(A continuation of a series, which was introduced here).

Modern venture capital is obviously successful, as demonstrated by the fact that five of the world’s six largest companies were funded by it. But success is as much about what you say ‘no’ to as what you say ‘yes’ to, and venture capital is no different. In addition to delivering massive collateral damage in the course of its work (more on that later), the prevalent VC model rejects all ideas that do not fit within its narrow definition of a “suitable” investment.

The primary contributor to this wholesale rejection is how VC delivers returns, so to understand why it’s broken, we must understand how it works. In this article we’ll go deep on how VCs get their money, how they turn that into more money, and what that all means in terms of what ideas they can and will back. Note that we’re focusing here on the ideas, not the people; the structural biases against women and people of color will be discussed in later essays (but it’s worth recognizing that they’re just as baked into the model). Ross Beard’s The Innovation Blind Spot goes into great detail on this topic.

Venture capital firms generally have managers and limited partners; the managers are the people we think of as the investors (they sign the checks), and the limited partners are the investors in the VC firms themselves; they’re “limited” in the sense that they have ownership in the VC firm, but no real control. They don’t actually invest in companies or VC firms; they invest in an individual fund, and all of the work done in investing is built around the fund, not the VC firm. This is partially why you might have seen an investor leave a firm, but stay involved in investments from the old firm: the investor is still on that fund even if they’re not at the firm anymore.

Most limited partners are very large financial institutions, like CalPERS or a university endowment, and they work with venture capital as part of a diversified investment strategy. They have pockets of money in all kinds of places, and venture is added in to ensure they have some high risk/high reward investments. These don’t necessarily even deliver better returns (and in general, VC as an asset class does not do that well), it’s really there to get the right mix of risk in the portfolio. In most cases, the LPs are represented by people who would not fit in at a venture firm, because they’re usually finance people at governmental or non profit institutions.

A fund is raised by investors (“managing partners,” in this context) seeking money from high net worth individuals, institutions, and anyone else with a lot of money lying around. Money is committed for the life of the fund; and except for rare cases, limited partners cannot just pull their money out, they must wait for companies to mature and either sell or go public.

One of the strange things about these funds is that they are explicitly modeled as long-term investments. Limited partners invest with VCs as a means of putting money to work over something like a ten-year period. If the money all gets returned quickly because of an exit, it throws off the spreadsheets, and they quickly have to find somewhere else to put the money. This sounds silly, but it does have a real impact.

Venture capitalists take the LP’s money and use it to buy stock from startups. Once invested, the fund holds a bunch of stock instead of a bunch of money. Crucially, this stock is all in private companies, which means it’s generally illiquid (i.e., you can’t easily exchange it for cash). It’s also usually preferred stock, which means the investors get a few extra terms around control and how cash is distributed if there’s a below-value exit.

If this were a traditional fund like you might buy in a brokerage account, there would be plenty of ways to make money, and the investors could deliver returns however they wanted; they could rely on growth, dividends, sales, or anything else. However, VC funds are limited partnerships with strict rules about what can be done with the money. No matter where you are in a fund cycle, if a company gets sold for cash, you have to distribute that cash to your investors (keeping 20% for yourself, of course — that’s called the carry). You can’t reinvest it in another company. (This is only generally true; firms that don’t have this restriction are called evergreen funds, and are usually funded by a single institution or family.)

This distribution on an exit is the primary mechanism for VCs to return capital to their investors. The other way is for a company to go public. This is a weirder one — it’s discussed as an exit, because it allows investors to return capital to their LPs, but it does not convert shares into cash. The difference is that the stock is now liquid, which means it’s basically equivalent to cash; the VCs distribute the now-public shares to their LPs, who can now all trade it in for cash whenever they want.

Ironically, distributing shares to LPs is a big risk to the company that got funded by the VC— if fifty percent of a company’s stock is owned by investors, and they distribute all of that stock to their LPs the day a company’s lockup period ends, what do you think the LPs would do? Well, they’re not experts in tech, or high growth companies, and more importantly, this stock doesn’t fulfill the same needs as the VC fund did in their asset allocation, so they sell it. Of course. And what happens to a newly public company who finds that fifty percent of its shares are suddenly sold on the public market? The stock gets hammered, because a huge upsurge in supply means an equivalent drop in price.

That’s why VCs distribute shares over a broader period of time, usually 18–24 months. They have some flexibility in how this is handled so they can protect these newly-public companies.

Ok, now you understand how it all works — how venture capitalists get money, make money, and then give it back to their investors in turn. Why does that matter?

