Venture Capital - A Broken Model

The stock market is low. The price of private deals is even lower. This should present great buying opportunities for Venture Capital, right?

Well, that would be true if Venture firms were actually in business today.

The Venture Capital model of recent years barely resembles the industry the one that I first learned of in the 1980s. In those days, investment funds made small investments ($1 - 3 million) in companies with modest valuations (single digit millions). The funds played a significant role in the oversight of their portfolio companies. The likely exit was through a sale - IPO activity was modest, and when IPOs occurred the deal sizes were small.

In those days, the funds themselves were modest size - $40- $50 million funds were big. The interests of the limited partners (ie the investors in the funds) and the general partner (the fund management) were aligned. They GP took a modest annual management fee (2%) and received 20% of the profits in good deals.

This changed in the middle 1990s. An IPO became the most likely exit. Some of the successes were mammoth (Netscape, Google, Yahoo) and this changed the business. The funds attracted huge pools of capital, and it was no longer efficient to make small investments or to provide much oversight. Further, the pricing changed: funds now charged 2.5% annually and as much as 30% of the profits on very successful deals.

When a manager makes 2% on $50 million ($1 million/year), from which he pays all his costs (rent, salaries, travel, deal expenses), it is clear that his interests are aligned with investors: he depends upon good deals, and lots of them, to meet his wealth objectives. When, as is the case with many funds now, a manager makes 2.5% on $1 billion annually ($25 million/year) - well lets just say that the wolf is certainly not at the door.

With a billion dollars or more to invest, managers started putting $15 million or more to work in deals, with the intention to provide follow-on investments of $10 million or more. And since venture firms rarely invest alone, that means another manager was investing similar dollars. Greater investment dollars drove up the pre-money valuations - it became commonplace for start-ups to have pre-money valuations of $25 million or more.

A "home run" might generate 20x. On a $25 million investment thats $500 million - and with 30% to the GP (up from the 20% of the old days) that's a cool $150 million. Since losers were not (and are not) netted against winners the Venture Capital firm had plenty of incentive to swing for the fences.

To justify these large investments, investors brought in high priced talent to operate these businesses and sell them to Wall Street as IPO candidates. Never mind whether they had the appropriate experience to run a small developing business. This jacked up the operating costs and the cash burn rates - essentially accelerating the rate of failure. But with a frothy market promising a quick exit via IPO at huge valuations - who cared?

Now - the IPO exit is non-existent. Funds have piles of cash, but little understanding of what to do with them. They cannot efficiently make small investments and expect to keep track of them, much less provide oversight. And even if they do, the nominal dollar returns on these smaller investments don't "move the needle" - ie are not large enough to make the VCs interested. So they sit, collecting their 2.5% annually - not a bad consolation prize - and hoping that Wall Street will revert to the way it was. Or worse - chase renewable energy deals by investing huge sums at a time with the same frothy misguided enthusiasm ( a recent solar energy deal had a pre-money valuation of $1 billion!).

What they should do is reduce the size of their funds (canceling commitments to $50 million or so), or split them into small sector funds with separate management. They should make modest investments in promising companies at modest valuations. They should plan on holding investments for longer periods, and assume that their exits will be through responsible M&A. In this way the managers actually have to work and be successful to get rich. They will bring in management appropriate for small entrepreneurial ventures. And they will provide the kind of oversight to maximize the likelihood that all of their portfolio companies can achieve some level of success.

Small, entrepreneurial companies that deserve funding will receive it.

And the interests of the Venture Capitalists will once again be aligned with that of their investors.