(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.