An Unified Theory of VC Suckage

Ah, Eu Tu Paul!!! First Joel Spolsky wrote about fixing venture capital and now Paul Graham offers his unified theory of VC suckage.  First a few caveats and disclaimers (I am a cowardly, sneaky VC after all ;-))

1. I enjoy Paul Graham's writings very much.  He is eloquent, insightful and logical and I aspire to write that way
2. I do not aspire to defend VC's.  Like everything else, there are good people and bad people, good Germans and bad Germans, and good VC's and bad VC's.

However I disagree with the argument that the structure of venture capital make VC's behave as they do.  Paul is kindly proposing that its the system that makes us the cowardly, deceitful, beasts we are:

I used to take it for granted that VCs were like this. Complaining  that VCs were jerks used to seem as naive to me as complaining that users didn't read the reference manual.  Of course VCs were jerks. How could it be otherwise?  But I realize now that they're not intrinsically jerks.  VCs are  like car salesmen or petty bureaucrats: the nature of their work turns them into jerks.

The nature of their work that Paul is referring to is the "fund structure" that VC's use:

The problem with VC funds is that they're funds.  Like the managers of mutual funds or hedge funds, VCs get paid a percentage of the money they manage.  Usually about 2% a year.  So they want the fund to be huge: hundreds of millions of dollars, if possible. But that means each partner ends up being responsible for investing a lot of money.  And since one person can only manage so many deals, each deal has to be for multiple millions of dollars.

This turns out to explain nearly all the characteristics of VCs that founders hate.

The system or the "fund structure" does not make people behave in a particular way, their arrogance, lack of skills or poor behavior is the cause. 

Let us consider the things that Paul feels VC's do that founders hate:

. . . VCs take so agonizingly long to make up their minds, and why their due diligence feels like a body cavity search. [2] With so much at stake, they have to be paranoid.

It explains why they steal your ideas. . .

. . . It explains why VCs tend to interfere in the companies they invest in.  They want to be on your board not just so that they can advise you, but so that they can watch you.  Often they even install a new CEO . . .  With so much at stake, VCs can't resist micromanaging you.

. . .VCs don't invest $x million because that's the amount you need, but because that's the amount the structure of their business requires them to invest.

. . . And of course giant investments mean giant valuations.  They have to, or there's not enough stock left to keep the founders interested. . .  You're rolling the dice again, whether you like it or not.

. . . Add up all the evidence of VCs' behavior, and the resulting personality is not attractive.  In fact, it's the classic villain: alternately cowardly, greedy, sneaky, and overbearing

Let us analyze the fund structure first.  The economics of venture capital are that most VC's get 2% management fee and a 20% carry on the funds they manage (some top tier firms get more carry but for the most part the management fee is the same).  The average venture fund these days is $300 Million so the venture capital firm gets $6 Million a year for 10 years in management fees = $60 Million.  This is a lot of money for sure but remember this has to pay for salaries, office, travel, due diligence, administrative staff, accounting, etc.  And most importantly the *FEES* have to be paid back to the limited partners.  The "carry" is only calculated on top of the $300 Million so the venture firm only starts getting carry after the fees are paid back.

Now let us look at the carried interest part of the economics -  if the venture firm triples the fund i.e. make $300 million worth $900 Million than the partners in the firm will make $900 - $300 = $600 * 20% = $120 Million.  This is even more money and you only have to pay "capital gains" tax on it versus the "income tax" you have to pay for the fees -  VC's are greedy bastards what do you think they will look to maximize?  Also institutional venture capital is about raising multiple funds and the way to raise future funds is to have stellar returns on the current funds.  So even if VC's were optimizing to manage big funds the only way they can do it is to get good returns on the money they are investing.  Ultimately you can only remain in the venture capital business if you have strong track records.

So the incentives of the system are set up for VC's to raise the *RIGHT* amount of money that allows them to maximize the "return" on the fund.  Now does that mean that every VC is doing the right thing - absolutely not!! Some firms especially those who are not focused on the long term have indeed focused on maximizing management fees rather than multiples.  However there are also some top tier firms who don't get a flat management fee but rather get a  budget based management fee depending on their expenses.

Now let us look back at some of Paul's other points:

a. VC's taking a long time to make a decision:  If a VC does not know the space, she is going to take  a long time to make a decision.  Trust me if you are starting another search company and you show up at  Mike Moritz or John Doerr's door, they will make a decision in less than 2 weeks.  However if you showed up at Mike's door with a biotech deal, he is not going to make a quick decision since he does not know that space well.  Diligence is a function of how well a VC knows an area and less of how much money he is going to invest.

b. VC's stealing ideas:  I am sure some VC's do steal ideas but for the most part this does not happen.  First of all ideas are dime a dozen - its the execution that matters and Paul himself wrote about that in his essays about doing a startup.  Also if your idea is so simple that all it takes is for me to know it to duplicate it then you don't really have a valuable business anyway.  The real issue is that ideas are not independent things that exists all on their own.  Every idea builds upon something else and therefore the lineage of ideas undermines sole ownership of any idea.  Malcolm Gladwell wrote this brilliant article about plagiarism that is worth reading.  I think the whole idea stealing concern is over blown.

c. VC's micromanaging: I think if you look at the history of the most successful venture backed companies - Amazon, Cisco, eBay,  Google, Oracle, Microsoft, Sun, Yahoo, etc. - they have all had the founders at the helm and the venture guys on those deals have not micromanaged them.  Good VC's get the value of not standing in the way.  Bad VC's don't.

d. VC's invest not what you need but what they want - again if a VC wants you to take more money that you need then she is a bad VC and you should find a different one.  This is not a function of the system but rather you are dealing with someone who does not understand venture capital.  The best venture capital returns have come from very small investments - Microsoft raised $1 Million in venture capital, Cisco raised $2 Million, etc.  Vinod Khosla has a great presentation on how his most successful deals have been ones in which he put a small amount of money first. 

This blog has turned out to be much longer than I first intended.  My overall point is that Paul does a good job of raising some valid issues with VC's but its not the system that's at fault, its the incompetence of the VC's in question.  Like everything else, there are good VC's and bad VC's - just try to find the good ones if you need money.