I'm often highly critical of VCs and the investments they make. After all, there is no shortage of funding announcements that make you go "huh?"

So why do VCs make so many stupid investments? Since the world of venture capital is currently in a "crisis," I figured now was as good a time as any to detail why I think VCs so frequently make us scratch our heads in curiosity and disbelief.

VCs are really money managers - not investors

VCs really aren't "investors" in the traditional sense of the term. When raising a fund, VCs typically only contribute 1-2% of the total capital. The rest comes from limited partners.

VCs collect a management fee (typically 2% of committed capital) and carried interest (typically 20% of the fund's profits).

Thus, VCs are really fund managers in that they manage other people's money and have very little "skin in the game." While the vast majority of their opportunity comes from carried interest, if a VC firm has a $250m fund and earns a 2% management fee, that fund guarantees the general partners $5m annually.

Thus, just like mutual fund managers, most of whom underperform the market, VCs are in a position where they really can't lose. While they do have a profit motive, their primary responsibility is to put other people's money to work, not to risk their own.

This creates a dynamic in which VCs make decisions differently than they would if they were investing only their own money.

VCs are often clueless

I've argued before that "most VCs are little more than McKinsey types who know everything about building a business in theory, but couldn’t run a local pizza joint if you gave them a manual."

VCs often have little practical knowledge of the markets they invest in. For all of their "analysis" and "due diligence," I believe many are ignorant to the realities of those markets.

In other words, they may have a decent high-level understanding of these markets, but they simply don't understand the "situation on the ground" because they've actually never been on "the ground."

Much of the funding currently taking place in the cleantech market, for instance, demonstrates this quite well. Many VCs making investments in this space have fashioned themselves as energy industry "experts", yet they've ploughed billions of dollars into companies that look promising on paper but are clearly not commercially viable (at least for the foreseeable future).

This is because they can't be scaled, can't compete without government subsidies or are severely hampered by existing infrastructure limitations, amongst other things.

At the end of the day, I think a reasonable generalization is that VCs are usually book smart but not street smart.

VCs are often unrealistic

Because they're often clueless to the practical realities of the markets they make investments in, VCs are liable to place too much emphasis on theoretical potential instead of practical potential.

This is problematic for three reasons

First, potential is often overestimated. As I've noted before, research firms projecting the growth of nascent markets typically overestimate the speed at which these markets will grow and the total size they will grow to. When making investments in early-stage companies targeting these markets, overestimations can be disastrous for obvious reasons.

Second, a focus on potential often blinds one to the barriers new companies face in realizing that potential. VCs often fail to look at the challenges that face the startups competing in high-potential markets. In many cases, I see companies that receive funding yet will clearly find themselves struggling to gain traction simply because they don't realistically have what it takes to compete, regardless of how much potential exists in the markets they target.

Finally, potential is not as important as revenue, cashflow and profit. All the potential in the world cannot negate the fact that if a company can't generate sufficient revenue, cashflow and profit, it isn't going anywhere. Thus, VCs who don't consider how a startup is going to translate potential into these things are avoiding reality.

VCs overemphasize past successes & relationships

One doesn't need to look very hard to find startups that are funded by "serial entrepreneurs" and individuals who are well-known on Sand Hill Road.

This is because many VCs place a great emphasis on past successes and relationships. Unfortunately this isn't always a good thing.

Past success is never a guarantee of future success, and as successful "serial entrepreneur" Glen Kelman observes:

"...we still insist on believing in the serial entrepreneur with the Midas Touch. We make celebrities of our entrepreneurs because we’d rather believe in talent than luck. And we tend to overlook reasons why second-time entrepreneurs are actually worse, not better, for their experience."

This is despite the fact that:

"Every Silicon Valley colossus — Amazon, Apple, Dell, Ebay, Google, Microsoft, Oracle and Yahoo! — was started by a first-timer 30 or under. Facebook was founded by teenagers."

Past success, name recognition and personal relationships are nice "filters" in theory, but they delude VCs into thinking that they know who is most likely to create the "next big thing" and which startups have a higher probability of success.

They don't and these delusions don't result in better investments. If anything, they may limit VCs to poorer investments.

VCs are vulnerable to herd mentality

When a market is "hot," VCs usually fall victim to herd mentality.

One need look no further than online video to see this. With the rapid rise of YouTube and its $1.65bn acquisition by Google, many VCs felt compelled to throw money at online video startups without asking:

"Just how many highly-successful online video services can the market actually support?"

As one would expect from money managers, VCs instead say:

"We need exposure to the online video space in our portfolio. Let's invest in an online video startup!"

Of course, this often a foolish approach because even in the hottest markets, there are usually a few winners and a whole lot of losers.

The eonomics of Venture Capital suck

The economics of VC funding are not all that great, in my opinion, and this has only become more pronounced as the average VC fund size has increased.

If you run a $500m fund, for instance, you simply cannot invest that money in small chunks. You have to find companies that you can put larger amounts of money into.

Early-stage companies often don't need large amounts of money and later-stage companies may have more favorable financing options. Thus, I believe that many of the companies that do receive funding, especially early-stage startups, are overfunded.

