Modern capitalism raises the flag of the free market while pitting centrally planned organizations against each other
It’s quite a journey from being born on a commune to raising more than $87m in funding at a software company. This journey forced me to wrestle with existential questions about my true beliefs, and how they intersected my life as an entrepreneur. One’s work is rarely a pure reflection of ideology, but companies need a clear and authentic strategy, which requires a tight alignment between company operations and the founder’s philosophy. I have discovered more about those differences between what I believe and the best ways to grow a corporation while studying economics - that is, how money is made and exchanged - than any other area.
A worldwide conflict between communism and capitalism defined the latter half of the twentieth century. The United States’ ideological battle was the central drama of my childhood, and it was with a combination of glee, pride, and “told you so!” that my fellow Americans watched the wall fall in Berlin, and the USSR dissolve shortly thereafter. I expect few would deny that the US is the standard bearer for capitalism.
Yet, there’s a flaw at the heart of this claim. While the United States operates as a free market economy, the key agent within modern capitalism - the corporation - works more like an authoritarian state. Given how much of our world is built around corporations, this truth and its impacts are critical.
I grew up apart from America’s passion for capitalism. In the era of Reagan, I was living on a commune. My parents did not earn money for their labor, and we didn’t have personal property. My family left the Farm when I was 8, and as I matured, my ideological roots were in conflict with the US’s nonstop pro-capitalism message. As I joined the workforce and eventually started my own company, I found myself attached to neither the communal roots of my childhood nor the Wolf of Wall Street world I moved into. I grew slowly in convictions, as I encountered problems in the course of scaling a company.
The first real conflict came when it was time to hire managers. I founded a company primarily because I did not thrive as someone else’s employee, so what led me to think others would? More importantly, anyone who has ever operated at the front line is aware of the severe costs imposed by the separation between the people who do the work and the people who make the decisions in hierarchies. Hiring managers was just going to make the company do worse, not better, right? Right?
I expect three of you are gleefully shouting, “Yay, holacracy!” right now, while the rest are confused and either offended or think I’m an idiot. I did consider a manager-less world, but a little research provided only examples of disaster, because the only available options just replace an explicit power structure with an implicit one. In other words, it’s still hierarchical with the founder on top, but now decision making is opaque and the system is easy to exploit because of the lack of controls (which looks surprisingly like the cult/commune I grew up in).
Those who are confused or offended by the idea that managers make performance worse would be informed by a deep dip in economics. One of the core principles of the free market is that central planning committees can never be as efficient or as effective as the people doing the work. By definition a free market economy lacks a decision-making hierarchy; the ‘free’ means every agent (individual or corporation) can decide for themselves, without needing permission from a manager above.
While there are many aspects of modern American capitalism I reject, this one I wholeheartedly support1. The downsides of a strong central executive were taught to me early.
Like many other communes, the one I grew up on routinely failed to feed its people - my parents speak with horror of the ‘wheat berry winter’, when we lived on little else. While his people were short on food, the founder of the Farm was off touring Europe as the 3rd drummer in a band, “bringing our message to the world”.
Thankfully none of us starved to death, but the failing was similar to what most communist countries experienced: The central organization could not feed everyone. For years, I assumed this was just incompetence, whether at the scale of the Farm or China. The truth was far more structural. Millions starved during the Great Leap Forward because the central organization was trying something impossible: Managing the productive output of an entire country. The Planet Money podcast tells a great story of how this central planning was walked back in China, but the general point here is that these communist countries did not just nationalize the means of production, they tried to centrally control all of it from within a small group.2
When people talk about communist countries not being a free market, this is what they mean: They tell the farms what crops to produce and in what quantity, rather than letting them decide for themselves. China even went so far as to dictate what hours a farmer should start and stop working, and then directed managers to ring a bell for transition times to control every little group of farmers. Anyone who’s ever had to punch a clock into a rigid, dysfunctional hierarchy is likely getting painful flashbacks about now.
It should be immediately obvious why this fails miserably: The distance between the central planning committee and the farmer is so great that good decisions are nearly impossible. It’s nearly impossible for critical feedback to make it from the edge, where the farmers are working, to the central planning committee in time to affect decisions, and then for those decisions to make it back to the edge in time to be useful. The podcast linked above also points out how unmotivated the farmers were under this regime, cutting productivity even further. Those who have studied lean manufacturing, agile development, and DevOps are likely seeing parallels here.
The result was catastrophe. When a corporation is painfully inefficient it loses money and might have to do layoffs, but when a country fails at growing food, its people starve to death. I don’t mean to imply that central planning was the only cause of famine under communist rule - there were political operations that led to mass starvation, just like in the West - but learning more about these helped crystallize what I do truly prefer about capitalist models. It also converted the phrase ’the free market’ from a catchy slogan into something meaningful to me.3
The most important feature of free market economies is that each person within them is able to make independent decisions in their own best interests4. If you’re a farmer, you can decide what to grow, how much to grow, and when to work to develop your crop. Heck, you can even choose not to be a farmer any more. Success is merely dependent on your finding a buyer for your work at a price you can tolerate. Any given year might not be perfect, but your decision making gets better over time as you learn to respond to customer demand.
