As a founder turned investor, I’ve immersed myself in the startup world for ~20 years. I have spoken with 100s of founders and investors and seen many sides of the ecosystem. As a founder, I’ve been the beneficiary of VC investment and seen it work.
I spend much of my time focused on the benefits and upside of startups. I’m a believer that there is value in VC. We should continue investing in startups. We should strive for scaling innovation to improve people’s lives.
Venture Patterns catalogs the strategies and mental models in VC and startups. I think these are worth focusing on because they offer strong benefits. I also seek understanding and nuance. So, I often include both the benefits and the trade-offs of the individual patterns.
But what about VC in general? What are the trade-offs for individuals and society in deploying the VC model?
I offer here a summary of the chief complaints or downsides of the current venture capital model. While there is a lot to celebrate about the current model, there is plenty to improve.
First, we should be understanding the issues and complaints. Then we can work to improve by generating and embracing alternatives.
If you have additions or suggested solutions/alternatives, I’d love to hear from you.
If you want to dive deep into this topic, please continue reading. I’ve included sources, reading, and my notes.
- Leaves Out Markets – VCs too often focus only on high-margin, obviously big markets that they can relate to and understand from some personal experience. Both the rational economic drivers of going for fast, big returns, and the bias of humans push VCs to not consider many big markets, could offer returns, and offer society benefits.
- Leaves Out People – The demographics of the decision-makers at VCs and the founders they fund are not representative either of the population or the available pool of companies. (For example, only 12% of decision-makers in U.S. venture capital firms are women. Just one percent of venture capitalists are Latinx and only three percent are black.)
- Not Enough Innovation or Productivity Growth – For all the talk of innovation, do VCs fund basic enough breakthroughs in the areas that will truly improve the human condition? Or do they innovate enough in their own models?
- Not Enough Profits – In the first dot-com bubble and in the current wave of unicorns, growth has been emphasized so to such a great degree that companies are achieving great scale without proving profitability. While some VC-backed companies have become profitable public companies, are too many of them financially unsustainable?
- Private Gain from Public Investment – Some argue that government investment in basic research is then privatized and too many of the profits are captured by entrepreneurs and VCs.
- Too Much Risk – Do VCs cause or embrace the risk of so many startups going out of business and leaving investors and employees with little to nothing? Could the benefits of VC be created without taking on such risk of wipeouts?
- Not Enough Support for Companies – VCs claim to add a lot of value for portfolio companies, but do they really?
- Forcing Exit of Company Not Just Investor – While investors often want to have an opportunity for liquidity, given the cap tables and structure of VC-backed companies, often that liquidity for minority investors requires selling the whole company. Founders may want to do that or may not want to depending on the situation.
- Too Few Exit Options for Founders – Once a founder has accepted a VC investment, it raises the bar for what would be an attractive price on the sale of the company. As the dollar amounts get higher, there are fewer possible buyers. Financing the buyout of early investors with debt becomes increasingly difficult, as well. Passing on a business to family members, as so many non-VC-backed companies hope to do is not an option. So, the number of options for an exit for a founder is reduced by raising VC.
- Not Enough Job Creation – While the first wave of big tech exits for VC many employees (think Cisco, Apple, etc.) the recent wave of big tech exits (think Instagram, Whatsapp, and Snap) have not created that many jobs.
- Not Enough LP Returns – For LPs, the purpose of a VC firm is to generate returns that are superior in order to justify the risk and lack of liquidity. Does it deliver the goods? Many funds do not perform well with a large concentration of returns in the best performing funds.
- Misaligned Incentives with LPs – VCs, particularly with larger funds, can earn good money from guaranteed management fees, on average ~20% of the entire fund, without generating excess returns. In addition, some LPs suggest that GPs should have more “skin in the game” by investing more than the 1 to 5% which is typical.
- Not Enough Public Investor Returns – The latest wave of US tech companies has tended to stay private longer thereby generating more returns in the private market and much less for the public shareholder. While this may be a case of VCs doing their job for LPs of making money, some criticize the model as it further aggregates wealth and does not allow access to growth investments for the average person.
Sources and Notes
For sources, deep dives, and more quotes, please read on for my notes on some of the key writing on this topic. If you have more to contribute to this list, please let me know.
by Luke Kanies (Founder of Puppet)
- Not enough innovation
- High risk for founders/companies that take VC
- “If you’re a founder given a choice between a firm that kills most of its customers and one with demonstrated success at creating long-running companies that generate wealth for everyone involved, why would you pick venture capital?”
