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Hey, Fred, the VC Model is Broken!

TheFunded.com Open Letter

Posted by Mr. Smith on 2009-07-06

PUBLIC:

It is shocking to see someone as smart as Fred Wilson say: "The venture industry is not broken, but some of the participants in it are."

http://tinyurl.com/p2j6vb

Let's take a look at this statement for a moment. The model of taking other people's money and investing it into startups for 2% as a management fee and 20% as carry is not inherently broken. That's like saying the model of selling hamburgers is broken. If everyone sold hamburgers that killed the consumers, then you could argue that selling hamburgers was broken. Similarly, the infamous "2 and 20" model breeds widespread bad behavior and poor performance, which is essentially the same as being broken. So, how is it broken?

Well, most venture capitalists have started to optimize for management fees versus carried interest, or sharing in the profits generated. It simply makes sense to raise larger funds every two or three years so that each partner can earn $2 or $3 million a year in guaranteed fees. With exits taking longer and failures rampant, praying to generate personal returns from the carry after paying back your principle is unrealistic. Returns are too uncertain, and some funds have been unable to return the principle, forget profits. And, the math is clear: a 2% management fee over 10 years generates a little less than $50 MM in fees on a $250 MM fund. Meanwhile, a 2x return on a $250 MM fund also generates $50 MM in carry, yet the carry is a lot harder to get, takes a lot longer, and is much more uncertain than the fees.

Venture capitalists pump new fund money into the "flavor of the moment" industries at a staggering rate. The goal is to quickly empty out an existing fund to make way for raising a new fund and to start earning the management fees. Firms only earn fees on invested capital, creating an incentive to invest quickly in "hot" industries without much thought. This roulette table investment strategy, where everyone bets on an industry in a short period of time, barely worked with telecom and the internet, but it looks like an abysmal failure with Web 2.0 and cleanteach. It seems like "0" and "00" have come up back-to-back. There are many analogies to justify the roulette strategy, like the "rising tide floats all boats" or "safety in numbers." You could also use the analogy: "lambs to the slaughter."

Caring about the entrepreneur has become an afterthought, almost a myth. What firms care about is raising their next fund and returning the principle. It's become a game. Return some principle, then raise a new fund. As a result, great entrepreneurs rarely go into venture capital anymore. It's financial three card monte, not entrepreneurship support. Meanwhile, all of the junior associates employed in venture capital need career mobility. These business school jockeys were brought in to identify classmates as funding targets and to run complex capitalization table analysis. The next thing you know, venture firms are populated with b-school grads as partners, who, in turn, are hiring and promoting more b-school grads. Now there are a bunch of "career venture capitalists" with no idea on how to start or grow a company besides watching others from the sidelines.

If all of this were not problematic enough, the current venture capital model requires deal syndication to justify next round valuations, ensuring that many different firms work together, whether they like it or not. The problem is that behavior in a syndicate deal can only be as good as the best investor, and is likely to be just a little better than the actions of the biggest jerk. For example, if one partner in a deal is constantly trying to oust management and take over a company, it's difficult for all of the other investors to fight this behavior. Even good investors with good intentions often take a back seat to the jerks, and they're quick to write off a deal, while sipping cappuccinos brewed off the fat of their fees. Preferred voting rights and shareholder politics are so complex that jerks prevail.

So, Fred Wilson said that venture capitalists need to look at the entrepreneurs "as the client." Essentially, he is saying that the model is not broken, just everyone is doing it wrong by focusing on the fees. Maybe the model encourages people to do it wrong, Fred. Wake up.

(please feel free to quote me)

Posted by mig8080 on 2009-07-06 20:47:02

I agree. I believe I had it right that VC's funded only 16% of the Russel 2000. So what are the great entrepreneurs doing to raise capital? Basically we need a new model that eliminates the VC middleperson that lines up the sources of capital to those who can make use of it, with a due diligent/oversight mechanism that has a stake and risk in the deal.

Posted by Anonymous on 2009-07-07 09:46:16

Great point. It seems fixable too: what if LPs encouraged VCs to take 30% carry and no management fee. Great entrepreneurs (like Marc Andreessen) and proven VCs (like Fred) should jump at that proposition since they have enough money that they don't need salary and because the carry income is taxed as capital gains (which is a huge scam, but that's another story). Because it's so much cheaper to run a small shop due to improvements in technology (cheap computers, Google docs, gmail), VCs shouldn't need the management fees just to operate.

This would not tempt VC to raise any more money than they think they could get a great return on, because they'd make nothing at all if they lost money.

By analogy, if an entrepreneur came to a VC and said I want a better valuation in exchange for never taking a salary or other non-preformance based compensation, the VC would be all smiles.

Posted by Anonymous on 2009-07-07 10:20:58

#2: Great point, and I agree. In order for a carry-only venture firm to work, the firm may need to receive distributions before the principle is paid back in full or have reasonable operating expenses reimbursed first. Another strategy would be to mandate that general partners contribute 10% or more of the principle. The challenge is that you may incentivize firms to seek quick liquidity versus long-term growth. A good approach would be to identify the desired behavior and the build the incentives to create that behavior. The "2 and 20" is fostering the wrong behavior, clearly.