This pattern is easy to understand in any system where the people doing the work make the decisions. If you’re a jeweler, you can decide what to make, how much to sell it for, and what to spend your time on. Same if you run a small restaurant, lead local tours, or are a one-person shop doing house remodeling. It’s a free market, where you can charge what the market will bear, and you can quickly and efficiently respond to its whims, ensuring that you are getting the best use of your time.
This was a powerful organizing principle for a long time. The history of human commerce developed largely this way: One person, or as many people as could fit in one shop, would turn labor into a product, then find a buyer for it. Most large-scale efforts were organized by the state of the time: Monarchs and the landed gentry, who were the only ones capable of marshaling enough resources to build palaces, roads, and other large construction projects.
This began to change in the 17th century when corporations like the Dutch East India Company were able to deliver massive windfalls to investors by pooling money and using it to extract resources from colonies. There was a step change in the 19th century, as corporations went from generating wealth to building and owning infrastructure. It’s one thing to outfit a single ship for a year-long voyage, yet another to maintain railroad schedules across the United Kingdom, or run a telegraph network around the whole US. These aren’t just short-term money-making exercises, they’re long-term commitments with big capital outlays and large returns over years and years.
We still live in a free market economy, but it’s not one Adam Smith would recognize. Instead of individual or small operators, ours is composed almost entirely of corporations. Really big corporations. And these companies, they use the same kind of central planning that we so despise in communist systems. I know. I’ve done it.
By the time my company got near 500 people, we had a multi-week planning process, where the leadership (i.e., me and my lieutenants) set out top-level goals, built a top-down plan to accomplish them, then drew information from the front line to see where it needed change. We called this a bottom-up plan, but it was only bottom-up from the perspective of numbers - how much money we’d have, what our costs were, etc. - rather than from the bottom of the organization. We could see no way to have a system where the people doing the work built a plan for the organization. Even thinking about it now, my reaction is, “How would they know what my goals are?”
That’s the kind of question you can only ask in an authoritarian state, not in a free market economy. My goals became my company’s goals, and the only real way to ensure people worked toward them was providing a plan. You might argue that a corporation should focus on shareholder value, but that doesn’t help make decisions about what the company should actually do.
Great leaders find a way to listen to everyone in the company, but in the end, leadership is about making decisions. That’s essentially the definition of the word. And we all know leaders who did not bother to listen, or just did not need to in order to be great; today’s most vaunted tech leader, Steve Jobs, was famously disrespectful of the opinions of others, yet made a lot of world-changing decisions (not all for the better).
This is exactly why working in a big corporation is so stifling. If you’re in a small company, the executives are close enough to the front line that it’s more like working in a tribe, but in a big company, the leadership is so removed from whose who do the work that executive teams operate like the politburo we so decry in communist countries. Certainly the bureaucracies are no more enjoyable or forgiving.
I find it both ironic and painful that my inability to work for someone else resulted in my creating a company that involved a lot of smart, capable people working for someone else.
I wish I had a solution. If this were an easy problem, its solution would already be pervasive, because the benefits are massive. Just in terms of efficiency, we’ve seen how much better the free market is than planned economies, but it also has a hugely positive impact on quality of life. People are happier when they’re in control.
I know the solution is not more freelancing and contract work, which America’s corporations are addicted to. That’s the worst of both worlds: The exploitative nature of capitalism with the inefficient bureaucracies of communism. Transactions on the free market work because they’re good for both sides, but most people only accept part-time contract relationships today when they have no other real choices.
Holacracy certainly isn’t the answer. It’s fundamentally flawed because of its implicit power structure - Tony Hsieh still runs Zappos, even if he does not use a central planning committee to do it - but the biggest problem is it makes no mention of economics. Without a clear system for scoring the transactions (i.e., money) it’s impossible to build a free market.
This problem of how to handle economics within a non-hierarchical company might lead some to think of using blockchain tokens as an internal currency. This is impossible today, beyond the fact that the world of blockchain is mostly about fraud and black market sales. The biggest problem is that we have no idea how to value most of the work people do. I mean, we might know that what a developer should get paid for a year’s work, but how much is that work worth? The majority of the work done in modern corporations is incredibly hard to value, which is partially why companies are so inefficient and make so many bad decisions.