It matters because there are only two ways for a VC-backed startup to be a success for its investors: Go public or get bought. As the CEO of Puppet, I always said any company has four options: Go broke, go public, get bought, or stay private indefinitely. If you take VC money, that last option is off the table.

It’s worth saying again: You take VC, you are committing to getting bought, going public, or going broke.

Crucially, that means that investors must push you into one of those outcomes. The reason they deride private businesses that generate cash isn’t because they’re bad businesses, it’s because they’re structurally incapable of profiting off of them. Their system is limited to valuing sales or IPOs; nothing else can have value to them, because nothing else allows them to make money.

This means that if you’ve got a great company that’s taken some VC but is at real risk of settling into a mere twenty percent growth rate with a sight to profitability but only making, say, $30 million a year, they’re going to push you out of that comfort zone. They have to. They’ll ask you to raise a “growth” round so you can “really scale this thing”, or they’ll try to sell the company. If that doesn’t work, they’ll just fire you and put someone in place who will do it for them. It’s not because they’re evil, it’s because their contracts essentially require it. They can’t return the stock of a private company to their LPs, so what choice do they have?

Now that we understand how investor behavior is driven by how capital is returned to investors, let’s discuss what it means to the technology startup ecosystem as a whole. (There are VCs for things outside of tech, but the asset class was basically invented for technology, and that’s where it is centered.)

If you’re seeking funding for your technology company, you essentially have to promise that you can and will sell your company for an outsized return, or that you can and will take it public. In reality, almost no one invests with the expectation of a sale; they’re all betting on an IPO, recognizing that a sale is a good second option. It doesn’t matter if you can generate a ton of profit; they have no use for that. In fact, it might get awkward if you started distributing dividends.

This has two big consequences. The first, of course, is that companies that don’t have a realistic shot of going public can’t get venture capital. This is a striking constraint, given how much of our economy consists of small, profit-generating businesses that generate jobs and cash locally, whereas the ranks of public companies that distribute returns only to the investment class have been shrinking for decades. The story they’ll tell you is that only those really high-growth companies “need” VC money, but it’s much simpler than that: Their business model doesn’t work if your company doesn’t sell or go public.

Bank loans do ok at providing funding for low-risk actions by mature companies, and VC does well at funding high-risk companies with the chance to be huge, but there’s a huge gap in the middle that struggles to get any funding. (Both of these funding mechanisms in the US also suffer from being overwhelmingly biased toward only funding white men, but that’s a different essay.) Medium-risk companies often do need funding, but can’t get it, which in many cases means the businesses either don’t exist or end up much smaller than they could be.

The second major consequence is that a lot of companies are able to convince themselves, and thus investors, that they could get big enough to go public. Yes, this is sometimes true, but in so many cases it is instead a lie that both parties tell in order to get the funding done. If you love your company, and the only way to keep it alive is to promise to keep growing, you will. You understand the risks, but they’re better than just letting your company die.

In too many cases, this absolute demand for continued growth is exactly what kills companies. They never learn the operating discipline necessary to generate cash (which, in the end, actually still is king), and they get too big to sustain themselves. At some point, the lie gets out, they can’t get more funding, the fundamental unsoundness of their business model becomes clear, and the whole thing deflates.

When you hear a VC say you should focus more on growth than cash, what they’re saying is “You should worry more about my ability to return capital to my investors than your ability to still have a company in a few years.” It might be that growth is the right thing to invest in, but it isn’t automatically the right thing, and it’s at least fair to say that the investor is not a neutral party in this recommendation.

So now we see that so much of what we find poisonous in the world of venture capital is actually the result of how returns are distributed to investors. The growth-at-all-costs mentality, the huge amount of dead companies, pushing employees to work to the bone until you get an exit, and much more can be laid at the feet of this simple constraint.

I don’t know if there is an alternative model that will work in the world of high-risk tech startups, but I do know there are plenty of other investment models that are able to deliver returns without introducing this kind of dysfunction. Conglomerates like Berkshire Hathaway are able to own significant chunks — or even the entirety — of companies and deliver great via growth, dividends, and clever use of float. This provides them the flexibility to let their portfolio companies choose their own best means of returning capital to investors. Coincidentally, Berkshire Hathaway is the one non-VC-backed company in that list of six largest companies.

If our industry could develop a funding model that was as compelling to founders as is the current venture capital model, the dysfunctions that we’re experiencing would be reduced as businesses naturally gravitated to whichever fit them best.

Fundamentally, venture capital isn’t causing the dysfunction in the markets; the lack of alternatives to venture capital is.