Venture capital has a self-dealing problem

http://fusion.net/story/102544/venture-capital-has-a-self-dealing-problem/

by julespitt • 11 years ago

126 87 11 years ago

fusion.net

sgwealti• 11 years ago

I can't believe the folks who disagreed with you are hand-waving away a huge conflict of interest.

InvisibleCities• 11 years ago

"It is difficult to get a man to understand something, when his salary depends upon his not understanding it!"

~Upton Sinclair

s73v3r• 11 years ago

They believe that money makes right.

coderzach4• 11 years ago

Venture capital isn't a game you can "win." The goal is to get a return on investment, not to fairly distribute money. Starting a company isn't a contest like american idol.

jjoonathan• 11 years ago

He addresses this point directly.

coderzach4• 11 years ago

Yes, by going on a tangent about how investors might agree with him and think it's "totally unfair." He doesn't actually address the point.

If the people funding these VC's are unhappy about it they can pull their money out.

jfoutz• 11 years ago

Not sure american idol the best example. Don't the "winners" usually get signed on the judges labels? Simon Cowell does this, it's really pretty brilliant. get paid to make them popular via the TV show, get paid producing the albums after you make them a star. If you squint your eyes right, all those contestants are getting angel funding, the top 12 get VC funding and the winner gets an IPO. The producers lose a little money at the angel level, break even to decent money at the mid tier, and rake in some serious dough once the album comes out.

I get your point, but you should pick a contest that isn't hit driven like VC money is. Starting a company isn't like the Olympics, for sure.

matthewowen3• 11 years ago

I think the bigger objections than "fairness" are:

1. These might not be good funding decisions. Maybe investing in Keith Rabois's new startup is a bad decision, but it is only happening because he's a partner at Khosla. If you're an LP in a VC fund, this is something you could reasonably be concerned about.

2. If you're an entrepreneur pitching to a investors, you expect that the pitch is being taken in good faith. If the investor is just taking your pitch so that they can access your proprietary information and use it to inform their own startup (funded by the firm you're pitching), that's pretty wack.

I have literally no information about these examples, so it wouldn't be meaningful for me to hold an opinion on whether or not impropriety is occurring. I also think that Keith Rabois probably has enough of a track record that he could easily raise funding for pretty much whatever he wants to do. I also suspect that most entrepreneurs aren't particularly worried about point 2.

Nonetheless, this is clearly right at the nexus of the objections that people raise about SV: that it's an old boy's network masquerading as a "meritocracy". It just smells fishy. Sometimes things smell fishy and are OK... but there's always a cost to doing things that smell fishy: the appearance of impropriety is often just as harmful as impropriety itself.

coderzach4• 11 years ago

1) If you're an LP and you think this type of thing is a really big deal, don't put your money in a fund that does it.

2) Even if they didn't invest in themselves, they could just as easily give your idea to a more competent entrepreneur and invest in her instead. If you're really worried about your proprietary idea being stolen, you shouldn't be in these meetings.

jacquesm14• 11 years ago

VCs are under no obligation to invest in outsiders at all.

Yes, it's an old boys network, old boys networks are not illegal nor are they bad. In fact they give the younger boys a fantastic opportunity to side-step the whole thing and start their own network, that's exactly what YC has done.

Whenever you see something like this there is an opportunity.

hkmurakami• 11 years ago

The "winning" is in creating a successful company, and VC tries to pick those winners. Getting VC funding isn't "winning" at all, and the author seems to conflate those two together.

As a LP, I would actually think that my GPs have a fiduciary duty to fund companies started by their partners if they thought it is a great investment opportunity (and ultimately VC partners are only beholden to their LPs and their own performance. Goodwill and good faith are valuable for achieving that end, not in itself)

Also,

Now, in the most competitive start-up environment in history, these founders no longer just have to worry about being beaten by other start-ups in their space. They have to worry about potential investors picking off their ideas and using them for personal gain.

You've always had to vet your investors like this. Nothing has really changed.

7Figures2Commas• 11 years ago

The goal is to get a return on investment...

This is a simplistic, overly idealistic understanding of venture capital that is unfortunately constantly repeated but rarely rebutted.

