
It takes a certain madness to do well, and that is not something you can pick up on the job. You cannot be taught how to think in a contrarian manner. Nobody can give you the confidence required to wait a decade to see if you have good judgement. You have it, or you donāt.
This is why great VCs earn a lot of respect. The role they play in financing entrepreneurial dreams is critical. From the semiconductor origins of Silicon Valley to SpaceX and our future on other planets, someone had to be there to write the check.
If the incentives were well aligned, thatās where this story would end ā as a fan-letter to weirdos. VC would remain a cottage industry investing in wacky stuff, offering strong returns for LPs.
Unfortunately, that is not the case.
Over the past decade we’ve seen the emergence of a new type of VC: one who moves between trends with the swagger of a heat-seeking missile, investing as if their money might go bad. This behavior is contrary to pretty much everything that we know about venture capital, and yet the trend has only accelerated.
To understand why, we have to look at VC compensation:
The ā2 and 20ā structure of VC compensation is pretty well understood and has remained unchanged for a long time: You get 2% of the fund per year in ‘management fees’ to pay your bills and support portfolio companies, and 20% of ‘carried interest’ as a share in any profits made.1
For people passionate about the outliers, carried interest is the hook. Secure enough big wins and you can make a vast amount of money, in contrast to management fees which aren’t exactly lucrative for a small fund. It’s also nice that carried interest aligns success of the firm with success of the founders.
However, as capital flooded into private markets over the last couple of decades, and exits took longer to materialise, some cunning individuals recognised an opportunity: the 2% is guaranteed, independent of performance, and it is possible to āhackā venture to maximise that income.
You can do things the old fashioned way, raising (for example) two $100,000,000 funds in a ten year period, with the implied annual income of $4,000,000. Alternatively, you can squeeze three funds into that period, at double the size, and scale your income to a mighty $12,000,000. All without really needing to worry about underlying performance.
To build that second scenario, you need to do three things:
Invest in the most overheated, capital-intensive industries, which allow you to justify raising and deploying larger funds ever more quickly. These industries are also an easy-sell for LPs, who want something to talk about at dinner parties.
Systematically undermine the understanding of valuation by promoting crude and illogical practices, and calling people nerds if they say things like “free cash flow”. Venture is a craft, not a science ā which basically gives you carte blanche, right?
Pour capital into brand and status building for your firm, which LPs love. Celebrities, political figures, impressive offices, big events… Anything that shows them you’re a serious institution (with the perks that entails) and not some garage-band firm.
Instead of looking 8 to 16 years in the future with your portfolio, you want to focus on the next 2 to 3 years in order to align with your fundraising cycles. You want companies that are likely to grow in value rapidly in the near future, so hype and consensus are powerful allies.
The aim is to invest in a company at Seed and propel it to a Series A within 2 years at a 4-5x markup, which ā if you can repeat it often enough ā will look great to LPs. If they ask about DPI just talk about how the IPO markets should open next quarter next year.2
You want to make sure the heat persists, to ensure prices at later stages remain frothy and your markups get better and better. So consider a bit of thought leadership to keep interest on your chosen sector. As long as LPs believe the hype, and keep investing in other funds on that theme, capital will keep piling in. Amplify that market momentum as much as possible. Volatility is your friend, and over time it can even help you wash out smaller managers that offer an unfavourable comparison on performance.
Obviously the actual investment returns from this strategy are likely to be terrible, unless you’ve somehow timed another ZIRP/2021 exit phenomenon and can unload all of your crap on the public markets just before the music stops. It doesn’t really matter, because the median return in VC is so poor that you might just luck your way into top quartile anyway. Keep the paper marks strong, keep bullshitting LPs about the market conditions and the insane potential of whatever it is you are investing in, and you can probably keep buying back in with a new fund.
It’s going to be toxic to founders, as they watch huge piles of capital being incinerated chasing hype instead of genuine innovation.
It’s going to be toxic to VCs, as good practices around markups, pricing and portfolio management are ditched in favour of capital velocity and short-term incentives. It’s already frighteningly clear how much basic investing knowledge washed out of VC during ZIRP.
The management fee is often frontloaded and scales back after the investment period. The 20% carried interest may also have a hurdle rate (e.g. 8%) which guarantees some return on investment for LPs before they split profits with the VC. [↩]
It might not matter though, as many institutional LP allocators collect their bonuses on markups, so their incentives are totally aligned with yours. They’ll probably have moved on to a new job in a few years anyway. [↩]
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 ā 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 ā especially with added transparency and scrutiny on practices ā 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 ā 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 capitalās evolution and fund managers adopting more sophisticated liquidity strategies. Pry a little deeper, and youāll 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 firmsā 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 aboveā¦
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 āarbitrary milestoneā 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 furtherā¦ 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 capitalās 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 wouldnāt have been so high to begin with.