- Lack of portfolio company support:
- When you know that a small percentage of your bets end up mattering, you don’t worry much about any individual one, and that plays out in the world of venture capital.
- “I’m convinced that a firm that directly invested in reducing its failure rate would have as many unicorns, but it would also have more positive returns throughout its portfolio, and in the midst of building more companies and making more money, it just might do a little good at the same time. “
- “many investors have told me that the most likely reason for a company to fail is the team. So what do they do to reduce the probability that a founding team will fall apart? Ah…nothing.”
- “founders will spend about a quarter of their time fundraising, rather than building the company”
- “as part of their investment, they deliver a playbook that uses the collective intelligence of their portfolio to help founders avoid having to make all the rookie mistakes, right? Hah! Nope!”
- Investment selection is biased
- There’s so much pattern matching going on that founders are contorting their companies to fit the funding schedule rather than discovering their own destinies.
- Investors are reliant on people near them, who resemble them, and who can absorb the weighty downsides of entrepreneurship
- “In a rational world, every reasonably sized market would have a well-funded ecosystem of software companies vying to take it into the information age.”
- “We’re not attacking the right markets, we’re not including enough people, and we’re not having a big enough impact on the economy, all because we’re relying too much on luck and timing.”
- Investors don’t really know what separates great companies from bad in the early days, so they don’t strive to create the conditions necessary for gestation, and once a company is started, they do little for the winners and even less for those who fail
- Bias in market selection – “We can really only increase the rate of great company creation by increasing the rate of experimentation, or increasing the rate of success.“
- “None of these realities show up in modern venture capital.”
- The best way to make money is to hold high-quality assets for a long time. If nothing else, Warren Buffett has demonstrated that this is the best way to make money and that it is indefinitely scalable.
- The majority of employment and wealth generation is provided by companies too small or too closely held to be public.
- The steady-state of good companies is cash-flow generation managed by long-term teams who take pride in their work. This is literally the entire history of for-profit enterprises. Any other solution must either fail or revert to this at some point.
Venture Capitalists Get Paid Well to Lose Money
By Diane Mulcahy
- “Yet 2013 annual industry performance data from Cambridge Associates shows that venture capital continues to underperform the S&P 500, NASDAQ and Russell 2000.”
- “A VC firm is, first and foremost, an investment vehicle created to generate returns for investors that exceed those available in the fully liquid, low-cost public equity markets. If that objective is persistently left unaccomplished, investors will allocate their capital elsewhere.”
- “A minimally viable venture rate of return is 300-500 basis points of outperformance above the public markets, a level of returns that investors haven’t consistently seen since the late 1990s” [article published in 2014]
- “But the bigger problem – and the real problem for investors – is how little of a problem this persistent underperformance is for VCs themselves. LPs have created and perpetuate an industry of such structural economic misalignment that VCs can underperform and not only survive, but thrive.”
- Misaligned incentives:
- “VCs aren’t paid to generate great returns. LPs pay VCs like asset managers, not investors.”
- “VCs barely invest in their own funds.
- “The VC industry has failed to innovate.”
We Have Met The Enemy… And He Is Us (Published 2012)
By Diane Mulcahy for Kauffman Foundation
- “Venture capital (VC) has delivered poor returns for more than a decade. VC returns haven’t significantly outperformed the public market since the late 1990s, and, since 1997, less cash has been returned to investors than has been invested in VC. Speculation among industry insiders is that the VC model is broken…The Kauffman Foundation investment team analyzed our twenty-year history of venture investing experience in nearly 100 VC funds with some of the most notable and exclusive partnership ‘brands’ and concluded that the Limited Partner (LP) investment model is broken. Limited Partners—foundations, endowments, and state pension fund—invest too much capital in underperforming venture capital funds on frequently misaligned terms.”
- “The average VC fund barely manages to return investor capital after all fees are paid.
- “Returns data is very clear: it doesn’t make sense to invest in anything but a tiny group of ten or twenty top-performing VC funds. Fund of funds, which layer fees on top of underperformance, are rarely an effective solution. In the absence of access to top VC funds, institutional investors may need to accept that investing in small-cap public equities is better for long-term investment returns than investing in second- or third-tier VC funds.”
- “Creating and negotiating a compensation structure that pays fees based on a firm budget, and shares profits only after investors receive their capital back plus a preferred return, would mean LPs pay VCs for doing what they say they will—generating excess returns above the public market.”
