How To Avoid a 3rd Venture Bubble

The fortunes of WeWork and the weak post-IPO performance of Uber, Slack, et. al. are causing yet again …. or for the first time for those of you that weren’t active in the venture space in the ‘90s….a re-examination of the conventional wisdom, incentives and practices of the venture model.

Conventional Wisdom

Since the venture industry was launched out of the Small Business Investment Company Act of 1958, the process of sourcing and investing in new innovation was well articulated in the documentary Something Ventured, and again by Naval Ravikant below:

Deal flow and access are the most important things to work on as an investor. Your judgment doesn’t have to be that great, because the returns follow a power law. And you can always get capital if you have good deal flow and access.” — Naval Ravikant

However, there is a growing recognition that maybe the incentives and practices are at best in need of innovation, or at worst disingenuous and perverse.

Skeptical View

Not all share the glamorous view of the venture industry as offered in daily headlines in the media, from CNBC to the New York Times , from the Wall St. Journal to your local newspaper or Business Journal.

The Kauffman Foundation, the preeminent non-profit supporting entrepreneurial activity and capacity-building in the country, released a less than favorable report following an examination of their own historical experience investing in venture funds.

Diane Mulcahy was even more blunt in an article in the Harvard Business Review article: Six Myths About Venture Capitalists:

Myths:

1: Venture Capital Is the Primary Source of Start-Up Funding

2: VCs Take a Big Risk When They Invest in Your Start-Up

3: Most VCs Offer Great Advice and Mentoring

4: VCs Generate Spectacular Returns

5: In VC, Bigger Is Better

6: VCs Are Innovators

Venture Investing Similar to Public Markets in the 1920s

Venture investments are selected largely based on social capital and/or signals of others’ investment decision. The process vcs deploy to invest in startups is a largely a ‘hot tip’ process.

And good luck getting vcs to admit the amount of ‘false negatives’ under their watch — the companies that were passed on by purported top tier vc firms and became wildly successful.

Sadly, this is also how investors sourced opportunities to invest in public securities prior to the Securities Act of 1933 (the ’33 Act), which both formed the Securities & Exchange Commission, and required proper standardized reporting by publicly traded securities in an effort to avoid the speculative risks and outcomes that triggered the Crash of 1929.

The ‘40 Act’ was later passed in an additional attempt to facilitate additional risk management via formalizing instruments for proper diversification — ’40 Act products’.

As a result of these two laws, investing in public stocks became much more professional, and successful for investors, just in time for the post-WWII economic boom.

If we are to learn from the past and;

  • avoid a 3rd venture bubble,
  • not reward silly business plans with over-subscribed and over valued funding rounds,
  • not enable opportunistically ill-intended or fraudulent CEOs,
  • if we want to improve outcomes for investors in venture funds,
  • reduce the friction costs, inefficient funding paths, and the chronic funding gaps startups that aren’t part of the social circles experience today,

…. there needs to be a level of formal professionalism injected into the venture industry.

Venture Capital is Not a Profession

Currently, there are NO requirement for any specific academic education, licensing, certification, adherence to recognized best practices, continuing education, industry oversight, etc.

Hair stylists have to adhere to more professional training & licensing than any venture capitalists.

At least they have to go to ‘beauty school’ and get a license confirming they have a basic level of training — if not skill.

Social capital, connections, ‘hot tips’, and the ever-present ‘pitchfest industrial complex’ needs to be replaced by tools, tactics and practices that have been practiced in the public markets for over 80 years.

Need for Institutional Scale and Rigor

For the $T’s interested in investing in this asset class, seeking both qualitative and sufficient financial returns (Impact investors), in addition to the larger pools needing higher nominal returns than the public markets are expected to deliver in the coming years (pension plans, foundations, insurance companies, etc.), then there needs to be better and more scalable tools, tactics and practices that manage risk better, allow for portfolios to be assembled with a level of professionalism that is more closely institutional investing practices in the public markets.

Urgent Need to Act Now

Given the decline in new business formation — in spite of all time highs in venture funding — there needs to be a broader definition of what is fundable than is being defined by the current participants adhering to the historical ‘social capital’ model — not to mention greater geographic diversity in communities beyond Silicon Valley, NY, Boston and LA — which captures over 80 of venture activity.

Research by the Brookings Institute, the Economic Innovation Group, and others have confirmed the link between the decline in economic opportunity in many parts of the country without access to entrepreneurial resources, and the decline in life expectancy in the U.S. beginning in 2016 and continuing today.

Do to the loss of hope in so many communities due to the loss of middle class jobs, the bifurcation of wealth, and the lack of new jobs available principally for young people, there has been an acceleration in deaths — principally suicide and deaths due to opioid overdoses — among young people.

Young people are literally killing themselves because of the jobs/opportunity gap.

Conclusion

The venture industry is largely unchanged for 60 yrs. and most LPs in venture funds would be better served by investing in a public markets index fund.

There is a chronic funding gap across the country, yet there are $T’s seeking a way into the asset class.

New business formations are in decline, and yet we continue to fund and celebrate business plans and entrepreneurs that (arguably) shouldn’t even get an audience.

And young people are killing themselves out of despair.

None of this needs to define our future if we learn from the past and apply some of the lessons, and professionalism, of the public markets.

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Joe Milam

Joe Milam

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Multi-family office originally at 3000 Sand Hill, mid-wife to Band of Angels, now looking to mobilize ‘legacy angels’ into the ecosystem.