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With Wall Street melting, public offering disappearing, over-regulation such as Sarbanes Oxley strangling, and bootstrapping igniting, venture capitalism is morphing.
Reminiscent of marketers losing control to consumers with the advent of social media, venture capitalists are starting to lose their tight grip over entrepreneurs.
Venture capitalism must be reformed. Specifically, the interest of venture capitalists and the interest of entrepreneurs must be realigned, the blockbuster model must be changed, roles must be redefined, compensation must be adjusted, accountability must be enforced, transparency must be introduced, and good work ethics must be promoted.
This article is a call to entrepreneurs who create value, to venture capitalists who manage funds, and to limited partners who invest in venture capital funds to come together and have a serious discussion about the future of entrepreneurship and venture capitalism that desperately needs some calibration. For the record, number of venture capitalists, including some of the top tier firms, were invited to comment before the publication of this article, but unfortunately, none came forward. Their silence is deafening.
When a venture-backed company becomes a blockbuster and exits, all parties laugh (not necessarily equally or equitably) all the way to the bank. However, by the very nature of the blockbuster model, the great majority of ventures will either fail or simply stagnate, and that's where the problems start. The reality is that only a very tiny minority of entrepreneurs who produce blockbusters have a good experience with venture capitalists, and the rest including those who got rejected, those who get funded but stagnate, and those who fail have a terrible experience. This article describes such experiences and exposes some of the predatory practices for the purpose of avoiding the meltdown of entrepreneurship like the one on Wall Street.
Even though this article is a whistle blower with a blunt tone, considering the importance and the sensitivity of this subject, there is no room to bash, bitch, and rant but it is time to rise to the occasion by putting aside any self-interest for the greater good of entrepreneurship. However, it is also time of leadership and courage to point the figure - it's called accountability.
I propose the following fundamental principles:
Venture capitalism was originally created to finance innovations. Companies with no revenues, no assets, and no credit history couldn't (and still can't) get any financing to support their venture. Venture capitalists stepped in to fund companies at the very early stages of their life cycle in exchange of very high return considering the very high risk involved with startups. They brought in not just capital but also their experience and their contacts.
Nowadays, venture capitalists rarely invest in seed or early stages. Yet, they still call themselves venture capitalists while they act more like private equity managers. Venture capitalism must be reserved exclusively for companies for seed or early stages. Thus, any funding prior to Series B should be treated as venture capital and anything beyond Series B should be treated as private equity capital.
Venture capitalists used to be successful entrepreneurs with extensive industry experience. Nowadays, too many venture capitalists are attorneys, investment bankers, or financial analysts with Ivey League MBAs but without much entrepreneurial or operational experience in an industry. Aside annoying, misunderstanding, and often mistreating entrepreneurs, the problem with those types of venture capitalists is that they don't invest, but they herd and speculate. They are the ones who create bubbles. Venture capitalism is neither a legal nor a financial transaction but a business opportunity to commercialize an innovation. Also, it used to be that one becomes a venture capitalist at the end of a successful career. Nowadays, recent business school graduates become venture capitalists with attitude - after just 10 minutes of meeting you, they lecture you on how to run your business based on the latest idea they read in Harvard Business Review, and then they decide to replace you, while you have not yet decided to accept their money. So, here's a very simple Littman test: "If you've never had to dig from your own pocket to meet payroll, then you can't be a venture capitalist." You can be a hired gun who crunches numbers or drafts agreements in the back room, but you can't be a venture capitalist and you can't sit at the same table as entrepreneurs.
Who needs whom? Entrepreneurs are the bloodstream of venture capitalism. Without entrepreneurs, venture capitalists have no reason to even exist. On the other hand, entrepreneurs can survive and even thrive without venture capitalists. In fact, beyond the technology sector, there are a lot more bootstrapped than venture-backed successful companies. Yet, the reasons why venture capitalists have been successful in creating the exact opposite impression are: (1) there are a lot more entrepreneurs than there are venture capitalists; (2) there are a lot more mediocre and bad entrepreneurs than good ones; (3) there are a lot more mediocre and bad entrepreneurs chasing venture capitalists; and (4) market impatience, love for speed, and instant gratification, especially in emerging markets, do not permit organic growth.
