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.