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Why Venture Capital Misses The Big Ideas

September 12, 2017

6:30 pm

For most people, “innovation” means what we invest in: Where’s the next Uber or Lyft? But there’s been very little innovation in how we find ideas. As one tangible example, most of the venture capital process today is a “one size fits all” system that has its origins in nineteenth-century whaling.

The following is an excerpt from my new book, The Innovation Blind Spot: Why We Back the Wrong Ideas – and What to Do About It, out today – September 12, 2017.

The Innovation Blind Spot by Ross Baird

“To accomplish his object, Ahab must use tools: and of all tools used in the shadow of the moon, men are most apt to get out of order.”
—Herman Melville, Moby-Dick; or, The Whale

A HISTORY OF THE CHASE: FROM THE WHITE WHALE TO THE UNICORN

Before the dawn of electricity, cities powered their streets and lit houses with the most efficient form of energy on hand: whale oil. Long before the days of ExxonMobil, whaling was a wildly profitable industry; according to Harvard professors Tom Nicholas and Jonas Peter Akins, returns on investment for a whaling expedition regularly reached three times the return in agriculture. Naturally, wealthy families sought to invest in whaling ships. But unlike putting up money for a new tavern or planting a crop, whaling was an expensive pastime. The typical voyage required an up-front investment of up to $30,000, nearly ten times the operating cost of the average manufacturing firm. Even families with money could rarely finance a voyage alone. And the voyages were risky: one in three lost money, and only a few netted huge returns.

People wanted to invest in whaling expeditions, but didn’t know how. In the 1830s, a cottage industry was born out of this dilemma. A new class of independent “agents” began to pool money from multiple families, recruit a ship and a captain, and assume responsibility for the voyage. If the voyage succeeded, they would split the profits from the sale of the whale oil among the investors. With the help of agents, investors were now able to finance multiple voyages at once. As “limited partners,” they weren’t allowed to second-guess the captain’s decisions. Their capital was spread across multiple voyages, so one very lucrative tour could offset the loss of another ship.15 Today’s limited partnerships in venture capital use much the same model, hardly changed from the 1800s. But it doesn’t end there.

To finance the day-to-day operations of whaling voyages, the agents, investors, and ship captains developed a structure for who got paid what. At the end of a voyage, the crew would return to port with their whale fat, known as their “carry.” The crew would get 20 percent of the carry, with investors retaining the other 80 percent. (Moby-Dick describes a spirited argument in which the crew negotiates about the “lay” they get after the voyage—the percentage of the carry.) Meanwhile, the captain would negotiate a percentage of the whole investment—say, 2 percent—to cover the cost of buying food and supplies for the crew. This “two and twenty” structure would eventually be copied and pasted for investing in startups.

Investors tried many other business models, but “two and twenty” would carry the day. Over time, the venture capital industry developed the now-canonical rule for management fees, and the term “carry” is still widely used. But today it’s being used to chase unicorns rather than whales.

UNTAPPED COMPANIES: BIG FUNDS LEAVE BIG GAPS

“Two and twenty” is hardly the only thing wrong with the venture capital process, but it’s one example of a structural problem that makes all our other problems more difficult to solve. In the introduction we spoke about the Procrustean bed—the danger of forcing a square peg into a round hole even if we scrape off the edges in the process. Venture capital has been stuck in the Procrustean bed of “two and twenty” since its early days, and the scraps of mangled edges are starting to pile up high on the floor.

But the process that worked so well for the titans of the whaling industry is causing us to miss out on companies today. A 2014 Harvard Business Review article, “Venture Capitalists Get Paid Well to Lose Money,” illustrates how the “two and twenty,” one-sizefits-all model can result in misaligned incentives and a blind spot for innovation.

To start, fund managers always make 2 percent fees on their “assets under management”—regardless of the fund size. If the fund is large, managers make good money regardless of whether the companies succeed (the median partner’s salary at the average venture capital firm in the United States is $750,000).17 So managers have an incentive to build as large a fund as possible, and that’s where the problem starts: if you’ve got a $1 billion fund, you need to decide how to spend large amounts of money very quickly. According to a 2013 World Economic Forum report, it takes the same amount of time to conduct “due diligence”—deep research investigating investment quality—on a $10 million investment as it does on a $100 million investment. So large investors will almost always go for the larger deal—or the one that fits patterns that are easier to understand.

The two-and-twenty structure encourages investors to raise as large a fund as possible, meaning they are more likely to overlook ideas that seem “too small.” Let’s get back to Jerry Nemorin. When he was originally raising money for LendStreet, he noticed that very few venture capitalists understood the problem of private debt refinancing. “In the Valley,” he said, “people are looking to solve their own problems, looking for things to build for the top 10 or 1 percent.” When you’ve got major incentives to raise a large fund and a serious time pressure to deploy capital, you likely won’t take the time to learn about debt refinancing. This oversight is unintentional, but it means that ideas outside the mainstream struggle to raise money.