That brings up an even bigger problem - companies today hire workers to make money from their labor. In other words, they generate profit because they pay their employees less than they’re worth. If everyone could trade their labor for exactly the amount of money it was worth, the corporations that employ them would have a much harder time making money. Instead, in modern corporations the shareholders and the executive team - again, the central planning committee we so despise - make the majority of the money, while the front line does all the work and makes very little. This is true even at the big tech firms; software developers might be well paid relative to hotel workers, but they’re paid a pittance compared to the founders and executives. This might speak to why we have no solution yet - free market corporations would tend to reduce concentrations of wealth, which would be terribly disruptive to the current system.
Like I said, I don’t have a solution. But at least now I know what makes the current system so painful, and it gives me some hope that we actually can come up with a better answer. I know I’ll be working harder in the future to manage the downsides of what we have today.
Although I might stress the “well regulated” part more than most modern economists. ↩
The arrival of the smartphone has convinced the world of the value of great software design, but it’s not all good news
The smartphone has reached more people and delivered more value faster than any technology ever seen. Much of the world has had to adapt to this arrival, but software design suffered the greatest reckoning. As the smartphone ascended, developers finally adopted reasonable design principles, realizing that they could not pack every feature ever seen into the smartphone experience. This recognition of the value of design - and especially, minimal design - is a good thing. Mostly.
I could not be happier that the industry finally accepts that there are principles of design, and there is a practice and discipline behind building great software. It’s great that we’re seeing more focused software that does little, but does it very well, rather than the previous age of the GUI when software attempted to own large parts of our lives by doing anything and everything. For a long time, Microsoft Word was used by nearly everyone who had a computer, and their strategy was to ensure no one ever had a reason to choose something else by building every feature anyone might ever need; their toolbar was the canonical example of never saying no.
The smartphone changed all that. Those rows of icons would fill the screen on a phone and leave no room for typing, and of course, no one would use them anyway because of how different the usage patterns are. As people realized they could no longer just throw in the kitchen sink, they began hiring (and listening to!) actual designers, and those designers have been steeped in the culture of Dieter Rams and the minimalism of the Bauhaus movement, which is awesome. Mostly.
Unfortunately, the phone caused everyone to focus on the final design principle of Dieter Rams (“Good design is as little design as possible”), without apparently remembering the nine that came before it, or why they were earlier in his list. I get it; the design constraints in a phone are intense, and it might not be a good idea to minimize everything, but it sure is easy.
The consequence of this mobile brutalism is a new movement building simpleton tools: Software that anyone can use, but no one can become an expert in.
Trello is a great example. I adore Trello. I think it’s great software, and it’s clearly a success by any measure. However, for all that I’ve relied on Trello daily for years, I feel no more an expert than I did just after starting to use it. It’s not because I haven’t tried; it’s because there’s no depth. You can pretty much plumb the product in a couple of days.
That’s fantastic for getting new users up to speed quickly, but deeply frustrating after a couple of weeks. Or months. Or years. Compare that with Vim, which I still use for all of my code editing, yet it’s so complicated that most people don’t even know how to quit it, much less use it. I’m not going to claim its lack of user friendliness is a feature, but I will defend to the death that its complexity is.
Apple’s Notes is the ultimate expression of this trend in text editor form. It’s a fine text editor. I know some people have written huge, impressive programs in similarly simplistic editors like Notepad on Windows. But I personally could not imagine giving up keyboard navigation, selection, text munging, and everything else I do. The fact that complicated work can be done on simplistic tools speaks to the value of having them, but in no way invalidates the need for alternatives. Yet, on the current trends, no one will even be trying to build this software I love because they couldn’t imagine two billion people using it on a smartphone.
I think it’s fair to say that that’s an unfair standard, and even a damaging one.
I miss the rogue-esque exploration that tool mastery entails. It’s not that I want tools to be hard; I want them to be deep. I want to never run out of ways to invest in my tools. I don’t want to have to swap software to get upgrades, I want to upgrade my understanding instead.
But I look around my computer, and everything on it was designed for the “average” user. I was not average as a CEO with 40+ hours of meetings a week while receiving more than 200 emails a day, nor am I average now as someone who spends more time writing than in meetings. There’s no such thing as an average user, so attempting to build for one just makes software that works equally poorly for everyone.
It is a rookie mistake to conflate the basic user who will never plumb the depths of their tools with the expert user who will learn every nook and cranny of your software. It is a mistake to treat the person who sometimes has to solve a problem the same as a person who spends 80% of their time working on that problem.
I don’t want to be an expert in all of my tools - for all that I take thousands of photos a year, I don’t think I’m up for switching to Adobe Lightroom - but for those tools that I spend the most time in, that most differentiate me, I want the opportunity for true expertise. And I’d happily pay for it.
Back in the days when computer screens were tiny, there were plenty of stats that showed that paying for an extra screen would often give people a 10% or more boost in productivity. I know it did that for me. As a business owner, it was trivial to justify that expense. Monitors cost a lot less than 10% of a person’s salary, and don’t need to be replaced every year. Heck, the whole point of the automation company I built was to allow people to focus their efforts on the most valuable work they could do.
