The venture capital model is broken, and this damning report explains why

http://www.geekwire.com/2012/venture-capital-model-broken-damning-report-explains/

by username3 • 14 years ago

93 53 14 years ago

rauljara• 14 years ago

>> In essence, the report suggest that VCs get paid “to build funds, not build companies.”

Sometimes it seems like the whole financial sector is just one long series of perverse incentives strung together. But I guess it doesn't make the news when it works the way it is supposed to.

jpdoctor6• 14 years ago

The report that they link is well-worth reading in order to understand the VC ecosystem.

tl;dr of the linked report:

* Somebody who relies on VCs to invest their money has finally noticed that VCs fail to beat the market over 10 years.

* They think the fault lies at the investor-VC interface: The way VCs are compensated is broken, and the way VCs report the performance of the portfolio is opaque.

* They make recommendations, which will never be adopted because it would expose and publicize the true VC returns.

j2labs• 14 years ago

Regarding your third point, if I was a VC that was beating the market - and there actually are many - I'd be happy to share my info and put pressure on the weaker VC's to expose themselves.

jpdoctor6• 14 years ago

> and there actually are many

But not with regularity, which is why they don't do it.

Even Sequoia, which seems to have a golden halo around here, had the partners pony up funds in order to keep some funds positive.

magicjuand• 14 years ago

It's easy to bash projects that fail. Wall Street is stuck in this place where they keep investing in the same boring business they have been for decades. They set unreal expectations, that cause firms to fudge numbers, leading to bail outs. Wall Street is short sighted and doesn't look at the big picture. Hell, if I was part of the largest (corporate) welfare class as well, I would bash failed ventures as well.

Fortunately, I am not tied to group think, so I can be as creative as I would like to be. VC's are great. They take chances, and are willing to invest in things that are more than likely to fail than be successful. Discovery is the ultimate reward, and I am more than happy to lose money so long as it leads to a discovery that helps society as a whole.

VC's allow for experimentation, and even if the experiment fails, lessons are always learned. It's amazing how narrow minded business people are. Personally, I feel that knowledge gained is priceless and far outweighs short term profits. Thank you VC's for taking chances and for willing to think outside the box.

TL;DR: Knowledge is the ultimate return on investment.

tomkarlo7• 14 years ago

VCs are great if they're funding your startup. That's not what this article (and report) are about - they're about how VCs don't really serve their real clients, the LPs who invest in them.

This matters - those LPs are generally large state and corporate pension funds, who may be investing YOUR retirement money. Many funds are underfunded and now are trying to chase yields, because they have always projected 7-8% annual returns across the fund and the traditional stock and bond markets have not been consistently providing that. So they're dumping more money into PE and VC funds in a (potentially disastrous) game of catch-up, because they alternative would be admitting defeat and the need to either cut benefits or massively increase funding of the pensions.

asanwal4• 14 years ago

Sorry but this argument is some combination of naive, inane and/or b.s. VCs are financial investors and their investors (the LPs like Kaufmann) who give them money are expecting a return. Discovery, social good, changing the world and other euphemisms don't cut it for them as that is not what they are sold. They are sold a story of high risk, high reward, and per these #s, that was not what was generated.

TL;DR: Until pension funds and endowments are happy to be compensated in rainbows and hugs, returns are the only thing that matter.

robocat5• 14 years ago

Ironically enough it looks like you are just as wrong as GP.

"The Kauffman Foundation was created to encourage entrepreneurship"

http://blogs.reuters.com/felix-salmon/2012/05/07/how-venture...

kyt• 14 years ago

You could swap out VC funds with hedge funds and the article would pretty much be the same.

asanwal4• 14 years ago

Interested to know if you have data to support this. Thanks.

jstanderfer2• 14 years ago

Read "The Hedge Fund Mirage" by Simon Lack

tomkarlo7• 14 years ago

Not really. There's a couple things hedge funds have to deal with that VCs don't - generally, it's easier to track the market value of their portfolios, so they have to show performance on a quarterly or annual basis. Also, the lockups for investors are much shorter (~2 years) so you can get out of an underperforming fund, whereas with a VC you're generally locked in from the start to the end of the fund. (Secondary markets do exist, but at a large discount.)

robocat5• 14 years ago

I think kyt's point is that 2%+20% causes the same mis-alignent of incentives for hedge funds.

mdda• 14 years ago

The majority of hedge funds offer quarterly or monthly liquidity (partly because this is what the fund-of-funds industry demanded).

