Jul 21, 2019

The venture capital model is wasteful, chaotic — and essential

written by Lisa Eason

I have been reading the business plans of new ventures for more than 30 years, and while the presentations have become a lot slicker, I’m not sure the underlying propositions have improved much.

PowerPoint and the rise of venture-capital culture have a certain amount to answer for on that. In 2019, no one sends a business plan: instead they deliver a “pitch deck”. The founders know all the right financing terminology — from drag-along rights to anti-dilution provisions — but I’m not sure they always understand their customers.

Often I get the impression that their objective is to raise capital rather than generate sales and develop a profitable enterprise. I’m astonished when I read about would-be entrepreneurs celebrating a new round of finance, because that’s when the work really starts: investors will have expectations and the company now has a lot of additional obligations.

Only a tiny number of businesses raise institutional venture capital. The rest fund their start-ups using personal savings, supplier credit, bank debt, money from family and friends or angel investors, invoice discounting and retained earnings.

Or they never raise any outside funding. This reflects the fact that the majority of new companies are small service businesses that never grow much; meanwhile, venture capitalists are only interested in backing what are called “scale-ups”. They want to support highly ambitious founders who, if successful, might produce substantial financial returns for their investors. In other words, venture capitalists seek a multiple of 10, 15 — even 20 times their stakes. Of course, most of the ventures they back never achieve that, and many fail. That is the nature of the game.

One of the paradoxes of the modern business world is that high-risk, high-reward start-ups get so much attention, yet most are doomed to go nowhere. In a sense, venture investing is another example of winner-takes-all economics, like show business or sport. A tiny proportion of contenders scoop up the bulk of the riches. It’s all about the hits, and the hits are all about rapid growth in big markets. The model is wasteful, in that enormous effort and plenty of capital falls by the wayside as the hundreds of losing propositions fade. Out of the chaos a few players will emerge triumphant, thanks to commercial innovation. It is through such competitive forces that consumers receive value, progress is made, new jobs are generated and prosperity rises.

Presentations by founders wanting cash are a particular craft. I rather prefer meeting entrepreneurs who have not done it hundreds of times before — if they are too rehearsed, you feel you’re no one special. It is important to persuade the team to go off-script and to probe the depth of their thinking.

Reading through a long document is laborious — even if it’s projected on a screen and has lots of charts. I much prefer to have detailed paperwork supplied in advance, so I can read it properly before the face-to-face meeting. I like to spend much of the first discussion learning about the founders — their experience, their motivations, their understanding of the market they are in. Most start-ups do not have much in the way of patents or unique technology — they are really just a management team and an idea. This makes being a venture capitalist as much an art as a science. Simply studying the spreadsheets will not forecast the winners.

Some entrepreneurs are skilled at pitching their business but poor at running an organisation. Being able to hustle and tell a story are not necessarily the skills that make a founder a money-maker. The best investors see through the salesmanship and instead cross-examine the founders on the nitty-gritty of the concept. Of course, certain companies can do well with a visionary founder who is not a practical operator; such a partner can be recruited later.

The most important trait for any investor is to remain enthusiastic about the Next Big Thing. It is easy to become cynical after decades of risking your capital in good and bad enterprises, but the best venture capitalists have delivered four times the returns of stock markets, according to a new book on the sector, VC: An American History, by Tom Nicholas.

There remain hundreds of problems looking for solutions from brilliant founders, and the remarkable alchemy of the free-market system still delivers new industries and exceptional profits for the brave.