The goal in venture capital is to be able to continue to raise funds. On a $500 million fund, a venture firm locks in $100 million in management fees over the life of the fund (assuming the standard 2% annual management fee and 10 year fund life) regardless of performance. Not a bad deal.

But it gets better. Because of the nature of venture investments, it's all but impossible to declare a fund a winner or a loser a few years into a fund. But a firm won't wait 10 years to raise its next fund. It's going to raise its next fund not more than a few years in, and in a hot market like this one, that fund is likely to be bigger, so the firm gets to lock in another 10 years of management fees on an even bigger pile of money.

Carried interest (your "return on investment") is icing on the cake for venture capitalists. Because most LPs are muppets who will continue buying the same inferior product, the real imperative for a venture firm is to make sure its funds are not total dogs. Given historical venture capital returns, that basically equates to not blowing up your fund.

jcdavis• 11 years ago

Not only that, but fund lives are getting longer. This article says the median time life is now 14 years: http://www.institutionalinvestor.com/Article.aspx?ArticleID=...

jacquesm14• 11 years ago

Cynical but spot on.

sharkweek3• 11 years ago

Two differing thoughts:

I'm not sure I would think the LPs would be all that concerned with this. After all, a VC firm is going to live and die by its performance reputation, so if their funds fail to return gains, it will haunt their firm for a long time.

What I do buy though is Kevin's other point in the conflict of interest of potential entrepreneurs walking into VC offices and pitching a great product (editing out the word "idea" for clarity) that gets rejected. At that point you've given up a lot of information with little recourse, and having a partner at a firm run with the idea themselves, with strong funding and a powerful network, would pretty much be a death sentence.

I have never seen this happen myself (although I do confess Seattle can be pretty far removed from the daily dealings in VC world), and I do choose to believe that most VCs operate with a moral compass, but it's still a terrifying thought.

Kalium6• 11 years ago

It shouldn't be frightening. It should tell us all what we already know - ideas are worth exactly nothing and execution is worth everything.

sharkweek3• 11 years ago

Generally I agree, but an entrepreneur who walks into a VC pitch with execution at least partially accomplished should feel confident they're not going to get their idea stolen.

notahacker• 11 years ago

Some companies pitching to Andreessen Horowitz et al. are a bit more than an "idea". None of them are likely to be labouring under the delusion that everything they say in that room is an absolute secret, but there's a big difference between some general idea of the direction of your growth filtering down to that VC's portfolio companies in the same space on the one hand, and on the other, a partner peppering you with questions about your business plan and then opting to found and fund their own "stealth" startup in that space instead...

trhway• 11 years ago

ideas are worth exactly nothing and execution is worth everything.

there is 3rd component - money. You may have good idea and be executing it well. The VC has money, has your idea and in this situation hey have choice - your execution or to implement their own. Due to money asymmetry, even having somewhat worse execution, they may still do better than you.

bjt2• 11 years ago

The VC has access to a lot more than the "idea" from a pitching company. A lot of time and effort goes into researching a market opportunity and iterating on the idea to refine it. You learn which aspects of the idea, though they sounded sexy, turn out to be dead ends. Getting that information for free could give the VC's company a significant head start.

jamiesonbecker3• 11 years ago

This is a myth, although it has some root in reality.

The best ideas are often borne out of the conviction of the founders and their ability to spot an untapped need.

Because of this, founders (and progenitors of the original idea) are often true believers... and they will execute harder and with more conviction (even if less effectively at first), because it was their idea in the first place.

They'll often have better reactions and can better see where the market is going, because it was their idea in the first place.

Depending on their personality, they may also be better able to conceive of and implement improvements, because it was their idea in the first place.

Execution is critically important, but one cannot exist without the other.

