Venture Capital Isn’t Good For Us…

A thought experiment into how Venture Capital could improve wealth equality, but probably won’t.

Aidan Kenealy
Apr 24, 2020 · 6 min read

I had an ‘interesting’ chat with a VC last week and it got me thinking…

Straight up, the vast majority of international Venture Capital is a Ponzi scheme.

Here’s why.

VC’s make their primary income via a ‘funds under management’ fees. This is usually a 2% p/a fee of total funds under management. Thus, for a VC to grow their income they need to raise sequential funds.

The VC model is to raise funds from investors and allocate portions of these funds to companies over sequential capital rounds. Each capital raise results in a valuation higher than the last, bringing a paper return to the fund. The VC’s point to the ‘growth’ of the old fund and leverage this fact to raise even bigger funds from investors. This allows them to start the whole process all over again, just at a larger scale, and earn more fees.

As an example, a VC may raise a $20M fund, let’s call it Fund 1. This fund would result in an annual income of $400k for the VC. After a few ‘successful’ capital rounds in its first year, Fund 1 now looks like it’s returning well. On this basis, the VC raises a $200M fund, let’s call it Fund 2. Annual fees for Fund 2 are now $4M. That’s a 10x increase in annual income for the VC within 24 months.

VC’s are in the business of fundraising and allocating capital, not backing sound businesses models. They back business that can spend money, and the quicker they can do it the better for the VC.

This means VCs don’t typically back companies that can support their growth with retained earnings as it doesn’t fit their model for growth. They grow to slowly and don’t have the need for extensive capital. And, as long as a company is reliant on venture capital to grow, the VCs don’t really care about what the company produces, or how.

The effects of this model are profound.

This model produces what biologist term an ‘evolutionary constraint on a natural ecosystem’, where something artificial influences the natural outcomes of the system.

The game is to inject a business with cheap capital and instruct the company to spend. This creates an evolutionary force that selects for companies that can spend money and grow on a user acquisition metric, not for business models that produce value for society or even make commercial sense.

Survival of the fittest is therefore influenced not by what a company produces, but by whether it can work out how to deliver its product in a way that fits the VC growth model. With the VC’s being the only funding option for many startups, this creates a bias within the ecosystem that affects how all startups form and grow.

The consequence of this bias in the startup ecosystem then plays out as follows.

First, the most ‘valuable’ companies coming out of the private markets are all geared up for nothing more than raising capital to capture a user. WeWork was the comical exaggeration of this pushed to the extreme, and, thankfully, we have now found the upper limit of what the public market is willing to accept out of Silicon Valley.

The second is that the general public misses out on the opportunity to benefit from the capital growth these companies produce. By the time these companies get to IPO all the value has been captured by the VC’s.

The third is that many of these start-ups entering the public markets rapidly lose value due to their artificially overvalued stock prices and poor commercial fundamentals.

In May 2019, Uber IPO’d with a share price of $45, giving it a market cap of $82.4 Billion dollars. This valuation was in spite of Uber's second-quarter losses of $5.2 billion dollars…. Its share price has since halved, meaning $36 billion dollars has disappeared in less than a year.

This is the Ponzi scheme. A few get rich inflating the price of startup companies on the private market, and the majority suffer losses when they go public. It’s all a consequence of how the VCs generate their returns, invest, and then govern companies.

So, what does this have to do with wealthy equality? It’s a good question and one that’s important and timely to ask in the midst of COVID-19. This is because there are always two things that become very clear during periods of crisis.

The first is how we rely on our low wage labour force, time and time again, to get us through periods of crisis. During the Australian bushfires (only four months ago), it was the volunteer firefighters that saved the day and, through this pandemic, it’s the orderlies, nurses, checkout workers and courier drivers that have kept society going. Our lowest-paid workers are the true MVPs of our economy and it’s simply a fact that we need these people to maintain our society.

The second is how, without fail, this group of society are the ones disproportionally affected negatively in the aftermath of a crisis. They have minimal assets, low wages, substandard housing, and jobs most at risk of being made redundant.

They simply can’t weather the economic consequences of a crisis like the wealthy can.

This is a major problem for society as a whole as we are seeing more server disruptions caused by natural events, at larger scales, as our global population grows and the planet warms.

We need our courier drivers, nurses, and warehouse pickers to weather these crises. We, therefore, also need them to be able to live with means and dignity before, during, and after these crises if they are to continue to help us through them.

It’s not good enough that in times of prosperity, we forget this and accept that it’s OK to distribute capital and wealth to businesses that favour a few yet produce little actual value for society.

This needs to change. Here’s how.

We start by first admitting that both ‘shareholder value at all costs’ and ‘growth at all costs’ mentalities are no good for a fair economy, society, or global sustainability.

Second, we invest in VC’s mandated to back companies that value capital efficiency and reasonable growth with foreseeable profitability.

We want them to be backing companies that produce things of value and build proper businesses upon solid, time tested, commercial principles. Businesses that account for all stakeholders, ensuring their social and environmental impacts are accounted for and are in line with profitability, not sacrificed for it.

This removes the evolutionary constraint from the startup ecosystem and allows for better, more meaningful and innovative business models to develop.

In doing so, yes, VC’s will no longer see 1000x returns, and yes, they will no longer be the sole benefactors of the capital gains of the successful high growth businesses. But, WE, the general public will have more companies, building more things of use, employing more people, that are more resilient to the increasing number and severity of the crises we are encountering globally.

Let’s be clear, I’m not naive enough to think this will actually happen. VC models are incredibly efficient at hoarding wealth and power, both for the VC and the startup founders. Greed and individualism will always trump a better way to do things for the commercial and social good of many. I’m happy to be proven wrong on this, though!

A further potential consequence of such an investment approach would be more companies IPO’ing earlier. If this were to occur, then the public markets would recapture the capital gains of successful high growth businesses currently only available to the venture capital and private equity firms.

Companies like Sharesies here in New Zealand, who offer anyone the ability to enter the stock market with small value investments, can then provide a way for the low wage public to take advantage of their growth.

Offering a simple and clear way for the general public to gain exposure to high growth start-ups would go some way to improve the economic situations of low wage workers.

So to sum all this up, VC’s are the gatekeepers of capital for start-up businesses. We need to challenge them to change their business models and return requirements so they will change the business models they invest in. The downstream effects of this will be more useful and robust companies, and it may also provide us with the opportunity to expose more people to the financial benefits of the capital growth successful startups can bring.

It’s worth a thought.

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