If you’re a fan of the All In Podcast like I am (yes, I’m one of the rare few who likes the pod even more these days than before), you’ve probably seen the rise of their All In summits and the replay of those expert guest panels as ‘downtime fodder’ on their channel. One such episode dropped last week and featured Roelof Botha, managing partner of Sequoia Capital. Similar to his critiques voiced several times in recent interviews, the headline is the all too familiar ‘Venture is Broken’ condemnation. Roelof is a very smart dude, so I wouldn’t be so egotistical as to attack his conclusions. I’ve also written articles in FastCo and the Phoenix Business Journal asserting the very same charge against VC, so at this point it’s quite clear that we agree. In fact, I think the points he makes about venture being plagued by an imbalance between excessive capital and insufficient high-quality investment opportunities are spot on. So what, then, you may ask, is the point? So, I’ll get to it.
The problem is that, despite the fact that I think his accusations are true – he fails to provide a solution. In fact, if you listen to his talk, the only real solution to his detailed list of fundamental VC flaws seems to be investing with Sequoia. This tired, opaque ‘black box’ value proposition is core to nearly every VC’s thesis. “Invest with us, we’re the only ones who have it figured out.
And THAT my friends, is the true reason venture capital is broken.
Here’s another not-so-subtle truth bomb – all of the ‘broken’ aspects of venture capital Roelof lists are also fundamental to the traditional VC business model – Sequoia Capital included. Let’s take a summary dive into the points he conveys on the podcast. He argues that VCs today (and, more accurately, investors in VC funds) enjoy a “return-free risk” and questions whether it even qualifies as a proper asset class. We all know VC is risky; we also know it can deliver an outsized return profile explicitly because of that risk. You get in early, company values grow, and early investors enjoy the fruits of that growth. At least that used to be the model — so what changed? What changed is that firms discovered that the larger their funds grew, the more they could alleviate their own risk – and still enjoy the occasional big reward on top. In fact, any fund over $100M in size has completely divorced its own success from the successes of its portfolio. Fees are the bane of investors, and the vast majority of VC firms are getting rich on fees.
But that’s just the beginning of what I call the ‘waterfall of failure.’ When incentives are aligned, everyone profits. When VCs make their nut on fees, it not only puts the investor at an insurmountable disadvantage but it also kicks off a chain reaction of woe that flows downhill.
Because you have now taken in such large amounts of money, of course, you now need to deploy that capital. No one wants to see their money sitting on the sidelines. So what do big firms do? They hire droves of associates and put them to work funding companies. To Roelof’s next point, there are only a finite number of great companies worthy of investment produced each year. AI is going to have an outsized impact on growth in this area, but it still won’t be enough to support the prevalence of VC firms and the massive funds they’ve raised. So, your aperture widens, and you begin to invest where you normally wouldn’t. If you don’t think this happens and that VCs are largely disciplined in their decisions, all I can tell you is that before launching In Revenue, I went on a roadshow interviewing firms to validate In Revenue’s value prop. Not a single firm I spoke with failed to tell me they hadn’t gone outside their thesis. At the end of the day, VCs have to put the money they’ve raised to work, but fund sizes have grown too large to do so responsibly. Period.
The last stop on the waterfall is also the last stop in terms of outcomes – the coveted exit point. Where do VCs seek to exit their investments and generate liquidity for their investors? Well, at the top of course! Encroaching back into ‘fund dynamics’ briefly, to justify an investment, VCs have to be able to return their entire fund’s capital based upon any one exit in that fund portfolio. When you have a $100M… $200M… $500M+ fund size, there needs to be a really BIG exit. And therefore, only one exit will do —and that is an IPO. I’ve written at length about the declining prevalence of public offerings, so I won’t belabor that here; instead, think solely about the decision-making that the goal of an IPO exit necessitates. Even more detrimental, consider the advice VCs provide if that is the only outcome that spells success.
I’ve seen this so many times; it honestly makes me sick to my stomach—terrible ‘moonshot’ advice given for the sole purpose of throwing a Hail Mary. If everything works, you have a dartling on your hands, the coveted unicorn. But in 98%+ of cases, it doesn’t work. The founder and their teams are just cannon fodder for the chance sake of nailing a hole in one. Oh, and your capital dies right alongside them.
All of this was born from sex appeal. VC firms with smaller funds made great decisions, built great companies, and made great returns for their LPs. That’s when the forbidden fruit rears its head. If you were able to generate a 30% IRR with a $25M fund, think of what you can do with a fund 4X that size! But it never works that way. The magic driven by quality always loses its luster when quantity is added to the mix.
The solution in our opinion (but backed up by the data of the last ten years) is simplicity.
Eliminate fees from the firm’s financial return equation. Yes, we charge fees, but we give them back through liquidity—they are nothing more than a line of credit that allows us to support our business and, in turn, our portfolio businesses.
Eliminate, or reduce the size of, funds. Funds create almost every negative dynamic in the VC model, as they necessitate rapid deployment and create unrealistic expectations. Doubles and Triples are good; profitable exists as well. Not everything needs to be a home run or bust.
Focus on the provision of value outside of capital. When you are putting in blood, sweat, and tears (not just someone else’s money) it greatly impacts your decision-making. Beyond that, it adds much-needed horsepower to a stage where companies desperately need it. Value-add venture capital can not be a superficial buzzword.
Provide hyper-transparency. On this one, Roelof and I agree – firms should publish their results, both wins and losses. And don’t forget the color, don’t be afraid to tell the ‘why’.
This is a doable thing – it’s not a crazy moonshot. It simply requires that we embrace honesty, bring back a real passion for helping early-stage companies succeed, and stave off greed. Venture should remain as the risk/reward asset class – all it takes is for both risk and reward to be distributed equally among the firm, its investors, and its chosen startups. Everyone wins, together.
