The Early-Stage Investing Manifesto

Why the Venture Capital Model is Broken and How We Can Fix It

tl;dr: The traditional early stage investment model doesn’t work. Let’s focus on building value rather than chasing unicorns.

Many years ago, when one of my startups was in its infancy, I did the entrepreneur-investor mating dance. I went from VC firm to VC firm, slide deck in hand and pitched my heart out. I was confident. The business had respectable revenue, happy customers, solid processes and modest and increasing profits.

What I did not know at the time is that my business was not a good candidate for an early-stage investment based on the traditional VC model. I recall how dumb I felt for wasting so much time and emotional energy on a model that clearly did not work for my business.

Forced to bootstrap my startup, we struggled for several years but I am grateful now to be on the other side of the dance as an investor.

While my experiences still more closely align to that of a founder, my life as an investor brings me back to my initial frustrations. I am increasingly of the belief that not only did the early-stage investment model not work for my business but the model does not work for most entrepreneurs and investors.

The long shadow of venture capital

Now, I am a private investor. I have some experience with founders and a good sense of intuition that is based on years of experience and lots of mistakes regarding what works and what does not work for a new venture. However, whether I am considering a company in Wisconsin or one in New York, the pitch I get from founders is exactly the same one that is given to a large VC firm. The problem is that, as a private investor, my needs are different. So are my expectations.

The fact is that VC firms cast a long shadow over all early-stage investments. These firms create and promulgate the de facto model used for every type of early-stage investment. The problem with this is that it is a broken model for the vast majority of investors and undermines investments in early-stage companies.

For a host of reasons that I will describe, I believe a new model of early-stage investing is needed. A model that focuses on reducing risk, does not create an “all or nothing” ethic of investing and allows more investors and founders to participate is the key to reframing early-stage investments in a way that helps founders and brings more money into early-stage investments.

Let’s begin by reviewing what is wrong with the traditional VC-backed early-stage investment model.

For the investor, the typical early-stage model is excessively speculative

Let’s unravel the normal VC model. The general partner launches a fund and solicits investments from several limited partners, LPs. The general partner, or GP has to put a lot of money into play quickly and seeks those investments that have the highest reasonable upside.

In the end, if a VC makes 10 investments, only one or two will be winners and create most of the gains in the fund. The result of this kind of investing creates the possibility for dramatic winners, but at considerable risk and with the likelihood of many, many losers. This is why some suggest that only 12 percent of VCs can be considered successful (and begs the question how a VC firm in Wisconsin that is focussed on chasing unicorns has any chance of success — the topic, perhaps, of a future post).

The bottom line is that returns from VCs are generally not good.

But for the GP, life is still good. That is because the GP traditionally has a “two and twenty” situation in which the fund pays the VC a management fee of 2 percent a year, plus 20 percent of whatever profits the fund makes on its investments. In short, the VC is getting paid no matter what.

So why is it that even those of us who are not VCs still use the same early-stage investment model?

It is part of the startup culture. At least that is how I felt when I was pitching my company. However, the fact is that individual investors should not be pitched the same way as VCs. Put another way, I am the recipient of the same slide decks and presentations given to VC firms, but I should not be.

The exit-only goal is foolish

We have all been told the entrepreneur fairly tale: Two starry-eyed founders launch a startup in their garage. After a year of toiling away, they have a proof of concept that they take to a VC firm, which in turn gives them a check for a gazillon dollars. The company grows, goes public and everyone gets rich, and famous to boot!

Think of all of the great companies that have followed this recipe. How exciting!

But in focusing only on the most fabulously successful companies, how many moderately successful companies are overlooked? How many great business — including some that may be ahead of their time or that only appeal to a niche market — never have a chance of exiting?

Exits are a great goal for a very small percentage of startups, but it should not be the only goal. The simple fact is that there are a ton of small but extremely promising young companies that need a small amount of funding and are willing to sell some equity to get it.

Like larger companies, there are many very strong, very good companies that generate good profits year after year. I believe there are many startups that fall into this category. But using the traditional all or nothing model, these companies are dramatically undervalued.

This is a huge problem.