It was not that the strategy was bad, it was that there wasnāt 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 ācooking the booksā 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. Itās 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 āquality revenueā and āsustainabilityā, this wasnāt 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 āunicornā companies, have essentially abandoned their traditional risk analysis.ā
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 COVIDās 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, thereās 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 PayPalās 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 imaginableā¦ of which there are many: āround trippingā, reporting gross revenue rather than net, sketchy definitions of ābooked revenueā, 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 didnāt 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 startupās 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 itās 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 arenāt required by investors or properly scrutinised by board members.Ā
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?Ā
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 doesnāt 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 andĀ 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, Iād go so far as to say that conventional business wisdom is a plague on founders. However, much can be standardised about the āunsexyā 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, itās 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 cynicās claim is that todayās āAIā 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. Itās 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.
Thereās 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 āin-groupā 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. Itās 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 arenāt, here a rough summary of the explanation from Nobel winning economist, George Akerlof, and his famous paper, āThe market for lemonsā:
Buyers in the used car market arenāt 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, thereās 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 ātier 1ā firms, in order to have those logos on their LP updates. Itās a superficial sign of āprogressā, and has no direct relation to the real goal of generating returns. They donāt really know how well they are performing on those terms, and they canāt really compare themselves to their peers.4
Turns out, when youāre building a venture firm truly from scratch (limited track record, no Ivy, didnāt 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, thereās increasing gravity around that āin-groupā network of VCs, and fitting into those patterns of behaviour and identity. Itās 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 āin-groupā 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 āgrokā or ārubricā into a conversation. [↩]
Once-upon-a-time it was popularly characterised by āVC Twitterā, 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 matterā¦š
…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 āBackableā? š”
Iāve reviewed over 3000 African startup pitch decks in the last 4 years. The most important question I ask myself each time is.. ā¬
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 donāt 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. [↩]
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, thereās 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 weāre 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 āfair marketā 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 shouldnāt pretend that an equity transaction represents an āobjectiveā read on value either; itās 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. Itās 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, itās 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 itās 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 hasnāt 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.
Itās 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 āfair valuationā 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 itās 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 doesnāt 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, theyād 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 thatās 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.
Especially given the extreme proclivity of investors to pass the buck, and base their pricing on other market transactions. [↩]
As a founder learning the ropes of venture capital, you might see VCs as asset managers, with LPs as their customers and your equity as the asset being managed.
This is heavily implied by the chain of responsibility: you are required to report your progress to your VC investors who want to see milestones crossed and targets met. Similarly, VCs then have to report on the fundās investments to their LPs.
It would be an odd relationship if customers were accountable to service providers, right?
Understanding the relationships
When an LP commits to investing in a VC fund, they are typically locking themselves in for a ten year relationship. Thatās three to four years over which they expect their capital to be invested, and six to seven years in which they hope theyāll start to realize those returns. This mirrors the kind of relationship you will have with a VC, which lasts a similar period of time from investment to exit.
In this context you might understand that LPs donāt really resemble a customer, and neither do VCs. Instead, they are the shareholders and operators of a specialized financing instrument for early stage companies. The relationship matters, updates are intended to prompt feedback, and success is shared. Crucially, both parties rely on the firm building a reputation for offering a good service, fair terms, and accelerating success stories.
Fred Wilson of Union Square Ventures shared more of the VC perspective on this in his 2005 blog post:
The entrepreneur creates the value, they are the āraw materialā in the venture capital business. If there were no entrepreneurs, there would be no venture capital business.
It can be difficult to view this from the perspective of a founder, as it assumes you are in a position of control – an odd fit with the usual perception of the venture capital process. Isnāt fundraising all about struggling with an endless string of rejections? Again, the bigger picture allows us to see how the relationships really function.
Healthy markets rely on consumers having freedom of choice, and this is where venture capital suffers from an image problem: When youāre hammered with messaging about how slim the odds are for success, it can seem like raising money from a top-tier firm is the most important signal for success. The moth-like attraction to the top of the market means those firms are swamped with pitches and thus issue even more rejections.1
However, if you look at venture capital as a marketplace of firms looking to service startups, you might be more inclined to think in terms of practical comparison. Ignoring the logos, who can best serve your particular needs? Where are the hidden gems and less obvious bargains?
Consider consumer brands, where bigger companies tend to be worse at serving more specific (more technical, higher performance) consumer needs. A larger target market implies more mainstream use cases, and your brand often becomes more important than the performance of your products. At that point, there are likely to be smaller brands that outperform in a particular niche where their expertise makes a difference.
This is a reasonable metaphor for venture capital, illustrating the benefit of approaching fundraising as a customer looking for a solution rather than an entrepreneur with their hat in their hand. As with any transaction, you are looking for the best bang for your buck, and smaller specialist funds are likely to deliver exactly that – for all sides of the transaction.
Highly specialist portfolios from young firms have a top-quartile hit rate of 61%, representing a 2x increase from the most generalist portfolios.
