As a young boy I would often drive with my dad to bank meetings. Waiting for him in the car or in the waiting room, I would think why my father talked so bad at dinner about “bankers”. He didn’t like them then, and he still doesn’t, but there he was meeting them nonetheless. That was Italy in the nineties, and in Italy seeking financing means banks.

Fast forward 20 odd years and for most people my age, and younger, financing means only one thing: Venture Capital. Venture capital is now the holy grail of everybody who wants to start a company. To the point where people are celebrating funding rounds as if they were actual great successes. I am sure most VCs don’t encourage that way of thinking, but for most entrepreneurs, especially first timers, getting venture capital is still associated to the first moment when you are “about to make it”.

Yet even in this environment, there are few topics that attract as much controversy as VC. Run a quick search and you will find headlines as:

“VC is funding is bad for your start up”

“Venture Capitalists get paid well to lose money”

“11 ways a VC will screw you” (ok, this is fake. But plausible)

Criticism is both directed at the performance of Venture Capital as an asset class and at the “poisonous” effects on the companies it funds.

I think a lot about this topic and I agree 100% with Jerry Neumann when he says that:

Getting the financing of innovation right is one of the primary institutional drivers of societal wealth creation.

We are not there yet and I do believe that the status quo is far from optimal, for both investors and entrepreneurs.

These are my reflections, thinking out loud.

Making money as a VC: Unicorns, ponies, thoroughbred

Very few VCs actually disclose their financial model. Most, however, agree about the fact that you need few, outsized, wins to achieve acceptable returns.

“Power law”, check.

This way of thinking is supported by the high fail rate of Venture backed businesses. Since 8 out of 10 investments will either go bust or give poor returns, you should focus on making sure that the 1 or 2 you get right can return your entire fund, and more. And since funds are getting really large this means you should only aim at billion + opportunities.

“Unicorns”, check.

It looks like there are practically two options to win as a VC:

1) Take a lot of market risk and aim at being right when everyone thinks you are wrong (outsized returns)

2) Aim at a huge markets (therefore less market risk) but make sure to be the first to the post where everyone agrees you are right. (outsized exits)

At this point, anybody with some basic understanding of arithmetic should say: “instead of few wins with high returns, can’t we aim at many wins with lower returns?” Enter the thoroughbred club. According to the members of this club (who often oppose the “unicorn” guys) there is a 3rd possibility to make it as a VC:

3) invest in lower risks, maybe smaller but still winning companies. (average returns, average exists, less fails)

I call this kind of startup a “thoroughbred.” They’re impressive organizations that have the potential to change the lives of their customers and employees, but differ from unicorns in that they are “only” likely to exit for $100–500 million dollars

So far so good.. right? No, wrong.

There is no such thing as low risk

If you believe that the past can teach something about the future then this incredibly well researched post is for you. Historically, VCs have done poorly in two cases: taking stupid level of risk (the 90’s) and taking too little risk (the 80’s). Investors attempting to make money by either investing in obviously large markets (option 2 above) or lower risk opportunities (option 3 above) seem doomed. According to the same post this is happening today:

The VC community is purposely avoiding risk because we think we can make good returns without taking it. The lesson of the 1980s is that no matter how appealing this fantasy is, it’s still a fantasy.

But why is this the case? We must assume then that the true defining factor in Venture Capital economics is the limited amount of successful outcomes. With this as a constant (so without the ability to improve the hit-rate) the only possibility is achieving exceptional returns on a small number of contrarian bets (the only “by definition” able to achieve that). Which leaves us only with option 1.

Exit bottleneck

Venture Capital is a special game because not only it requires hitting a winner, but also successfully exiting it at a good price. Looking at these slides from Mark Suster it appears clear that only a small share of companies ends up with an exit. Hence the low hit rate.

But what happens to all the remaining businesses? Were they all simply doomed to fail? Likely not. What happens is simply that a system whose DNA is geared towards binary outcomes (a new market either happens or not) tends to produce binary outcomes. What happens is that when Venture Capital embraces businesses whose outcome is not meant to be binary it fails, both towards its investors and towards the entrepreneurs it is supposed to support. What happens is that some businesses are simply not a fit for VCs (and vice versa).

