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Business Finance

Venture Capital Is Broken—But Who Can Really Fix It?

Illustration by Meg Marco

This piece was originally published at Observer.com

Geoff Chapin started a very cool company in a very hot space.

C-Combinator, which launched last year, tackles at least two major problems at once. Every year, mountains of seaweed amass on Caribbean beaches and slowly rot, creating not only a tourism-alienating stench but also methane gas, which contributes to global warming. The company scoops up the seaweed and turns it into a variety of products that might otherwise be petroleum-based, including emulsifiers and a kind of natural leather.

You might think that a tech company with a sustainable end product that is also actually preventing greenhouse gases from being released into the atmosphere would be catnip to venture capitalists, those highly specialized middlemen, lavishly compensated to invest other people’s money in companies who rave a lot these days about “climate tech.” And you might be right, but Chapin hasn’t pursued the VC path.

“We’ve considered it,” Chapin told me. “But we have been fortunate to have many impact investors fuel our growth now and in the future. We found investors that care about profit capitalism, but also bringing new solutions forward.”

On one level, it’s surprising that venture firms aren’t blazing a path to Chapin’s door. By many yardsticks, venture capital, that storied fountain of so many companies and billionaires that have defined American (and other!) lives in the technology era, has never been more plentiful or more ubiquitous. The titans of the industry (disproportionately located in Silicon Valley, part of a problem detailed below) are doling out more money than at any time in human history. During the first half of 2021, on average more than a billion dollars of capital was invested in private companies every single day. That surface success, however, masks fissures, critiques, and existential threats inside and outside the venture capital system as it has been established over the last half-century.

Before enumerating those slings and arrows, a quick primer on how traditional VCs operate.

The Magical Wealth Machines

Most of the money that VCs invest is not their own; they pool money from “limited partners” and invest on their behalf. Although in theory anyone could be a limited partner in a venture firm, the biggest players have been pension funds, university endowments, large nonprofits, institutional investors, and wealthy individuals.

While investing through a VC firm is inherently risky and can tie up money for years while the VCs decide which companies to invest in, the payoffs—which happen when a company is sold or goes public—can be spectacular. One may bemoan the fact that American social institutions like universities and hospitals feel forced to fund themselves through investments (instead of, say, through taxpayer dollars), but there are very few legal ways beyond VC for a nonprofit to get a return that is five or ten times the size of its original investment. As a reward for choosing the right companies, VC firms typically charge the limited partners 2% of the money that’s been invested per year over ten years, and 20% of the profits the investments make (the 2/20 fee structure is also commonly used by hedge funds and private equity firms).

It’s little wonder that these magic wealth machines have, for decades, hugely satisfied the people inside their world—and tempted many more to get in the game, or beat it. In the meantime, VC has also helped create just about every post-’70s tech company you can think of, as well as a number of other companies—in fields such as bioengineering and health care—that are arguably more socially important.

The Red Queen’s Race

For all its phenomenal success, however, traditional venture capital is under attack and evolutionary pressure from nearly all sides. Some of these attacks are about the outcomes of VC investment, some are threats from VC spinoffs, some could very well be viewed as the success of traditional VC ultimately eating its progenitor. These assaults, even combined, won’t exactly overthrow VC, but it’s a reasonable bet that traditional VC is going to have to make a lot of adaptations over the next decade or so.

There is a cluster of obvious criticisms around venture capital’s outcomes. Earlier in the 21st century, being the driving force behind Facebook and Twitter was something to brag about, but for several years both VC and the tech-saturated world it funds have been on the defensive. Silicon Valley has long been one of the least diverse industries in America, not only in terms of who works there but crucially also in the companies that venture capital funds. While approximately 10% of all American businesses are owned by African-Americans, only about 3% of venture-funded companies are. The numbers for women are even worse; in 2020 just 2.3% of venture funding went to female-run firms, and that number is actually down from the year before. And of course it is not hard to see VC and the firms that it funds as a major driver of 21st century inequality.

The exclusivity of the Silicon Valley VC model is not limited to who gets the money or provides it, but also who is allowed to put money in (more of that in Part II).

Yet as important as the diversity critique is, it’s not especially dispositive. Venture capital’s performance on that score is not massively worse than in other parts of the financial world—investment banks, private equity, etc.—or indeed than much of corporate America. A more tailored outcome damnation might be labelled the frivolity critique, neatly summarized in a Peter Thiel quote from 2013: “We wanted flying cars. Instead we got 140 characters.” (A corollary of the frivolity critique is the lemming critique, for which the poster child is probably Theranos.)

In November 2020, New Yorker writer Charles Duhigg gave these arguments a thorough hearing, asserting that venture capital has become “increasingly avaricious and cynical.” Today’s VC invests in ideas and founders not, Duhigg argued, because they are likely to make the world a better place, but because they tantalize with paydays that must be chased to keep up with the competition. What’s worse, Duhigg observed, is that VCs allow money-losing companies (such as WeWork) to build up near-monopoly positions and crowd out other businesses.

The frivolity critique’s poster child is surely Juicero, the much-mocked $400 device that squeezed packages of juice into a glass. The company raised an eye-popping $120 million in venture capital, from highly respected firms including Kleiner Perkins and Google Ventures. When a Bloomberg story revealed that the juice packets could just as easily be squeezed by hand, the writing was on the wall and the company closed up shop in 2017.

