The VC Industry Is Broken. Now What?

Photograph by Shaun Lowe

The investment team at the Kauffman Foundation believes the venture capital industry is broken and that they, or rather investors in VC funds, are partially to blame. The report condemns venture firms for being too big, not delivering returns, and not adjusting to the times. Then it blames the situation on a misalignment of incentives—namely, that limited partners investing in venture firms have done so in a way that encouraged VCs to raise mammoth funds at a time when huge hoards weren’t really warranted. Now, says the Kauffman Foundation, the chickens have come home to roost. From the report (PDF):

“The most significant misalignment occurs because LPs don’t pay VCs to do what they say they will—generate returns that exceed the public market. Instead, VCs typically are paid a 2 percent management fee on committed capital and a 20 percent profit-sharing structure (known as “2 and 20”). This pays VCs more for raising bigger funds, and in many cases allows them to lock in high levels of fee-based personal income even when the general partner fails to return investor capital.”

The solutions to the problem—changing the compensation structure, investing in smaller funds whose partners have committed at least 5 percent of their own capital, investing directly in startups or alongside funds at later stages, and taking more money out of the over-saturated VC market—are already happening. Look at the widespread trend of angels, or smaller funds created by a few investors. Look, too, at the rise of hedge funds or at the direct investment by Digital Sky Technologies at crazy valuations in hot companies such as Twitter or Facebook.

Although it’s unclear if other LPs will take the advice in this report, the trends around VC investment these days are fairly clear. Plenty of firms are willing to put in small amounts at an early stage, so they have the option to keep playing if the deal gets hot. And they are just as likely to drop firms quickly around the second (Series B) fundraiser if they aren’t shaping up to turn into Pinterests or a Spotifys. This hit-driven style of investment is a symptom of too much money chasing a new type of startup, and it’s likely that venture investors will compete until much of the return is squeezed out of a hot deal. That’s no good for limited partners, either.

The report lists the ways Kauffman has decided to solve the mismatch between LPs and venture firms, and it goes into a lot of depth on how to improve the industry overall. But even if one agrees with the assessment and solutions it offers, it also raises questions about the startup economy. In 2011 the venture industry invested $28.4 billion into 3,673 deals, according to the NVCA and the PWC MoneyTree report. About 50 percent of the total investment was in seed and early stage companies.

If followed, the Kauffman Foundation’s suggestions would shrink the pool. This would be a good thing, leaving less money chasing the few standout deals. It would also open the door to thinking about building companies in a connected era. Angels are already picking up some of the VC slack and are likely to continue doing so. Once Facebook goes public, I expect we will see a host of newly minted millionaires playing at being angels, or perhaps using their riches to build something new.

For those without soon-to-be-liquid options, Kickstarter and the gold rush promised by the JOBS Act are likely to fill the gap. The pool of venture capital may shrink while the pool of startups remains about the same. In such a scenario, VCs, angels, and then the rest of us will play the role of investor. It’s a role millions already undertake: Kickstarter has enabled $200 million in pledges and funded 22,000 projects.

The passage of the JOBS Act means executives at startups can now beg for money among friends and family members who aren’t accredited investors. I, for one, am leery of this development, believing it ripe for scams. A side effect is that the law can cloak information about companies until right before they hit the public markets, which I think is the exact opposite of what a bill that encourages consumer investment ought to do. Still, legitimate companies will be able to start businesses, thanks to the bill.

As lawyers and entrepreneurs grow comfortable with the law, new funding platforms should arise. Perhaps the Kauffman Foundation will find itself on the cusp of a trend—from the old-school style of fundraising in which an entrepreneur has few choices and must play by the VC industry’s rules to a crowdsourced, connected capital-raising era that mimics how the Web is changing a variety of businesses. Maybe the VC industry really is like Motown. It’s going to have to adjust to the new reality.

Also from GigaOM:

Facebook’s IPO Filing: Ideas and Implications (subscription required)

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