Some marriages are not meant to be…

And what are these businesses?

In the past, the expression “Lifestyle businesses” has been used to describe almost derogatorily companies that were considered not ambitious enough to become VC-investable. (Luckily this trend is changing, here and here )

If we follow the reasoning above,however, ambition level has little to do with being a good fit for a VC or not. Great businesses with bad VC fit could be:

• Businesses that don’t attempt to create an entire new market
• Businesses that focus on sub-billion dollar opportunities
• Business that don’t openly suffer (or can benefit) from winner takes all dynamics

To make some concrete examples that are quite popular right now:

• Service businesses (some of the so-called “full stack startups”). E.g. Alt School
• Brands (clothing, niche food, design furniture and accessories). E.g. Blue Bottle Coffee, Philz Coffee, Bonobos
• Software companies (especially if regionally or vertically focused — but not only). E.g. Bufferapp, Clio

Today, all businesses are software businesses, that’s right, but that doesn’t make them by definition a good fit for VC money.

Experiments

I have no specific knowledge about these companies, nor about the plans and exit scenarios that their investors and founders envision for them, but my impression is simply that they could fare better with a funding model that wasn’t so dependent on a liquidity event. In general, in lack of a dramatic increase in IPOs and M&As, it seems unreasonable that the Venture Capital industry can fund so many businesses without either changing its structure or affecting its performance (back to the 80s).

What could the alternative be?

There are a number of experiments going on that, directly or indirectly, try to challenge the traditional economics and setup of Venture Capital:

Startup studios and other “balance sheet” investors

Different from the traditional closed-end limited partnership structure of VCs, some investors have set themselves up as companies and invest directly from their balance sheet. In many cases these are startup studios like Betaworks, Science-inc and us at Founders, or straight-up investors as Anthemis (although they do more than “just” investing).

While being “evergreen” in nature, these setups are not necessarily against exits (we at Founders are probably the one that put more emphasis on the non-exit focus), but their structure give them in principle the possibility to fund themselves from the cashflow of portfolio companies.

Indie.vc

Another interesting experiment is indie.vc. Its structure may not be that far from traditional venture debt but the unique blend of debt and equity, and the clearly cashflow focused “ideology”, makes it something I’ll be watching very closely (and even test in some ways in our setup).

One unique aspect of the Indie.vc terms is the option for founders to make cash distributions to investors from profits as a return on their investment instead of selling out or taking their company public to create a liquidity event. This is not a new concept in most other industries, but it hasn’t been widely adopted in tech.

The “Buffer” model

The people at Buffer are really pushing the limits when it comes to doing things in a different way. Late last year they closed a new raise proving that a successful and profitable company can attract investors with a longer term vision and push back the need for a fixed exit horizon

We found that traditionally, people believe there are 2 ways to build a company. You can bootstrap or you can be a venture-backed company raising Series A, B, C, and then eventually doing an IPO. For a long time we believed these were the only two ways. And, both have good things going for each other. However neither felt quite like the right approach for us.

They did it by “setting up a precedent for multiple regular liquidity events for investors and team members”, and by finding investors can believe in this approach.

(obviously a strong secondary market — or even a different public market — could go a long way in this direction)

What about crowdfunding, Angellist, micro VCs and superangels?

All these examples are also great, and they are shaking things up incredibly, especially in early stage funding. Their challenge however is being part of a food chain that thinks in traditional VC terms.

Conclusion

By now, I came to the conclusion that the Venture Capital industry is overgrowing its role, pushed by the popularity of the startup dream among entrepreneurs and by the clear inability of banks or traditional capital providers to fund new ventures. Financial and human capital, at all levels, is being channeled towards entrepreneurship (which is great) but the channeling system used (VCs) was created for another world, and probably for another purpose.

I believe we need an alternative. Founders is our attempt to create one.

Originally published at www.buildingsquared.com.