Who are the Venture Capital investors?
The strange interplay of venture capital firms, family offices, corporations and the government
Let me start by saying that venture capital (as “investment in long-tail risk”) has been with us for a very long time and will likely remain with us for a very long time. To the extent that individuals and society desire any form of non-incremental progress there will be long-tail risk. Printing press? Long tail. Electricity? Long tail. Internet? Long tail. Over time, who the capital allocators are may vary from venture capital firms to corporations, wealthy individuals, or the government (or all of them, like it is today), but as long as the risk is there somebody will likely underwrite it. While it is a fascinating indulgence to think about earlier forms of venture bets (hey there, Ferdinand and Isabella!), let’s try to keep this relatively concise and stick to the modern era.
Even today, the lines are somewhat blurred. In a somewhat artificial way, we could argue that very long-shot bets (like fundamental scientific research) are funded by governments and corporations, the more moderate, commercialization-focused risks are funded by venture capital investors, and the least risky, execution-focused risks are funded by banks, PE investors, and the public markets. I am sure that not even halfway through the prior sentence you started thinking of examples of exceptions. Venture debt, DARPA grants, “deep tech” VC funds, and Virgin Galactic being a public company are just the few that come to mind. Trying to put together a rigid, formal structure by risk stage is likely to be a futile exercise.
There is, however, a way to explain the existing venture capital ecosystem if we ask a somewhat different question — why is each type of investor in it? Or, more broadly, why is venture capital not the exclusive domain of a single type of investor, be it the government, or corporations, or venture firms? My high-school economics classes might suggest that there is some competitive advantage at play.
The Government and Positive Externalities
You might argue that the government has no business meddling with private enterprise, and when it starts investing in risky endeavors it will lead us to either socialist hell or self-perpetuating crony capitalism (depending on where on the economic philosophy spectrum you sit). I am going to politely ignore that argument because, well, the government has been doing that for a very long time and here we are, still standing. From research grants (more risky) to small business incentives (much less risky), the government does underwrite long-tail risk, and it often does that at what might seem like a subsidized rate. But why?
The reason is that the government has a unique ability to capture the positive externalities generated by all those long-tail bets. Let’s say, for example, that we are back in the mid-1950s and find ourselves working on some cutting-edge semiconductor technology. It is hard and unlikely to be successful, but if it is, we and our investors will become very rich. This is, however, not where it ends. If we are successful in producing a better, cheaper, faster, more reliable transistor, our customers will be able to produce a better, cheaper, faster, and more reliable computers. Those computers will then make a bunch of end uses better, cheaper, faster, and more reliable. Industrial automation, medical equipment, consumer electronics, weapons guidance systems — our success will cascade through the economy. We and our investors can only capture a fraction of that economic value that is created by setting the wheels in motion. Well, maybe our investors can capture a bit more if they have a computer manufacturer or a defense contractor in their portfolio. But still, nobody can capture more than a sliver of those positive externalities propagating through the economy — nobody, that is, but the government.
The government is uniquely positioned to capture the large external benefits of our invention both directly and indirectly. On the direct side, if we just managed to single-handedly usher in a new age of progress and innovation, that translates into a more productive society, a higher economic output, and more tax dollars flowing into government coffers. But beyond that, the government gets to benefit in other ways — it has seen our country become more economically competitive, it has helped its citizens gain access to a better quality of life, and (if the times called for it) it has created a stronger military deterrent against foreign threats.
The government is the big winner here — and that is its competitive advantage. Due to its structure it is able to take bigger, bolder, and more long-shot bets than most other backers of long-tail risk. In fact, it did that very successfully with large defense contracts in the wake of the Second World War, and it put much of today’s venture ecosystem in business.
Corporations, Industry Knowledge, and Economies of Scale
In “Why does Venture Capital exist?” I touched on the industry’s extrinsic ability to provide a hedge against the future. This is perhaps most valuable to corporations who are locked in a constant struggle to keep up with innovation. Luckily for them, they also have a couple of competitive advantages.