Yet, when it comes to software being built and purchased today, to the tools we use on a daily basis, somehow our software ecosystem is failing us. There is no calendar I can buy that makes me 10% better, no email client available that I can spend five years getting better at.
It’s great that people are finally making software that everyone can use, but that’s no excuse to stop making software for specialists, for experts, for people who could get the most advantage from that extra 10%.
Venture capital’s reliance on unicorns provides cover for the huge failure rate of startups, and investors make no effort to reduce it. Part 5 of a series
Venture investing is fundamentally uncertain. You’re making big bets on people, ideas, and markets that might never work out, and there are more ways to fail than succeed. As a result, investing has to take into account the likely failure of many efforts. If your financial model assumes each of your investments will be a success, you will have a short career indeed.
Manyinvestors have written about how they need some companies to win big in order to cover for other companies failing completely. As a simple example, Fred Wilson at Union Square Ventures tells his investors to expect 1/3 of his investments to fail, 1/3 to return their capital (which is also failure; they sell for a small enough amount that investors just get their money back, and in most cases the founders and employees get nothing), and 1/3 to “succeed”, where his definition of success is that they return 5-10x the original investment.
He says his actual record is a bit better than that, but like Warren Buffet, he’d apparently rather set achievable expectations.
Let’s use some concrete examples. Remembering that most companies raise more than three rounds of funding, and keeping in mind that investors usually get about 20% of your company through each of those first few rounds, here’s what needs to happen to deliver that 10x return:
Your seed round is $500k at a $2.5m pre-money valuation, so you have to sell for $25m dollars. The investor gets $5m, and founders split $20m.
Your A round is $5m at a $25m pre-money valuation. Now your company has to sell for $250m. Each investor gets $50m, and the founders split $150m.
Your B round is $15m at a $75m valuation. Your target exit price is now almost $750m. By this time the founders own less than 50% of the company, but hey, if you can exit at that price everyone is pretty happy. Notice also that while this is a solid 10x win for the last investor here, it’s delivering close to a 300x return for the first investors (not counting pro rata costs). It’s nice work if you can get it.
Beyond three rounds, investors usually have smaller return expectations (e.g., 3-5x) but also have a shorter time horizon. That growth round investment of $50m is only expected to turn into $150m or so, but it needs to do it in 3-5 years instead of 7-10. Tripling a $750m valuation ends up being pretty hard in any time horizon.
It’s worth noting that if the company sells for $20m after that B round, then the founders get nothing. According to the preference stack (where the later investors all have priority over earlier ones), even with the cleanest term sheet the B and A investors get all their money back, but the seed investor, founders, and employees get nothing. In practice, the buyer will usually negotiate something for the employees and founders — you rarely buy a company without wanting some kind of golden handcuffs on the people who work there — but it’s basically a pittance. You’ve always got to manage your downside, even while you build toward the upside.
Note how quickly the exit price for the company escalates as you raise money. Realistically, it’s only once you’re around a billion dollars in valuation that you can consider going public, so if you’re smaller than that your only choice is to sell the company.
This model helps to explain the industry fetish for unicorns. The returns you get from a billion dollar exit swamp all the failures. And if those unicorns hide a lot of ills, the really big ones overwhelm even the successes. WhatsApp returned $3b to Sequoia on around $60m invested for a 50x return, which means every other investment in the portfolio could have failed and they’d have still made a ton of money.
You can see how the unicorns make or break a firm. How does this affect how they treat the rest of their portfolio?
When you know that a small percent of your bets end up mattering, you don’t worry much about any individual one, and that plays out in the world of venture capital.
Obviously investors don’t actually ignore the other firms; after all, they don’t really know which ones will win big. Equally, though, there’s no evidence they care whether any given startup succeeds.
Of course, investors would say otherwise: They’d say they work incredibly hard to help their companies, they work massive hours, answer the phone late at night, etc. Sure. I mean, they don’t put in nearly as many hours as the founders they’re helping, or even as much as a typical financier does (just thinking of the hours bankers put in these days makes me shudder) but I do believe they work hard. I do have a couple of anecdotes that show it’s not as hard as they’d imply, though.
I had one investor tell me that he loved the transition from operator to investor because the lifestyle is so much better. Again, this is from an investor class that publicly derides “lifestyle” businesses that generate cash for its founders but don’t scale massively. When I asked him about the hypocrisy of him working 9-5 but demanding his founders put in crazy hours, he defended it as their needing to lead from the front. Guess that tells you where the investors aren’t.
I also know a great investor who left a top-tier firm because he said he could not spend any more time working three days a week and being paid for five. Pretty honorable, if you ask me.
But mostly, yes, I do think many investors work hard.I just don’t think the work they’re doing helps their companies much.
Let’s walk through a couple of obvious examples.
