Why Are VCs Attempting to Kill Unicorns?
The startup entrepreneur’s vital analysis of the VC industry’s flawed investment strategy, and how to correct its severe ROI problem.
Approximately twenty-five years ago, Venture Capital (VC) morphed from “visionary” betting to “reactionary” betting on the proverbial racehorses in the startup gate. The fallout that ensued impacted the VC fund’s investors’ profitability to less than zero. Questions whether VC’s are currently committing investment-malpractice, stifling technological-societal growth, and ultimately defeating the intended purposes of VC — by attempting to kill-off the very Unicorns they are allegedly trying to find.
”Since 1997 less cash has been returned to VC investors than they have invested” — Harvard Business Review
It was 1994. There sat the young and unproven jockey, Jeff Bezos, atop his young and unproven thoroughbred Amazon. If the VCs were to bet on this duo in their first race, they’d have won beyond handsomely. Yet, because the thoroughbred didn’t have any official races, and given that the jockey was some unknown lightweight, the heavy-hitter betters didn’t examine the available training statistics to recognize the extraordinary set of circumstances that would likely propel this duo into Triple Crown status, to become the rarest of Unicorns.
As the story goes, Jeff couldn’t initially secure VC for his Amazon startup, so his parents ponied up their retirement savings to bet on the race of a lifetime. They became “visionary” investors in the Amazon business plan, believing their capital would forge Amazon into significance.
So, why did the VCs pass on the Amazon opportunity? And why were Jeff’s parents more capable of envisioning the future, than seasoned VCs?
We don’t have to dig for the granular details, because there already exists a broad pattern of practised industry “reactionary” consensus over three decades.
Affirmed by Amazon and many others you will see later, VCs tightened the size of their Unicorn lasso loops in the mid 1990’s, for what they believed to be more “precisioned roping” of startups that were already off to the races by demonstrating user acquisition and revenues — commonly referred to as “traction” — applied as a litmus test to “react” to.
VC only became interested in investing in Amazon after it achieved traction, ultimately forfeiting priceless equity it could have purchased for less.
Consequences of “Reaction” Versus “Vision”
Presumably, the VC management teams believed they could make more sure bets if the equine had already been proven, rather than betting on a green maiden at the racetrack — thus ostensibly producing higher returns on the VC firm’s investors’ capital.
Considering that 25 years ago and prior, visionary VCs historically achieved 1 significant investment out of 10 success-rate, they eventually became convinced they could increase their success rate to 2 or 3 — maybe even 4 out of 10 investments, by solely investing after development, launch, and demonstration of traction.
This strategy-shift from “visionary” to “reactionary” VC investing is further exemplified by the fact that Pre-Seed (prior to traction) startups are still shunned en masse today, by virtually every VC in town. The often-heard line from VCs to startup entrepreneurs is: “Go build it on your own, then come back to us when you have traction and we’ll help you scale,” i.e., reactionary investing.
We’re not just talking about a handful of VC firms or even a few dozen who’ve taken this same approach. We’re actually talking about nearly the entire VC industry who’ve purposely put on horse blinders to every startup that doesn’t demonstrate traction, to the extreme they won’t even entertain a phone call, let alone a meeting. In other words, VCs are flat out rejecting phenomenal horses (ideas) with capable legs, regardless of their poise in the racetrack (marketplace).
It appears venture capitalists in all their wisdom, have locked themselves into a Silicon Valley group-think mindframe, which they’ve ended up holding themselves hostage with for the past quarter century.
Consequently, not only did VCs miss a 12,000,000% return on Amazon, they missed many other Unicorns, all with similar stories.
Jack Ma of Alibaba was rejected 40 times by VCs and is now worth half a trillion. Vlad Tenev, the co-founder of Robinhood was rejected 75 times by VCs and is now worth $7.6 billion. Jack Smith and Sabeer Bhatia, founders of Hotmail, were turned down no less than 20 times, now worth billions (under MS Outlook). Larry Page and Sergey Brin, founders of Google, couldn’t initially achieve a VC investment, now worth $931 billion. Rob Hull, the founder of Adaptive Insights, was rejected 70 times, now worth $1.6 billion. Marc Benioff, the co-founder of Salesforce was rejected by every VC in Silicon Valley, yet is worth more than $100 billion today.
