Venture Model Makeover & Diet Plan—Step One
A lot of people have been asking lately if the venture model is broken. But it seems to me that it’s just decrepit. Like an aging, rotund former football star, the venture industry is scratching its head and realizing that its glory days are long past. The industry collectively doesn’t really know how to handle its new reality. In the heyday, top-quartile funds might have gotten away with treating their important stakeholders arrogantly, but given that even top-quartile firms have not provided great returns over the past 10 years, venture GPs will need to make herculean efforts and adhere to a strict regimen in order to make the upcoming cut. With almost the entire industry needing to raise new funds over the next two years, there may be few survivors. I propose a three-step makeover plan for those paunchy firms that are on the edge.
Step one: Stop devouring entrepreneurs. These tasty morsels can be irresistible, to be sure. They work for years to create a business, innovate, and execute, and they bring the fruits of their labors to you. GPs, you must learn to control your appetite and realize that these individuals are not going to continue to feed you if you chew them up and spit them out.
A case in point was hinted at in an earlier post about “down” being “the new up” by Michael Greeley of Flybridge Capital Partners, chairman of the New England Venture Capital Association and a board member of the National Venture Capital Association. Greeley made the argument that venture-backed companies “should be considered fortunate to just raise capital, at any price, in this environment.” I don’t mean to pick on Michael, as he is only reporting on the current prevalence of this kind of thinking among VCs, but why should a company be lucky to take in financing that wipes out the ownership of everyone but the venture funds who participate, just because we are now in a tough economy? Venture capital is a long-term game that is meant to take companies to an exit years from now when the economy will probably be completely different.
One could argue that it’s only reasonable and good business to protect the venture firm’s downside at the founding team’s expense, but is that really true? Usually the founders are only left with a small percentage of the company after a few rounds of funding even in the best-case scenarios, so for an additional 5 to 15 percent of the equity is it really worth alienating those individuals while proclaiming on your LP road-show how you are “good partners to entrepreneurs?” Either you truly are a good partner to founders or you are optimizing your financial return at the expense of everyone else—you simply can’t do both. Furthermore, one could point out (in the way that venture GPs often do) that a smaller percentage of a bigger pie is more valuable. Arguably the best deals will be competitive and therefore the entrepreneurs will choose those firms who both offer the best terms AND have a reputation for treating founders well after the initial investment.
Has the industry really reached such a low point that the only way to get good returns is by financially engineering out the founders? How about a different idea—what if we all make money if the company succeeds since we will all lose if the company fails anyway? Sounds reasonable to me.
Tranches, liquidation preference multiples, VC-controlled boards that put their own interests ahead of the best interests of the company—these and other examples of gluttonous industry trends have somehow become acceptable practices. I propose that as an industry we do some self-regulation before we financially engineer ourselves out of existence.
Taking the example of tranches: imagine a fixed-rate mortgage that can be converted to an adjustable rate at the sole discretion of the bank and only to its advantage, and then add a restriction that prevents the homeowner from negotiating a better rate when market conditions change. Well, a tranched venture financing is even worse. Entrepreneurs are force fed larger rounds than they need, tranched so that value inflection milestones receive no pricing recognition for advancing the company. The entrepreneurs have restricted ability to go to the market and get additional financing at decent terms because the existing investor, the insider VC, is the one all new investors look to for guidance.
The other side of the same coin, liquidation preference multiples, limit the upside of the non-VC shareholders by paying out to the VCs a multiple of their cash investment before or instead of the pro-rata distribution. In some cases it gets to an extreme of a 3x liquidation preference, which is higher than what most venture firms make on most of their companies. I propose that instead of excelling at dividing up a small pie so we can essentially slurp down the whole thing, we should be putting our emphasis on launching industry-transforming companies that have potential to create outsized returns. This is where VC has traditionally made money, and those companies will be created by entrepreneurs who will have a choice of what kind of funding source to work with.
The third example of venture fumbling is the VC-controlled board. We need to remember that our role is to support rather than control these companies. Companies that are essentially being managed by venture firms through VC populated boards are as foolish as the proverbial defendant acting as his own legal counsel. The venture firms sitting on the board often have only a fraction of the company knowledge, domain expertise and time-share of the founding/managing team and independent directors. Being heavy-handed in this regard is also a recipe for draining the company of the entrepreneurial spirit and sparkle that made it interesting to begin with.
So how do we add value in a challenging environment? Those of us who are earnest about our mission are hustling to help our companies refine and execute on plans that will help them achieve value inflection milestones in the most efficient way as well as making introductions to strategic partners, world-class team members to fill gaps in expertise, and independent directors.
Our business relies on innovation and collaboration. Those firms that devour entrepreneurs like insubstantial crumpets may not be around for much longer, given that most VCs are fundraising now. Some LPs actually make reference calls to founders (not just current management)—and hopefully make a point of calling those that are not listed as formal references. (LPs—more on this subject in step two of the makeover plan.)
Without entrepreneurs there would be no venture capital industry, but the opposite is not true. In a world with no VCs, entrepreneurs would bootstrap, work collaboratively with strategic partners, and create new models to finance their companies. Entrepreneurs have creativity and perseverance. They will continue to create innovative companies and make money for those investors who really are great partners to them.
The venture model is not broken, it just has some unattractive features that could benefit from a strict diet and perhaps even a surgical procedure or two.
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