Last month, I moderated a panel discussion about reinventing the venture capital model. I’ll be doing the same next Friday in New York. In both cases, the underlying thesis was that the venture capital model is broken at worst, and dysfunctional at best. It’s a thesis with which I won’t argue, given that median fund returns since 2002 are underwater. When most LPs would have been better served by putting their money in the mattress, it’s clear that something must be done.
Unfortunately, almost all of the discussion to date has been around the edges. Very reminiscent of the 2002-2003 “back to basics” era, which focused on things like reduced fund sizes, more conservative valuations and fewer investments into saturated spaces. Those were necessary steps, but in many cases slowed the bleeding rather than stemmed it. What we may need is something far more radical.
The trouble with radical proposals is that they’re tough to come by. Luckily, a Boston-area VC has come up with one such suggestion, which I lay out below. For reasons that should become obvious, he asked not to be identified. There are obviously a lot of moving parts here – both pragmatic and philosophical – and I’ve already gotten feedback from some prominent LPs and GPs. I hope you’ll also contribute either via email or comments. And if you have a different concept for reinventing venture capital, please be sure to pass it on:
Venture capitalists are a lot like professional athletes. They often work in teams, but are largely judged on their individual statistics. A great VC can be part of a lousy fund, because his successful deals get drowned out by the aggregate performance of mediocre partners. To keep the analogy going, think Paul Pierce on the ’06-’07 Celtics.
But what if you could have changed the ’06-’07 NBA from team vs. team to one-on-one? Wouldn’t Pierce have become far more successful?
That’s kind of the idea here. This proposal would have an experienced institutional LP (likely a fund-of-funds), create a series of loosely-affiliated evergreen “funds,” with each fund to contain just a single VC. In other words, cherrypick the cream of the crop. Give the VC an annual salary of around $1 million, an assistant, an associate and 15% of any carry. Perhaps a three-year contract, with a two-year LP option.
If the VC’s investments are successful, both he and the LP would make more money than had they both been working under the traditional structure. If the VC’s investments fail, then the LP presumably would lose less money than had it invested in a failed fund of multiple partners.
There obviously would be tons of issues raised by something like this, so let me briefly address a few of them:
- Isn’t the VC partnership model inherently valuable, because it provides a VC with feedback and advice? In many cases it is, but in just as many cases it becomes a quid pro quo of silence. Don’t knock someone else’s deal too hard, because then that guy might come at me. Plus, a good VC should have his own network of industry experts to provide advice.
- What would be the relationship between the individual VCs selected? The LP would have to hire some sort of general manager and CFO to oversee the whole thing. I could also envision a monthly meeting for all the VCs, in which they’d discuss their own work. This could provide some of the aforementioned feedback, but without any risk of veto power. It also would help lay the groundwork for the group to (at least temporarily) manage one of the VCs deals, in case he gets hit by a bus.
- Just a monthly meeting? Yes, which means LPs would get three extra workdays per month from their VCs. That’s 36 extra workdays per year.
- Wouldn’t you have to legally structure this as a partnership, to maintain preferential tax treatment? Yes.
- Would a superstar VC want to be beholden to a single LP? If the LP has deep pockets, I don’t see why not.
- Are LPs smart enough to pick the right individual VCs? This is the multi-million dollar question. A good LP should already know which individuals in his general partnerships are performing better than others. This includes younger partners who may have strong deals, but who have not yet generated returns due to the macro exit blockage. It’s entirely possible that an LP would pick wrong, but that’s also true of the current partnership model. My advice would be the following: Imagine each of your GPs was trying to raise follow-on funds. Is there an individual or two at any of those firms whose departure would cause you not to reinvest. If so, that might be your guy (or gal).
Again, this is a very rough draft of something. I’m hoping you, dear readers, can help polish it up…