Considering that venture capitalists are constantly in touch with innovations, they have surprisingly failed to evolve, let alone innovate, their own business. From its origin, venture capitalism is an elitist model based on blockbusters - a brutal winner-take-all model designed to produce homeruns. Corollary, if a venture is not likely to hit a homerun, it won't get funded, and if a venture gets funded but does not hit a homerun, it is quickly dumped or left to die. The rational is that: (1) it takes a lot of work to manage new ventures; (2) it takes as much, if not more work, to manage a mediocre or failing venture than a successful one; and (3) it takes at least 10 times the investment to make it worthwhile. It is indeed this last argument that makes the blockbuster model inherently wrong and unfair. It unduly burdens the entire system and unfairly taxes successful entrepreneurs. Essentially, venture capitalists argue that venture capitalism is a "hit & miss" business. Yeah, but who's hitting and who's missing?!!! Why should a successful entrepreneur who produced a blockbuster pay (through lower equity) for the mistakes made by the venture capitalists for having chosen the wrong ventures?!! That's audacity and arrogance.
Clearly, the business model is wrong. The great majority of companies are not destined to become blockbusters but they are not necessarily losers either. Venture capitalists have been obsessed and blinded by the desire and the myth of homeruns. There has been no attempt of flattening the curve by nurturing those ventures which fall in the middle or long tail. Arguably, the blockbuster model hinders innovation. Considering the very nature of startups, the blockbuster model produces a great deal of failures that could be avoided if the model were a bit more tolerant and patient. At the macro level, such tolerance is likely to enlarge the entire pool of ventures which ultimately, and ironically, increases the number of blockbusters. In other words, tolerance, which is the very thing that venture capitalists lack, could be one of the greatest contributors to what venture capitalists seek - blockbusters. Tolerance could produce a recursive self-feeding eco-system that will greatly benefit all constituents. By adjusting their expectations, limited partners and venture capitalists no longer need blockbusters to achieve respectable and reasonable (but not greedy) returns based on the current market realities.
Risk is at the heart of entrepreneurship and venture capitalism. So who are the parties who are actually taking risks? Entrepreneurs take risks by investing their savings in their venture. Limited partners take risks by investing their money in venture capital funds. What risks do venture capitalists take? Unless general partners of a venture capital firm invest their own money in their fund or in a venture, which is rarely the case, they are not personally taking any risk whatsoever.
Neither risking other people's money, nor risking potential profits, nor risking projected capital gains, nor risking one's reputation, can be claimed as real risks. Reputations, projections, and sweat equity can't be claimed, and if they were, they must be claimed by all parties, and therefore they would be a wash. Put it simply, money talks - no money, no risk. Considering the fact that venture capitalists typically don't risk their own money, their control and their compensation are an aberration that must be fixed.
Currently, the only risk considered is the absolute risk, which is the actual amount of capital invested in a venture. However, there is a relative risk which must also be considered, albeit modestly. The relative risk is the ratio of capital invested versus the assets held. For example, if an entrepreneur puts $80,000 in her venture, while an investor puts in $8 million, on the surface, it seems that the investor took 100 times more risk than the entrepreneur. On a closer look, if the entrepreneur is worth $100,000 and invested $80,000, that entrepreneur took an 80% risk on her asset, while if the investor is worth $100 million, that investor took only 8% risk on his asset. Thus, while the investor invested 100 times more than the entrepreneur, the entrepreneur took 10 times more risk than the investor, relatively speaking. While admittedly the relative risk is dicey and difficult to measure, yet it should not be ignored even though it may represent a small percentage compared to the absolute risk.
Limited partners are insurance companies, banks, pension funds, mutual funds, trusts, university endowments, and wealthy individuals, who have the means and the desire to invest in risky ventures in exchange of higher returns than what they can get from the market. Thus, they invest in venture capital funds which typically offer them 3 times their money (even though they shoot for 10 to get 3) representing an Internal Rate of Return (IRR) of about 30% within a period of 10 years.
