Adeo Ressi, founder and proprietor of TheFunded.com, made waves this week, after the PowerPoint slides of a private presentation he gave was leaked to bloggers. peHUB has asked Adeo to expand on the presentation, and to give a fuller understanding of what his slides were intended to present. We thank him for the contribution:
“The Canary is Dead” presentation was delivered to a group of Harvard Business School professors to encourage classroom dialogue about better models for venture capital, before students graduate and enter the workforce with bad training.
The Model is Broken
Investing in growing companies has proven to be economically and socially rewarding to a broader society. However, the venture capital model of delivering preferred equity investments in the $1 to $15 MM range is broken for three specific reasons. First, over 90% of companies that require investment in this range do not receive the capital they need, because they are rejected by the model, discouraged by the process or unaware of the rules. Second, the process of raising the capital has anecdotally proven to destroy shareholder value through enormous time commitments, significant legal fees and deteriorated morale. Lastly, the venture investment model, in its current form, does not generate returns for any of the stakeholders when examined in aggregate or on average.
Despite this broken framework, the venture capital model has resisted change. More and more money has flowed into venture capital, and partnerships continue to receive the same management fees and economic rewards. The bursting of the Internet bubble eight years ago was an obvious time to re-examine the model, but many VCs soon began guaranteeing returns by selling new portfolio companies to old ones at a premium. Still, a few VC firms threw in the towel, and terms like participation were widely adopted to further protect returns, hurting entrepreneurs.
It’s Time for Change
Now, the venture capital industry faces a second major collapse in eight years without a substantive period of prosperity in between. Limited partners are pulling billions out of the model, are selling positions and may end up rejecting capital calls. It seems logical that this may be the right time to re-examine many of the underlying principles of how venture capital operates to improve an important and broken service of capitalizing growing businesses. It also seems logical that all of the venture capital stakeholders, from entrepreneurs to limited partners, should be involved in a dialog about how to improve the state of affairs.
What’s Not Working?
Present day venture capital is in the business of finding a needle in the haystack, finding a truly great company from within the many new businesses formed every year. Let’s look at how the model addresses this challenge.
- First, venture capitalists haphazardly select industry sectors and invest en masse into various companies within a short period of time.
- Next, most venture firms select investment prospects from within their direct networks, and many firms don’t take inbound opportunities at all.
- Third, it is common that every partner in a firm, regardless of their experience, must vote unanimously to approve an investment decision in a specific company as well as the investment terms.
- Lastly, the company is put through a difficult due diligence process that can last multiple months before receiving the investment.
This process results in funding 10% of companies that require growth capital, and many start-ups tailor their operations to the present day venture requirements, creating many false positives for the model.
Where Do We Go From Here?
The original presentation at Harvard did not include specific recommendations, as the slides were designed to inspire conversation and new ideas. A few recommendations seem obvious and were added to the slides afterwards.
First, if the venture capital model is neither effective nor efficient at identifying great companies, then the whole selection process needs to be changed. Right now, a small number of highly filtered companies go through a hazing process to get the capital that they need. Why not make the process and the guidelines transparent, providing anyone in any industry of any gender or race with a fair chance to raise capital?
Second, the fact that the model has been so resistant to change despite overwhelming evidence of failure means that the incentives and governance of the model are poorly structured. Venture firms earn management fees regardless of their portfolio selection or fund performance, encouraging firms to raise larger and larger funds despite the need for less and less capital among entrepreneurs. Additionally, there is no oversight, regulation, or governance on almost all of the venture partnerships. At a minimum, make the management fees contingent on some performance metrics and introduce a board of directors for the firms themselves.
Lastly, it seems senseless that there are hundreds of undifferentiated firms serving physically small markets, such as the Bay Area, and it seems equally senseless that the purchase of preferred equity in pre-revenue start-ups should cost $25,000, $50,000, or even $100,000 in legal fees.
Now seems like the perfect time for a reality check. If the NVCA or the venture firms themselves are unwilling to take actions, the Members of TheFunded will be happy to supply some ideas to work with.