Apparently, VCs have a track record of looking a gift horse in the mouth.
Win-Ratios Unchanged, Less Than Zero Profits
One might argue, even though VCs have passed up dozens of massive Unicorn opportunities along the way, they must be at the very least “in the money” on more of their investments overall. Otherwise, they’d surely revert-back to funding Pre-Seed startups, right?
Think again. Let’s take a look at the results.
The photo finish line at the VC racetrack today reveals near similar success rates compared to the 1950’s when the VC industry started. Even after the VC’s “reactionary” investment strategy-shift had been employed in the 1990’s; the same metrics have persisted, consistently producing 1 significant winner out of 10 for more than half a century.
Sure, some break-even, and others are fairly “successful”, but they don’t strongly increase the VC fund’s Return on Investment (ROI). Only an intense 1 of 10 may become the tide changer. Even then, don’t let the success numbers fool you, the industry as a whole isn’t profitable, as Harvard Business Review reported.
So if the VCs haven’t been winning the trifecta or superfecta they’d hoped for, what have they gained? And if they haven’t gained, how much have they lost? Furthermore, who else is affected outside of their self-imposed, closed-circle racetrack?
Let’s follow where the hoofprints in the track lead.
Losing Out On Ludicrous Multiples?
First off, let’s understand the purported investment-motivations of VCs; which is to cash-in on the highest valuations possible, having disparately bought equity at the lowest valuation.
For more than two decades the tech markets have been boasting ludicrous multiples of revenues, compared to 25 years ago and prior. Examples: Netscape: 171x, Yahoo: 238x, eBay: 48x, Broadcast.com: 98x, Yelp: 20x, Facebook: 100x, Twitter: 50x, Alibaba: 20x, Snap: 59x, Palantir: 54x, Slack: 45x, Square: 69x, Shopify: 31x, Lending Club: 45x, AirBnB: 50x, Trello: 106x, Nicira Networks: 630x, etc.
If VCs were concerned the higher-multiple markets might wane, it could serve as motivation to invest in later-stage companies to get to IPO or acquisition sooner.
However, higher valuations are persisting. Netflix, Uber, Lyft, WeWork, Dropbox, Tesla, Peloton, and many others are currently achieving radically high valuations and stock prices compared to sales (P/S Ratio), especially considering these Unicorns have never produced profits.
Moreover, higher valuations are not biased to aged startups to warrant exclusive late-stage investing. Hot tech companies started a year ago are equally capable of garnering high valuations and P/S Ratio acquisitions. Groupon was valued at $1.35B at a little over a year old. Six months later $5.3B by Google.
Thus, investing later doesn’t increase the odds of achieving a higher multiple exit. Only perceived valuable tech does.
Loss of Equity & ROI, Increased Risk, Decreased Opportunity
Considering the average time it takes to exit (IPO, acquisition, etc.) is statistically six years, the only seeming gain to invest at the later stage would be to cash-out sooner. But is this really a gain for the VCs?
Not necessarily.
When VCs opt for investing in a tech company at its Series A or B stage, they are also taking a hit on buying equity/shares at a higher valuation. In other words, if VCs had invested $2M in the Pre-Seed stage when a startup initially had a $4M valuation, they would own 33% of the company, compared to investing $10M into a Series A/B at a $75M valuation, owning approximately 12% equity.
Therefore, this determinant question needs to be asked… If a startup were to achieve Unicorn status ($1B) in six years, which investment result would investors in the VC fund rather achieve?
A) $2M invested Pre-Seed @ 33% equity, with $1B valuation in 6 years? = $328,000,000 ROI
B) $10M invested Series A/B @ 12% equity, with $1B valuation in 4 years? = $110,000,000 ROI
In other words, is investing two years earlier worth triple the ROI? Of course! That’s double the ROI on a yearly basis. Not to mention 1/5th the risk, leaving $8M for investing in other Pre-Seed opportunities that might also become a Unicorn.
Thus, in this Unicorn scenario, we learn intentional holding-back from investing in young horses results in increased risk, decreased opportunity, and restrained ROI to the VC fund’s investors’.
