Apologies in advance for the click bait title — I actually don’t think venture capital is ‘broken’. Keep reading though, as I hope this article will be worth your time.
This is one of the several ‘big ideas’ I have been pondering that I mention in my ‘Contemplating my Next Adventure, Part III”
It is not yet a ‘big idea’, as I don’t yet have a solution for the problem
As a Managing Director and GP in a Fund (Coast to Crest), I now understand the dynamics of running a fund, I know firsthand the dynamics of the decisions that drive the behavior that startup founders despise. I try hard not to be an asshole, but I understand why startup founders can think of me as one (as hard as I try not to be).
Venture capital is ‘broken’, not because it does what it is designed to do (return value to the LPs), but because it does NOT do what many in startup ecosystems across the country want it to do, which is to help be the vehicle to ‘fix’ the dynamics of entrepreneurship and be the driver of the change that everyone says they want.
Everyone wants more startups — they are the fuel for the economy. Everyone wants more ways to see inclusion of women and people of color participating in the American Dream (including me).
The Zebra Movement has the right idea. There should be a way to help finance startups in a way that allow those that are willing to go out on a limb to push the world forward.
Looking to venture capital to be the driver of that change is, in my opinion, not the right way to think about the problem. To an investor in a fund, adding this responsibility to the challenges of running a fund is asking a lot.
Believe it or not, while running a fund is an amazing experience, it is not exactly what I would consider to be ‘fun’. It is isolating, and in a lot of interactions, I am considered ‘the enemy’. While running an accelerator, I was on the front lines of helping these companies, dealing with their problems and challenges, and now that I am ‘money’, I don’t get to see that side of the companies I worked with. I now see the sanitized fiction of their startup story, which I know is a lie.
As a human, it is hard to not to be able to connect to people working in startups in the way that I did before. In the past, I could connect on a human level — and that changes when you are running a fund. I am trying hard to be the mentor I used to be, and can compartmentalize well enough to be able to see the ugly and not have it cloud my judgement as an investor, but the dynamic makes it hard for all parties.
And I am not complaining — just noting that being on the money side of the table changes the dynamic, and it creates a distance that makes it difficult to mentor.
When I was mentoring, I saw all of my advice and stories as just information, data to help the founder develop a framework for solving a problem — a problem that may have many solutions. Now, as an investor, a piece of advice is now viewed as a hoop to jump through. I give advice and if it is followed, it is expected (possibly unconsciously) that it will lead to $.
This makes it very hard to really understand what the challenges really are with startups. It creates a dance based on a fiction, a distortion of reality. The conversation changes, and it makes it difficult to have a true connection given the change in context.
It creates distance from the startups I used to be in the trenches with. It isolates me from being a member of the community. It changes the dynamic, and, I am a human being. The transition from being a founder to an investor is an interesting one.
Being a founder can be isolating. Starting a company has a psychological impact that isolates us as a human. Not many people understand it, and it puts you in a different tribe, one of founders, who ‘get’ what you are going through. Transitioning to be an investor is similar, but it has the added baggage of now being ostracized and a little ‘cast out’ from your old tribe.
The Lone Wolf dies alone. As a human being, I do not have enough clarity from my perspective on how this transition has changed my attitude. I will say that it is a lonely feeling, not unlike when I felt lonely and misunderstood as a founder — except that it is a little lonelier. And I ask for no pity, as I am really just trying to express that it is new, weird, and I have to adjust to it, and that it changes me, and it changes the dynamic of how I interact with people.
This distance stands in the way of structural change in the startup ecosystems in which a fund exists.
The problem is two-fold. Yes, I want to see more people doing startups, in all sectors. I think it is important that we find ways to get financing to the people that are trying to start things.
That being said, startup founders need to understand where the money comes from. Investors are not sitting there with a full bag of cash with nothing to do with it.
Wealth is created by compounding interest. If you have wealth, the best way to make more of it is to have it sit, untouched, in an instrument that has a return, and leave it alone. If you put it in the stock market (where it is possible that you could lose ALL the principal, though this is highly unlikely)- you make around 8% on it, which means it will double in 9 years.
What we do (as investors) is get some of that money from people who have it, and put it into something that makes more than that.. and since the entirety of the investment is at risk, it should be substantially more.. and given that most funds have some sort of fee, it needs to cover that as well.
Which means that in order to be investible, even at a minimal level, you need to start your company and have the value of the investment grow by at LEAST 10–12% — minimally — and you need a way to at some point have that value increase get returned to the investor — the whole thing, the principal PLUS the increase. Given that many startups fail outright or fail to get real traction, when you are running a fund, you are not looking for each one to make 10–12%, you are expecting at least half of them to return nothing — which means that the winners need to make up for the losers, so each investment needs to do MUCH more.
and in order for this to happen, the fund would need to exceed, predictably, the returns on commercial real estate and REITs. And then it becomes a question of scale. How much can you deploy, the larger the amount of $, the more you can invest — the larger the portfolio, and the more distributed the risk.
