The VC Model, The Funded, and The Problem With Associates

There’s an interesting article over that The Funded which discusses the state of affairs in the VC market.  The post itself is a response to the Fred Wilson post about the current state of affairs in the VC market.  Fred’s claim is that the VC model is not broken.  He’s right.  Sort of.  Being broken would imply that it was fixed or working correctly at one point in time.  I would in fact argue that the model was flawed from inception, and was based on the imbalance of supply and demand for risk capital.

I am about to go on a bit of a (LONG) rant here, but my point of view is one of someone who has worked in a private equity firm, sat on boards, invested privately, worked in multiple startups, founded a company, been a CEO, and raised money from angels and VCs, including securing term sheets from some of the most well known names on Sand Hill Road.  I am an entrepreneur first, and someone who has been smacked around by the VC community as a seeker of funds.

Let’s start with the venture funding process.  The Funded rightly points out that the junior folks at these VC firms are all business school guys who have no depth of experience from which to draw on when they are deciding which deals to pursue.  That is mostly correct, though there are a few I have met in my travels who at least had some real operational experience before going to a venture firm.

The trouble isn’t so much that the associates don’t know what actually constitutes a good business, it’s that they believe that they are uniquely qualified to make that determination.  Further, they actually believe that their few years of business school entitles them to an opinion as to whether or not a leadership team is going to get the job done.  This is particularly pronounced and troubling when the management team has 20+ years of experience, but the associate doesn’t think is “cool.”  If the associate doesn’t like you, you don’t get through them as a gate keeper.

When working to raise venture money, your path to meeting with the partnership must and will run through the associates.  They are primarily concerned with their ability to remain employed, which means minimizing their risk.  They are not going to push hard for anything, for that would entail taking on risk.  They don’t score points for being risky, and they certainly don’t score points for pushing for a deal which doesn’t get done.  They score points by not wasting the partners’ time, and showing the partner what the partner thinks they want to see.  As such, they are even more risk averse than the partners will seem.

The incentive system that the partners have laid out for themselves is a great one.  I have to admit, it’s one of the main reasons I wanted to get in venture investing.  What greater business than to sit around and get paid to dole out money to companies you think might build something for which you can then take credit?  When capital was scarce, and risks were high, the 2 and 20 model made a ton of sense.  Unfortunately, we now live in a world that is not only flush with capital, meaning the cost of capital has dropped precipitously to the point where it is essentially free.  The risk premiums that the VCs want for their money to go into your deal don’t make sense when there is plenty of capital out there that doesn’t require that premium or their desired levels of control.  Further, the capital requirements (both human and financial) for starting a company have also declined to the point where the amount of capital that a VC can deploy into a deal is far below what they need in order to justify their time on a deal.  That’s a big problem for them.

The problems with the VC model further compound themselves when you consider what the investors are buying.  I used to work at one of the largest private equity firms in the world.  You would think I have enough good sense to know what type of security to allow investors to invest in for one of my companies.  When you are trying to raise money, it’s very easy to lose your senses, and you find yourself just wanting to get the deal done; afraid that if you don’t, the deal will fall apart.  The security that was created for the angel round of my last company had some features (more on that in a moment) that were horrifically bad for the common shareholders, but I allowed it to happen anyway.  I not only should have known better, I DID know better.  I can only imagine how hard it is for young kids, some barely out of college, to navigate this process and not have a security thrust upon them which ultimately is unfair to them.

I had a conversation with Andrew Warner, of Mixergy, about my last company.  This is a guy who built a very, very successful business with a nice exit (he even bared his soul and showed the financials in a blog post – wow) and even he was completely clueless about the venture funding process (he never raised money – there’s a lesson in there kids), and what goes into a security that investors buy.  This was astounding to me.  What I take for granted is a black art to even the most successful of entrepreneurs.  I suggested that he get the book Terms Sheets & Valuations, by Alex Wilmerding.  This is a MUST HAVE for anyone who is thinking about raising capital.

The main rule for VCs is that they want to protect their capital.  They are going to use terms like “liquidation preference”, “participation”, “anti-dilution”, and “control provisions” to ensure that you don’t do what they don’t want you to do.  These “features” enable them to recoup their money, ensure that they are getting “adequate” returns, and keep you, presumably the expert, from doing anything they don’t want you to do with what they view as their money.  Funny, it’s “our company” and “our product,” but “their money” when they are talking to the entrepreneur.

Worse, the anti-dilution features enable investors to retain some level of their original investment percentage should the company have a down round in the future (meaning the valuation of the business went down).  The entrepreneurs and any common shareholders have no such provisions.  VCs are your friend on the way up, and tax you on the way down.  Painful.  They are penalizing the entrepreneur for making a good initial deal (for the entrepreneur, getting a higher initial price means retaining more ownership), or, paradoxically, taxing the entrepreneur for the idiocy of the VC because they paid too much up front for the deal.