Irreplaceable Value of Early Capital
There’s another huge problem, the stifling of technological-societal growth by holding back the early-capital needed to bolster early technological progression.
Somewhere, right now, there is a modern Thomas Edison, Alexander Graham Bell, and Nikola Tesla, who figuratively need capital to develop the next “lightbulb”, “telephone”, and “A/C” electrical current to power those inventions — arguably three of the most important, out of a dozen of the most transformative technologies that ushered in the 20th Century.
It should be noted that each inventor was backed by ample private capital, similar in size to VC in today’s world. Dissimilar to today’s Angel Investor’s smaller capital threshold — which oftentimes is inadequate to produce monumental game-changing inventions.
Bell’s telephone patent became the single most valuable patent in history. Imagine if Edison, Bell, or Tesla hadn’t secured early capital. At the very least, their lack of capital would have slowed technological and societal progression.
Therefore, how many innovative-future Edison, Bell, or Tesla Unicorns are invisible to VCs at this very moment, because they’re “too early” to invest in? (Teaser: There’s a real-time example near the end of this article.)
Missing Out On Dominating the Market
A lean, under-capitalized bootstrap startup takes longer to launch and get to revenue, increasing the risk of a head-to-head race with the competition.
Whereas capitalized startups employ larger development teams, shortening the time to launch and revenue, ensuring the invention is more likely to stay ahead of its sure-to-come competition, i.e., first to market, contributing to potential market domination.
Thus, investing late is detrimental to dominating the market, while investing early empowers the objective.
The story of Alexander Graham Bell’s patent filing timing is the quintessential example of perfectly timed early-capital. Had Bell not been backed with ample capital, it is virtually certain his telephone patent wouldn’t have been filed before his competitor’s patent — which was filed later the same day.
Preferring Cheap & Easy Tech Over Quality Tech
Not only is capital-timing oftentimes essential in dominating the market — but the inverse late-timing of capital — deleteriously impacts the availability of quality technology to invest in.
Let’s see how.
All can agree, one of the major factors in Unicorn-birthing is finding/producing a life-changing or monumental problem-solving technology which has a strong appeal to a massive market, or a life/death necessity to a smaller market with a high-profit margin.
Examples would be the jet engine, microchip, satellite, pacemaker, fiber optics, heart-stents, iPhone, 3D printing, Intuit, Photoshop, Salesforce, biometrics, blockchain, Netflix, Uber, Airbnb.
The key is that none of these examples were cheap, quick, or easy to develop and deploy.
Thus, we learn the simplistic, cheap-and-easy-to-create technologies will naturally be the first to cross the VC’s “traction” requirement threshold, long before an expensive-to-develop magnitudinal game changing technology will reach that same “traction” requirement to get through the VC’s doors.
This is extremely important.
In other words, the VC’s “traction” requirement is de facto designating the potential revolutionary game-changing baby-Unicorns as “lame”, and thereby attempting to put them down before they’ve even examined how fast they could run.
A lemonade stand with neighborhood sales driven by an Instagram post and transactions with ApplePay, literally has a better chance of getting VC attention as a “hot tech startup” with traction.
This partially explains why the VC’s “reactionary” investing track record isn’t as stellar as they’d hoped for 25 years ago. VCs are oftentimes pigeonhole-investing into trivial, cheap-and-easy-to-create tech rather than more expensive problem-solving technologies that change the world.
Startup Entrepreneur 101
An example of a cheap-and-easy-to-create tech company was Yik Yak, a carbon-copy of Twitter which hyper-focused on users’ locations. The app predictably failed. VCs invested $73.5M into the app in repeated rounds to scale the operation, because they couldn’t find anything better to invest in.
Are entrepreneurs’ missing something here? Watch this Bloomberg TV interview with Olivia Sterns asking: “How are you going to make money off this, what’s the business model?” Yik Yak CEO Tyler Droll’s reply: “Yeah, well, right now we have no plans, and we’re not focused on that.”
Isn’t Startup Entrepreneur 101 supposed to include the most important factor — showing how you’re going to make money? Otherwise, what’s the point in investing!
