One of the costs of raising venture capital is overhead: it takes a lot of energy to navigate the complexity of term sheets, to manage investors, and to navigate follow-on rounds of funding. It gets even worse if you’re dealing with “unique” investor personalities, immaturity, lack of experience, or intra- and inter-firm politics. One CEO friend recently bemoaned that 25% of his time went to “investor stuff” — that’s a typical number.
Venture investing is not a simple business, and investors are adept at adding terms and structures that protect increasingly narrow outcome cases. If getting a home equity loan were like raising venture capital using a FHA loan application, the kick off meeting has 4 people coming to your house and would take all day.
Investors argue this is the cost of doing business: no capital, no company. True, but the overhead has become a real issue in certain sectors (e.g. Internet projects) where the capital requirements are dropping. If you have an idea that needs $500k, and you raise money the “classic” way, you’ll spend 10% of your capital on the legal bill alone. (Remember, the company is paying both sides of the legal bill).
There’s got to be a way to fund capital-efficient ideas with lower overhead (and more time going into creating value in the company). I don’t know what the answer is, but I did think Dave McClure’s rant on the general subject was dead on.
Hey Andy, welcome to the blogosphere!
I think the whole situation is indeed about how VC investors are (as they must be) obsessed with their need to (as you write) “protect increasingly narrow outcome cases”.
In plain English, almost no VC fund or firm is making any money for their investors, or LPs.
But the supply of capital to VC funds is huge and growing, as LPs have been making so much money elsewhere (e.g. in public equities, hedge funds, buyouts, bonds) that their losses in VC are not material. So “asset allocations” have stayed the same, while the underlying endowments and pensions have swelled, increasing the dollars allocated to VC, despite the bad economics of the VC asset class.
The results is, partners at VC funds are making humungous amounts of compensation thru their management fees (2% of COMMITTED capital per year for 7-10 years!) with no penalty for funds that either lose money or don’t beat treasury bond returns, let alone the S&P500. So they have very little incentive to reform the system.
Of course the partners at VC firms are super smart and know that someday they will have to produce returns but they also know that, in the interim, if they just beat their peers and have their funds appear in the “top quatrile” or top 25% of VC funds returns, they will get an almost endless re-upping from their LPs — a bunch of folks who are often simple, low-compensated, mid-level bureaucrats who don’t make asset allocation decisions and rely entirely on Cambridge Associates or other such “research” firms to tell them who is “top quatrile”. And who love partying with super-wealthy VCs and their fabulous soirees.
All of which is bad for the entrepreneurs, founders and startup staff — for in such a world of “increasingly narrow outcome cases”, the only place to look for additional “outcome” edge is… from the common stock.
Startups aren’t like the Broadway shows in “The Producers” — you can only ever sell 100% of the ownership. But the more investors own, the more “outcome” benefit (if there is any) accrues to their funds. And while VC funds and firms sometimes dislike one another they rarely if ever act hostile to one another (unless a firm abandons a company when all is fair game) because they know they will need each other and work together on a lot of other deals. So they don’t fight with each other for scraps of ownership — and again, the common stock gets drawn into the crosshairs.
Which leads to increasingly “complex” financing terms — terms that seem bland but aren’t when it comes to dividing up the spoils. That is, at a glance it may look like preferred shareholders own 75% of the company, but at liquidation they actually take a heckuva lot more of the liquidation proceeds.
None of which is to say VCs are bad people or are acting unethically or anything like that. They’re super smart people with high integrity who are 1) human beings and so subject to emotions like greed and ambition and competition, and 2) businesspeople doing their jobs as best as they can.
And in any case, startups should always remember they are buyers of capital and “caveat emptor”!
But for the ecosystem of VCs and startups to really change or get back to a healthier relationship, very fundamnetal change has to happen at the VC and LP level, stuff like radically lowering management fees, and recalculating future returns based on allocating fixed percentages of outcomes to common shareholders (which, btw, is how VCs own “carried interest” is calculated and paid.)
I’m not holding my breath. Human nature being what it is, there will have to be a wipe-out before a rebuilding.