Given the high probability of failure of a given investment, you’d think that the industry would be great at reducing the risks for their companies and thus increasing the survival rate. Not so much. For example, many investors have told me that the most likely reason for a company to fail is the team. Ok. So what do they do to reduce the probability that a founding team will fall apart?
Ah… nothing. No coach for each founder, no coaching plan, not even a packet providing best practices. Nada.
Their explanation for this is pretty simple: Coaches are expensive, and the investor can’t afford to have them on staff because the measly 2% on their $300m fund just can’t support bringing on staff to help founders. They could have the company fund it, but then that’s less money going to build the company.
This is the highest risk to your investment, and you’re literally not willing to spend any money mitigating it? Further, you’re tacitly recommending that your founders also avoid this easy bit of risk mitigation? Huh. Ok.
Investors will also tell you that the most valuable resource at a company is the founder’s time, and he or she needs to be laser-focused on building the business. It’s obvious they don’t actually believe that.
We’ve already established that founders will spend about a quarter of their time fundraising, rather than building the company. You could argue that this is the most valuable use of their time, but that’s only true in the sense that it has to be done and there’s no one else to do it. Most founders suck at fundraising and are tortured by their need to focus on that rather than building their business. Investors do help a little with this, but not so much that it implies the founder’s time actually is a precious resource. There’s a pretty clear sink-or-swim attitude around fundraising, even though success at it has little to do with the ability to build and run a company.
You see this same disregard for the founder’s time when you look at what they end up spending it on.
There’s a vanishingly small part of any business that’s truly innovative — maybe some part of your market definition or your solution itself — and everything else you do is disappointingly similar to what every other founder ends up doing. Great, so investors have figured that out and as part of their investment they deliver a playbook that uses the collective intelligence of their portfolio to help founders avoid having to make all the rookie mistakes, right? Hah! Nope!
The best firms do enable founders to talk and work together, but it’s all ad-hoc, and let’s be honest, that’s pretty minimal help. Every founder is basically doing a random walk around the possible solution space for “how to build a great company”, taking on huge technical risk with untried platforms and experimenting with idiocy like holacracy rather than focusing on the most important parts of their business, the one or two bets that will make or break the whole thing.
It shows how little investors are willing to do to help founders mitigate the biggest risks in their business, thus improving its probability of survival. If they cared about their portfolio companies making it, they’d specialize in helping them navigate the different phases of the company, minimizing probability of failure at each phase and especially when transitioning.
So now we see that it’s not just that investors are focused on unicorns, but also that the failure rate that those unicorns cover for is just irrelevant to investors. They know most of you will fail (again, they expect 2/3 to at best return their capital, which is failure in their model and even then only accomplished by a fire sale of the company). Heck, if you don’t fail and instead just continue on being neither a big sale nor a failure, they’ll have to push you into one or the other category in order to close their fund.
As I found running a growth company, success hides many ills. One of the biggest problems in venture capital is how much they let the success of their unicorns hide their indifference to the rest of their companies. This fails their founders, their employees, and the whole market, for no reason other than that it’s easier this way.
I’m convinced that a firm that directly invested in reducing its failure rate would have as many unicorns, but would also have more positive returns throughout their portfolio, and in the midst of building more companies and making more money, they just might do a little good at the same time. That would be a nice change.
The success of companies and founders in modern venture-backed startups is highly reliant on peer validation of investor decisions. Part 4 in a series.
Say you’re an entrepreneur building something new and different, and you know you need capital. After pitching up and down Sand Hill Road (and all over South Park), you’ve finally found a believer, someone who sees what you’re trying to do and thinks you and your team are the ones to do it. Great! Now you can focus on building your business, right?
Nope. Get used to more of the same. You probably raised just enough to get to your next milestone, not enough to get to self-sustaining profitability, which means you’ll be raising again soon. After all, on average startups raise more than three rounds of funding. I know what you’re thinking: But this investor is a true believer, and given how hard it was to convince others, they’ll sign up for the next round instead.
Nope. It does happen, but it’s rare. In general, every round you raise has to be led by a new investor. Part of this is about dollars: Your seed-stage investor writes $500k checks out of a $50m fund, but your A-round investor writes $5-10m checks out of a $300m fund. That seed investor will participate in the larger round (doing what’s called their pro rata, to keep their ownership share the same), but if they led the round they’d burn through their fund too quickly and would not be able to lead enough investments to make their model work.
Even if dollars aren’t the restriction on your first investor leading later rounds, you’ll still likely find yourself pounding the pavement again. Imagine you’re an investor, and you see a peer investor leads follow-on rounds for most of their portfolio companies. One of those companies comes knocking on your door asking you to invest, and of course your natural question is: Why isn’t your existing investor leading? There’s no good answer to that question.