Is the IRR expected by the limited partners justifiable? Maybe when investors could get 20% to 30% returns from the market. Nowadays, there is no place to park one's money for more than 3%. Thus, in principle, the IRR expected by limited partners must be tied to the current market conditions and should be around 15% and not 30%.
In consideration of their work, venture capitalists earn the following compensation:
Thus, after 10 years, on a total investment of $500 million, the limited partners would earn $866.25 million while the venture capital firm would collect $383.75 million (excluding the interest earned on the administration fee). Those numbers are nothing short of staggering! No wonder why limited partners invest in venture capital funds and why everybody wants to be a venture capitalist. What about the compensation earned by venture capitalists? Is it justified? All venture capitalists claim that they add value by strategizing with entrepreneurs, introducing entrepreneurs to customers, helping entrepreneurs raise additional capital, establishing partnerships, recruiting key executives, etc. While the majority of venture capitalists pay a lip service to such services, the good ones perform an excellent job which often dictates the success or failure of a venture. Thus, while the majority of venture capitalists should be treated like brokers because they simply act like matchmakers, the few who make real contribution should be compensated appropriately. But are they? Absolutely not!! Venture capitalists (the good, the bad, and the ugly) are all excessively paid for the following reasons:
For example, a company raises $2 million from angels who receive 35% equity stake. The company then raises another $5 million from venture capitalists who receive 40% stake. A Stock Option Plan of 20% is reserved for employees. The founder is actually left with a mere 5%. Three years later the company is sold for $100 million. Great! It looks like it's a great outcome. Yeah, but to whom?!! Let's examine the distribution of the proceeds from the sale:
Party Equity Proceed
Founder 5% $5,000,000
Employees 20% $20,000,000
Angels 35% $35,000,000
Venture Capitalists 40% $40,000,000
Actually, from the 40% assigned to venture capitalists, $31.95 million goes to the limited partners, and the venture capitalists collect $8,05 million representing their commission of 23% on the capital gain of $35 million ($40 million of the proceed minus the $5 million invested). Thus, the venture capitalists made more money than the founder yet they have taken no risk, invented nothing, and worked a lot less than the founder.
Let's now replace the venture capitalists by independent experts in order to figure out how much they have been overpaid. It would cost $300K representing 6% of $5 million for an investment banker, $600K for two board members at $100K per year for three years, $300K for recruiters at $60K per executive for 5 executives, $800K for miscellaneous professional services to be generous and conservative. That's a total spending of $2 million. That means that the venture capitalists got overpaid by $6 million, and if not $6 million, it's $5 million, and if not $5 million, it's $4 million, etc.
Putting it in simplistic terms, unless the entrepreneur ends up with at least 20% of equity upon exit, the venture capitalist will end up making more money than the entrepreneur. Now you know why venture capitalists preach their self-fulfilling prophecy that it is better to own a small percentage of a big pie rather than a big percentage of a small pie. Actually, what's even better is to own a big percentage of a big pie.
Clearly, the compensation structure must be adjusted. Limited partners should earn the highest return because they are taking the highest absolute risk and they are the ones who are investing the most amount of money. Entrepreneurs should earn the second highest return because they are taking the highest relative risk and they are also the ones creating value and doing the work. Venture capitalists should earn the lowest return because they are not taking any risk. Their compensation ought to be no more than a reasonable premium above the fees normally charged by independent service providers. If the limited partners wish to continue overpaying their venture capitalists, it would be their prerogative. It is the limited partners who should dictate how much the venture capitalists ought to be paid. On the other hand, the limited partners should not be allowed to earn such outrageous IRR. Thus, by reducing the IRR, limited partners will have to reduce the compensation of venture capitalists.
Venture capitalists brag about the fact that they get intimately involved with their portfolio companies. That's one of their main selling points when courting entrepreneurs. They justify their compensation by claiming that startups require a lot of hand holding, which is true. Specifically, venture capitalists scout the landscape, select companies, perform due diligence, sit on the board of directors where they don't just advise and govern, but also strategize, plan, manage, control, introduce, recruit, and often execute when there are gaps in the management team. Thus, in all fairness, good venture capitalists are far from being just brokers, matchmakers, headhunters, or investment bankers - they truly contribute to the success of a venture more than just the capital that they invest on behalf of their limited partners.