CPLX• 11 years ago

ideas are worth exactly nothing and execution is worth everything

Unless you make an SMS based concierge service and call it Magic

jacquesm14• 11 years ago

VCs with execution capability are rare and word would get around if someone pulled a stunt like this.

sharkweek3• 11 years ago

I agree, and I choose to believe this fear is irrational, but it's still a thought that might creep around in the back of my mind. I do think the key thing once again touches on my first point, that a VC firm's reputation needs to be positive for both LPs and entrepreneurs to want to do business with them.

tptacek2• 11 years ago

Big VC firms are populated with people on the bubble between permanent partner-track involvement with the fund or an operating role (often CEO) of a future portfolio company; they're called EIRs. The underlying concern here --- which I agree is overblown in this thread --- is almost universal, isn't it?

mblevin2• 11 years ago

The edge case of a VC launching a company themselves is so rare that we're talking about a single instance of when it happened.

Let's not forget every day some entrepreneur goes in to pitch an idea, and a VC picks up the phone and calls a portfolio company and says "hey I have an idea for you."

"VCs will steal your idea and launch it themselves" is not a real risk, especially relative to existing risks.

The issue of VCs launching their own ideas is purely between them and their LPs - if CALPERS is ok with it, then there's no issue.

eridius• 11 years ago

To nitpick: the blog post was triggered by a single instance of it happening, but while he doesn't go into specifics, he says that all the top tier firms are doing it, which obviously means there's a bunch of instances of this. And one of the common criticisms he got was "everybody's doing it", which suggests it's even more widespread than that.

dsjoerg• 11 years ago

Imagine if you gave money to Warren Buffett to invest and he turned around and invested it in a company started by one of his own cronies?!

scott_karana• 11 years ago

I'd be suspicious, but then again, since his reputation is based on past successes, I'd still be okay with it.

The corollary is that the crony's company did fail, his reputation would suffer, and he'd lose business!

shawnhermans2• 11 years ago

Warren Buffett has a solid reputation of making excellent investments. As long as the money returned a good investment, I wouldn't care at all.

bsdpython2• 11 years ago

If the entrepreneurs, venture partners and investors are fine with it then who are we to argue?

youssifa• 11 years ago

The entrepreneurs who are fine with it are likely, for the most part, the ones who actually get funded.

bsdpython2• 11 years ago

Well sure but nobody is owed a chance to get venture funding from a particular fund. We are really stretching to find victims here, no?

bjt2• 11 years ago

The article addresses that point directly.

Investors (specifically LPs) might not know that it's happening.

aaronbrethorst• 11 years ago

It's not corruption, just 'more of the same' nepotism. If you're shocked by this, you haven't really been paying attention.

jacquesm14• 11 years ago

By this definition every bootstrapper is 'self dealing'. VCs get to decide how, when and where they allocate their funds, if they decide to bankroll one of their own partners in a new venture then that's totally ok as long as the partners and LPs are in agreement (it's their money after all) and you can bet that they'll have extra outsiders scrutinize the deal to avoid being accused of nepotism in case the company eventually goes south.

VCs with partners capable of executing on their own ideas are pretty rare, but when it does happen it is usually because someone had a side project (possibly even before joining the VC) that got legs (either unexpectedly or belatedly) and this person then uses his excellent VC contacts to secure a deal. And of course he/she does not go to a competing VC, that would be a harder pitch and it would be strange not to offer your partners a shot at the deal first.

All in all I can't see much wrong with this and if you think that it is 'unfair' you have to remember that VCs are not under any obligation to invest in outsiders at all (private funds exist).

thesteamboat5• 11 years ago

Bootstrapping is not a conflict of interest. When people are operating as both VCs and executives there are conflict of interest considerations.

Situations involving conflicts of interests are not inherently unethical, but greater care is needed.

jacquesm14• 11 years ago

How can it be a conflict of interest if it is in the end their own money? They get to spend it any way they want it and of course they will spend it on those that they know better more readily than elsewhere.

It's not as if VCs are distributing public funds and those VCs that have taken public funds (or pension funds) would likely never engage in a deal like this.

If you think you're 'in competition' with the VCs partners for capital you have it backwards, they have the capital and they can dispense it at their discretion, or even not at all.

soneca• 11 years ago

Two issues with that:

i) bootstrapping is different from self-funding. All of them might start with self-funding, but bootstrapping is getting revenue to fund the startup. Not the founder's money to fund it.

ii) VC's money are not their own money in totality. They raise funds with outside investors and they decide where to invest other people's money too.

jacquesm14• 11 years ago

Bootstrapping is usually defined as 'pulling yourself up by your shoelaces' so using the revenues to fund the growth, but the prototype and initial capital is almost always provided from another source (savings, loans).