The most obvious one, and I would argue, the weaker one, is industry knowledge. Having a profound understanding of the technology and business behind the products you bring to market is undoubtedly a good thing. The CEO of a major pharmaceutical company should, by definition, have more access to insight about pharma development than any individual entrepreneur or venture capitalist. The materialization of this advantage is most often visible in the prevalence of corporate research, development, and innovation labs. More often than not they contain a decent number of long-tail bets, funded by the organization in the hopes of discovering the future before someone on the outside does. Unfortunately, the corporate structure often makes them experts in incremental rather than truly disruptive innovation. Even when the R&D effort achieves its goal of successfully capturing a long-term bet, the rest of the organization can squander the opportunity (the classic example being Eastman Kodak and digital cameras). This said, corporations are able to leverage their knowledge advantage in placing external bets through their corporate venture capital groups. These groups face a host of other challenges, but long-standing successes like Intel Capital, J&J Innovation, and others show that this is a viable strategy.
Another, less obvious, but potentially more powerful competitive advantage that corporations have comes from their scale and scope. Despite often having heavy bureaucratic machines, corporations are larger and more global than many other venture investors. If you thought of Walmart’s revenues as GDP, it would rank together with the Top 30 countries in the world. It operates in 27 countries and has over 11,000 stores. Shell is a bit smaller than Walmart, but they have operations in 70 countries. Corporations are uniquely positioned to build an information advantage not just over time, but also over space. If executing well, corporations should be able to have both a global view of what’s coming behind the curve, but also to test, improve, and deploy innovation to more people in more countries than anyone else. This is an example of the information arbitrage discussed in “Why Does Venture Capital Exist?”.
Permanent Capital, Long-Term Horizons, and Flexibility
It is strange to discuss permanent capital like endowments and family offices when we discuss long-tail risk. After all, they should be focusing on capital preservation and wealth longevity, so this whole talk of risky endeavors seems out of place. To top that, it’s not like endowments and family offices are a significant portion of the venture ecosystem anyway, other than being allocators in venture funds (which hopefully hedge away a decent portion of the risk).
Here’s the thing though: I think they should be playing a bigger role due to one unique advantage they have — long-term horizons. It is easiest to explain this in contrast to everyone else. Venture capital firms tend to be on a 2–5 year fundraising cycle in which they need to show successful bets and realized returns; patience is not really an inherent virtue of the model. Corporations, while hopefully managed for long-term returns, are subjects to the constant short-term pressures of quarterly reports, evolving management team priorities, and changing board dynamics. Even governments, who should seek stability and continuity of policy more than anyone else, tend to face elections every few years (although this does make me think I should start working on an article on “Venture Capital in Dictatorships: Taking Risks while Staying Alive“). Endowments and family offices don’t have to deal with this short-term mindset or mandate.
Let’s say we had a pool of capital to invest and we were measured on a 50-year basis while everyone else was measured on a 5-year basis. We could do a bunch of interesting things!
For one, we can just bet on opportunities that others can’t fund. Your really promising company needs 5 years before it hits revenue, and it might not be profitable for another 10 years? Even if you don’t need that much money, it is highly unlikely that an investor will back you just because of the time horizons. We, however, can help.
Even better, though, we could try to beat VC firms at their own game. Venture capital firms typically have a fund life of about 10 years and an individual hold period of about 7 years (less than that for growth and more than that for seed, but this is just an example). If they are lucky, they can keep pouring more money in their winners and maybe span 2 or 3 rounds of investment, but at some point of time they have to cash out. The opportunity cost is particularly large for earlier stage funds that have to spread their money among many bets, so there might not be that much capital for follow-ons anyway. Of course, there are creative options like setting up a follow-on opportunities fund, or getting another investor to take over your pro-rata rights for future deals, but there is still money left on the table. If we were, however, managing long-term permanent capital we could place very early stage bets in 500 companies and then follow them through all the way to the end. We would have an information arbitrage relative to any new investor in each subsequent round, potentially all the way into the public markets. It might take 8 rounds of funding or 15 years for a company to run its course from a seed-stage idea to an industry leader, but we can reap the benefits every step of the way.