When a venture succeeds, venture capitalists justifiably reap the benefits, but what about when the venture fails?!! Are they held accountable for its failure?!! Absolutely not!!! Venture capitalists are quick to point the figure at the entrepreneur. They even wash their hands from cases where the original founder is replaced by a CEO selected by them. If the CEO disagrees with the venture capitalists, he/she is often found between a rock and a hard place: if the CEO resists the venture capitalists' will, the CEO risks to get fired, but if the CEO reluctantly accepts the venture capitalists' advice then the CEO is blamed for a failed execution. So, dam if you do, and dam if you don't. Of course, the buck must stop at the CEO's desk. However, the venture capitalists are not innocent bystanders either. They can't have it both ways: either they are involved and must be held accountable, or they are silent investors and must get out of the kitchen (i.e., not sit on the board).
Who should hold the venture capitalists accountable? Other than achieving the desired return on the totality of the fund, limited partners are not qualified to assess the performance of venture capitalists. Limited partners are not at all concerned with the failure or success of any particular portfolio company. In fact, if all companies fail miserably, but only one succeeds hugely, limited partners would be quite delighted of such outcome, and incidentally, so would the venture capitalists. That's exactly what the blockbuster model produces. Thus, limited partners are neither qualified nor interested in holding venture capitalists' feet to the fire.
What about entrepreneurs? Can entrepreneurs hold venture capitalists accountable? Not with the current unfair and biased investment agreements designed to protect venture capitalists with preferred liquidation, anti-dilution, and vesting schedules. As a result, venture capitalists can have their cake and eat it too. They have a huge upside and no downside. In addition, they have total control. That's one of the most fundamental unfairness in the current system. Venture capitalists must bare their share of responsibility for the failure of any venture in their portfolio. Venture capitalists must no longer be allowed to hide behind the blockbuster model to justify their failures. No more free lunches.
Preferred shares are the reasons why venture capitalism is mocked as "Vulture Capitalism". They offer venture capitalists an unjustifiable and disproportionate amount of control including liquidation rights, registration rights, anti-dilution rights, vesting periods, etc. The justification of the preferred shares is their higher price compared to the common shares. However, considering the control given away, that's one heck of a price to pay.
Preferred shares are a source of arrogance, audacity, abuse, unfairness, and predatory behavior. They treat the entrepreneur as a second class citizen. They put all the responsibility on the entrepreneur's shoulder and none on the venture capitalists'. Their higher price does not justify the fundamental unfairness, discourse, and friction that they cause. The most recent gimmick is the Founder Stock recently introduced to mitigate some of the issues. While Founder Stocks do benefit founders, they don't quite level the playfield with venture capitalists. Furthermore, the introduction of yet another class of stocks has its disadvantages. We need to simplify things by eliminating preferred shares and not add an additional class of stocks.
Here are some examples that expose the abusive and predatory practices used by venture capitalists which resulted in many lawsuits:
Limited partners are concerned with the return on the investment of the overall fund. They may not be even aware of the existence of a particular venture, let alone its failure. The blockbuster model calls upon the venture capitalists to play the numbers game. They expect and plan for failures. They have mastered failures. The market expects their portfolio to include many failures and a handful of successes. For as long as they hit some homeruns, they are hugely successful despite many failures.
On the other hand, entrepreneurs, especially first-time ones, are not equipped to deal with failure like venture capitalists and limited partners are. Entrepreneurs are passionate and in love with their venture. They borrow money, use their credit cards, mortgage their houses, neglect their family, and put their marriage on the rocks. The pain and suffering caused by a failure is financial, emotional, personal, and professional. Regardless of how much one can learn from failure, it can still be devastating for an entrepreneur.
Venture capitalists have no incentives of struggling it out when the tough gets going. To them, it is just a number game. Once they recognize that a venture is not going to produce the return expected, they are too quick to throw in the towel. Their thinking is that there is no point of throwing good money over bad one. Furthermore, they have very limited bandwidth - they would rather spend their time on a venture which is likely to become a blockbuster. On the other hand, entrepreneurs tend to be more feisty and persistent. Their venture is the and only venture that they have. All their eggs are in that basket.
