Venture Capital Is Ripe for Disruption

It’s time to develop new sources of capital for founders, to help them generate wealth through solving their customer problems without the massive failure rate. Part 7 in a series.

Originally published on NewCo Shift.

The venture capital world that funds the technology ecosystem appears to be specially designed to back the best founders working on the economy’s most important problems. This series has shown that it has instead evolved over time, with no higher purpose in mind than any other financial instrument.

This evolution is in many ways a strength, as by definition it is built on the successes of the past, but it leaves our ecosystem more blind than we realize. We can fear the fragility this engenders, but should instead see it as an opportunity to reach beyond its artificial limitations, to solve hidden or devalued problems. Technology funding’s demonstrated ability to change should give us confidence we can stretch it further, clearing new paths to success.

Wikipedia covers the history of venture capital better than I could, but it’s worth highlighting key epochs. The system as we know it was birthed by the windfalls from early funding wins, including DEC and Fairchild Semiconductor, so by definition there was no technology funding system in place at that point. Every deal involved people flying around the US collecting enough money to back a new venture.

These early big successes motivated a few people in the west to set up firms dedicated to funding technology companies — prior to this, the vast majority of American capital was in New York. Within a couple of decades, partially enabled by some regulatory changes in the US, there were enough firms around (including modern heavy hitters like Sequoia and Kleiner Perkins) that we had what felt like the first stable system, which of course led to over-investment and the first pull-back in the late 1980s.

What survived went on to fund the internet boom in the 90s, when a huge amount of wealth was created (and then destroyed) and this new ecosystem first made it into the public consciousness. Much of what we believe about venture capital comes from those days, but it was still changing quickly, with no seed funds, relatively small amounts of funding for software companies, and no obvious pattern of success.

Right now, the system looks dangerously stable. There are hundreds of seed and venture funds, all following the same playbook: Try to get their investments to the magic number of $1m in annual recurring revenue (ARR), raise an A round of funding, and keep on the funding train until you go public or go bust. There’s so much pattern matching going on that founders are contorting their companies to fit the funding schedule rather than discovering their destiny.

It’s important to recognize that this appearance of stability is a recent arrival. We might tell a story of how it’s a natural consequence of previous eras of success, but much of current best practice is cargo culting, copying the behaviors of the successful rather than understanding what made them work. If you step back even a little to gain perspective on the industry, you quickly see how much the system is still changing, and still needs to.

Don’t get me wrong: the system we have works. It is, essentially, functioning as intended, and any ideas or recommendations need to take into account not just what we dislike, but what makes it work. I hope this series has educated you somewhat both on how VC works, and why it works that way. As usual, when we dig deeper we find no villain at the heart of a web; we might not love venture capital, but it makes sense, and it works this way for good reason. And indeed, the system is working very well for a few people, and in the process is driving huge change in our economy and lives.

As much as the system of venture capital makes sense, we must ask: What sits outside? The industry generates money through positive feedback loops, but absence from the industry is merely an indication that something hasn’t worked, not that it can’t. What are we missing by doubling down on what we know, instead of exploring the unknown?

Investors are reliant on people near them, who resemble them, and who can absorb the weighty downsides of entrepreneurship. We’ve seen that investors don’t really know what separates great companies from bad in the early days, so they don’t strive to create the conditions necessary for gestation, and once a company is started, they do little for the winners and even less for those who fail. But don’t worry, all of this is hidden by the massive profits that the biggest winners generate for the top-performing investors, and the rest of the industry (while failing to meet its investment return goals) glides along in the afterglow.

(To think I was asked recently if I had become cynical about venture capital.)

It’s a funny thing. I grew up a communist (literally, on a commune) but have become a pretty big fan of well-regulated open markets (although they seem to exist only in theory; in practice we have lost the taste for effective regulation). A self-respecting capitalist can and should argue that this is a market, and it’s performing exactly as it should. I can hear it now: “Capitalism is inherently Darwinian, where evolution gives all prizes to the winners and the losers don’t live long enough to make it into the archeological records.”

It’s a fair point. Humanity can afford stretch goals like less collateral damage than the battle for life and death on the savannah, but we could ask for better even without that ideal. It took millions of years for nature to come up with the Dodo, only for it to promptly die off once it encountered outside species. How convinced are we that our apparently stable system is any more safe from an outside force?