Read up on the participation features to really have an emotional moment.  While Fred is right that it’s just an economic issue, so too was it with the feudal lord and their serfs.  I would hardly argue the case for the benevolent feudal lord.

Subterfuge and confusion are the names of the game when you are allowing a VC to invest in your company.  There will be plenty of VCs who decry this and say that they have the entrepreneurs interests at heart, and they want to form a partnership, blah blah blah, but it’s all bullshit.  They want to protect their capital, and the VC is already thinking about how to show the founder/CEO the door once the money goes in so that they can bring in “proven” talent.  As long as you know this going into your deal, then you are OK.  I would just hate for any would be entrepreneur to be surprised by this.

If there was one thing that continues to surprise me about the way that VC (and all alternative investment classes) works is that the people who are chartered with supposedly assessing the risk of funds, and making the decision to invest or not in those funds, are usually people who were neither as well educated or well paid as the very people they are looking to measure.  An extreme illustration of this would be like having a high school flunkie teaching a university level calculus class, and relying on the students to make their case as to whether or not their work is correct and what their grade should be.

If you are wondering why there appears to be no amount of risk assessment in the finance world (hellooooo, AIG anyone), it’s because the people in charge of monitoring are not as smart, capable or (and this is the important bit) well financed as the people they are watching.  The system isn’t fair, and the incentives are for VCs/hedge funds/PE funds to take excessive risks with other peoples’ money.  There is no risk to their own personal wealth (which they amass over time through management fees or bonuses), and their mobility within the industry is surprisingly high, even when they blow up in spectacular fashion.

The sad reality of the finance world today (and I say this as a guy who graduate from Wharton, and has done stints on Wall Street) is that the people who are being disproportionately rewarded are not the people who are actually taking any risks of their own.  You are better off working in an investment bank for 2-4 years and then taking the hedge fund job and living the cush life than you are actually trying to build a company that makes something people want and will pay for.  It’s stunning to me to see how many times this has played out with my classmates and peers.  The folks that tried to build companies and make things, more often than not, have fared far worse economically than those who invested other peoples’ money without risk of loss to their own capital.  That’s the way it is folks.

To make this point more real, I would like to quote from the most excellent book “World War Z” by Max Books (seriously, read this book if you haven’t…what will you do when the zombies come?):

Ours was a post industrial or service-based economy, so complex and highly specialized that each individual could only function within the confines or its narrow, compartmentalized structures.  You should have seen some of the “careers” listed on our first employment census; everyone was some version of an “executive,” a “representative", an “analyst,” or a “consultant,” all perfectly suited to the prewar world, but all totally inadequate for the present [zombie] crisis.  We needed [people that made things]…over 65 percent of the present civilian workforce were classified F-6, possessing no valued vocation…we needed to get a lot of white collars dirty.

The cost of starting your own thing has never been lower.  Go build something people want.  This imbalance should force the number of VC firms down to a scant few.  It may take a few years, but there’s a shake out coming.  That has two implications.  First, the power has shifted to the entrepreneur, but the entrepreneur has to realize this and take advantage of it.  Second, there will be a great number of unskilled (except in the art of “doing deals”) blue shirt and khaki pant wearing MBAs walking around Silicon Valley looking for biz dev jobs.  I’m not sure if they are the zombies or the F-6 workforce, but either way it’s a bad deal.

  • Tom

    This is an excellent, excellent post. You hit the nail on the head – too many VCs getting fat on their 2% fees, and too many freshly minted MBAssociates.

  • Good post, I particularly like the feudal lord analogy.

  • Brandon Watson

    Thanks for the kind words. I don’t want it to seem that I am anti-MBA. I am one, and wanted to be a VC straight out of school. I was told (mid 90s) that I should get some real work experience first. Having worked at a fund for close to 4 years, I am still shocked at the sheer lack of actual operational experience at even the highest levels of the partnerships. The only real way to tell if you have a VC/investor who knows what they are doing is how they react when the shit hits the fan.

  • I used to do a lot of business with my friend Rosalind Resnick, a woman who bootstrapped her business and didn’t take any outside funding until she listed her company on NASDAQ.

    Rosalind used to say that she took venture funding — but not directly. She earned it from her heavily backed clients when they bought ads from her.

    I like her attitude.

    By the way, I just got a new copy of Term Sheets and Valuations here, based on your recommendation.

    Thanks for this post.

  • Brandon Watson

    What a great comment Andrew. The Facebook ecosystem had this problem for a while…the new VC money was funding companies that would buy users from the more well established Facebook app companies. Silliness.

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  • George A. Romero

    Well written, well reasoned. Why should the change wrecking Wall Street end there? Sand Hill Road is no less anachronistic. Middlemen == zombies; nice image. (Back the in the day, weren’t the VC firms small partnerships, like startups? They didn’t even _have_ associates before the 2/20 perversion.)