The trouble with Duhigg’s argument is not that it’s wrong (indeed some version of the frivolity critique is often heard in Silicon Valley itself). The trouble is that it risks viewing old-school venture capital through a lens of unwarranted nostalgia. True, the average company funded by a VC company in the ‘70s or early ‘80s had an arguably more socially useful purpose than the average company today, in large part because the true believers of that earlier era had so few funding options. It’s also true that in the first decades of traditional venture capital, life sciences and biotech companies—which, fairly or not, probably convey a greater sense of “seriousness” to most observers—represented a higher percentage of VC investments than they do today.

But venture capital’s frivolity or lemming problem is not recently acquired. The Internet highway is littered with roadkill of venture-backed companies that would have been considered silly even if they had succeeded. Most readers have probably forgotten AllAdvantage.com, a late ‘90s company that paid people to surf the Web, but morphed into an incentive to send spam to friends and strangers. The company raised nearly $200 million in venture money—an astronomical sum at the time, considering that Sequoia Capital’s initial 1995 investment in Yahoo was $2 million—before collapsing.

Then there’s Theglobe.com, Pets.com, Zynga—VC eagerness to back lightweight ideas goes back a long way. Of course, when such bets are successful, they are hardly frivolous in investors’ eyes; thus, somehow loosely demanding that venture capital invest only in socially productive companies is doomed to be ineffective, even if it is intellectually or morally satisfying. Nonetheless, the persistence of these critiques has begun to assert itself on VCs.

Efficiency, Meet Inefficiency

A more recent, and potentially more potent, threat to traditional venture capital has emerged on the edges of the VC industry itself; let’s call it the efficiency critique. Venture capital has been massively successful over the last half century by keeping three camps happy: the limited partners (who make fantastic returns on their investments); the startup founders (who get cash and connections to grow their businesses, and often personally end up very wealthy); and the VC firms themselves (which, when successful, turn the 2/20 into billions of dollars in profit).

Over the last 10-15 years, a growing chorus of people in the startup ecosystem have begun to argue that the VC model increasingly serves the interests of the third camp at the expense of the other two.

In large part, that insight is the fruit of a far more competitive funding landscape. For starters, venture investing has become globalized to a degree that was unthinkable a generation ago. As recently as the mid-1990s, 95 percent of all venture investments involved investors and startups headquartered in the United States; today that figure is about 50%. The relative ease with which, say, US venture firms today invest in Asian startups, and vice-versa, is a profound shift that will only increase in significance. (Indeed, if the COVID pandemic has demonstrated anything to the VC community, it’s that the in-person meeting—the much-vaunted “warm intro” between founder and funder—once considered essential to the investment process…isn’t.)

To Silicon Valley incumbents, the spread of VC outside their fiefdom represents simultaneously opportunity and threat. In the last few years, the influx of billions from Japan’s Softbank and New York’s Tiger Global has forced traditional VCs to move more quickly and spend more money to compete.

It’s Time to Quote Karl Marx

But the competition comes from more places than other locales. To tweak a famous quote from Karl Marx, venture capitalism has sown the seeds of its own destruction; there now exists a critical mass of individuals who have made so much money from founding VC-backed tech companies or owning tech stock that they compete with traditional VCs to invest in the next generation. Such investors may not be household names (yet), but they yield increasing influence in tech investing. A recent Pitchbook story on “solo VCs” revealed: “It’s an open secret in Silicon Valley that this group of investors is willing to offer founders better terms and higher prices than traditional VCs in exchange for a chance to back fast-growing startups.”

Similarly, there has been a dramatic increase in corporations creating their own venture arms. And even some nonprofits have decided that it no longer makes sense to pay a VC firm to invest in startups when they could do it themselves.

Taken collectively, these developments point to a clear, if still nascent, trend: the existing VC model isn’t working consistently well for anyone but the VCs. Another way of putting this is that the benefits once conferred by a VC investment have become largely commoditized and undifferentiated. A recent essay from Sam Lessin, a general partner at Slow Ventures, underscored the fact that the traditional VC package—Here is a check and a board member, please kindly over time surrender something like half of your business—no longer exclusively or at a competitive price provides the startup founder with what she most needs:

“The broad-based knowledge among entrepreneurs of how to start successful companies has been widely distributed. A ton of infrastructure is now in place–from Amazon Web Services on down—to support business building. The dark art of growth and engagement has been demystified and people know the playbooks. And, of course, the finance community’s knowledge about how to evaluate startups and price risk has gone mainstream.”

Lessin told me that he’s skeptical that traditional VCs can fix this commoditization by adding services–helping founders make new hires, or find new customers–because it threatens their margins and turns them, he said, into a firm like Bain: “You don’t want to be in those businesses, real entrepreneurs don’t.”

And so, if the traditional VC model is broken, what will replace it—where will the paradigm shift come from? That will be the topic for Part II.

James Ledbetter is the Chief Content Officer of Clarim Media, and the editor and publisher of FIN, a newsletter about the fintech revolution. He is the former Head of Content at Sequoia Capital.

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