- “Evaluate VC fund performance by modeling a fund’s cash flows in comparable indexes of publicly traded common stocks.”
The fundamental problem with Silicon Valley’s favorite growth strategy
By Tim O’Reilly (Founder of O’Reilly Media and OATV a VC)
- Reaction to Blitzscaling book
- “The pursuit of monopoly has led Silicon Valley astray”
- “investors, awash in cheap capital, anointed the winners rather than letting the market decide who should succeed and who should fail. This created a de-facto duopoly long before either company had proven that it has a sustainable business model. And because these two giants are now locked in a capital-fueled deathmatch, the market is largely closed off to new ideas except within the existing, well-funded companies.”
- “for every company like Paypal that pulled off that feat of hypergrowth without knowing where the money would come from, there is a dotcom graveyard of hundreds or thousands of companies that never figured it out”
- “In short, there are compelling reasons to blitz scale, and the book provides a great deal of wisdom for those facing a strategic inflection point where success depends on moving much faster. But I worry that the book oversells the idea and that too many entrepreneurs will believe this is the only way to succeed.”
- “Blitzscaling can be used by any company, but it can encourage a particular kind of entrepreneur: hard-charging, willing to crash through barriers, and often ruthless.”
- “Venture-backed blitzscaling was far less important to their success than product and business-model innovation, brilliant execution, and relentless strategic focus. Hypergrowth was the result rather than the cause of these companies’ success.” [Google, Facebook, Microsoft & Apple]
- “The monetization of the company is sought not via the traditional means of accumulated earnings and the value of a continuing business projecting those earnings into the future, but via the exit, that holy grail of today’s Silicon Valley.”
- “Silicon Valley venture capitalists want entrepreneurs to pursue exponential growth even if doing so costs more money and increases the chances that the business will fail.”
- “its worst turns entrepreneurs into the equivalent of Hollywood actors, moving from one disposable movie to another.”
- “Winners-take-all is an investment philosophy perfectly suited for our age of inequality and economic fragility, where a few get enormously rich, and the rest get nothing. “
- “Indie.vc’s search for profit-seeking rather than exit-seeking companies has also led to a far more diverse venture portfolio, with more than half of the companies led by women and 20% by people of color.”
- “one of those responsibilities is to provide an environment in which other, smaller companies and individuals can thrive. “
- “The goal for Lyft and Uber—and for all the entrepreneurs being urged to blitzscale—should be to make their companies more sustainable, not just more explosive; more equitable, not more extractive.”
More Start-Ups Have an Unfamiliar Message for Venture Capitalists: Get Lost
By Erin Griffith
- “But for every unicorn, there are countless other start-ups that grew too fast, burned through investors’ money, and died — possibly unnecessarily.“
- Tech companies would behave better if more different types of people were running them and they did not emphasize growth at the expense of all else.
- Zebras Unite
- Black & Brown Founders
- “The V.C. path forces you into this binary outcome of acquisition or I.P.O. or pretty much bust” – what is the definition of winning?
- Examples of businesses buying out VCs or being successful without VC
- Indie.VC
Zebras Fix What Unicorns Break
By Mara Zepeda, Aniyia Williams, Astrid Scholz and Jennifer Brandel
- “We believe that developing alternative business models to the startup status quo has become a central moral challenge of our time.”
- Startup culture pushed by VCs “chases after ‘unicorn’ companies bent on ‘disruption’ rather than supporting businesses that repair, cultivate, and connect.”
- “When VC firms prize time on site over truth, a lucky few may profit, but civil society suffers. When shareholder return trumps collective well-being, democracy itself is threatened. The reality is that business models breed behavior, and at scale, that behavior can lead to far-reaching, sometimes destructive outcomes.”
- “From that business model flows company culture and beliefs, strategies for success, end-user experiences, and, ultimately, the very shape of society.”
- New culture and new model needed
- Leaves people out – race, gender, geography, etc.
- Feminism and gender issues including: different questions for female founders, speaking differently about them, and sexual harassment issues.
- “The capital system is failing society in part because it is failing zebra companies: profitable businesses that solve real, meaningful problems and in the process repair existing social systems.”
By Mariana Mazzucato
- “Modern economies reward activities that extract value rather than create it. This must change to ensure a capitalism that works for us all.”
- Private Gain from Public Investment – Some argue that government investment in basic research is then privatized and too many of the profits are captured by entrepreneurs and VCs.
- Much much more!
The Real Trouble With Silicon Valley
By Derek Thompson
- “Big Tech continues to find new and profitable ways to sell ads and cloud space, but it has failed, often spectacularly, to remake the world of flesh and steel.”