The other reason why permanent capital has an advantage in underwriting long-tail risk is because of their flexibility in terms of structures and outcomes. For starters, they don’t really need to sell their investments to realize value. The portfolio company’s CEO wants to stay private and run a profitable concern for another 30 years while generating large profits and paying generous dividends? Have at it! Very few venture firms are allowed to even consider that notion. Permanent capital is also unshackled from fund mandates. Opportunities can be found not only in company equity, but also in debt, licensing rights, intellectual property rights? Most funds can’t venture that far out. In fact, most venture capital firms can barely invest outside of the industries and business models they outlined to their limited partners. This is just good governance and risk mitigation in an attempt to minimize principal-agent issues. It also leaves a significant white space for permanent capital to play a role.
Of course, nobody is really measured on a 50-year basis. Even if we built our family fortune by age 20 and managed it until age 70, I bet that every few years we would be tempted to compare ourselves with what everyone else was doing, and likely find them doing better (for now). I would imagine that is why we don’t see more long-tail bets from permanent capital — but, damn, I wish that were not the case.
Venture Capital Firms and the Profit Motive
Saving the stars of the show for last — venture capital firms! While general partnerships are the core drivers of the venture investment ecosystem today and what usually comes to mind when you say VC, the purpose-built venture capital firm is a relatively modern invention. While there have been some significant risk takers through the history of the world, we can probably point to the model established by Georges Doriot at ARDC as the original, structured venture capital firm.
The core reason for the formation of general partnerships, the source of their strength, and potentially their Achilles heel are all rooted in the profit motive. A corollary of investing in long-tail risk is that with some luck (and skill and hard work) you can actually hit on a wildly successful outcome. In all the previous entities we discussed, the vast majority of the profit from that outcome does not go to the individual or the group who made the investment. Governments, corporations, and permanent capital pools often have practical difficulties in incentivizing their investment managers (it gets a bit tricky when the corporate venture capital head makes more than the CEO). They might also be right in doing so, as there is a tradeoff — in places where the upside for the investment manager is capped, they tend to benefit from a good corporate compensation package, government employee benefits, or other forms of downside protection. At the very least, they are not being asked to invest their own money (as general partnerships often are). Nonetheless, if we are a good investment manager with faith in our own abilities and maybe a bit of a hot streak, it is tempting to hang out our shingle and open up a venture capital fund.
The obvious consequence of the profit motive is that there is more on the line for venture capital firms — as the incentives are higher, they are more likely to work. They are motivated to be quick, agile, and responsive. They also get to reap the benefits of their success (as carried interest for individual investors, but more importantly as a growing fee pool for the firm as a whole) and reinvest them into being better, smarter, more helpful supporters of their portfolio companies.
The profit motive also generates a certain alignment of incentives with profit-minded entrepreneurs (which many, if not most, are). If you started a business with the hope of making it big and becoming rich, you might not want all your investors to primarily be interested in “better life for our citizens” or “fueling corporate innovation”. You want them to want money, and to have the money they make tied to the money you make and tied to the overall value of the company. Don’t get me wrong, it is great to do well while doing good. It is also ok if some of your investors have somewhat different goals from making you rich. But it sure it helps if the big decision-makers are aligned — and if you want to build a company and sell it for a handsome profit, venture capital firms are about as close as it can get.
Naturally, there are friction points. Not all entrepreneurs are primarily and exclusively focused on wealth. Many of them, like all human beings, have multiple priorities — fame, stability, power, feeling of belonging, or making the world a better place. Some entrepreneurs might care about the wealth less than they care about the other things, and when coupled with a profit-motivated investor things can get awkward.
There are many other competitive advantages that a venture investor can develop and build their business around — access to deals, functional expertise, speed of decision-making, ability to add value, reputation, market-making — and there are investors out there who are capitalizing on them.
I have also not covered other participants in venture-type investments like angel investors, banks, accelerators, startup studios, and many many others. While some of them can likely be grouped with one of the categories above, they carry their own nuance.
What is more important, at least to me, is that the question of competitive advantage seems to be a decent way to think about how the venture capital system was formed, where it stands today, and how it might evolve.