Not all VCs take outside investors, but plenty do.

tolmasky• 11 years ago

As long as the money is private, they should be able to do whatever they want. If they're actually bad decisions (a worse startup getting money solely due to being inside), then they'll suffer for it. If the decision however gives a return, then what's the problem?

I don't feel suspicious of family's investing in their kid's venture -- wow how unfair! so biased, they should have given the kid next door a fair listening to as well!

The problem only arrises if bad decisions are then publicly de-risked (as is the case in banks, etc -- don't know specifically if this happens in an indirect way with VC's). But in and of itself -- "people you know" is one of many possibly good or bad metrics you can use to invest your own money (or the money interested to you by funders that know how you operate).

shubb• 11 years ago

Depending on the fund it does. This diagram explains it: http://www.agilevc.com/wp-content/uploads/2014/10/Startup-Ca...

RodericDay• 11 years ago

I don't feel suspicious of family's investing in their kid's venture -- wow how unfair! so biased, they should have given the kid next door a fair listening to as well!

someone a while back made the case that SV is an offset economy where instead of CEOs you have VCs, and instead of Managers you have Startup CEOs.

Keeping the vague analogy in mind, how is flooding your kids with easy credit not available to other people not a form of nepotism?

mc32• 11 years ago

It is, but what's the problem? It's like you taking your money, assuming you earned it, and buying things for _your_ friends or _your_ family. So long as your husband/wife/partner is okay, why should that be a problem?

Should I think it's unfair you spend nothing on me?

mblevin2• 11 years ago

It certainly is a form of nepotism, but since when do we regulate nepotism?

jklein11• 11 years ago

I think the author's Simon Cowell example actually disproves his point. If you wanted someone to win American Idol who would choose to do it? Someone who who you have to train to sing well and coach them on the judges preferences? Or would you choose the person who has worked with the judges for years, knows exactly what makes contestants win or lose, and helps to make the decision themselves. I would choose Simon Cowell, not because it would warm my heart to see him win, and make me believe in the Meritocracy of American Idol, but because he would be the best bet. Venture Capital is about making money, not about giving everyone a chance to make their start up happen.

_broody• 11 years ago

The problem is you're feeding the other candidates (and the audience) the illusion that they have a fighting chance against the insider. This deceit won't be taken kindly after they realize how they were beat out.

This is the equivalent of insider trading among government legislators. It's a very real problem, and there is no realistic solution since it is a systemic flaw of the startup/VC model.

It's quite possible startup culture can't continue working forever, and if this is a growing trend, that eventually too much encroachment by VCs will smother and scare away everyone who isn't an insider.

Hoffmannnn• 11 years ago

I don't want someone to win American Idol, I want American Idol to pick the best singer, whether or not said singer is a judge.

As an investor in a venture capital firm, though, you would expect the firm to award funding to the best, not to the insiders. As a politician interested in fostering a successful startup environment in your district, you would expect the firm to award funding to the best, not to the insiders. As a fledgling startup yourself, you would expect the firm to award funding to the best, not to the insiders. As Simon Cowell, you would want to pick yourself. Therein lies the issue. Only Simon Cowell wants Simon Cowell to win over other, more qualified startups.

chralieboy2• 11 years ago

But the thing is, being an insider is usually a good indication of future success.

If you already have those connections, that means you have a huge leg up on the competition. You can raise more money at better valuations (meaning you can make longer term bets, build a better team), you have access to better talent, and you have access via your network to other executives that can make deals happen.

We are upset because it isn't fair, but that isn't really the point. They want to make a ton of money. Yes, they also want to change the world, but tenacity and people skills (required in the VC word) are huge indicators of executing on whatever vision you have.

gdix• 11 years ago

Don't you think they consider the people they hire to be "the best"? Do you think being "the best" and being an "insider" are mutually exclusive?

Sealy• 11 years ago

I totally agree, poor moral standard is at the root of a lot of shady investors.