  • Bob A.

    A great post. And in some VC’s, I wish they had analysts or associates, they have ‘interns’ doing the initial vetting, somebody shoot me please. I almost walked out when this nice intern walked into the meeting room with a large smile on his face. Yes, please, somebody, shoot me now, please.

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  • Excellent post

  • Adam

    Although many associates may make more mistakes, what % of early stage deals are actually completed that started with an associate level introduction? In my experience only 10-20% of the deals completed were ever touched by an associated before the partner saw it.

  • Brandon Watson

    Adam, you are right that most of the introductions happen at the partner level, but let’s be clear, the analysts/associates do the front work. They are doing the research, looking at other companies in the space, etc. Often times, they take the first meeting. A VC partner friend of mine said that I was being unfair in painting such a broad generalization for the industry, but I don’t think I am that far off. I am pretty surprised at the level of interest this one post has spawned, but I guess that means I struck a nerve.

  • Kobi Wrongun

    Although you claim to go on a long rant, I see valid arguments which explain flaws in the venture business. Thanks for the article. However, I do not understand your motivation to first thwart MBA associates. Shouldn’t your first attack target the most gigantic problem – incentive scheme? This misplaced priority causes distraction and comic relief. Now you have a bunch of readers eager to agree with everything you say no matter what comes after. I wish the structure invited people to see the logic in the rest of your article and appreciated it for its substance.

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  • Hey Brandon,

    When it comes to the VC model, I think that Churchill’s old dictum about democracy applies. The system is broken, but so far, no one has come up with a better one.

    Entrepreneurs need risk capital, and as problematic as VC investments can be, the alternatives are even worse.

    Banks? The government? Angels? Please.

    I’d be curious about potential alternatives to the VC industry. Personally, I see some promise in single GP structures like Jeff Clavier, but that remains to be proven.

  • JK

    Great post. The truth about VC is that most people in VC have no business in the business. Outside of introductions to potential customers, VCs add no value. You are paying dearly for someone’s network but you have no idea whether it’s real or not before you sign terms…

    so VCs rip off entreprenuers and LPs. Sounds gerat

  • Brandon Watson

    Chris!! So great to see you here. Hopefully we can make time next time I am in SFO.

    As for the right model, I don’t have an answer. I have some things I would like to see VCs start doing:

    1) allow foudners to take money off the table – having some money in my bank account doesn’t make me lazy. it makes me greedy, and greed works as a motivator.

    2) have standard series A docs for all deals – the amount of money that is wasted on early financings is stupid.

    3) let founder/CEOs continue to run the business – asking them during the funding process if they are OK with stepping down is kind of lame. you just met them. besides, why risk disenfranchisement with the other founders/early employees?

    4) be OK with smaller returns – having terms that require 4 and 5x deal pricing to force a change of control is lame.

    5) make your money on the alpha – why you are basically locking up 20% of committed capital for management fees (2% a year over the life of the fund) is lame. Reduce the management fees and increase carried interest.

    6) make founders pay for your services – take a smaller percent of the deal, but work on a retainer for your companies. this could supplement the reduced management fees, and makes sure that the founders know that it’s encumbent on them to get max value out of the investors. i am sure there are all sorts of issues with this, but on the surface it feels better than giving up more of my company.

    That’s just a short list. The single biggest problem I have with VCs is their ability to leverage themselves over multiple deals, but their insistence on the opposite for founders – a founder can only work one deal at a time, and must be working 24 hours a day.

  • 1) Allow founders to take money off the table. Agreed. There is a misalignment of incentives; VCs want moonshots to maximize expected value, but the utility of one’s first million is much higher than that next million.

    2) Have standard Series A docs. Absolutely. 99% of the time, a plain vanilla termsheet should suffice.

    3) Let founder/CEOs continue to run the business. This depends on the founder/CEO. Many times, the person who can get the company off the ground does not have the skills to lead it to success. The correct answer should be, “I’ll be happy to bring in a CEO if we’re all convinced it will increase expected value for everyone.”

    4) Be okay with smaller returns. I disagree that VCs should be satisfied with smaller returns, but liquidation preferences above 1X are unnecessary and abusive.

    5) Reduced management fees and increase carried interest. I totally agree with this one; management fees incent bloated funds. And if you really believe in your investing ability, you’d want to boost carry as much as possible.

    What %s do you think would work?

    6) No founder will ever go for it.

  • Sam Jew

    6) All founders are willing to pay for professional services that add value sufficiently exceeding their cost.

    However the value VCs add to the innovation ecosystem consists of the money they bring to the founders, in service of their vision – not the other way around. If VCs happen to provide advice and contacts, great, but despite the plethora of amateurish magazine articles that have appeared out of the woodwork in recent years to sully the thinking of the culpable masses with sheer nonsense, let us not lose sight of the broader reality here.