Why 70-80% of VCs do harm

There has been a lot of debate over Vinod Khosla’s comment that 70-80% of venture capitalists (VCs) add negative value to their investees. I agree with Vinod.

I always advise entrepreneurs to look first for an investor who won’t actively reduce your company’s value. For VCs, in my opinion, Vinod’s 70% number is right. For other investors, such as high net worth investors or family offices, maybe 20% are harmful.

Already having an investor who is neutral – who neither adds nor subtracts value – is a victory. For VCs, this covers maybe another 20%; for other investors, having no impact is more like 70% of the total.

The dream of having an investor who actively increases your company’s value is often just that, a dream. If you’re in that top 10% and get into the dream state, good for you!

The question is: why is this? Why do most VCs reduce shareholder value? I believe there are three reasons:

Other people’s money

Venture capitalists invest other people’s money. They report to the limited partners (LPs) who have invested in the VC fund – who are often high net worth individuals and family offices.

A big part of the VC’s pitch to their LPs is that they are experts in making and managing small company investments. They know if the investment goes badly, they will be held responsible by the LPs. So their default position, if things aren’t going as planned, is to ‘do something’.

It’s far better for a VC to report back to the LPs that ‘things were going poorly so we took action’ than to say ‘things were going poorly and we did nothing’.

Better to have tried and failed, than to have sat on your ass.

Simply the fact that they are investing other people’s money biases VCs to take action vs. most investors, who take no action.

Of generalists and specialists

VCs will often present themselves as experts on an industry, and will consider themselves as much wiser than the entrepreneur, who may be running a business for the first time.

What is the truth?

  • many junior VCs have an MBA and/or investment banking experience, and very limited experience with small private companies
  • very few VCs have ever run a company before
  • those VCs who have run a company ran a different company; if they have industry experience it will often be selling a different product to different decision makers
  • the entrepreneur, by the time of the investment, will have thousands of hours of experience in their industry, with their customers and in their exact business: the VC may have 100 hours, at most
  • the entrepreneur will know the people on their team intimately, with hundreds to thousands of hours of working together; the VC will be forced to make snap judgements based on limited interactions

To sum up, the VC is a generalist. They know a little about the business, but far less than the entrepreneur, who is a specialist in their business.

As any good generalist, the VC can bring a lot to bear: experience in other businesses that may be valuable, a knowledge of patterns and advice that they can share, and so on (for those with useful prior experience).

This can make a VC a very powerful advisor to an entrepreneur, just like a good experienced lawyer can be a very powerful business advisor.

There are two problems.

First, due to their business experience, and their presenting themselves to their LPs as ‘the expert in managing small businesses’ many VCs feel that they ‘know better’ than the entrepreneur. They often feel that they are the real expert.

Their environment creates and reinforces this feeling. Entrepreneurs suck up to them every day for money, which only reinforces this feeling of superiority. It’s really hard to be and feel truly humble when you are a VC, surrounded by sycophantic supplicants.

Secondly, VC-CEO relationships are very different than lawyer-CEO relationships. The VC sits on the board. The entrepreneur reports to them. The VC probably spends as much if not more time managing the board than the CEO does.

If one of the two is going to get fired, it will almost always be the CEO, not the VC. Therefore VC advice comes from ‘your boss’, not from a service provider who you feel you can ignore if you wish.

Misaligned incentives

As part of showing their expertise in investing in small companies, the vast majority of VCs do so through preferred shares or convertible debentures, whose terms generally give control to the VCs in the case the business does poorly.

Many entrepreneurs foolishly focus on the valuation, and accept these terms instead of negotiating for common shares and sacrificing valuation.

The problem is that people who have different classes of shares have different incentives. A bankruptcy or a low-value sale may often be in the interest of debtors or preferred shareholders, yet it is almost always harmful to the common shareholders.

By imposing these terms, VCs are consciously setting up misaligned incentives. (Even worse, most then sit on the board, where they are supposed to represent the interests of the common shareholders, and then vote in favor of a reorganization that benefits them while harming other shareholders.)

VCs also have a very different timeline than entrepreneurs.

By the terms of their partnership, VCs are often forced to wind up their fund within a fixed number of years. VC partners also get their bonuses paid when the fund gets wound down. If the business takes longer than expected to develop (newsflash: it almost always does), then the VC will be impatiently looking for a way out, any way out, when everyone else may be still focused on building the business.

What does this add up to?

To sum up, venture capitalists:

  • know less about the business than the entrepreneur
  • often have limited experience in the industry and even in running businesses
  • often feel that they know better (their environment encourages it)
  • can fire the entrepreneur, so their ‘advice’ carries too much weight
  • have a different share class so have different incentives
  • are on a fixed timeline that may impose looming deadlines
  • are biased to take action if things seem to be going poorly

While VCs still do have valuable experience to share, and can be very powerful advisors, given the structural problems it is unsurprising they often do more harm than good.

What is the solution? VCs can have great strength of character to stay extraordinarily humble, they can invest via common shares … and for more look at the next post on ‘the secret to managing investors‘.