I run a VC backed bitcoin startup myself and more then one of the investors we pitched to as early back as two years ago have gone on to create their own bitcoin-related companies in suspiciously similar product verticals to ours.

jacquesm14• 11 years ago

Do better vetting. You pitched to your would-be competitors, not to your potential investors. In the 'angel' (what an interesting choice of word that was) investor world this sort of thing is done far more frequently than in the VC investor scene. Entirely different groups, though the former tend to try to make money when the latter enters the scene (and it's not rare to see angel investors be re-educated about the nature of investing during later rounds).

ChicagoDave• 11 years ago

Any investment group, upon hearing a pitch, will do one of three things; a) ignore it, b) figure out how to leverage the new information in existing pitches/plans, c) fund it. To even get a pitch in front of an investment group takes a lot of networking to begin with, so the reality is by the time you pitch, you're probably already an "insider" of sorts.

As an as-yet-successful entrepreneur, you should know that at any time your idea or portions of your idea may be stolen or "adopted" by anyone who hears you talk about it. And forget NDA's. No one signs those anymore...certainly not an investor.

This is why, if you have an idea, you need to bootstrap it, get customers, and generate revenue. Then let the investors come to you.

I think the entire "pitch" process is rigged and pointless. If you're going to build something, be passionate, find great partners and advisers, and bootstrap.

Let the VC's play their game. You weren't invited anyway.

Spearchucker• 11 years ago

"This is why, if you have an idea, you need to bootstrap it, get customers, and generate revenue"

Another thing in addition to this - you need to out-execute future competitors. Imagine that the idea is public anyway, and build it better than anyone else could.

jamiesonbecker3• 11 years ago

This actually happened to someone recently... VC invested millions in itself and created a clone (and not a very good one). Needless to say, that company is self-funding now but got stuck on that for months. (upside: now growing at > 6% per week.)

shawnhermans2• 11 years ago

I'm really struggling to understand the issue. I understand the issue of conflict of interest when it comes to things like government contracts and public corporations. Here conflict of interest occurs because the person makes decisions on how to spend money that isn't their money. It is either the taxpayer's money or the stockholder's money.

In a private company, like Andreessen Horowitz, they are effectively spending their own money. If they choose to invest in a company founded by one of their partners, I do not see the conflict of interest. From the outside we may question whether or not the startup is really worthy of being funded, but it really isn't our call to make.

But what if it was our call to make? Did they make a bad decision by funding one of their own? Looking at his track record he already has experience as a co-founder and a CTO. On top of having prior experience, he has worked as a partner at Andreessen Horowitz for over a year. The people making the decision whether or not to fund his startup have experience working with him. They probably have a good idea of whether this person can or cannot deliver.

I think most people object to this, because they imagine a situation where a better startup is not funded because the partners decided to fund their buddy instead. Let us say that is true. For the sake of argument, assume this guy is incompetent and should not be given funding. Imagine this guy worked at Andreessen Horowitz for over a year and everyone knew he was incompetent, but decided to fund him anyways just because they were BFFs.

I guess it is possible something like this happened, but I doubt it. I recently finished reading Horowitz’s book The Hard Thing about Hard Things and he doesn’t seem like the type of person who keeps incompetent people around just because likes them.

The only valid objection I see is if they are using information provided to them under a non-disclosure agreement to gain unfair advantage. But is this a valid concern? As others have pointed out, most ideas are cheap. Even if that information provides some short-term advantage, it won’t help in the long-term as the market changes.

dlu• 11 years ago

Hrm, didn't think this particular "Twitter fight" would end up as an article. I see Kevin's point, but maybe I've been in the water too long. It doesn't bother me much. There's plenty of networking and such already. Serial entrepreneurs have nearly as many connections as any VC would anyways. And the VC partner that is "self-dealing" isn't going to be able to deal himself single-handedly. There are other partners at the firm.

There's lots of other unfair things in the Valley when it comes to privilege like this.

JabavuAdams• 11 years ago

It's interesting how once practices become the norm in a group or industry, the practitioners become blind to conflicts of interest that are obvious to outsiders. "This is the way it works." is useful information, but not a convincing justification.

