If not us, who? If now now, when?
The need to modernize and improve how entrepreneurs source funding is gaining a growing audience (e.g. HERE, HERE & HERE), and for good reasons.
The current level of funding is at one of the lowest points in a decade, with most of the $’s deployed concentrated in a few regions, technologies, and firms.
Why?
1: The model is largely unchanged for the past 60 years, and has NEVER been professionalized.
From ‘VC — An American History’, by Prof. Tom Nicholas of Harvard’s Business School;
The fact that partners’ talent matters most is an important finding, and is consistent with the fact that the VC industry has been remarkably devoid of organizational innovation since Draper Gaither and Anderson was founded as a limited partnership in 1959. pg 311
2: The reliance on personal relationships causes a concentration of investing.
Even the Federal Govt. has recognized the need to mobilize more $’s into more startups, in more regions around the country, including:
- The Opportunity Zones Legislation (passed in 2017)
- The New Business Preservation Act (bi-partisan support, introduced 5/2020)
- The SEC’s Office of Advocate for Small Business Capital Formation (2019)
- The Endless Frontier Act (bi-partisan support, introduced 6/2020)
3: Investment results are largely sub-optimal for the majority of venture funds.
4: The necessity to avail greater opportunities and mobilize more venture $’s for diverse entrepreneurs is also clear.
Where Do We Start?
Thanksfully there has been some objective work done by University professors, data scientists, etc. (see HERE), and eventually Innosight — a consulting firm originally founded by Clayton Christensen (Mr. Distruptive Innovation) — was hired to study the venture industry and make an assessment regarding the possible future.
The report — The Future of Venture Capital — produced a thoughtful and logical vision of the future, illustrated as follows:
Becoming More Like The Public Markets
With the growing involvement of investment platforms like Blackrock, Vanguard, Wellington, et. al., we are seeing an ‘institutionalization’ of the industry, and more specifically the adoption of more ’40 Act’ structures and strategies; closed end funds, ETFs, and open ended mutual fund structures.
This is a natural and healthy evolution to establish long-overdue professional standards and practices.
What Risks Need To Be Managed?
The venture asset class has unique risk & return characterists:
- Limited downside — you can only lose 100% of your investment, unlike derivative contracts, shorting, etc.
- Limited liquity
- Imperfect information
- Asymmetric upside — you can make multiples on your capital investment.
As such, the dominant portfolio strategy should be to manage the downside risk, so more capital would be deployed to capture the asymmetric upside.
The specific risks are:
- Systematic risk; this is also ‘Market’ risk, timing risk, and in the venture asset class, ‘thesis’ risk. This can only be managed with staged capital deployment — dollar cost averaging.
- Non-systematic risk; also transaction risk. While thoughtful due diligence is a must to spot blatant risks, the best way to manage it is with proper diversification.
- Decision Process risk; while self-explanatory, this is what plagues the venture industry and results in such inefficiencies and biases in the funding process.
What Might An Optimal Fund Look Like?
If one were to apply all the research which defines and confirms;
- Proper diversification levels at each round
- The appropriate % of capital to deploy at each round
- The optimal data-driven/algorithmic decision model
….such a fund would look like:
Why Now?
If you’ve followed the the venture industry over the past few years (or 25+ yrs like I have), you already recognize the insanity of;
- continuing to structure venture funds similiar to the first venture fund launched back in 1959.
- repeating the same ‘concentrated portolio with high conviction companies we intend to add value’ behavior and expect a different outcome.
- the lack of any professional standards, training requirements, certification, pursuit of best risk management practices, or any material accountability.
We need to ‘build a better venture mousetrap’ to deploy risk capital better;
- Better/more consistent returns for investors
- Better allocation across regions around the country
- Better diversification across business models and entreprneurial profiles
- Better professional practices within the venture industry
- Better liquidity for investors
- Better support for entrepreneurs
It’s time…..
