I had a very brief internship in college with a second tier VC that was affiliated with a well known sand hill firm. I was only there for a few months so I saw only a tiny peek at the industry, but it was enough to see through all the bullshit.
With the exception of a handful of partners at a handful of firms (nothing but respect for a16z here), they are all complete dunces, and they don't have the slightest clue what they are doing. This article is right that they are going for the biggest possible outcomes, but it misses out on the largest and most exploitable quirk of the VC industry: that they're all chickenshit. They wont invest unless someone else does, thereby validating their decision to invest.
The most effective cold pitch I've ever seen at our fund involved what was to me a completely obvious lie about outside interest. I met the guy after I left and he basically confirmed that he pulled the same stunt at all three of the firms that invested. He worked them in rotation, building actual interest off of what was initially fake interest. And it worked like a charm.
You've probably got to be quite bright academically to get in but if you look at how their compensation works they mostly get a cushy job with a high salary paid for by a 2%/year or so charge on funds invested. Performance fees on exit are years away. So if they can say to investors "we're in all the hot starups like color.com" it works if the investors throw in billions even if the startups are disasters. So they may be dunces at understanding startups but are probably quite good at their core business of fund raising.
> "They aren’t looking for a guaranteed $1M, they want a chance at $1B or $100B. This is really weird, because software business that are profitable might not be fundable."
Huh. Sounds like an inefficiency on the funding side. Or is it that these biz's profitability typically enable self-funding? Why does a profitable startup that doesn't have VC-style growth potential need funding?
I've seen this story before - worked for a company with very disciplined management, focusing on steady predictable growth - 25% a year, not 200% a year, but doing so profitably without VC capital. And then the venture backed competitors who didn't care about making a profit popped up...
It is a vicious cycle - once a market attracts the attention of VCs, it becomes really hard not to join in.
There are other options - first of all debt financing. Equity is tricky because of the principal agent problem. The manager or whoever contrlos the company can easily keep the profits low while paying himself or his friends much. There are some ways out:
a) strict management/information rules - so burdensome that it is available only for big companies - i.e. corporations
b) startups with scaling - that is high growth business - where growing is the only option for the manager
c) having a partner with money who takes part in the management
Imagine your business was making a solid $1m/year in profit. But, if you had a one-time cash injection of $10m, there's a good chance you could expand to $5m/year in just 2 years. That's a risky but potentially profitable investment that is not interesting to big name VCs. It is an inefficiency on their part. But, their schedules are already overfull juggling the moonshots. I expect there are people working in that space, but they don't get a lot of press coverage.
My point with the "involuntary" aspect is that if you had this thesis, you'd still get power law returns. I'm not sure this has been pushed as hard as it could be, but this is very consistent feedback from VCs.
Yep. My scenario was told from the POV of an individual company. That's not a good way to explain the behavior of investors deciding between companies.
Lower middle-market private equity firms are probably the most likely investors. Often, they'd want to buy the entire business, but in some cases they might look at taking a minority stake with some control rights.
An immediate corollary: only pursue VC funding if you are either: a) rich, and you don't care about money, but you do care about making a dent in the world; or b) young, and you don't care (yet) about money, but you want a very slight chance of going into the big leagues. Being both rich and young also helps a lot.
In my work I often use the Vapnik-Chervonenkis dimension. Whenever I see titles such as this, I hope for a moment for some interesting technical content, only to find that it is about a different VC :)
Anyone from the music or movie industry care to compare VC to your business? I figure most big studios are also operating under the power rule, but I haven't spent a lot of time researching it.
I come from the film and TV world. Pretty much the same way of thinking applies to projects in that space -- with a key difference being that the projects there are usually zero-sum. Only one TV network can win the bid on a hot property. So you end up with insane bidding wars on pitches, scripts, and projects that get hot.
Film is sometimes slightly different, in that two or more studios can co-finance a film and share in distribution profits (though this occurs through convoluted means, and for all intents and purposes, there is usually a clear winner among the herd).
Ultimately, however, the same power law usually applies. One hit is often said to cover the cost of 10 or more failures, and then some. (Of course, the converse is sometimes true: one massive failure can tank a studio's year, and occasionally even a studio.)
I'll tell you this much: Disney doesn't give half a shit about any and all box office failures in fiscal 2015 when "The Force Awakens" made $920M+ at the domestic box office, to say nothing of its billion+ more overseas and untold billions in merch. And on any given year, if it had the choice, it would much rather have one hypothetical "Force Awakens" and a handful of flops than, say, a better average return per movie without an outsized monster hit.
PE and HF financing of film slates is one of the bigger trends to have reshaped the industry in the last several decades. Legendary is a particularly noteworthy example, but there are many others like it. Similarly, the big studios often turn to investment banks to finance film slates.
The highest levels of the movie business, like the highest levels of most corporate America these days, are virtually indistinguishable from the finance industry.
Because most (if not all VC's) base their investment decisions on the power law, I'd argue most entrepreneurs (other than the ones looking to disrupt the world and all of God's creatures) would be better served by pursuing PE funding. This crowd has A. a longer term view and B. a bell curve of expectations on investment returns.
Or family offices, which are becoming increasingly popular sources of financing for startups who either don't want to go the VC route or don't feel they'd be a good fit at a given stage.
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I don't know about that... When you're a VC, you're likely already financially stable. So you have more flexibility in having fun playing the game. Why fund a lightly-profitable boring company when you can have a seat at the table of a company moving or defining entire markets?
You should understand that VCs do not invest their own money but rather invest the money of "general partners" -- universities, pension funds, wealthy families, etc. Those investors are sophisticated and have very large portfolios relative to the amount of money they have allocated to VC (as an asset class). To gain access to their money, the VC had to both put on a song-and-dance about how they were going to get returns which were uncorrelated with the larger market (and huge) and then execute a series of contracts which constrains the VC's ability to do anything outside of the investment strategy which they've agreed upon.
It's not just a matter of "swinging for the fences makes me feel more fulfilled." It is "I have promised Yale that I will swing for the fences or I'll receive a call from their attorney asking politely for their $20 million back, and that call will be polite exactly once."
With the exception of a handful of partners at a handful of firms (nothing but respect for a16z here), they are all complete dunces, and they don't have the slightest clue what they are doing. This article is right that they are going for the biggest possible outcomes, but it misses out on the largest and most exploitable quirk of the VC industry: that they're all chickenshit. They wont invest unless someone else does, thereby validating their decision to invest.
The most effective cold pitch I've ever seen at our fund involved what was to me a completely obvious lie about outside interest. I met the guy after I left and he basically confirmed that he pulled the same stunt at all three of the firms that invested. He worked them in rotation, building actual interest off of what was initially fake interest. And it worked like a charm.