In Venture, this is the ‘home run’ mentality that drives the 10x thinking. And, truth be told, it is easier to look for those and place bets in those that ‘might’ be runaway successes than to invest in several that might show a 3x return in 9 years.. which would exceed the returns on the stock market, and be a viable model — which is actually what most real estate is.. if can do 9–12%. — doubling in 6.5 years.
And that is the challenge for the model. What everyone WANTS is some sort of robust structure that invests in startups of ALL types (not just the ones that show outsize returns) —
And outsize returns are usually done in software. When you look at exit multiples (the multiple that people are willing to pay on current yearly revenue) — all companies are not created equal. Software can bring multiples of 8x or more… Food companies 1x. Which means a software company doing $10m revenue can be worth $80m and a food company doing $10m is worth $10m. Sorry people, that is reality.
Why the disparity? The reality is in the margin. Much of the value of a software company created by the software company is captured internally, by the little software ‘robot employees’ that don’t eat, don’t have apartments, don’t frequent local coffee places, and don’t need flour and butter delivered to them on local bicycle couriers (who also have apartments and frequent local establishments). Things that use ‘atoms’ are just generally more labor intensive and cost more. This does not make them ‘bad’, it just makes them less attractive.
And in the startup world, if I meet with two companies, both looking for $100K seed investment, one a software company and one a food company, I am thinking that one is worth $800K and one is worth $100K..
And the unfortunate part is that the investment in the food company will do SO much more for the local economy, in terms of all the suppliers and service providers and etc which will capture some of that economic value. It will lift up everyone, not just the software company bottom line.. the problem is, unless I invest in EVERYTHING that is capturing the value, as an investor I will not see those returns. Great for the community, I want that. Not so great for MY investors, who will say.. um.. no.. and instead place their money with someone else — probably with someone doing commercial real estate.
And the challenge goes down to everyone in the ecosystem. As an investor in the ecosystem, I WANT to fund everyone and everything — I want to enable everyone that wants to take the leap and try to create something new, create jobs, create vibrancy, and generally move the world forward. The reality is that there is not enough capital, and do EFFECTIVELY monitor and process a high volume of investments, you would need infrastructure to do so (like a bank).
I know from working with our portfolio companies, that getting updates from them is a pain in the ass for them (and for us).. and although there are some companies looking to help streamline the back office (Carta), there is not presently a full turn key solution that would allow communities across the country to roll out a fund, and manage it appropriately (or maybe there is and I am just not aware of it).
and that is where we are at. Startup communities across the nation want more capital to help fuel the growth of their town or city— they want to create jobs and opportunity. The founders have the right idea. The pools of capital to fund it right now are kind of a mess.
As an investor, I am very interested in looking into models that are robust and help to fuel entire communities and encourage growth for all, not just for software. Founders need to do their part as well. Investors are NOT the enemy. Those that invest in startups usually love startups, and could be making more $ much more easily in commercial real estate (and truth be told, many of the pool of money that make up venture funds do both). Don’t vilify the investors. They are doing what they can, and although it is never enough.
And the founders need to do their part. All of what I have written above, I would say that 80% of the founders I have met with have zero fucking clue (excuse the profanity, it is there to make it stand out) as to how any of this works. All they know is that they need $.
Founders, be part of the solution. Put some effort into understanding the capital ecosystem a bit more.. and I really mean, just a bit. Some idea, as I stated above, most have zero clue. Get your clue quotient above zero. Make yourself slightly more investible by understanding at even the basic level the business model of a fund. Understand what your are selling to an investor, and understand what you are selling against and what the expectations are.
The antagonistic dynamic of startup investment needs to be tempered. Investors are not mean people who will not give you money, they have a job and they are trying to do it the best they can.
As an aside, I am not going to excuse individual lameness, rudeness, arrogance, or generally demeaning behavior. Being lame is being lame, and I am calling no one out here.
The problem is mostly structural. VC, and by extension, most seed and angel funds were not designed intentionally to be the solution for startup ecosystems. They are what they are — they are presently the best we have, and yes, we need to step it up, because the current system is not what most founders want it to be, and I will say that it is not the system that at least some investors want it to be.
Educate yourself, or, do as I did and raise a fund to help. I know that what we do at Coast to Crest does not make everyone happy, but we are helping by adding capital to the ecosystem.
VC in not broken. It is a screwdriver being used to pound a nail. It is a tool, and the wrong tool for the problem we are trying to solve, which is how to create a system, a vehicle, or a collection of vehicles, that can streamline the process of getting capital into an ecosystem and increase the number of startups, which is the pathway to prosperity for our communities, and by extension, our nation.
I am exploring (reading, researching, writing this post) what a vehicle that does solve the problem looks like, so any comments to point me in the right direction would be appreciated.