Recently there seems to have been a heightened level of existential discussion on the venture capital industry, its future and appropriate structure and objectives. Perhaps kicked off with Paul Kedrosky‘s report for the Kauffmann Foundation and taken up by people like Fred Wilson, Chris Dixon and others.
A few years ago, when I first started to take a close look at the venture capital industry, its structure and its business model, I must admit the first thing that leapt out at me was that it seemed just as settled in it’s status quo, comfortable in it’s received wisdom as the investment banking industry I had spent over 15 years navigating. Perhaps I shouldn’t have been surprised, however I couldn’t help but find it ironic that an industry ostensibly focused on finding and financing innovative technologies, business models and people, should itself seem so immune from these forces, almost to the point of being anachronistic.
And so I set out about educating myself as to why this was the case. Why was this just “the way things are done”? And unsurprisingly I found a couple good reasons buried in a mountain of inertia and vested interests buttressing the flimsiest of rationales. So answering my friend Max’s request for ideas, here are a few of my ideas on how to improve venture capital.
- Greater diversity of economic models: monocultures are naturally fragile – my point is that the GP/LP with 2 and 20 isn’t necessarily wrong or right, but it has weaknesses that would be mitigated by competition arising from a more diverse ecosystem of economic models and approaches.
- More emphasis on clear, well-defined sector expertise and specialization (both in terms of firms and people.) Clearly we are talking our own book here, but if don’t believe me, Marc Andreessen makes the point as well.
- More permanent equity and secondary markets (and less frequent fund raising.) The most profitable private equity and venture capital firms are the ones that are much better at raising capital than investing it. You get what you pay for. Change the structure and incentives and you’ll change the outcomes. Further, the best course of action for any given company should obviously not depend on their investors’ capital structure and yet under the current industry structure, the dynamics of your partners, venture firm and/or individual fund can and does often drive strategic decision making. It’s called the tail wagging the dog and it’s as sub-optimal as it sounds.
- Management fees at cost (not as a % of assets under management) and restricted equity as performance incentives. This one seems like a no-brainer: management fees have a minimum fixed component and generally are correlated with both the number of investments and the complexity of these investments. Typically there is some degree of positive correlation between these factors and assets under management but the implication (which underlies fixed % management fees) that it is mechanical and linear is completely wrong. You would think that investors (‘LPs’) would be 100% behind this innovation, and yet I have been surprised to find that many are at best ambivalent, and some actually hostile. The only reason I’ve been given for this attitude is having ‘certainty’ in terms of costs, although I think this is a total red herring: a cost-driven management fee would entail the venture capital firm getting their budget approved by their Board and given the relative simplicity of the business, would be relatively trivial to determine with a high degree of certainty, even over time.
- Standardize investment terms by developing and adopting a document analogous to the ISDA Master agreement structure and pricing supplements (for individual deals.)* Not only would this lower costs and reduce complexity but it would also facilitate a more active and robust secondary market.
- More syndication – lead underwriter rewarded for driving process forward; increasing use of ‘managed accounts’ (vs discretionary management.) The idea here is to bring together complementary syndicates of specialist investors, each bringing something slightly different and valuable to the table, as opposed to just a jump ball between a number of more or less identical generalist funds.
- Price ancillary services (advisory fees, directorships, etc.) transparently and honestly. This is an area where I think venture capital could learn a lot from their private equity cousins by making more explicit – and charging appropriately for – services they provide to their portfolio companies. Clearly this approach is not perfect nor is it immune from abuse, but by combining with point (4) above and structuring much/most of the payment for services in equity rather than cash, it would actually reduce the scope for abuse and discrimination amongst shareholders and would force both companies and venture capital providers to justify any additional value (beyond investment capital) that venture capital firms or partners provide. Under the current operating model, the venture capital firm’s investors effectively subsidize the portfolio companies’ use of the professional resources of the venture capital firm. And there is a cross-subsidy within the portfolio, with companies that don’t need any services effectively subsidizing those that do.
In fact, if you take a step back and look at these recommendations, they would have the effect of making venture capital look a lot more like a collective, scaled-up version of professional angel investing. And as I was writing (and re-reading) these points, I fear that the short form of a blog post is probably ill-suited to make relevant and nuanced arguments as to the pros and cons of various elements of the venture capital business model. And yet I simply don’t have time to write an essay. I’m not Fred, but perhaps if I’m lucky, that essay will write itself in the comments here and elsewhere. So have at it!
* (via Wikipedia) The ISDA Master Agreement is a bilateral framework agreement. This means it contains general terms and conditions (such as provisions relating to payment netting, tax gross-up, tax representations, basic corporate representations, basic covenants, events of default and termination) but does not, by itself, include details of any specific derivatives transactions the parties may enter into. The ISDA Master Agreement is a pre-printed form which will not be amended itself (save for writing in the names of the parties on the front and signature pages). However, it also has a manually produced Schedule in which the parties are required to select certain options and may modify sections of the Master Agreement if desired. The Master Agreement would be modified to the extent the modification is mentioned in the Schedule. Details of individual derivatives transactions are included in Confirmations entered into by the parties to the ISDA Master Agreement. Each Confirmation relates to a specific Transaction and sets out the agreed commercial terms of that trade. Confirmations are generally quite short as they will normally incorporate one or more of the definition booklets published by ISDA. Each of these definition booklets relates to a specific type of derivatives transaction and, in addition to defining terms, they include mechanical provisions (e.g., Articles 5 and 6 of the 2000 ISDA Definitions set out how to calculate the Fixed and Floating Amounts payable under an interest rate swap) which do not then have to be laboriously reproduced in the Confirmation.
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