How the VC model guarantees failure most of the time
It’s easy to be scornful of venture capitalists. First of all, they’re paying themselves handsomely to gamble with other people’s money. Secondly, although some are quite intelligent as individuals, as a herd they’re reliably foolish. Thirdly, their model is atrocious. Fourthly, most VCs these days came straight out of MBA school to be Associates and then, a decade later, became Partners. Which means they’ve never had any operational experience relevant to the companies upon whose Boards they sit.
Today all these follies are being compounded by a predictable shift in the financial markets that is reminiscent of the dot-com meltdown that began in 2000. The collapse of WeWork has led formerly effervescent public market investors to pause for a moment and consider whether a business model based on ever-larger debt is actually viable. One would imagine this concern could have surfaced several years ago but there’s nothing so foolish as a mob, and markets are nothing more than mobs throwing around billion of dollars of other people’s money.
Let’s dissect the VC model and see what conclusions we can draw.
First of all, the VC model for the last decade and more has not, repeat not, been about investing in companies that can become profitable fairly quickly by delivering value that’s worth more than the cost of providing it. Instead, the VC model has been about throwing hundreds of millions or even billions of dollars into companies that are being managed intentionally to lose vast amounts of capital every quarter.
This is the latter-day version of the so-called “land grab” that obsessed VCs in the mid-to-late 1990s where they imagined that the fundamental rules of economics had been magically changed forever merely because people had worked out how to create HTML pages and use TCP/IP as a unified transport system.
For the last decade VCs have insisted that companies burn as much cash as they can in order to “blitz-scale” even if they have no clue as to how these companies might one distant day become profitable. Growth was the Great God and all worshipped at its altar. The more you could burn, the more attractive you were. Cue Uber, Tesla, et al.
If you questioned this notion you were clearly far too naive and therefore not worth having hundreds of millions of dollars thrown at you.
Partly this madness was because VC funds became so big that they had to throw hundreds of millions at each portfolio company merely in order to show their LLCs they were making investments. Partly it was because everyone assumed the public markets would continue to swallow the high-growth story indefinitely.
Mostly it was because the fundamental investment model the VCs use is hopelessly broken.
Here’s the situation: VCs can’t really guess which companies will succeed and which will fail. This is partly because there are so many variables and the tech landscape is so dynamic. Partly it’s because today’s crop of VCs has zero operational experience and thus no means to evaluate the management teams that pitch their “can’t fail” plans.
So what the VCs do is they assume 70% of their investments will sink without trace. In any other world this would be a cause for re-evaluation and the development of better strategies; in the VC world it’s taken as a fact of life, as if it’s an unalterable universal reality akin to Newton’s Laws or Einstein’s field equations.
They further assume perhaps 20% of the companies they fund will limp along and eventually return their initial capital, yielding a 0% return on investment.
So that final 10% is the make-or-break for VC funds. Only if some magic unicorn comes along and repays at least ten times capital invested can the VCs go back to their LLCs with big self-satisfied smirks (aided by the 20% carry on the profits they retain for themselves) and then… ask for even more money for their next fund.
This means that VCs become increasingly desperate for super-high-growth companies that can IPO or be acquired by Google or Facebook at an eye-watering premium. This means if the VC fund is $1 billion and each portfolio company swallows $100 million, that single winning portfolio company needs to return at least $1 billion in order for the VCs to keep themselves in Maseratis and mansions in Portola Valley. (Note: the numbers here are obviously simplified for ease of comprehension.)
For a while, so long as Google and Facebook are happy to pay over the odds and so long as the IPO market continues to be irrationally exuberant, it’s just about possible to get away with this game, though even during these boom times a lot of VC funds fail abjectly and the Partners involved have to accept the hard fact they’ll need to keep their Maseratis an extra year or so before trading up to Aston-Martins.
But in normal economic conditions life is far less rosy. Today, thanks to the collapse of WeWork and disappointing post-IPO performance of several other former unicorns, things are changing fast.
So what are the VCs doing?
Precisely what you’d expect them to do: something stupid.
After a decade of screaming at portfolio CEOs to burn more capital and grow faster, VCs are now screaming at portfolio CEOs to get profitable by tomorrow afternoon at 2.35pm.
This is a little tricky given that from the ground up, the portfolio companies are all structured for loss-based growth. All the metrics, all the personnel, everything, is oriented around burning money in return for hitting KPIs associated with grabbing more users. It’s not unlike telling a pilot to rebuild an aircraft in midair. Sure, it sounds easy when you’re at a Board meeting and pounding your chest because you’re a smart & stable VC; it’s not so easy in the real world, which is where CEOs have to operate.
Predictably this course of action will almost certainly take down companies that might just have transitioned into being real and profitable entities one day, because you can’t rush an in-flight rebuild. You can’t be both high-growth cash-burning and high-growth instantly-profitable, given the kinds of companies VCs have invested in over the last decade.
Sure, there were companies out there that could have been strong growth and quickly profitable, but the VCs all scorned these opportunities. They weren’t high-growth enough, they wouldn’t have needed hundreds of millions of investment dollars. So they didn’t get funded.
The companies the VCs need today didn’t get funded three years ago because the VCs were all busy investing in companies that couldn’t be profitable early on. Now, having invested in cash-burning financial black holes, the VCs are screaming at their CEOs for being exactly what the VCs wanted them to be.
If you can think of a better recipe for failure I’d love to hear it.