The VC model is broken

These days, the more you talk to folks about Silicon Valley’s venture capital industry, the more negative the message is becoming.

And for good reason. There’s no more patience. Last time, circa 2001, the entire VC industry got a “get-out-jail-free card” after the Internet bubble burst. That’s because the scores of new firms created in the late 1990s argued they should be forgiven for any poor performance — it was the bubble’s fault, and everyone was affected. Their investors — chief among them, the elite university endowments –agreed, and gave the VC firms more money to invest again. With most VC funds lasting for ten years, this ensured the VCs a very long life indeed.

However, several things have changed. Adeo Ressi, founder of TheFunded, the site that lets people rate venture capitalists, is the latest to try to articulate the changes with a dour set of slides. He gets some things right, and some things wrong.

Ressi was invited to present his views to the finance and entrepreneurship faculty at Harvard Business School, a place that historically has produced a lot of venture capitalists. Ressi’s message is that the venture capital industry is fundamentally broken.

Ironically, his audience (HBS) might be part of the problem: One of the shortcomings with the VC model, Ressi argues, is that venture capitalists rely on their network of friends. Of all networks, HBS is one of the tighter ones. Needless to say, Ressi’s message wasn’t very warmly received. In fact, while blasting the old boys network is a popular thing to do, I’d actually disagree with Ressi on this point. Increasingly, you’re seeing diversity within the VC community, and they’re pushing themselves hard to find great entrepreneurs of any kind. I disagree that the Google founders were outsiders. They were part of the Stanford engineering student machine, a source of Silicon Valley magic for years.

Where I do agree with Ressi is in the ugly economics overall. Most daunting is that there’s more money being invested into venture firms than those same VC firms are generating from their investments in start-ups — in other words, Ressi argues, they’re now having a net negative affect on the economy. You’d expect this lopsided dynamic to exist temporarily in a downturn. But the worrying thing is that this state of affairs may last for quite some time.

I’m not sure how long this negative balance will last, but for now it certainly contradicts the message traditionally propagated by the VC industry — that it, that VC is a net creator of value, namely of stock market growth and job creation. That positive impact was indisputable — until now.

There are a number of key reasons why things are so ugly:

1. The early successes in the valley (Intel, Cisco, Genentech, etc) attracted so much venture capital after the late 1990s that VC became an official asset class that money investors around the world sought to get a portion of. However, this is a niche industry, and should have stayed that way. Too much money has swept in, with too few deals to accommodate it. This has distorted the economics badly. Valuations are driven up for the good companies, making it prohibitively expensive for VCs to invest. Everyone loses.

2. Others have become smarter. Larger companies put start-ups on their radar much earlier. Yahoo, Microsoft, Google, Cisco have acquired start-ups very early in their life, taking them off the market for tens or hundreds of millions of dollars — but potentially keeping some start-ups from becoming billion-dollar companies. Amazon famously balked at buying Google for about $1 billion back in 2000. That may not happen today.

3. Greed. Pure and simple. Good venture capitalists have an incentive to raise ever larger funds, because the 2 percent they get in fees on the funds can bring them millions of dollars in cushy salary and expense accounts (including private jets, at least in the good old days). But to put all that money to work, the investor can’t focus on early-stage companies, because those small companies can’t absorb enough dollars. So greedy VCs turn to invest tens or even hundreds of millions of dollars into each company. That’s why there was this rush to invest at the lastest stage possible, namely private equity. There’s major pain in that sector right now, because there’s no way for anybody to liquidate their investments. This is something we saw coming a while ago; we’re surprised people supported the Blackstone IPO; it was so obviously set for failure.

Is it really all gloom and doom?

I remember meeting Draper Fisher Jurvetson partner Tim Draper in mid-2000, when it had first become clear that the first Internet bubble had permanently burst. At the time, to my surprise, he exhorted me to be positive in my reporting, that is, to show the good side of the valley and not dwell on the bad. Of course, I largely ignored him. I ended up writing about three years worth of aggressive, negative coverage of the industry and its fallout, and didn’t make a lot of friends.

But I’ll never forget how sanguine Draper was — and how in the end, his view proved to have merit even though it sounded so absurd at the time. While Benchmark‘s Bob Kagle predicted a huge shakeout in the industry (half of all firms would disappear in a few years, he said ) that shakeout actually didn’t happen. The number of VC firms actually grew through 2005 or so. DFJ itself thrived, making big money from companies like Skype and Baidu. Draper was only half right, of course. He said that venture investing would remain strong, and possibly even grow. VC investing dropped back down to where it was before the bubble, but it did remain solid and grew through last year.

It is noteworthy, then, that I found myself yesterday contacting Tim Draper again, upon hearing that his firm DFJ is raising a large $800 million fund. Just like last time, the economy and overall investment environment has deteriorated badly. Limited partners (the institutions that give money to VC firms like Draper’s) are panicking and some are actually having trouble making good on their existing commitments (not meeting capital calls). Why on earth would DFJ think it could raise a fresh big fund in this environment?

Draper declined to comment on his firm’s fundraising efforts, but here’s what he said:

It wouldn’t be a bad idea to spread some VC good will around about now. Washington could stand to hear about Venture Capital job creation and wealth building. After all, ours is the asset class that may be able to pull the US out of this mess. You might also go on an anti-Sarbox rampage. That might be the regulation that has sucked the most value out of the entrepreneurial economy in the last 5 years.

In other words, we’re back to where we were ten years ago. The bubble a decade ago inspired a new set of regulations — known as Sarbanes Oxley — that forced startups to be much more conservative with their reporting and which required more burdensome auditing. The VCs complained about it — until the IPO market opened up in 2005-2007. Now that’s over, and we’re facing the possibility of an even more severe drought. That’s because there will be less mercy for VC firms this time around. And thus the plea not to focus too much on all this negativity. For Draper, such positivity is his natural demeanor. DFJ is widely known as the most aggressive venture firm in the valley — offering much larger amounts of money for an ownership stake in start-ups than other VC firms offer.

However, a lot of VCs are likely to go under this time. This asset class significantly underperformed other asset classes between 1998 and 2006. A handful of firms — Sequoia, Kleiner, Benchmark, Accel and a handful of others — have pulled up the average performance somewhat, because they’ve produced an inordinate amount of the successes (a small group of homeruns, the eBays and the Googles, account for 25 percent of total VC returns over the past 20 years; see Ressi’s slides). But if you invest in the average firm, you’re doing very poorly. So limited partners will probably shift from endowments and foundations increasingly to fund-of-funds and sovereign wealth funds.

So, yes, the VC model is badly broken. This time, Bob Kagle’s statement about half of all VCs going out of business is more likely to be true.

[Photo:flickr/Duke LeNoir]