Misaligned Incentives in Venture Capital
The difference between optimistic and self-interested
As an outsider who had no plans to join the venture capital industry, it turned out to be a whirlwind of unexpected people, norms, and behaviors.
A quick background on myself: I grew up outside of Chicago, was a film major at Northwestern, spent six years in LA as a digital media strategist, and backpacked through Europe for 4 months by myself in 2016. I’m hardly your “typical” venture capitalist. Which (I think) makes my perspective a little different than normal. When I moved to San Francisco and joined a venture capital firm in January 2018, I somewhat quickly became skeptical and cynical about the industry.
Here’s the deal: the overall goal for everyone in the VC community (whether Managing Directors, General Partners, Operating Partners, Principals, Associates, Analysts, or any other titles like “investors” …) should hypothetically be to return as much capital as possible to “LPs,” or Limited Partners (the wealthy individuals and institutions who invest in VC funds).
The problem that I noticed early on (and I’m not the first), is that the incentives are simply not aligned between the LPs who invest millions of dollars in VC funds and everyone else in the VC ecosystem. Very few people that I met had any interest in the returns of their LPs versus their own personal ambitions.
Analysts, Associates, and Principals are incentivized to get as many deals “done” as possible internally. The more companies these junior VCs can get their firms to invest in, the better their odds of having a successful VC career are. The average junior VC has two years to prove themselves worthy of a promotion, so in the timeline of startups there are no rewards for passing on companies — only for actually making investments. Further, junior VCs are incentivized to pass deals around to other junior VCs regardless of quality — not only for mutual “deal-flow,” but for potential future job opportunities — whether at another VC firm or startup that they make introductions to investors to. In this context, VC analysts / associates / principals are highly incentivized to be the most optimistic salespeople, regardless of their conviction in the long-term viability of any startup. As a contextual marker — essentially no current junior VCs have ever lived through an economic downturn… they’re the ultimate optimists.
New General Partners: There are more VC firms than ever before. There is more LP capital than ever before. The only way to raise a new VC fund is through storytelling: explaining to potential LPs how and why you have an advantage versus the rest of the market. For new fund managers, it’s all about dealflow and sourcing. The primary way to build dealflow is through your network and reputation — both of which grow primarily through volume of investments. Making 10+ investments per year grows a network and reputation more than making 6 investments per year. The best narrative for a potential LP is a list of your previous investments, network, and notable co-investors.
Let’s set two examples:
Alpha Fund #1: Invests in 25 companies in year 1, and now has, 25–50 founders / logos, and allies in the startup community. When raising Alpha Fund #2 in 1–2 years after launching Alpha Fund #1, Alpha has a much more vast network, deal flow, co-investor network, and can focus the narrative on the most successful of 25 portfolio companies.
Beta Fund #1: Invests in 6 companies in year 1, despite seeing the same amount of pitches as Alpha Fund #1. When raising Beta Fund #2, fewer entrepreneurs recommend Beta Fund, fewer investors have co-invested with Beta Fund, and the 6 Beta Fund #1 portfolio companies are under the microscope.
It’s too early for both Alpha and Beta Funds to report reliable IRRs and other relevant financial metrics, so which do you as an LP invest in?
Tierhood: Much like high school or college greek life, the investor community features tiers of venture capital firms based on reputation and historical performance.
The “best” investors pass down deals that they are not interested in to “lower tier” partners, who feel fortunate to have a top tier investor recommend something to them, and are more likely to make investments if they were “sourced” from a top tier firm. This is “trickle down economics.”
All VCs: One of the less discussed jobs of venture capitalists is the salesperson. Not only do VCs need to sell themselves to entrepreneurs in order to win the best deals — they also need to sell their portfolio companies to other VCs, regardless of their current conviction in a company. This is a little bit like “hot potato” — if a firm can convince another firm to invest in a subsequent round of their portfolio company at a higher valuation — they can show a markup on their investment to their current (and potential) LPs! Regardless of their honest assessment of the company…
All VCs live in between LPs and the actual backbone of the industry — entrepreneurs. By investing in a lot of entrepreneurs, regardless of the probable financial returns of their companies — investors have career options. Founders they backed (with someone else's money) may feel indebted to them down the road, and hook them up with other opportunities.
The most egregious misalignment I’ve yet to address is probably the most commonly written about— management fees. VCs are paid handsomely whether they succeed or fail. You can read more about that here.
Traditional VC “logic”
The prevailing logic in venture capital is akin to a prisoner’s dilemma: It’s better to invest (and be wrong) than to not invest (and be right).
Essentially, missing out on Amazon is orders of magnitude worse than investing in Pets.com.
This is embodied in David Tisch’s comments to Fortune, where he says: “The cost of missing something is much more expensive than the cost of funding a bad company. If I funded 100 bad companies, and I funded WeWork, my returns would be perfect,” he goes on, “In order of things I care about, the thing that bothers me the most is not seeing a company. The second is seeing a company and not investing in it when I should have. The third is seeing a company, investing in it, and seeing it not work — that is at the bottom because part of my job is to make mistakes, whereas for the first, I would have wanted to have the choice to make the mistakes.”
How the best of the best do it
In an industry full of self-interested salepeople, Kathryn Gould was a standout. Over her career, she had an unbelievable 90% IRR. She was not a believer in funding 100 bad companies to find one “WeWork” (101 bad companies?…)
One of my favorite quotes from her also strikes me as the most badass, well-aligned, best LP-pitch phrase of all-time:
“You also hear VCs talk about how one company in their portfolio will be a huge winner, two or three will be also-rans, and the rest will be write-offs. Well, that’s bullshit. I didn’t go into a deal unless I thought it was going to be a winner. All 10 had to win, that was my attitude. A lot of VCs run and hide, but I worked hard, I was a good fixer, and I earned my money.” — Kathryn Gould
For most Americans, their job and responsibilities are clear-cut. Somehow, one of the most prestigious and cushiest careers in history also happens to be one of the most conflicted. It’s reasonable to understand why many in the venture community would invest in companies they don’t have 100% conviction for — the cost of missing out is high, reputations and networks are at stake, and fundraising is really just storytelling.
So, new fund managers, GPs, and junior VCs are all highly motivated to make many investments over making convicted investments.
But for the prospective LPs out there — I suggest you find the real deals — the Kathryn Goulds of the investing community who don’t compromise quality for quantity. Those who say “I didn’t go into a deal unless I thought it was going to be a winner. All 10 had to win, that was my attitude.”
Now that’s alignment.