Ever since Harvard Business School professor Clayton Christensen popularized the term “disruption” in the late 1990's, more than a few entrepreneurs, business executives, and investors have used the term to describe their work with missionary passion.
The concept is simple enough: established companies are bound by their rationality and risk-aversion to innovate incrementally, while some upstart comes along with an entirely different way of doing things — often using technology to offer similar or better product or services at previously unimaginably low prices. The result is annihilation of not just the incumbent players but, more fundamentally, the very “laws of physics” of the world in which the incumbents lived.
The concept is not perfect. Jill Lepore, professor of history and Christensen’s colleague at Harvard University, composed a scathing critique in the June 2014 issue of the New Yorker. The article renewed debate on the evidential support for and empirical validity of the concept, including a vigorous response from Christensen.
Nevertheless, disruption is a useful prism through which we can interpret an emergent phenomenon in the world of venture funding.
Since the birth of modern venture capital in the 1970's, its business model has worked much like cable television. The venture firms (“general partners”) raise money from investors (“limited partners”), invest the money over the course of three to five years, exit those investments in another three to five years, and return the money to the limited partners minus fees and carry. During this six- to ten-year period, LP’s generally have little visibility to, and certainly de minimus (if any) control over, which start-up company the venture firm invests in. In fact, even the most powerful LP’s such as state pension funds and university endowments count the lack of transparency amongst the top complaints against the venture capital model as a whole. Conventional wisdom in the industry, however, tends to brush off such cries of “a broken model” as whiny, if not somewhat amusing, reactions of the LP’s when they don’t get the returns they were hoping for, as Mahendra Ramsinghani of First Step Fund and Mod N Labs writes in his thoughtful book, the Business of Venture Capital (2014, Hoboken, NJ: Wiley).
While the Ricardian theory of comparative advantage offers one reason why institutional LP’s have historically tolerated the cable television model of venture capital, there is growing anecdotal evidence that non-institutional LP’s have begun demanding, and getting, a more transparent and a la carte service. Borrowing Kickstarter’s model of crowdfunding, a new type of venture firm has emerged that conducts all the sourcing, due diligence, and deal structuring that a traditional GP would do, but then opens up the deal to accredited investors so they can choose to participate (or not) on a deal-by-deal basis. Yet another model is where a nimble venture firm develops a “curated” group of investors, typically senior executives in a particular sector and non-institutional investors, who have just enough time to help source deals or to provide selective and strategic advice to the portfolio company but not enough time, experience, or the career aspiration to become a GP themselves. This latter model could become particularly powerful as it taps into a vast legion of high-powered, high-income, and entrepreneurially-minded business executives who are looking for outsized returns with a higher risk profile but historically have been shut out of the venture capital asset class. When consolidated, this fragmented capital base could become a heavyweight on par with the more traditional sources of venture funding.
Fittingly, these budding new models ask for lower management fees than traditional models, in return for a larger carry in the event of a highly successful exit. But this only enhances the alignment between the GP and the LP, as GP’s remuneration is even more subject to performance.
For entrepreneurs, the new class of transparent venture firms and their investors mean that you not only get the benefit of the GP’s experience and network, but also those of the LP’s — a much broader universe of expertise and relationships. They also mean that the money is potentially a lot more flexible and generally not in a “counter-party” situation, as the new model could serve as sole lead, a friendly “second investor,” or a strategic yet elastic tranche to fill the gap in a given round.
In her criticism of Christensen’s work and the mania it has since given birth to, Lepore mocks the venture capitalist John Linkner who proclaimed “disrupt or be disrupted” and concludes that despite any such nifty concept the future is inherently “unreadable.” Perhaps she is right — the ideological fervor and certainty with which many in the investment and entrepreneurial world have used the term “disruption” indeed borders on comedy. But theoretical constructs have long served a useful purpose in helping humans understand the universe and ourselves. Christensen’s construct, tempered and modulated by Lepore’s call for less militaristic overtone and more humanist tenderness, would serve well as a framework to witness what may well be a disruption to the lords of disruption themselves — the world of venture capital.