98% of VCs Aren’t Dumb

http://www.bothsidesofthetable.com/2013/05/25/as-populist-as-it-may-feel-98-of-vcs-arent-dumb/

by ssclafani • 13 years ago

102 48 13 years ago

rayiner4• 13 years ago

I felt Dunn's post missed two things:

1) The 2% who make most of the returns is not consistent from year to year.

2) A VC who underperforms the market isn't a loser, because he's still collecting his paycheck (maybe with a smaller bonus than otherwise).

The combination of 1 and 2 is why the "98%" can keep raising capital, and is the open secret of the professional investment management industry. You can see the same trends in say hedge funds or other actively managed investment funds.

rdl15• 13 years ago

In VC there are 5-10 funds, universally known, who are the winners, and who continue to win. They get the best dealflow, meddle the least, and generally are on top.

The crazy thing is that KPCB used to be in that set and then essentially voluntarily abdicated to do cleantech crap.

A16Z came from nowhere to join that set pretty much as they launched.

The others (greylock, sequoia, benchmark, accel, etc) are pretty static.

rayiner4• 13 years ago

Note the distinction between some funds being consistent winners, and the whole set of winners being consistent over time. The 5-10 funds who are consistent performers: 1) aren't the whole of the "2%" who manage to make above-market returns over some time frame; 2) can't absorb all the money investors want to put into the venture capital as an asset class. That keeps the other VC firms who aren't Sequoia, etc, in business, even if the generated returns are less than stellar. That does not mean, however, that the other VCs are "losers." They still get their 2 and 20, and as long as everyone is consistently mediocre and the top VC funds can't absorb all the capital the big institutional investors have sloshing around, they'll keep being able to raise capital.

Interesting (and fairly recent) analysis of VCs from the point of view of a limited partner with investments in a range of VC firms: http://www.kauffman.org/uploadedFiles/vc-enemy-is-us-report.....

The mediocre return of VCs also says something about Silicon Valley. The idea of venture-capital funded startups as some exceptional economic engine is probably a myth. There is a lot of economic activity in Silicon Valley, no doubt, but you have to distinguish between expenditure of capital and return on capital. $20 million spent on a startup that never ends up making much revenue is not a net gain to the economy even if it shows up as economic activity. It's just expenditure of capital. So the success of specific VCs aside, the way to measure the economic contribution of VC-funded startups is by looking at the return on investment of the sector as a whole. And since that return isn't great, relative to blue-chip companies, that tells us one of two things about the sector:

Either: 1) VCs aren't great at the job of allocating capital to the right places; or 2) VCs are doing the best job they can, and its just inherently difficult to separate the winners from the losers when it comes to startups.

My gut feeling is that the answer is (2), which implies that the nature of the industry is such that it's so hard to separate the winners from the losers that the gain from the exceptional success of the winners is largely offset by the cost of funding the losers, which makes the economic returns from the industry as a whole unexceptional compared to the returns from traditional blue chip companies.

jonmrodriguez2• 13 years ago

> to do cleantech crap.

Considering that climate change already kills 150,000 people per year [1], and that this rate will continue to (dramatically) increase, I think it's pretty rude for you to belittle the few good people who choose to fund cleantech (putting their fellow man above short-term economic "rationality").

[1] http://www.who.int/heli/risks/climate/climatechange/en/

late2part• 13 years ago

Yeah, you have to be pretty smart to convince pension funds to give you money in an area that underperforms the S&P.

tyang2• 13 years ago

VCs are quite smart.

Where else can you charge 2 and 20 for long-term returns below the far less risky small cap index funds?

http://www.kauffman.org/uploadedFiles/vc-enemy-is-us-report....

michaelochurch6• 13 years ago

The problem with VCs is not that they're dumb. I'm a pretty severe VC-istan critic and I would never say that lack of IQ is their problem.

Their problem is that they're ill-equipped to make the judgments necessary to solve half the problem. They know business and acquisition structures and legal pitfalls, but in order to really get signal on the judgment of people-- I'm ignoring the judgment of ideas because I don't think anyone has that down-- they need to hire someone like me to vet technical choices, talent strategy, culture, etc. because an iPhone app is not going to give them that kind of data.

How do you find that kind of person if you're not that kind of person? I think it's almost impossible. How are they going to tell the people like me from the many who claim they are? Likewise, I'd be incapable of vetting them for whether they're good at their jobs for the exact same reason. I'm not superior to them in any way; we just excel at different things and it's very hard for one side to judge the other.

Perhaps the best way to start a venture fund is to have the selection made not by permanent VCs judging "the team" but by top-notch programmers who do the vetting part-time (no more than 10 hours per week). That way, they don't lose their technical touch and can tell based on technical choices whether a company has a future. (How would a VC know that a company running a typical enterprise Java stack is doomed? It's not his job.)

By the way, the reason VC-istan sucks is not that VCs are evil or stupid people, because they're not. It's that humans are bad judges of character and VCs are no exception. When you can't judge expertise (and they can't evaluate technical expertise) you miss out on the associated proof-of-work and default to social polish, which means that you're going from a slightly positive correlation to what really matters (character) to a slightly negative one. VC-istan generates some awful startups, but not because VCs are bad people.

rdl15• 13 years ago

VCs already do this.

0) VCs with technical/operating background. I'd put a lot of faith in e.g. pmarca's evaluation of a team. 1) EIRs 2) Outside advisors 3) Portfolio companies (you do some pre-screening, then have your existing portfolio CEOs meet with the founders of non-competitive new ventures. It's win/win, because the portfolio companies may have some useful business relationship, or if the founders can't raise, might be a good hire.

michaelochurch6• 13 years ago

They're not doing it successfully. They could be.