You can’t say, “Well, they’re a bad investor, and I really need new blood”, for pretty obvious reasons. Even if it’s true, badmouthing existing investors will never get you new ones. You can’t say, “Well, they like us, but even though they lead follow-on rounds in 90% of their companies, they don’t like us enough to lead one for us.” You’ve just told this new investor that you’re in the bottom 10% of your investor’s portfolio. Now there’s no chance they’re going to invest. If the investor that knows you really really well doesn’t want to write a check, no one else will.
To prevent this problem, the industry has the habit of not leading follow-on rounds. Again, not that it never happens, but it can’t be the common pattern, because the company that breaks it gets a black mark. I’ve had many investors (including those invested in Puppet, the company I founded) tell me they follow this habit religiously, for exactly this reason. “Nope, as much as I like you, you’re going to have to get the money from someone else.”
Out you go.
Thankfully, venture investors recognize the downsides of this and build deep networks of firms and individuals who frequently work together. There are even later-stage firms who specialize in following specific investors whose track record they trust. But while this pattern was developed for good reasons, it also has downsides that no amount of networking or help can compensate for.
First, of course, it means most CEOs spend a huge percentage of their time either directly raising money or doing the work necessary to do so later. You might not have wanted to become best friends with tens of investors, but if you’re taking venture capital, that’s your job now. Given that investors are professional meeting-takers, they’ve got time to meet for coffee any time, so this can be hugely time consuming. Then when it comes time to actually raise a round, you should expect it to consume your life for at least three months. And that’s the success case.
This time sink is pretty bad if you live near all the investors you need to meet, but what if it’s a flight to the bay area instead of just a drive? Oh, if you’re one of the top companies they’ll come to you, but if you’re not, it’s one more way you have to work harder than the ones they love. It was only in our late-stage rounds we had luck getting investors to come to us, and we were only in Portland, an hour and a half flight away. I can’t imagine trying to raise money in a place that shudder needs a connecting flight to get to. I nearly killed myself in a rented PT Cruiser (the first available car at SFO) trying not to be late to an investor meeting, and of course, he passed on us anyway because I could not convince/did not want his buddy to join us as COO.
This all adds up to a massive tax on the companies that do succeed, where CEOs become experts in fundraising rather than experts in building great companies, which is, of course, stupid. But it has a much worse impact on who and what can get funding in the first place.
Again, put yourself in the head of an investor. You look at tens of potential investments a day, and you have far more opportunities than time or money, so you have your pick of what to invest in. On the one hand you’ve got a woman or a person of color pitching a company that sells to markets they deeply understand, maybe something more focused on customers who look like them. On the other hand, you’ve got a Harvard-educated CS grad who’s found another great use for AI in the cloud.
What we want is for the decision to be made based on what’s the best investment, who’s the best founder, but it’s not. It’s obviously not. If it were, you wouldn’t see such rank discrimination in the world of VC, where women and people of color are almost entirely excluded.
Instead, a key factor is whether the investor believes this person can raise another round. Note: It’s not whether the person actually can, because you don’t know that until you try it. It’s whether the investor thinks they can. And, of course, investors know that women and people of color don’t fit into the pattern of other investors, so they pre-discriminate in expectation that later investors would have anyway. I mean, why give someone $500k if the company won’t be able to raise another round anyway? You’ll lose all your money.
Like with all patterns, it’s as much about the company as it is about the founder. It’s not just about who gets money, it’s about what kinds of problems are worth solving, and what kinds of customers make good markets.
Silicon Valley has a well-known fondness for investing in products that solve the needs of white boys who just got out of college and are having to learn to live on their own, but less obvious is that this means they often consider other customers to be worthless. It is fantastically hard to convince an investor to back a product built for women, or people of color, or international buyers, when the investor is none of those things.
That is, it’s not just about investing in people who are different — it’s that their ideas are different, the problems they care about are different, and the markets they want to attack are different.
In a world where you’re taking risks, where you’re actually focused on brilliant founders in big markets, those differences would be positives, they’d be signs you can do something ground-breaking. But when that world requires multiple rounds of belief, where failure at any round destroys your company, suddenly those differences become reasons for people to say no, for companies not to get funding, for founders not to get support.
There are some firms out there, like K9 Ventures, who make these bets anyway and recognize that it turns their job into finding follow-on rounds for existing investments rather than just finding new companies. Too many investors either don’t see the consequences of this pattern, or preemptively admit defeat and just don’t even consider investing in a company that they are concerned couldn’t get another round.
Once again we see how a key aspect of venture, one that exists for good reasons, has pernicious consequences that help to explain how the world of venture works today, in all its glory and misery.
There’s no obvious fix to the problem, as either an investor or an entrepreneur, if you truly do need capital to grow but you don’t fit the pattern. One of your best defenses is to focus on profitability first, so you don’t need those follow on rounds and the levels of approval required to make them happen, but that’s not possible for every firm, and even when it is it can result in heavy compromises on growth.
