The convention venture narrative speaks to pursing ‘big outcomes’ because of the need for a ‘Power Law’ outcome to deliver worthy fund-level returns.
While the research on venture returns suggest otherwise, the persistence of this narrative can be traced back to the original carried interest calculation established by the venture industry — The American Waterfall calculation.
Calculation
Known as the “deal-by-deal” waterfall because it distributes profits on a deal-by-deal basis, this allows GPs to capture carried interest profits on the ‘wins’ within a fund without any consideration whether the LPs actually get their money back before the GPs participate in profts.
This created a natural (and perverse) incentive to chase big wins with less regard for the outcome of the entire portfolio. This birthed the ‘Power Law’ narrative of venture capital.
Power Law as Bug, Not Feature
While the needs for a big win — a Power Law outcome — is true on it’s face, it is a by-product of poor porfolio construction risk management disciplines. With decades of venture return data available, there has been some terrifc research done on the impact on returns of:
- Proper diversification
- Staging investment over multipe rounds
And when you recognize the importance of objective, data-driven decision-making (Think ‘MoneyBall’) in making initial and follow-on investment decisions (professional investors are thinking ‘DUH’ right now), even the most cursory examination of the ‘typical’ ventue fund reveals just how simplistic and unprofessional the conventional venture fund is today.
Venture Industry Remains In ‘Dark Ages
Few investors (LPs or direct/angel) realize the venture industry is one of if not the last Financial Services industries that has never professionalized.
As such, there is:
- ZERO barriers to entry:
- NO training required
- NO ‘best practices’ body of knowledge study requirements
- NO licensing or certification
- NO industry-standard performance calculations
If you can ‘fog a mirror’, pay lawyers and raise some $s, you get to put ‘Venture Capitalist’ on your LinkedIn and nametag.
While ‘caveat emptor’ remains a First Principle in a capitalist society, at best these unqualifed investors create ‘noise’ in the burgeoning entrepreneurial ecosystems around the country, and at worst…well, two Silicon Valley insiders may have said it best:
- Bill Gurley; ‘Why Venture Capital is a Bad Industry
- Chamath Palihapitiya; ‘Silicon Valley Ponzi Scheme’
Conclusion
With the perverse incentives created by the American Waterfall calculation and no professional starndards and practices, it is no wonder we continually see the headlines of:
- Boom & bust cycles
- Bad venture returns
- Frustrated entrepreneurs
- Reluctant LPs
- Gross mismatch between capital being deployed and entrepreneurs seeking capital
- Under-allocation to the venture ‘asset class’ by pension plans, family offices, and other serious investors
These are all ‘down-stream’ from the Original Sin of the venture industry, and ‘pepertual sin’ reflected in the lack of professionalization.
But change is coming.
It needs to.
Getting how we fund innovation right is too important for our future.
