Alex Western
Sep 4, 2018 · 4 min read

Too Obsessed with Growth??!! This is What We Mean, Part 1

After our first post, many thoughtful readers questioned our premise that the industry’s growth focus is excessive. They also asked why such an intense focus would even develop in the first place, let alone persist.

Good questions. We’d like to answer in two installments. In this post, we define the structural reasons behind the VC growth fixation. In the next post, we’ll examine the behavioral causes. And through both posts, we’ll highlight its excessiveness.

We’ll start with microeconomics. To put it simply, VCs’ and company founders’ incentives are not aligned. This misalignment prompts VCs to drive the companies they invest in to grow as fast as possible. Why? Because rapid growth maximizes the value of VCs’ portfolios, even if it does not maximize the value of individual companies.

A Fan of Possible Futures

Think about a company’s future as a fan of possible outcomes. The worst outcome is losing 100 percent of money invested in the company. The best is achieving (let’s say) 6x multiple on money invested.

Consider an entire portfolio of companies. An experienced VC knows that returns will not follow a “normal distribution.” On the contrary, only one or two portfolio companies will deliver monster returns. Two-thirds will actually lose money and the rest will plod along, returning between 1 and 1.5x their invested capital. Indeed, VC company returns follow a “power distribution,” not a “normal distribution.”

So statistically, all that matters to a VC is finding one or two companies that are grand slam home runs to make up for the rest of the strikeouts. What’s one more or one fewer “total loss” weighed against three 6x-ers? Think about it. So, VCs force all their companies to grow as fast as possible. And forcing this growth heightens volatility, widening the fan of possible outcomes for each company, and increasing the chance at least one portfolio company will return (let’s say) 12x invested capital, not just 6x.

Most risk-averse company founders would not , in a vacuum, opt for such volatility, because it increases the possibility of “a zero.” Founders don’t want an increased chance of total loss on their “one shot,” even for a remote chance of higher returns-on-invested-capital. Diminishing marginal returns on one side of the spectrum, with a whole lot more at risk on the other side.

But VCs do choose volatility. Because one hundred percent is the most they can lose on any one company, And most of their companies don’t drive returns, so they don’t care about increased chances of total loss on specific companies. Volatility gives them as many chances as possible to achieve a high flier, and one or two are all they need.

VCs’ approach to their portfolios is similar to investors in call options. Volatility increases the value of call options (Black Scholes, anyone?), period. That helps explain why VCs rationally, repeatedly, introduce as much “volatility” into each of the portfolio company “call options” as possible. Company founders might well balk at realizing this is the mentality of VCs, even if only subconsciously. Because founders’ companies represent their hopes and dreams, not just a spin of the roulette wheel, a call option on a big potential win. But it is what it is.

This misalignment has always existed, at least since the maturation of VC industry in the early 1990s. But it’s a bigger deal now because the industry is so much bigger. Global PE assets under management have reached almost $8 trillion (see Preqin, or even our previous post). Worldwide PE AUM grew by nearly 10 percent in the first six months of 2017. There is too much money chasing too few deals. This exacerbates the “power distribution” we explained earlier, because more, expensive failures necessitate bigger outlier successes. This puts all the more pressure on VCs to push their portfolio companies to grow at all costs. And because if and as the market corrects, VCs have to push harder to make up for losses, this incentives misalignment is self-reinforcing, not self-correcting, so it will only get worse.

A Growing Gap Between VCs, Founders

Let me clarify, this post does not aim to criticize the VC industry. VCs and their companies are each rational economic actors coming to respective agreements. We’re not saying that VCs are unfair or pernicious. We are saying incentives of VCs and company founders are inherently misaligned and founders should be aware of this widening misalignment so they go into deals eyes wide open.

Implicitly and sometimes explicitly, this (growing) misalignment leads VCs to over-focus on growth. That, in turn, hoodwinks or at least influences founders to focus too much on growth, too. Our next post focuses on other reasons for VCs’ growth fixations, and then we will share an example of excessive growth ruining a once-great business.

Trilogy Holdings

Based in Austin, Texas, Trilogy Holdings focuses on buying, strengthening, then growing mature business software companies.

Alex Western

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Trilogy Holdings
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