3 Signs Early Stage Venture Capital Is Losing Its Way

The genesis of the modern venture capital industry is most often traced back to a man called Georges Doriot, widely acknowledged as the “father of venture capital”.

Setting up the American Research and Development Corporation (ADRC) in 1946 with three partners, Doriot pioneered a new type of financing that provided equity investment to very early stage companies, many of which were founded by soldiers returning from World War II.

As well as the novel financing approach ADRC took with its investments, it also began democratizing the limited partner universe beyond wealthy families, and graduated alumni that went on to found several prominent firms, including Greylock Partners. Much of this success was down to Doriot’s principled approach to investing that has relevant lessons today.

Doriot believed many things, but at its core, he saw investing as the creation of a deeply personal relationship with founders. This meant getting to know each founder’s family, sharing the highs and lows of the entrepreneurial journey, and being emotionally invested in each company’s mission. On a practical level, Doriot and his team would work hard to support ADRC’s investments with their expertise and access to their network, and, ultimately, saw themselves as company builders.

Today, the abundance of capital in the market has seen the principles Doriot – and most other early practitioners – held dear watered down or abandoned in favor of business models that look more like those applied in the public markets.

Indexing

A decade ago, when firms were described as adopting a ‘spray and pray’ approach, it was not typically meant as a compliment. It was a strategy that involved making investments into lots of companies – perhaps as many as 50 or 100 per year – and seeing which ones would survive.

After the cheque was written, the investor would not provide any support to the founder as the business model does not allow for it, even if the marketing of the firm said otherwise. The investors spent all their time fundraising, sourcing, and executing investments, leaving no time for anything else. Today, this approach is more kindly referred to as trying to ‘index’ the market (in other words, trying to build a fund that tracks the overall performance of the early technology market).

However, a new name does little to hide how far this approach strayed from the initial vision Doriot had for the venture capital industry, where investors were meant to help and support the companies they invested in, build strong personal relationships with the founders, and be emotionally invested in the journey. Seeing founders as an asset class and not as a group of unique humans may seem like a nuance to some, but it is a core philosophical difference between Doriot and these indexing funds.

A high-volume, indexing approach can be challenging for founders. They will necessarily get less time from their investor at all steps of the investment process and particularly post-investment. This can lead the relationship to feel transactional with the only value being delivered in the form of cash.

Founders following the oft-stated advice to optimize their shareholder base – or cap table – so that every investor adds value in some way, should be wary about investors that either admit – or are known – to be entirely passive. 

Misalignment On Value-Add

A report last year by Forward Partners and Landscape.vc – More than money – found that 59 percent of founders report a negative experience with value-add compared to what they were promised.

In all other service industries, this would see founders vote with their feet and fire their advisors, but the long-term nature of the investing relationship means this is not a viable option in the venture business.

For Doriot, who saw his role as doing whatever he could to make his founders successful, these findings would make for unhappy reading.

Taking the most charitable interpretation, funds are promising to help their founders, but find themselves without the capacity to do so as a result of competing priorities. In the worst examples, funds are cynically making promises to founders that they know they will not be able to keep. In other service industries, this would be viewed dimly as a form of misrepresentation, and have serious professional and reputational consequences.

Some investors argue that their job is to finance a company and then step out of the way to let the founders build. This can work if the founders are experienced entrepreneurs but is a missed opportunity for the vast majority who would benefit from being provided with well-placed support and guidance.

In a competitive funding environment, it is unlikely that behaviors will shift back to the ideals imagined by Doriot when he started ADRC. Funds will often say whatever they need to win a deal and then disappoint the founders post-investment. The emphasis, therefore, falls onto the founders to do their due diligence before accepting investment.

Figuring out the deal volume of each fund, who at the fund will be involved with your company post-investment, how they will offer value-add, and conducting extensive references from portfolio companies and the ecosystem are all essential steps to make an optimal decision.

Longer-term, founders making the most informed decisions they can is also healthy for the ecosystem as funds that are not delivering what they claim will be unable to win the highest quality deals. 

Fees

The two and twenty fee arrangement common across most venture capital funds requires investors (limited partners) to pay for all of a fund’s operating costs. The result is that when a fund invests in a company, 100 percent of the amount committed is received by that company without any deductions – an investment of £1m means £1m. This is a desirable outcome since early-stage companies are cash-intensive.

Increasingly, this approach is being challenged by funds that introduce fees payable by the company. This is a zero-sum game and the effect these fees have is to reduce the amount of capital available to invest in the company’s growth. They have no place in early-stage venture capital where investors should be focused on making their investments successful rather than stripping out fees to augment their overall management fee rake on each deal. Doriot would be incredulous if he learned that investors are giving money with one hand and immediately taking away a percentage with another.

Typically fees are defended on the basis that they are relatively small amounts – for example, five percent of the commitment amount – but imagine the impact if all these amounts were aggregated and re-directed to help companies grow. In some cases, it could be the difference between success and failure.

As an industry, we need to do better. Honestly and openness about what each fund will do for their founders post-investment and abolishing any type of company payable fees at the early stages would be a great start.