Meanwhile, $73.5M would have gone a long way at the racetrack if it were bet on 73 Pre-Seed game-changing startups. Even with a 1 out of 10 success rate the capital would produce seven winners, with possibly one becoming a Unicorn.
Serious Breach of Ethics?
These kinds of repeated investment-actions place the VC’s in a knowingly errant and practically malpractice position of enticing investors’ capital (based on overtures of handsome ROI) while deliberately bypassing the potential Unicorns they’re supposed to be investing in. Meanwhile, the VC’s are racking up healthy fees as a reward, not for ROI performance, but for booking statistically-projected lower-yield investments.
This ultimately questions the VC’s integrity. Not only is there an appearance of a conflict of interest, but in all practicality one can argue it is an active-ongoing misappropriation of investment funds, because VCs refuse to change their investment strategy to include Pre-Seed opportunities which will produce more winners.
Playing the Odds the Smart Way
Given the nearly 70-year history of VCs winning approximately 10% of the time regardless of strategy, wouldn’t it make sense to spread the capital to as many startups as possible, to produce as many winners as possible? A $100M VC fund, spread to 100 Pre-Seed startups, would statistically produce 10 winners, compared to spreading the same amount to 10 investments in Series A, which would statistically produce 1 winner. Does there even need to be a discussion? Moreover, the first scenario would have a greater chance of producing a Unicorn.
But here’s where the horseshoe meets the dirt.
VCs will likely argue; “We can’t supervise that many startups with our VC team size.”
Entrepreneurial jockeys would reply; “We don’t need VC’s to micro-manage us! We simply need capital, plus on-demand resource-support teams for legal, contracts, capitalization tables, PR campaigns, recruiting, advice, negotiations, clout, and introductions to contacts. Then allow us, startup entrepreneurs, to run the race on our own.”
Entrepreneur’s Recommendations To Investors In VC Funds
Therefore, to be able to maximize the number of deals invested in, as well as simultaneously addressing the entrepreneurs’ preference for à la carte services-on-demand, the investors’ in VC firms would be wise to restructure the VC fees so that they’re tied to the number of successful services rendered to the entrepreneurs. Similar to the way law firms bill clients for hours and services.
Think of it this way, if VCs are “so good” at running businesses as self-touted ultra-qualified business-judges, they should easily be able to run a profitable service-shop 10 times out of 10 by keeping the entrepreneurs attracted-to-use, and happy with their resource services!
Curiously however Harvard Business Review noted; “for founders who have bought into the idea that VCs provide lots of value-added help, it can be a source of great disappointment.”
So when VC’s syndicate-invest a large portion of their fund into high-valuation companies like Uber — valued at $120 billion spring of 2019 with $24.7B raised historically over 23 rounds comprised of countless syndicates — one has to wonder what the VC syndicates’ do to earn their management fees? Certainly all the syndicates aren’t supplying hands-on value-added services to Uber. That’d be like having 25 trainers for each racehorse.
If the fund’s investors’ were to require the VC firms to measurably earn their fees by providing services, it would entice the VCs to spread their investments to more startups.
Entrepreneur’s Recommendations To Venture Capitalists
The entrepreneur’s recommendation for VCs is to harken back to the days of old:
- Open the doors to Pre-Seed opportunities,
- Work to find the monumental game-changers,
- Catch the vision,
- Invest early,
- Secure more equity,
- Render resource-services to grow the startups,
- Dominate the market sooner,
- Increase exit ROI,
- Overly satisfy the VC fund’s investors with more wins and higher profits,
- Help to further technological-societal growth.
Everyone wins: Entrepreneurs, VCs, investors, society.
If the VC’s are unwilling to do the work, or cannot comprehend how to effectively place the most strategic bets at the racetrack, they should be honest and stop blowing ROI smoke, because they certainly aren’t maximizing the ROI flames as promised.
How To Identify Future Unicorns By Pedigree
By now we’ve seen that VCs need to believe to see (vision), rather than see the data to believe (reaction).
But to steer the reins to invest in the faster inside lane, VCs still need to find incredible pedigree to bet on. The typical list:
- Unique; idea,
- Disruptive; problem-solving market-position,
- Massive; market size,
- Defensive; intellectual property, unfair advantage,
- Profitable; monetization structures,
- Talented; execution team the VC’s believe in.