They pick advisors who know how to do what they already know how to do, to validate their decisions. That leads to some improvement in the process, but they're not picking people who complement their skill sets. They're picking less shiny versions of themselves.

justinbeaver2• 13 years ago

Dear dumb entrepreneurs who want to raise VC: bootstrap instead. VC forces you into a 'go big or go home' strategy. There's nothing wrong with going big, but just do it the patient, more sustainable way. And then you never need to worry about the points made in these articles. You just get to sit back and laugh at them while you're owning and running your own business.

P.s. there is a time and place where big time capital is necessary to start but most of those businesses aren't reading HN.

mindcrime3• 13 years ago

There's nothing wrong with going big, but just do it the patient, more sustainable way. And then you never need to worry about the points made in these articles. You just get to sit back and laugh at them while you're owning and running your own business.

This is our mindset. We definitely plan to be big (real big) but we're patient and we don't have to paint ourselves into a corner or take any bad deals by trying to do it all at once.

That's not to say that it wouldn't be nice to have more capital to work with, and that's not even to say that we won't ever take VC money. But if we do take VC money, the goal is to do it when we are well positioned to get more favorable terms.

justinbeaver2• 13 years ago

Agreed on the growth capital point completely. Was referring specifically to early stage capital in my comment - should have been clearer. Thanks.

blazespin• 13 years ago

Maybe not 98% of all VCs, but I do wonder about 98% of VCs who weren't successful entrepreneurs at some point.

mindcrime3• 13 years ago

This reminds me of an exchange from a few weeks ago (https://news.ycombinator.com/item?id=5500592)

Somebody said:

As a former investor, an entrepreneur that thinks he/she understands my business better than I do is a big red flag.

and I replied:

As an entrepreneur, an investor that thinks he/she understands my business better than I do is a big red flag.

To me, this gets to (or near) the heart of the thing. If you're a VC / angel, you're probably fairly smart, probably well connected, and probably have a modest amount of interesting experience in many things. But if you're not one of the VC / angel types who came from a background as an entrepreneur, why should I believe that you have much knowledge that will be specifically relevant to my business. And why should I think you are particularly well suited to judge my business?

msuster, sgblank, pg, and a few others, I would put a lot of faith in, based on their backgrounds... but most other VCs, I really wouldn't be looking to them for much besides: A. money and B. introductions / referrals. I almost certainly wouldn't be looking for product advice or marketing strategy, etc. from them (unless they had some proven background in that area).

tptacek• 13 years ago

One reason is because, operational experience or not, VC partners all sit on the boards of companies, most of which fail, and so have a front-row seat for their implosions.

mindcrime3• 13 years ago

Fair enough.

I still have my doubts about how much the gain from that experience, that will lend value to any specific future potential investment, unless the firm that failed was in a very similar business. And you also have to consider that VCs frequently sit on multiple boards, and have routine "vc firm dealflow" stuff to deal with, so their attention gets spread around a lot.

Anyway, I don't mean to say that they don't have anything of value to add. But I will stand by saying "you claiming to be an expert in my business is a red-flag", barring some specific evidence to the contrary.

rdl15• 13 years ago

Benchmark is almost all non operators, and is one of the most ballerest of VC funds.

Instinctively I think "should be operators", but when I look at the backgrounds of the VCs I like the best, a lot of them were not operators, or were operators of pretty bullshit businesses in comparison to their VC careers.

jabbernotty• 13 years ago

Offtopic, but I am wondering why you are overloading the word 'operator' in such a confusing fashion.

niyogi• 13 years ago

The irony of this blog post is that it's very existence proves that the 98% routinely behave (and believe) they are the 2%.

The other important point is that the 2/98 split is largely exaggerated but you could make it 10/90 and the point would remain valid.

It's sad that all VCs want to be "entrepreneur-friendly" publicly (largely to widen dealflow) but are largely the opposite behind closed doors.

dyno12345• 13 years ago

They're not stupid. VCs make more money than entrepreneurs do in the long run.

josh2600• 13 years ago

VCs yes; a better question is LPs or GPs. The answer matters greatly.

ivankirigin• 13 years ago

This is the first article I've read that mentioned what the typical return on a fund is. I have had educated guesses, but why don't we see this broadcast more broadly. Is it that only LPs care?

I'd generally prefer to get investment from people whose judgement has proven they know how to get a good return on an investment, because founders typically get the same "return" from that stage on.

wellboy• 13 years ago

For me, the 98% of VCs are all like Gandalf the Grey. They have kind of an idea what they are doing, they maybe actually understand 98% of investment, but they just can't get the last 2%. The thing is, they are all followers: Never would they be able to recognize the next Facebook, because it doesn't fit their pattern, whereas their pattern matching has to look out for startups that don't fit their pattern.

How do you become a 2% VC? You have to have been a successful startup founder before. Otherwise, you just don't have the understanding of building the future. The 98% VCs got there from studying business to working at McKinsey, to being an Investment Analyist. Yeah they can do fine by investing in proven startups, that have been done before, but they'll never get their 50x-100x, because they can't predict the future.

So if you haven't been a founder before and you want to be a VC, please quit your job, stop wasting everybody's time and money, start a company, and come back as Gandalf the White.

jeffehobbs• 13 years ago

What about the 2% of investors that are Dave McClure?

tyang2• 13 years ago

A friend and fellow ex-Wall Streeter notes:

"All hedge funds are smart. Period. End of story. Whenever you can gamble with other people's money and get paid on the wins and eat none of the losses, that's the real win. Anything after that is gravy."

[edited in honor of grammar nazis]

98% of VCs Aren’t Dumb

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