Posted by muse on 2009-07-07 12:31:31

This is exactly on the money. In general, our culture has encouraged jerks and not capital effectiveness. In fact, the current structure is inherently ineffective. In the case of web 2.0, it doesn't take into account the nature of the business - doing lots of different opportunities and affording a much higher loss ratio than typical (1 in a hundred instead of 1 in 10). These deals that do get funded can easily be injured by the jerk behavior. So the competitiveness of venture capital is reduced by a factor of 100 to one on top of these success numbers because of this jerk factor, because the jerks blindly kill off ventures to rush to the next fund to feed at the fee trough. They are wrecking the entire ecosystem for deals whole cloth now. The reason they still raise funds is that most limiteds are staffed by morons who don't re-evaluate - they just put money into the same old funds (branding stasis). This will continue until those morons are forced out and new ones take over. I expect this will be a long five to ten years. In the meantime, there are other conduits of funds, and TheFunded should be exploring those more fully.

Posted by hollywood on 2009-07-07 15:29:35

Great thoughts, however, we actually need much more broad reaching VC activity. If 97% of all net job creation since 1989 has been from small business and less than 1% of our GDP is invested by VC's it stands to reason that our economy has stalled. If small businesses can't get equity, which BTW used to come from their home equity line, they can't borrow any money. I'm not just talking about tech here, I'm talking more broadly. That won't solve the problem of tech investing, since the blind leading the blind has always been the rule. To most VC's I would say you should focus on developing businesses that can generate cash flow, not just eyeballs.

I have a company that can do $100M in revenue in 2010 on a $25M investment and VC's won't even look at it. Ironically this business is capable of growing to almost $400M with $175M in EBITDA by 2012, so exit strategies are many.

I suppose that if you can't get funding easily for this company, the whole thing is really broken. Even more ironic is the VC who passed on the investment, only to have the partner who presented the idea invest personally.

May the Valley RIP.

Posted by Anonymous on 2009-07-07 16:03:46

Very well done. Thank you.

Not only do the "jerks prevail," but there really are no consequences for being a jerk in venture capital. (a) Entrepreneurs are fearful of retribution or blacklisting, so they tolerate bad investor behavior. (b) Most startup lawyers live off of fees generated by venture capitalists, so they often refuse to pursue litigation on behalf of entrepreneurs and companies. (c) Other investors will often roll over rather than engage in a time consuming fight, and, with the funding environment so bad, jerks do not even get blacklisted within the VC community.

In fact, jerks are rewarded because they get their way.

Posted by crunkykd on 2009-07-08 20:08:46

Guys, this website is devoted to startup founders. We need to know who to avoid. So start naming names - not "some VCs".

Posted by tylerwillis on 2009-07-08 20:58:10

Not sure I agree with everything you've said. Without commenting on your thesis statement, these are the points that gave me some pause:

Your Statement:
"Venture capitalists pump new fund money into the "flavor of the moment" industries at a staggering rate. The goal is to quickly empty out an existing fund to make way for raising a new fund and to start earning the management fees."

Response:
There's an easier explanation here -- there are more entrepreneurs, with more ideas, more technology breakthroughs and more people supporting them. The rate of innovation has inarguably risen and it's safe to expect that VC involvement would rise in connection.

Your Statement:
"Even good investors with good intentions often take a back seat to the jerks, and they're quick to write off a deal, while sipping cappuccinos brewed off the fat of their fees. Preferred voting rights and shareholder politics are so complex that jerks prevail."

Response:
In my experience, good investors will often help companies combat investors who've gone off the deep end -- unless they think the jerk's move is actually raising the value of the company. This is based solely from personal experience. It sounds like your assumption is too. This strikes me as something that needs more data before a conclusion can be drawn. You may have a point in this, but it raised my eyebrow.

Your Statement:
"the infamous "2 and 20" model breeds widespread bad behavior and poor performance, which is essentially the same as being broken. So, how is it broken?"

Response:
Actually, this is an incorrect statement, broken would imply it does not work, or that it is not working according to the design. As I understand it, the system was designed with this incentive structure knowing firms had to have operating capital to keep the lights on. While funds can be short sighted in raising several concurrent funds just to milk management fees, they will have a hard time raising money for their next fund if they don't return the investment. That means there are negative incentives for over-committing (if it decreases your ability to return profits). Your argument doesn't support that the model is broken, but it could be restructured to support support a statement that the model is inefficient and should be improved, which I'm down with.

May sound like I'm splitting hairs, but it's easier for interested parties to get behind increased efficiency, but their response to "this is broken" will almost always be inherently negative.

Posted by Mr. Smith on 2009-07-09 02:14:33

@tylerwillis: In terms of the "pumping money" statement, billions per year have poured into new new industries, one after the other. More entrepreneurs are being funded, true, assuming they are pursuing opportunities in the right sector. This creates a problem of "false positives" for the VC model. It's easy to game the system by bulking up your resume and jumping into a hot field. The "visionary sheep" VCs will fund a sector until the LPs are bled dry...

Posted by carlwimm on 2009-07-18 07:13:49

Fred Wilson does have it wrong.

The VC industry has it right.

The fees come from the investors. That is a guaranteed flow to the VC partners. The carry is just the come on. Maybe it works, maybe it does not. But the VC gets the fees anyway.

Once funded, all the VC is really doing is piling up a great story to get re elected, into a new fund once the old one is finished.

And just like Congress, where incumbents get re elected 90% of the time, the LPs pile into the old "names", even when they have not performed.

Do you want a model that shows the VC is truly performance based????

Make it all carry and no fees.

Let the VC demonstrate his own "skin in the game" by paying his way for ten years and getting his reward out of actual success at the end of the game.

But ... you say ... that would mean that a Venture Capitalist actually "ventured".

Never happen.

The real "venture capitalists" are the entrepreneurs who do work for ten years, without any fees and who succeed only if the project succeeds.

The last people who actually venture are the "money brokers" who work with OPM.