LargeCompanies• 11 years ago

Start-up success can be much easier if...

A. You went to the same ivy league schools as VCs

B. You have a certain look

C. They give you the opportunity to work with them & you take advantage/work the opportunity to get funded.

Case in point, while I was participating in an incubator, there was a 20 year old mentor. He was mentoring a 40 something first time female founder. He had millions in funding and he went to sell his company for millions.

How did that happen when he had no previous experience. Well for one he graduated from the same top school as his VC (one of the biggest), who in which gave him a job working at the firm, who then funded his company and steered it to a huge sale using his huge/immense network.

Start-ups can be very unfair if you don't look the part, gone to the same ivy league school, given an opportunity to work with X huge VC & make the most of it and or struck gold/got lucky by publishing the next big thing you had no idea would take off.

VC is definitely a boys club filled with all the popular people from your high school who left you out & talked trash about everyone who didn't fit their part.

chralieboy2• 11 years ago

No need for an Ivy, just go to Stanford.

There is an argument for prescreening, but having been part of the interview process for a high profile YC company in its early days, I can say that the weight placed on "likeness" is very high.

The correlation between likeness and competence, not so much.

NhanH• 11 years ago

Not to contradict your post. But Stanford is equivalent in term of prestige to any Ivy out there, including Harvard. It seems like you agree with GP so that's probably just a wording matter.

graycat• 11 years ago

Oh, maybe the sky is not falling. Maybe it is not true that "We've got trouble, right here in River City. Trouble starts with a T and that rhymes with a V and a C and they stand for venture capital"!

Why? Well in information technology (IT) venture capital, in recent years a strong theme has developed: The VCs want the founders to be technical, e.g., design and write software. As I recall, the firm A16Z is an especially strong supporter of this theme.

Well, then: For my startup, I've read a lot of VC bios: My conclusion is that only a tiny fraction of VCs are in any very significant sense technical in anything in or very close to IT. E.g., when was the last time they designed and wrote 10,000 lines of code? Invented a new algorithm? Did some technical work prior to the software, e.g., the applied math of machine learning or data science, e.g., some applied math for ad targeting? How about some applied math for computer and network security via anomaly detection? How many VCs are qualified to direct a major IT development project with planning, hiring, training, software project management, server farm planning and implementation including performance, reliability, security, growth potential? Gee, let's keep it simple: How many VCs could step into to a slot as database administrator of, say, a major site of SQL Server, Oracle, DB/2?

So, in an IT startup at the seed or Series A level, why would a founder want to hire a VC, and why would a VC want to invest in a VC as a founder or a founder who would hire a VC? How 'bout they wouldn't?

Sure, at the Series B, C, ..., maybe some VCs could do business development, marketing, setting up the sales channels, running the sales organization.

Net, bottom line-wise, the goal of the VCs and their limited partners (LPs) is to make money, and a VC firm that doesn't make money will have a tough time raising more. And, LPs may look with surprise and even concern at losing bets on VCs within the firm. Or, such a VC darned better make money!

kyllo• 11 years ago

The public company version of this is like a buyer at one company starting a service provider as a side company and then using his authority as a buyer to award himself a contract.

It's a conflict of interest and any publicly traded companies will fire you for it because it's stealing from the (other)　shareholders.

andrewfong• 11 years ago

Interestingly, venture capital LAW definitely has a self-dealing problem. Many (if not most) major law firms in the valley have both company-side and investor-side clients. And even if they don't, law firms often see a fair amount of company-side clients based on investor referrals. As a result, company-side counsel can often be reluctant to push too hard against investors lest they risk jeopardizing future business.

My first company actually had a situation where the same firm represented both us and the investor during our seed round AT THE SAME TIME. To be fair, this was the investor's idea, not the law firm (and the law firm made sign all sorts of waivers), and we ultimately saved a small amount in transaction fees and I can't say we would've gotten much better terms with independent counsel. But the entire affair makes me cringe a little every time I look back on it.

In case you're wondering, yes, there are rules against all of this. But you can waive a lot of the rules by providing written consent (and many clients don't think twice about this).

Venture capital has a self-dealing problem

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