Additional genetic business traits that will likely increase the equine’s speed and rapid ability to grow the Unicorn horn:
- Trend; transactional trend currently occurring in the physical world,
- Software; duplicatable at-scale, aggregating physical transactions through digital platform,
- Exponential; growth-capacity, rapid end-over-end (preferably mobile) adoption,
- Viral; coefficient built-in, garnering extreme public interest, and media sensation.
The first three traits are taught by Marc Andreessen, from one of Silicon Valley’s most recognized VC firms, Andreessen Horowitz.
In Andreessen’s acclaimed article “Why Software Is Eating The World”, Marc beautifully elucidates how entire industries are paradigm-shifted from the physical world into software, by entrepreneurs with vision who are first to uniquely identify a sizeable market-trend in the physical world, then create a desirable software platform that robustly services that market and brings value to the customer and industry. Ultimately resulting in aggregating a significant amount of the industry’s physically spread-out transactional volume through the exponentially-positioned software platform. This template has forged many Unicorns.
Think Blockbuster → to Netflix, or Taxi Cabs → to UBER, or Borders → to Amazon, or BofA → to PayPal. Looking back, it’s easy to comprehend why these software-based companies became Unicorns.
While Andreessen usefully teaches the business traits to look for, he surprisingly doesn’t recognize the near-absolute necessity of early capital to forge extraordinary Unicorns into reality.
Ignored Pedigree = Negative Societal Impact
At the end of Marc Andreessen’s article, he illuminated two physical-world industries that had not yet been disrupted with software, which he opined were “primed for tipping”: Medicine and Education.
Education is foundational to the survival and growth of every economic society. The U.S. economy is dependent on students’ proficiency in science, technology, engineering, and mathematics (STEM). Due to decades-long education-ranking decline, the U.S. is in desperate need of game-changing education technology (EdTech).
Providentially, there’s a vital EdTech in development that will help reverse that decline.
The EdTech’s pedigree? In separate testing environments conducted by Harvard University, the U.S. Department of Education, and other studies, the EdTech’s applied technology taught students 60% faster with 90% longer retention, and increased test scores as much as 40%. Disrupts a physical transaction trend of hundreds of billions of dollars. Has a go-to-market-strategy-access to more than half the schools in America. Is strategically partnered with dozens of Fortune 500 companies. Has patented intellectual property. Led by a capable and genuine team. 100% of students polled want the app, 88% of teachers, principals, and school districts, and 91% of parents.
What more could VC’s ask for! Yet this vital technology is senselessly being shunned. The reason? You guessed it. The EdTech is Pre-Seed. VC’s are literally expecting the entrepreneur’s to build the technology without any capital, before they will invest. Talk about putting the cart before the horse!
The severity of this true story is being experienced by the author writing this article, compelling him to sound the “wake up!” alarm as a teaching moment. VCs are literally stepping over potential billions, to quarrel over the penny-opportunities. Meanwhile, all of society is losing as a result.
Cracking the Whip
The fact that VCs are blatantly passing up Unicorns should be the burr under their saddle to move in a different direction. Yet the VC’s continue to bet on the same ill-fated racehorses, while insanely expecting a different result.
They’re defeating the entire purpose of Venture Capital: To propel the most revolutionary technology in exchange for earning handsome ROI.
The accredited investors, investment banks, and institutional investors investing in the VC’s fund need to crack the whip to coerce the VC tack — into higher returns just waiting to be claimed.
“Seabiscuits” are out there for VCs to find. They just need to take off the Pre-Seed blinders to see them. Until then, you can lead a parched VC directly to ever-flowing water, but you can’t make ’em drink.
Note: If you are an entrepreneur reading this, immediately send this to five entrepreneurs you know. Be the groundswell movement to change VC to help yourself get funded!
Patrick J. Leddy is a 23-year serial entrepreneur in diverse physical and digital industries. He has founded, directed, and advised dozens of startups, earning the reputation as the ‘go-to’ guy for everything business.
You can connect with him on LinkedIn, or follow his current entrepreneurial inventions and endeavors on BillionDollarListing.tech.