However, many hedgefunds have the concept of 'gating' - where if everyone rushes for the door at the same time, the fund can restrict outflows. This is to let them to unwind illiquid investments without causing market disruption (to enable them to treat the people leaving on a fair basis as the people who stay : The portfolio doesn't have to just sell off the liquid positions to satisfy cash withdrawals, leaving tougher ones behind).

michaelochurch• 14 years ago

I think the binary nature of the VC model is a big part of the problem. I don't know what the alternative's going to look like (crowd-funding?) but right now we have a two-caste system. There are "the funded" and the cold and hungry. The inside and the outside. Losers and winners selected before a single one of either side has had an opportunity to accomplish much of anything. There are a lot of things that could be said about this model, but I think it's pretty clear that it's not good for technology. As we see, most of this bubble is in "social media" VC darlings with mediocre leadership and MBA culture... and still little investment is going into Real Technology startups founded by actual engineers.

A VC cash infusion puts someone from one category into the other immediately. Someone goes from being (in terms of VC-istan social status) a beggar to a baronet in an afternoon. It's really an all-or-nothing game being played. Making it a million times worse is that VCs usually talk to each other about the deals they're making, which means that one VC's opinion influences the multitude. If there were more independence among VC decisions, we'd see an order of magnitude more good startups getting funded.

I think VCs tend to get distracted by their kingmaking powers as well. It's no longer about delivering the best returns for their client. It's about using that magic wand to be "cool" and minting the right baronets, the ones who will use the press access and social status they get from being Funded to make that VC (individually) seem more stylish. Like Tyrion Lannister, they just (::sniff::) want to be loved.

larrys3• 14 years ago

"which means that one VC's opinion influences the multitude."

But if the idea is to make money and spread the risk among many "bets" that makes plenty of sense.

"If there were more independence among VC decisions, we'd see an order of magnitude more good startups getting funded."

I think you are overestimating the influence of any single person. PG trying to get USV to invest in Airbnb comes to mind.

Taking an investment that others have decided is good and deciding if you agree is much simpler than doing the same without that social proof. Added: and filter.

gravitronic• 14 years ago

If this is what you or anyone else reading this worries about when they go to sleep at night I strongly suggest you start a business that is bootstrappable instead of the next social network.

asanwal4• 14 years ago

The VC market is one where the buyers of VC funds (LPs such as Kaufmann) have a lot less information than the sellers (the VCs themselves) - a market with a high degree of information asymmetry. In "a market where sellers have more information than buyers about product quality can contract into an adverse selection of low-quality products."

http://www.nobelprize.org/nobel_prizes/economics/laureates/2...

jstanderfer2• 14 years ago

LPs commit money to new funds before the first investment is ever made. What type of information does the seller (VC) have that the buyer (LP) does not?

larrys3• 14 years ago

My guess that the answer to that will be "past performance".

But as the cliche goes, "past performance is not indicative of future results".

Additionally my guess is that creative accounting could make that data near worthless in many cases.

pge4• 14 years ago

One of the challenges is that the buyer (LP) is usually managing billions of dollars (e.g. a pension fund or large endowment), and venture is only a tiny fraction (a couple of percent) of his total asset base. It's difficult for those LPs to have expertise in an asset class that is such a small portion of the portfolio. The obvious objective criteria is past performance but understanding the potential of a team requires a deeper understanding of what makes firms successful.

asanwal4• 14 years ago

Not totally correct. VC firms often have many concurrent funds. So while they're investing out of fund 1, they're raising for fund 2.

And they're using Fund 1 early returns (often paper returns) to make the case for why the LP should invest in Fund 2.

Felix Salmon summed up the phenomena well here:

"In reality, reported returns peak very early on, in month 16 — which just happens to coincide with the point at which the GPs tend to start going out on sales calls, trying to raise their next fund. Of course, at month 16, none of the returns are realized: they’re driven instead by increases in portfolio-company valuations, and those valuations are set by the GPs themselves."

His article here - http://blogs.reuters.com/felix-salmon/2012/05/07/how-venture...

nl• 14 years ago

Kaufmann isn't a LP, they are a foundation setup to study and promote entrepreneurship.

rdl• 14 years ago

Kaufmann is both. They have an endowment, and invest part of that with a bunch of VC funds, in which they are LPs.

davidu2• 14 years ago

LPs need a two-tiered investing model. It's true, outside of the very few top performers, everyone else is a loser. Unfortunately, once in a while, a loser, or more likely, a new fund hits a home run. They should have a portion allocated to investing in new funds with less capital at risk.

The 2 and 20 is also only a problem for bigger funds. For smaller funds ($40mm for instance), it's not really an issue. Assuming two partners, that's $250k annually for each, leaving 300k for office and misc expenses. Not getting "VC rich" with those kinds of dollars. It's when a 2 and 20 fund raises a 500mm or 1b fund that the 2 and 20 causes the base salary to be excessive.

pg2• 14 years ago

Surely most users of this site already knew only the top VC funds make money. The Kauffman Foundation certainly should have. But that doesn't mean the VC model is broken, just that there are a lot of lame firms using this model as well as the good ones.

tlogan• 14 years ago

I think the point of the report is that system as now does not force "lame" firms to improve.