Thankfully, there are now firms out there focusing on founders who are women and people of color. These firms will help in multiple ways. First, of course, they’ll provide the direct funding that is not currently available to so many great founders and companies, but second, they’ll begin to build out those networks of social proof that will enable these companies to get as many rounds as they need, rather than just the ones they can provide.
We’re going to need a lot more firms like that to truly unlock the potential of venture capital, to bring world-changing solutions to those who can get the most benefit, wherever they are and whoever they are. I’m hopeful that the competition these new firms bring will change the behavior, and the opportunity, of the existing ones enough to make the difference, but what’s really going to shift behavior is when the companies invested in by these companies start to deliver outsized returns specifically because they don’t fit the pattern.
Modern venture capital is obviously successful, as demonstrated by the fact that five of the world’s six largest companies were funded by it. However, success is as much about what you say ‘no’ to as what you say ‘yes’ to, and venture capital is no different. In addition to delivering massive collateral damage in the course of its work, the current model rejects all ideas that do not fit within its narrow definition of suitable.
The primary contributor to this wholesale rejection is how VC delivers returns, so to understand why it’s broken we must understand how it works. In this article we’ll go deep on how VCs get their money, how they turn that into more money, and what that all means in terms of what ideas they can and will back. Note that we’re focusing here on the ideas not the people; the structural biases against women and people of color will be discussed in later essays (but it’s worth recognizing that they’re just as baked into the model). Ross Beard’s The Innovation Blind Spot goes into great detail on this topic.
Venture capital firms generally have managers and limited partners; the managers are the people we think of as the investors (they sign the checks), and the limited partners are the investors in the firms; they’re “limited” in the sense that they have ownership but no real control. They don’t actually invest in firms; they invest in an individual fund, and all of the roles are built around the fund, not the firm. This is partially why you might seen an investor leave a firm but stay involved in investments from the old firm: the investor is still on that fund even if they’re not at the firm.
Most limited partners are very large financial institutions, like CalPERS, and they work with venture capital as part of a diversified investment strategy. They have pockets of money in all kinds of places, and VC is added in to ensure they have some high risk/high reward investments. These don’t necessarily even deliver better returns (and in general, VC as an asset class does not do that well), it’s there to get the right mix of risk in the portfolio. In most cases, the LPs are represented by people who would not fit in at a venture firm, because they’re usually finance people at governmental institutions.
A fund is raised by investors (“managing partners”, in this context) seeking money from high net worth individuals, institutions, and anyone else with a lot of money lying around. Money is committed for the life of the fund; except in rare cases there is only one way for an investor to get the money back.
One of the strange things about these funds is not just that they are planned to be locked into a fund for a long time, but it can be awkward if they aren’t. Limited partners invest with VCs as a means of putting money to work over something like a ten year period. If the money all gets returned quickly because of an exit, it throws off the spreadsheets and they quickly have to find somewhere else to put the money. This sounds silly, but it does have a real impact.
Venture capitalists then take this money, and use it to buy stock from startups. So now, the fund holds a bunch of stock instead of a bunch of money. Crucially, this stock is all in private companies, which means it’s generally illiquid (i.e., you can’t easily exchange it for cash). It’s also usually preferred stock, which means the investors get a few extra terms around control and how cash is distributed if there’s a below-value exit.
If this were a normal fund, there would be plenty of ways to make money, and the investors could deliver returns however they wanted; they could rely on growth, dividends, sales, or anything else. However, VC funds are limited partnerships with strict rules about what can be done with the money. No matter where you are in a fund cycle, if a company gets sold for cash, you have to distribute that cash to your investors (keeping 20% for yourself, of course). You can’t reinvest it in another company. (This is only generally true; firms that don’t have this restriction are called evergreen funds, and are usually funded by a single institution or family.)
This distribution on an exit is the primary mechanism for VCs to return capital to their investors. The other way is for a company to go public. This is a weirder one — it’s discussed as an exit, because it allows investors to return capital to their LPs, but it’s not a sale of the company. The difference is that the stock is now liquid, which means it’s basically equivalent to cash; the VCs give distribute the now-public shares to their LPs, who can now all trade it in for cash whenever they want.
Ironically, distributing shares to LPs is a big risk to the company — if 50% of a company’s stock is owned by investors, and they distribute all of that stock to their LPs the day a company’s lockup period ends, what do you think the LPs would do? Well, they’re not experts in tech, or high growth companies, and more importantly, this stock doesn’t fulfill the same needs as the VC fund did in their asset allocation, so they sell it. Of course. And what happens to a newly public company who finds that 50% of its shares are suddenly sold on the public market? The stock gets hammered, because a huge upsurge in supply means an equivalent drop in price.
That’s why VCs distribute shares over a broader period of time, usually 18-24 months. They have some flexibility in how this is handled so they can protect these newly-public companies.
