Notes of Note from John F. Ince

Scrutinizing Seven Popular Myths About VCs

by John F. Ince

As the VC industry picks itself up and dusts itself off it’s a good moment to take a critical look at the popular myths that surround the industry in general.  Here is my analysis of seven popular VC myths:

Myth Number 1:  VCs are motivated primarily by greed.

John Ince’s Analysis: If greed is the same thing as the desire to maximize return on investments, than this not a myth.  VCs take their fiduciary responsibility to their limited partners very seriously, because their LPs give them the opportunity to play this game. To the extent that this is a game, VCs clearly want to win. Their competitive juices flow and they hate it when one of their competitors has scooped up a great deal that they wanted.   A lot of VCs keep track of their successes, by the amount of money they’ve made.  That is their way of keeping score.

But to suggest that VCs are primarily self-serving, also hits wide of the mark,  for their motivations are complex. The best VCs also a great deal of pride  in what they do to helping entrepreneurs nurture their visions.  They also derive satisfaction by playing a role in catalyzing the formation of the high tech industry.

So, if VCs are greedy, it is not  unlike the vast majority of people who go into business.  Venture capitalists are in the final analysis, capitalists.   What particularly irks some entrepreneurs  isn’t that VCs are greedy, but that they have acquired so much leverage, and as a result, seem to be able to bend circumstances so easily to their advantage.

Myth Number 2: VCs are now investing so much capital that they are stretched too thin and they cannot possibly give individual companies the assistance they need and deserve.

John Ince’s Analysis: During the crazy days of the dotcom bubble, this was becoming true.  But the the best firms have recognized the downside here, and are moving to better leverage the time of their GPs by providing them with the resources they need to better assist portfolio companies. Also, as VCs steer more of their capital to existing portfolio companies, the pressure to sit on more boards is diminished.

Myth Number 3:  VC are our societies primary catalysts for the development of high tech and emerging growth industries.

John Ince’s Analysis:  This is now almost boilerplate in VC public policy pronouncements.  Clearly this is more than rhetoric.  But to suggest that VCs are the primary catalysts is to diminish to the role of entrepreneurs.    The high tech boom that has propelled the US economy for the last decade, would never have happened without the growth and maturation of the venture capital industry, but VCs would be nothing without the entrepreneurs who make them what they are.

Myth Number 4:  VCs have been exploiting the recent market downturn to extract a few extra pounds of flesh from the entrepreneurs they purport to support.

John Ince’s Analysis: Valuations are a function of the marketplace. Any value set is a function of negotiation.  Let’s face it,  venture capitalists try set the valuation as low as possible, and the entrepreneur tries to do the opposite.    In this environment, even though there is a lot of capital, most of it being steered to keep existing companies alive, so there is less available for new companies.  That works in favor of the venture capitalist in the negotiation process. According to Vivek Wadhwa, CEO of Relativity Technologies based in Cary, NC “If you speak to a VC, they have all these formulas to come up with a valuation for a company.  But in reality, it’s a game to see what they can get away with.  They’re trying to pay the least money to get the maximum ownership of a company.”  Many entrepreneurs feel they are getting taken to the cleaners with lower valuations, sometimes with anti-dilution clauses kicking in followup rounds of financing. Under these clauses,  early round investors are entitled to increased shares, when a company’s valuation is lower in later rounds of financing,   even if the material facts surrounding their operation improve.  Yes, to some entrepreneurs, this appears to be exploitation, but let’s face it: market valuations 18 months ago were vastly inflated, and the reality of the current market is simply a reflection of that fact.   In the final analysis, VCs still want the dynamic of an entrepreneurs motivational scheme to remain in force.  Remember, VCs are also suffering in this climate, and they have their fiduciary responsibility to investors.

Myth Number 5:  VCs are hugely overpaid for what they do.

John Ince’s Analysis: VC are paid well, very well indeed, but what they do is hugely valuable.   Sure, some VCs have hit home runs that put them in upper stratosphere of income brackets.  But not unlike the lottery, those few cases exist as incentive for the rest of the industry to assume often unreasonable risks, largely on a hunch.   For 20 years, the VC model has been simple.  The “VC’s law of threes” holds that one of three VCs investments will fail, the second will be like watching paint dry and the third be a winner.  The hurdle VCs set varies depending on the environment.  Some require a return as high as 65-70%.  Others are lower. Says, Rick Frisbie of Battery Ventures, “We set a hurdle of a 40% weighted return for each deal, where the average of four different scenarios–best case, optimistic, conservative and downside must produce a 40% return in discounted cash flow on our investments.”  Most top tier VCs want their investment to operate in a market large enough to justify a half billion market cap within the startups gestation period. That gestation period in 1990 was about 6-7 years, but it has been telescoped down to two years.  It will probably settle back somewhere in the range of three to five years.

If one questions the value VCs bring to the entrepreneurial equation, one need go no farther than eBay example.  Despite 40% growth quarter after quarter, eBay’s founding entrepreneurs Pierre Omidyar and Jeff Skoll, couldn’t recruit the sort of CEO they needed to run the company. That’s what lead them to Benchmark Capital in 1997.  According to Bob Kagle, General Partner at Benchmark, “At the time Pierre Omidyar, approached us, his company was not only profitable, but cash flow positive.  So he didn’t really need money.  In fact the $3 million that we invested directly in the company, went into the bank and was never touched.  But Pierre felt a professional venture capitalist could be a constructive influence in helping to build the company.  Specifically, Pierre was mature and enlightened with regard to what it takes to build of significant company in terms of experienced and capable executive talent.” With the imprimatur of a top tier venture capital firm, eBay flourished, and none of eBays entrepreneurs today would question the value of Benchmark’s contribution.

Myth Number Six:  With the explosive growth in the industry, an unsavory new breed of VC has begun to infiltrate the industry.

John Ince’s Analysis: This is indeed a myth.  In any industry with the sort of growth we’ve seen in venture capital, there will be some mercenaries–people who enter primarily to get rich quick. But to raise the sort of capital needed to survive in this industry there is a lot of investor scrutiny.  The level of scrutiny can only increase with the recent market corrections.  Those few newer VCs who have lower ethical standards, won’t be VCs for long.

Myth Number Seven:  VCs are risk takers.

John Ince’s Analysis: In a professional sense, VCs take huge risks in their portfolio companies.  But personally VCs are not risk takers.  While some VCs invest their own money in their funds and other investments, the vast majority of what they invest is other people’s money.  Their management fees, ranging from 2-3% of the capital under management, are guaranteed.  Their carrying interest (usually between 20-30% depending on the stature of the firm) on the appreciation in their portfolio kicks in only on the upside.  They share none of the downside risk of their portfolio companies, unless one factors in the possible damage to their reputation when their dotcoms become dotbombs.

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