In other words, top VC funds will be top VC funds - the improving rules will not influence them. The question is: Is there a better system to force bad VCs to improve (or to make them bankrupt faster so they can be replaced with better ones)?

rscale• 14 years ago

The report also cites Landmark's simulated auction of carried interest, which showed that they might be able to collect 42.5% carried interest if they actually implemented such an innovation. That'd be wonderful for Landmark, and democratizing as well, since it'd shift investment in oversubscribed, top-tier funds away from cozy relationships, and towards those who value that investment most highly.

As such, this really isn't a report saying 'VCs make too much money', but rather that standard LP/VC terms overcompensate poor VCs and undercompensate top-tier VCs, and that this is unlikely to change unless LPs change their behavior en masse. There were numerous examples of GPs who were open to innovations in the VC/LP relationship, but didn't pursue them because of intransigent LPs.

pge4• 14 years ago

I think it's important to distinguish the "VC model" (meaning investing LP money in early stage companies) with the current compensation models that are prevalent in the industry. The first is alive and well. The latter is broken.

edanm• 14 years ago

The article isn't talking about the fact that most VCs don't make returns. It tries to analyze the reason this is happening.

According to the article, that the reason is misaligned incentives - the VCs get lots of money when they raise lots of money, regardless of whether they get a return on their investment.

tptacek2• 14 years ago

You'd be better off replying to a post of the actual Kauffman report than the summary on "Geekwire.com". From the beginning of the report:

Recommendation 1: Abolish VC Mandates: The allocations to VC that investment committees set and approve are a primary reason LPs keep investing in VC despite its persistent underperformance since the late 1990s. Returns data is very clear: it doesn’t make sense to invest in anything but a tiny group of ten or twenty top-performing VC funds. Fund of funds, which layer fees on top of underperformance, are rarely an effective solution. In the absence of access to top VC funds, institutional investors may need to accept that investing in small cap public equities is better for long-term investment returns than investing in second- or third-tier VC funds.

Kauffman isn't disagreeing with you, but is observing that LPs are often required to allocate capital into VC as an asset class, and can thus be required to plow money into huge and underperforming funds because it's too difficult to get enough money into the smaller funds that do outperform the market.

You can read just a couple pages into this report and see that they're on the same page you are in this regard, right?

pg2• 14 years ago

Obviously they're "on the same page" now. But they must not have understood the sharp dropoff in VC performance when they invested in mediocre funds, or they would not have done it.

larrys3• 14 years ago

Note this which appears on the last page:

"Several peers listened to our list of topics andresponded by cautioning us that “this is a relationship business,” implying a view that we are better off accepting the status quo and being in misaligned, under performing VC relationships than pursing negotiations for better terms."

"this is a relationship business" is a frequent phenomenon in sales and even in lawyer client relationships. Lawyers become friends of their clients and this prevents the clients from easily doing something that isn't in the best interest of the lawyer. Large ticket salesmen frequently wine and dine clients (including sports tickets and if you believe some accounts prostitutes). Specialty doctors entertain primary care physicians (well at least in the old days they did) in order to maintain a flow of patients. The very clear intent of all of that is to protect a legacy system and prevent you from entering into a relationship with another entity that may actually be better for you. This happens even in cases where the person being sold is spending their own money. But when people are spending someone elses money all bets are off.

JVIDEL• 14 years ago

What do you expect when half the VCs say they invest using "their gut"? as if "feeling" a company is going to be successful is a valid metric. In any case if you fail more than once it's obvious your gut isn't very precise and you should use other methods.

Anyway, that the system is broken is hardly something new, have you all forgotten "The canary is dead" slides from TheFunded? and it was 4 years ago!

What I'm asking is: does it matters? When those slides were released it was all doom and gloom, wantrepreneurs were going to disappear, nobody was going to be able to raise funding, etc...

And nothing happened, which is not me saying it doesn't matters, just that it seems no-one cares.

tptacek2• 14 years ago

Ouch:

Longer fund lives are an expensive trend for LPs, who often are asked to pay additional management fees for a fund that extends beyond ten years. Many funds have several companies left in the fund at the ten-year mark, and demand additional fees, frequently based on the value of the portfolio (e.g., 1.5 percent of the cost basis of the remaining portfolio). The alternative available to LPs is to receive a FedEx package of private company share certificates. Which of the two evils is lesser?

Context: VCs market funds to LP with a lifetime of 10 years, but usually can't liquidate all their holdings in that time frame; they apparently then go on to charge management fees during "overtime".

tomkarlo7• 14 years ago

Given that investors were already paying ~2% management fees during the life of the fund, paying a few points a year while the VCs try to liquidate the remaining assets doesn't seem like that big a deal. The remaining assets are probably less than 10% of the original fund size in terms of their cost basis, so you're talking about an ongoing fee that's less than 10% of what they were already paying.

The alternative would be to fire-sale the assets when the fund closes, which would probably cost the investors a lot more.

The venture capital model is broken, and this damning report explains why

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