Ok, now you understand how it all works — how venture capitalists get money, make money, and then give it back to their investors in turn. Why does that matter?
It matters because there are only two ways for a VC-backed startup to be a success for its investors: Go public or get bought. As the CEO of Puppet, I always said any company has four options: Go broke, go public, get bought, or stay private indefinitely. If you take VC money, that last option is off the table.
It’s worth saying again: You take VC, you are committing to getting bought, going public, or going broke.
Crucially, that means that investors must push you into one of those outcomes. The reason they deride private businesses that generate cash isn’t because they’re bad businesses, it’s because they’re structurally incapable of profiting off of them. Their system is limited to valuing sales or IPOs; nothing else can have value to them, because nothing else allows them to make money.
This means that if you’ve got a great company that’s taken some VC but is at real risk of settling into a mere 20% growth rate with a sight to profitability but only making, say, $30m a year, they’re going to push you out of that comfort zone. They have to. They’ll ask you to raise a “growth” round so you can “really scale this thing”, or they’ll try to sell the company. If that doesn’t work, they’ll just fire you and put someone in place who will do it for them. It’s not because they’re evil, it’s because their contracts essentially require it. They can’t return the stock of a private company to their LPs, so what choice do they have?
Now that we understand how investor behavior is driven by how capital is returned to investors, let’s discuss what it means to the technology startup ecosystem as a whole. (There are VCs for things outside of tech, but the asset class was basically invented for technology, and that’s where it is centered.)
If you’re seeking funding for your technology company, you essentially have to promise that you can and will sell your company for an outsized return, or that you can and will take it public. In reality, almost no one invests with the expectation of a sale; they’re all betting on an IPO, recognizing that a sale is a good second option. It doesn’t matter if you can generate a ton of profit; they have no use for that. In fact, it might get awkward if you started distributing dividends.
This has two big consequences. The first, of course, is that companies that don’t have a realistic shot of going public can’t get venture capital. This is a striking constraint, given how much of our economy consists of small, profit-generating businesses that generate jobs and cash locally, whereas the ranks of public companies that distribute returns only to the investment class have been shrinking for decades. The story they’ll tell you is that only those really high-growth companies “need” VC money, but it’s much simpler than that: Their business model doesn’t work if your company doesn’t sell or go public.
Bank loans do ok at providing funding for low-risk actions by mature companies, and VC does well at funding high-risk companies with the chance to be huge, but there’s a huge gap in the middle that struggles to get any funding. (Both of these funding mechanisms in the US also suffer from being overwhelmingly biased toward only funding white men, but that’s a different essay.) Medium-risk companies often do need funding, but can’t get it, which in many cases means the businesses either don’t exist or end up much smaller than they could be.
The second major consequence is that a lot of companies are able to convince themselves, and thus investors, that they could get big enough to go public. Yes, this is sometimes true, but in so many cases it is instead a lie that both parties tell in order to get the funding done. If you love your company, and the only way to keep it alive is to promise to keep growing, you will. You understand the risks, but they’re better than just letting your company die.
In too many cases, this absolute demand for continued growth is exactly what kills companies. They never learn the operating discipline necessary to generate cash (which, in the end, actually still is king), and they get too big to sustain themselves. At some point, the lie gets out, they can’t get more funding, the fundamental unsoundness of their business model becomes clear, and the whole thing deflates.
When you hear a VC say you should focus more on growth than cash, what they’re saying is, you should worry more about my ability to return capital to my investors than your ability to still have a company in a few years. It might be that growth is the right thing to invest in, but it isn’t automatically the right thing, and it’s at least fair to say that the investor is not a neutral party in this recommendation.
So now we see that so much of what we find poisonous in the world of venture capital is actually the result of how returns are distributed to investors. The growth-at-all-costs mentality, the huge amount of dead companies, pushing employees to work to the bone until you get an exit, and much more can be laid at the feet of this simple constraint.
I don’t know if there is an alternative model that will work in the world of high-risk tech startups, but I do know there are plenty of other investment models that are able to deliver returns without introducing this kind of dysfunction. Conglomerates like Berkshire Hathaway are able to own significant chunks — or even the entirety — of companies and deliver great returns whether via growth, dividends, or anything else. This provides them the flexibility to let their portfolio companies choose their own best means of returning capital to investors. Coincidentally, Berkshire Hathaway is the one non-VC-backed company in that list of six largest companies.
This essay series is an attempt to capture what I’m learning as I’m looking for a new way to invest in great startups. I think it’s possible to build an investment model that directly attacks the weaknesses of VC; success in this quest would mean both huge returns for whoever cracks it, but also a sudden increase in new companies with completely different promises and risk profiles.
I’m a tech founder and recovering SysAdmin. I helped found DevOps and grew up in open source. These days I am convalescing from a decade of physical and mental neglect while running Puppet.
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