The ultimate weakness in the Capitalist defense of venture capital is that for all the apparent competition we have a homogenous system. Shouldn’t we have multiple types of funding competing for the best companies and the best outcomes? That is, not competition between VCs who all work the same, but competition between different funding strategies?

Because there is no open market here. At best we have a dysfunctional oligopoly (is there any other kind?) with some churn at the top. For all the talk of disruption, everyone is trying to win by copying the winners, rather than seeking to disrupt them. The only people willing to step outside the current system are those who don’t have a choice because they aren’t allowed to succeed within it. Unsurprisingly, they find it challenging to compete not with another investor but with a whole system of funding.

As just one example, the most common barrier I hear to starting a new kind of venture capital is that the limited partners — that is, those who invest in the venture capital funds — would not be willing to support a new kind of capital. This is a perfect example of an ecosystem limitation, rather than a problem with individual players. I hear no argument that founders, employees, and customers don’t want competitive models; only that the source of capital would need to be educated, and that’s just too hard. Except… this whole industry is only a few decades old, and its creation required that same kind of education. Why should we expect a new kind of financing to be any easier to start, require any less systemic change, than the one we’re fighting against? And isn’t it ironic that an industry built on stories of disruption finds the idea just too hard for its own work?

That competition will show up eventually, though. We need it. There are too many software markets lying fallow, unfundable in the current model and thus deemed to be of no value. Someone will figure out how to finance those companies. And just as the first winners in venture were big winners indeed, the first few investors to step out of this world into a new one should make out like the oligarchs who laid the groundwork for our current world.

I’ve said before I don’t have the solution, but there are some market truths give me confidence there are better answers available:

• The best way to make money is to hold high quality assets for a long time. If nothing else, Warren Buffett has demonstrated this is both the best way to make money and indefinitely scalable.
• The majority of employment and wealth generation is provided by companies too small or too closely held to be public.
• The steady state of good companies is cash-flow generation managed by long-term teams who take pride in their work. This is literally the entire history of for-profit enterprises. Any other solution must either fail or revert to this at some point. None of these realities show up in modern venture capital. Companies can’t run on venture capital forever (although try telling that to Uber), and do usually need to show a profit to be sustainable (I expect Amazon begs to differ), but the companies that do either of these are explicitly leaving the world of venture capital.

It’s unquestionable that the financing structure of venture capital is tied in to this separation from market principles. The risky software companies we build today are funded via a structure invented to support the risky ventures of the 19th century: whaling. Suddenly the term ‘venture’ in venture capital makes more sense, doesn’t it? (Tragically, even though it was the days of slavery, those whaling fleets had better representation in some ways than current tech companies, with up to 20% of their employees being African American. Wow.)

We’re using an incentive structure that works perfectly to support individual voyages that might last a couple of years. Is it any surprise it is not great at building companies that last for decades, or have a high survival rate? In fact, whaling had a better survival rate than current venture capital, with more than 80% of the fleet surviving, and delivered better returns (14% IRR on average, and 60% IRR for the best). The funding perfectly matched the ventures.

I should not need to say this, but whaling is unlike company building. It’s unrelated to developing a product, it has nothing to do with creating a new market. It’s inanity to expect a funding mechanism built for one would work as well for the others. The fact that it’s making some people rich, and it hits a jackpot once in a while, should not confuse us.

Venture capital’s apparent stability convinces me it’s at its most vulnerable. Instead of continuing to fund disruptors, I think it will itself be disrupted.

If you’re a founder given a choice between a firm that kills most of its customers and one with demonstrated success at creating long-running companies that generate wealth for everyone involved, why would you pick venture capital? The only reason you do today is because it’s your only option.

Founders want this competition right now. Some want to build Facebook, but most want to build a great company, help their customers by solving a critical problem, and hope to get rich along the way. They don’t want a lottery ticket; they want upward mobility, entrepreneurial fulfillment, and to feel like they made a difference. Unfortunately, low-probability gambling is all the venture world sells.

The new models will start at companies run by women and people of color, because they’re the ones shut out of the current system, but as they start to succeed, they will start to pressure to rest of venture capital, and we will see just how stable the system really is.

I have tried in this series to help you understand not just what venture capital is, but that what you love and hate about it are intrinsic to how it works. I hope this deeper knowledge will help you make higher quality decisions about how to involve yourself in this world. Even more so, I hope it convinces you to seek out, or even create, other ways of funding companies, other ways of building them.

It’s time for founders to have truly competitive options for funding. Let’s go make it happen.