In an effort to fix the VC model, here is some advice for entrepreneurs and investors that will allow a new model of early-stage investing to take hold.

Combining value investing with early-stage investments?

The current VC model is akin to a little league player who swings for the fences every time he goes to the plate. Sure, he’ll hit the ball over the fence one out of every ten at-bats, but he will also strike out 90 percent of the time.

But we love that kid! That kid has guts. He goes for it.

Less celebrated is the quiet player who consistency gets singles and doubles every game. It is this second player, though less exciting in his day-to-day productivity as a hitter, who is, over time, the better player.

This is how we should look at early-stage investing, as a focus on small ball over home run hitters.

Let’s check the numbers.

Fund A invests $1 million into 10 early-stage companies. Nine of the 10 investments flame out but one has a 20x return. At the end of 10 years, Fund A has a return of 7.18 percent compounded over ten years.

Now, let’s consider Fund B. Fund B invests $1 million in 10 small but profitable early-stage companies. One of the 10 companies closes, but the remaining nine produce regular dividends — something I will outline in a moment — of $10,000 per year starting in the third year and sell for 2x after 10 years. Under this scenario, Fund B will return an 9.65 percent compounded return over the same period.

But more importantly, Fund B has far less risk.

So, how do we fix the early investment model? Here are some thoughts.

Investors: Take fewer risks and demand dividends

While all early stage investing is risky by nature, risks can be minimised. In our new business, Forward Venture Partners, we use testing to determine not only what markets we should enter, but what our expected rates of return will be in the early years. We test as much as we can. If our testing shows undue risk, we try something else.

Testing is critical and the ability to test business ideas makes the speculative nature of startups far less so.

I will admit that it is fun to invest with the dreamers and game changers — and believe that you should on a limited basis. That said, put most of your early-stage investments with founders who show an understanding of the business side of startups and who will get to profit quickly. Expect to begin seeing dividends starting by the third year and arrange ahead of time with founders whether and how you will exit from the investment, including a founder buyback.

Founders: Get to profit now

I meet with a lot of entrepreneurs and I give a lot of advice. Rarely do I not pass on this very simple piece of advice, “Get to profit. Now.”

Many entrepreneurs forget that they are not only creating a startup, they are launching a new business. It is the business side of the business that can cause the most trouble for new entrepreneurs who feel their great idea and great coding skills will make them rich. In most cases it won’t.

Unless you have an idea that rivals Facebook or Google — and you likely don’t — focus instead on getting your venture to profit as quickly as you can. In most cases, this can be done using this simple two-step process: (1) stop coding; (2) start selling.

Investors: Stop insisting on useless projections

When I was pitching my company to VCs there always came a point in my presentation when I would outline my wildly ambitious projections for five years out. The projections were largely pulled from thin air, something the VC knew as well as I did.

Let’s forgo the projection nonsense and all realize that none of us know what a company’s revenue will be five years from now. If we did, we should be in the public markets. Instead, focus on getting to profit now and scaling from there.

Founders: Stop with the ridiculous values

I recently met with an experienced entrepreneur who has worked on a project for more than a decade. The venture has never been profitable and by all estimations is bleeding money. I like the business and I have an extraordinary respect for the entrepreneur, but I was floored when I was told the pre-money valuation he placed on the business was over six times its revenue. This is a business that is years away from profitability.

For this entrepreneur, the answer is to stop all development and get to profitability fast. However, under the absurd incentives of current VC model, this entrepreneur is incented to go all-in and proclaim an outsized valuation in the hope that the business can get a huge cash infusion so it can take a flier.

What is this business worth? Without the promise of imminent profit, in my mind, it’s worth very little.

Founders and Investors: Let’s focus on value

Let’s just admit that the VC model of investing is a charade. Founders know it and investors know it too. Instead of focusing on the once in a lifetime unicorns, exits and impossibly outsized returns, let’s focus on building value, seeking long-term, sustained returns and something that we all seem to forget: making a profit.

The current VC model is broken and it is not worth fixing. As private investors, let’s do something that seems absurd in the current context of early-stage investing: prioritize the fundamentals of sound, basic value investing.


Follow Joe Donovan on Twitter or at JoeDonovan.com.