- “The internet age was hailed as a third industrial revolution—a spur for individual ingenuity and an engine of employment. On these counts, it has not delivered. To the contrary, the digital age has coincided with a slump in America’s economic dynamism.”
- “failed to create enough middle-class jobs to offset the decline of the country’s manufacturing base, or to help solve the country’s most pressing problems: deteriorating infrastructure, climate change, low growth, rising economic inequality”
- “We were promised an industrial revolution. What we got was a revolution in consumer convenience.”
- “But no matter how aggressively you torture the numbers, the computer age has coincided with a decline in the rate of economic growth.”
- “Tech’s biggest winners have effectively built monopolies”
- “America’s innovative talents have devolved from versatility to specialization. If we’re going to concentrate so many resources in one sector, that sector had better produce.”
- “I’m also worried that it’s sapping talent from other industries that might benefit from more innovation.”
The Warning Label That Should Come with Venture Capital
By Founder Collective
- VC money is a tool but can be dangerous
- Use it to fund a working model and achieve hypergrowth
- Capital itself won’t give you insights you didn’t have before
- Limits exit options
By All Raise, PitchBook, Jenny Abramson, et al
- 2018 investment in startups with at least one female founder reached $46 billion, representing 18% of total VC funding.
- “We still have a lot of work to do, and to get to the place of parity, but the data really shows there’s been a huge amount of progress,” Jenny Abramson
- female-led startups exit one year faster than their male-only counterparts and the exit value was at $26 billion by the end of 2018
- Only 12% of decision-makers in U.S. venture capital firms are women
- only 11.2% of CEOs that scored VC deals were female
- “An increase in diversity in the venture ecosystem can do more than provide companies and investors with better returns and faster routes to exits, it will ultimately be a driver in the demographic makeup of future fundraising opportunities.”
Dear Silicon Valley: America’s fallen out of love with you
By Ross Baird
- Leaves out people (demographic and socioeconomic status)
- Narrow background/perspective for less innovation
- Too much risk
- Not innovative in solving a wide range of societies problems
- Too many wipeouts
- Too few acquirers so narrow innovations
Is Venture Capital Worth the Risk?
By Nathan Heller
- VC is like whaling – high risk and few get the rewards
- “In principle, venture capital is where the ordinarily conservative, cynical domain of big money touches dreamy, long-shot enterprise. In practice, it has become the distinguishing big-business engine of our time. Can it offer both returns?”
- “Venture capitalism is behind most of the platforms on which people lament the gaucherie of ‘late-stage capitalism’; it has become the chief industrial backer of the self-aware, predominantly upper-middle-class approach to lifestyle now called woke.”
- “A marriage between social enlightenment and manic growth defines the business of the past decade. Venture capitalists, having helped officiate the ceremony”
- WeWork, Theranos, Juicero, and Zume
- Facebook and Uber share value down after IPO
- “Acquisitions are one reason that, despite the efflorescence of new startups, power in tech flows toward the giants at the top.”
- Rockefeller funded startup aviation industry even though was losing money
- “Nicholas quotes the then head of the Investment Bankers Association of America: ‘No one in the high-income tax brackets is going to provide the venture capital and take the risk which new enterprises and expansion require, and thereby help create new jobs, if heavy taxes take most of the profit when the transaction is successful.’”
- But, during WWII government funds spurred innovation (direct contracts and education)
- “The war and its aftermath, which saw the growth and reimagining of such companies as I.B.M. and Hewlett-Packard—plus the first programmable digital computers, the jet engine, mass-produced antibiotics, and oodles more—was by most measures a golden age of American innovation. It happened largely on the government’s tab.”
- “quotes early venture capitalists saying that they wouldn’t have got into the game if it hadn’t been for federal incentives”
- “Did the government’s investment pay off? Yes, venture capital in the seventies helped bring us Apple, Atari, Genentech, and the like. And, yes, in the nineties it was crucial to the launch of Netscape Navigator, Hotmail, and Google.”
- No VC: Microsoft, Mosaic, and Craiglist
- “Subtract venture capital from the landscape of late-twentieth-century innovation, and we would have reached the new millennium with roughly the same technological capacities.”
- “As a whole, the venture-capital industry has significantly outperformed the public markets only in the nineties”
- “undesirable treatment of employees, who may find themselves overworked, underpaid, or verbally abused”
- VC incentives management fees and not enough downside
- Zebra mentioned