INUNDATED BY IDEAS, WE LACK THE TOOLS TO EVALUATE THE BEST

The problem with innovation does not come from a lack of ideas. I’ve probably seen, in my career, over five thousand examples of “Famous Startup X for Industry Y”—think “Uber for tennis coaches” or “Kickstarter for nonprofits.” If you’ve ever played the game Mad Libs, you can generate a hundred ideas in an hour.

Most venture capital firms I know hear about a thousand new ideas a year. According to a recent Harvard Business School study, the average firm spends a total of three minutes and forty-four seconds evaluating each pitch deck. Out of those thousand ideas, a firm will invest in a dozen at most.

Humans are genetically predisposed, when we’re facing information overload, to save time by making rules. This has been in our DNA from the beginning: animals with big teeth are bad; water is good. Gerd Gigerenzer, of the Max Planck Institute in Berlin, calls decision-making rules “fast and frugal” heuristics: we can’t possibly analyze all the information in front of us, so we develop shortcuts.

But these shortcuts exclude most of our best ideas. Why does almost 80 percent of startup investment go to just three US states? Because that’s where the money lives. Only four of the top twenty-five most active venture capital firms in the country were headquartered outside New York City, Boston, and San Francisco. Why does the majority of startup investment go to founders who are white, male, and from connected networks? Because that’s who investors know from their networks and their personal lives. We all have biases that affect our decision-making, but as psychologist Khatera Sahibzada puts it, “Because of the pressure and uncertainties investors face in making decisions, any bias factor can be amplified and become detrimental.”

We’re much more likely to see millions go to a company that delivers food faster to yuppies in urban areas than one that helps struggling rural families simply put food on the table. Because venture funds are under extreme pressure to deliver quick profits to investors, they prioritize short-term value capture over longterm value creation.

IS BIGGER ALWAYS BETTER?

Diane Mulcahy of the Ewing Marion Kauffman Foundation analyzed thousands of venture capital funds and their performance and found one surprising result: over time, smaller funds significantly outperform larger funds. In the banking and asset management industry, people often think that bigger is better, but in the venture capital process, that isn’t necessarily true.

We may have set ourselves up for failure. Venture capital partners have an economic interest in raising massive funds. But the size of the fund is often negatively correlated with the returns that it provides to investors. This isn’t because the partners aren’t smart or well intentioned. It’s because partners have lots of money to deploy quickly. And entrepreneurs who aren’t in the system may die on the vine.

Not all venture capitalists think that bigger is better. Many venture capital funds have built the right fund, for the right size, to solve the right problem, rather than raise as much money as possible. Fred Wilson, founder of Union Square Ventures, is one of the most successful and thoughtful venture capitalists in the industry. He’s invested in Tumblr, Lending Club, Foursquare, and a dozen other companies whose services you may have used. Wilson has kept the size of each subsequent fund at about $150 million, which is small for a venture capital fund. In a blog post after the closing of his last fund, Wilson wrote, “The goal of VC fund economics is to incent the partners to focus on carry and not on current cash compensation. . . . [The system] can break down as the dollars under management get larger and larger and the management fees turn into huge numbers. We have purposely kept USV small to avoid that. And I think that has been a good decision for us.” Union Square Ventures could have $2 billion under management, based on their performance, but has decided to stay small in order to innovate.

Venture capitalists Brad Feld and David Cohen cofounded a group called Techstars that provides small funding to batches of companies through a program known as an accelerator. Techstars now provides funding in the $100,000 range to groups of companies in Boulder, Austin, and New York, and has recently arranged partnerships with Ford in Detroit and with Target in Minneapolis. Like Union Square Ventures, Techstars could raise a $2 billion global fund but has decided to invest in new ideas through a hyper-local model.

Globally, investors Dave McClure and Christine Tsai founded a group called 500 Startups in the Bay Area, which has launched $10 to $20 million micro-funds around the world (as 500 Luchadores in Latin America, 500 Kulfi in India, 500 TukTuks in Thailand, and so on). Instead of setting up a Mexico City, Bangalore, or Bangkok office, McClure and Tsai recruit local fund managers, seed their work with a small base investment, and rely on those fund managers to invest in the ideas they can see on the ground.

Thinking with intellectual curiosity and self-awareness about how we invest is critical, because the way we structure our investments shapes who and where we invest.

The Innovation Blind Spot book by Ross Baird

Read more about funding on TechCo.


This was an excerpt from Ross Baird’s book, The Innovation Blind Spot: Why We Back the Wrong Ideas – and What to Do About It, released on September 12, 2017. Ross Baird is founder and President of Village Capital, a venture capital firm that finds, trains, and invests in overlooked entrepreneurs solving real-world problems.

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Executive Director of Village Capital; also teach at University of Virginia. Enable entrepreneurs to solve major global problems. Big fan of University of Virginia basketball and the MLB Atlanta Braves.

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