There is indeed a huge chasm between the mindset of an entrepreneur and the mindset of a venture capitalist. It is a balancing act. There is time to fight and time to fold. The point is that venture capitalists are too quick to fold. They are also unduly insensitive towards the needs of entrepreneurs.
Apparently, in order to become a venture capitalist, one has to graduate from a course called "Irresponsiveness 101". Venture capitalists are like black holes. The lack of courtesy and professionalism is mind bugling. If sales representatives treat their customers the way venture capitalists treat entrepreneurs, they would be fired on the spot. The sad part is that venture capitalists know that they are misbehaving, and few brag about it thinking that it is cool to have bunch of entrepreneurs chasing them - it feeds their ego. We all understand that venture capitalists have the upper hand but that's not a good reason to misbehave. Real powerful leaders don't abuse their power. Real wealthy people don't show off their wealth. This "nouveau rich" attitude is getting old and got to go.
The minute a venture capitalist opens his door for business, he has the duty to timely respond to each and every inquiry, regardless of the number of inquiries. It is his responsibility to establish the necessary system to be responsive without jeopardizing his time and his productivity. That's the cost of doing business. As an analogy, good employers make sure to respond to each and every applicant - it's called "employment branding". The Art of Rejection might help in this regard.
Other than collecting statistics, maybe the Venture Capital Association ought to introduce and enforce a code of conduct along with a whistle blower newsletter to be named "Venture Capitalists Revealed" where all the misbehaved venture capitalists are exposed and black listed (somewhat similar to a review website called The Funded, but more official like the list of disbarred attorneys).
Under normal circumstances, venture capitalism ought to be left alone to operate freely in a free market without any government intervention. Very unfortunately, we no longer live under normal circumstances. We face global competition, astronomical debt, and unprecedented trade deficit. We now live in the second most severe economical crisis since the great depression. With manufacturing outsourced to Asia, entrepreneurship is all what we got left. It has become our lifesaver. Entrepreneurship must be raised at the national security level.
While overall, venture capitalists have made substantial contributions to our economy, they could have achieved a lot more without the greed and the gouging of some of the bad apples who have shown their true colors with their irresponsible, unprofessional, and even unethical behavior. It is ample clear that the bad apples are neither capable nor interested in self-governance. It is also clear that the good apples are not capable of influencing the bad ones. On the other hand, entrepreneurs are too weak to bargain with venture capitalists. Finally, it seems that venture capital associations are more interested in statistics than ethics.
As a result, in order to protect and foster entrepreneurship, the venture capital industry including its role, practices, ethics, agreements, and compensations must be regulated by a government agency with real teeth. However, unlike the SEC for example, such regulatory body should not be manned with bureaucrats but should include leaders in the venture capital community and successful entrepreneurs endowed with the public trust to defend entrepreneurship. Like financial brokers, real estate agents, attorneys, mechanics, physicians, or hair dressers, venture capitalists must be licensed to practice. They must be held to high standards and work ethics.
Venture capitalism must be restricted to seed and early stages, especially if the IRR, which must be tied to market conditions, is expected to be high (but not outrageously so) considering the high risks.
While venture capitalists make critical contributions to the success of ventures, they are excessively overpaid. The billions of dollars milked out of the system because of their staggering fees must be restored and put back to work in the system to encourage more innovations. Their fees must be adjusted accordingly.
While venture capitalists reap the benefits of their successes, they must also be held accountable for their failures. The blockbuster model must be changed to allow companies who are not destine to become blockbusters to thrive. Predatory practices must be eliminated and the interests of all parties must be realigned.
Entrepreneurship is critical to growth. In order to remain competitive on the global market, entrepreneurship must be elevated to a national security issue. In order to avoid a meltdown similar to what we are currently experiencing on Wall Street, and considering the track record, the inability, and the unwillingness of limited partners and venture capitalists to police themselves, controlled regulation based on common sense is required to protect venture capitalism from its vice.
What we need is venture capitalism 2.0 - a compassionate, tolerant, transparent, flexible, ethical, equitable, and accotable venture capitalism.
Dr. David Saad
Chairman & CEO
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