In some cases, it is the amount of funding - not the funding itself - that makes an investment "stupid." After all, many funding announcements don't cause one to ask "Why did that company receive funding?" but do cause one to ask "Why does that company need that much money?"

As I've pointed out before, being overfunded can be just as destructive to a new company as being underfunded. Yet because the economics of venture capital often require VCs to overfund, stupid investments are made simply because VC economics encourage it.

Drama 2.0

Published 28 July, 2008 by Drama 2.0

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Comments (13)

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Deri Jones, CEO at SciVisum Ltd

Hey, spot on analysis!

Listening to a Radio 4 business program just recently, where the VC was saying some things that highlight your points nicely:

i) she meets hundreds of companies, for every one investment (meets them, not just reads their business plan).
That means no way does she have time to understand each business: and it probably doesn't help to get a street-smart view of any market, if you have a constant stream of meetings with people talking it up.

ii) she only invests in markets with 'massive upside potential'. She wants to throw $1->10M at your company, and knowing that 9 out of 10 of the investments will go nowhere, the lucky 10th must pay for them all: so she wants an exit worth $100Ms.
Which rules out small niche markets - in fact rules out every 'sensible' business of the type that you see on Dragon's Den: where world domination is not on the cards.

iii) VC's best kept secret : they don't actually invest in start-ups.
They come along at round 2, after you've got the business started with seed funding/angels: after you've proven some kind of a model: so their risk is less. Luck is a huge part of it: if your sector is flavour of the month with VC's you'll have a shot at getting your silly money.

about 10 years ago


Nic Brisbourne

First I should say I am a VC, so take these comments in that light.

Second - I agree that having a practical perspective is critical, but I think that many VCs have that. I would advise anyone raising money to make sure they respect the opinion and advice of their investor, anything else stores up problems for the future.

Third - venture capital isn't right for every business, in fact it is only suitable for companies that have big ambitions and need to raise say $10-30m in order to achieve them in a sensible timeframe. Many of the problems with the business model you describe come when companies and/or their investors don't quite figure this out. As practitioners in the VC industry our bet is that there are enough companies in our target zone.

Couldn't resist a response!!

about 10 years ago

Drama 2.0

Drama 2.0, Chief Connoisseur at The Drama 2.0 Show

Nic: you are absolutely right that venture capital isn't right for every business but your comment highlights some of my points.

Let me ask you a simple question: why are you looking for companies that need $10-$30m of investment?

The answer, of course, is not that they have "big ambitions" and that statistical analysis has shown this amount to be conducive to success.

The answer is that you are a money manager - not an investor - and the economics created by your fund size (over $500mn according to the DFJ Esprit website) dictate that you "spend" this money in chunks of this size.

Of course, there's nothing inherently wrong about your approach if you can make it work and I don't want to be condescending.

But let me ask a few more simple questions. Assume for a minute that I'm a high-net worth individual and I'm considering putting $15mn into a new fund DFJ Esprit is raising.

1. How many members of the Fortune 1000 took $10-$30mn (adjusted for inflation, of course) in funding before they had some sort of exit?

2. How many required less than this or more than this?

3. How many raised their funding from venture capitalists (or similar entities)? How many raised their funding from other types of entities (i.e. private investors, banks, etc.) or were self-funded?

4. How many members of the Fortune 1000 developed into booming businesses within 3-5 years?

Frankly, as I look at the Fortune 1000 list, I don't see a whole lot of companies that are likely to have met your criteria.

To the contrary, I can only come away with the impression that your approach/strategy limits opportunity and when I look at your industry's numbers, can only conclude that there are far too many firms with too much money chasing too few good opportunities given your handcuffing criteria.

I instead put my $15mn into the Paulson Credit Opportunities fund.

about 10 years ago


Deri Jones, CEO at SciVisum Ltd

Paulson did unbelievably well in 2007 - you made an unbelievably smart choice there :<)
How's he doing in 2008?

about 10 years ago

Ashley Friedlein

Ashley Friedlein, Founder, Econsultancy & President, Centaur Marketing at EconsultancyStaff

I agree with your points. I guess there are two points of "consolation" to bear in mind:

1. In theory, at least, if you are unsuccessful in running a fund then presumably it is much harder to raise money for the next one? i.e. is there some kind of longer term performance-related motive to do with one's future prospects at risk for a VC? Or does this industry also reward (repeated) failure as many large companies appear to do?

2. There must be lots of companies who would never have made it at all, or not to the scale they have, unless fuelled by the cash and the ambition (for a massive exit..) of a backing VC? Some management teams must actually have seen huge benefit from the focus and input of their VCs?

I've been mulling over a model which I'm interested to know if there are precedents for. I can't seem to find many which might suggest it's a bad idea...

My idea is to create a fund which is focused on investing in a particular sector - digital marketing and e-commerce. Why? Just because I know it very well. But I think the model would work elsewhere.

The investors would all be 'angel' like (rather than institutions) and would probably be putting in around £50k-£3m. They would be digital marketing and e-commerce professionals who've probably already been successful and made some cash. They're probably working on their next big thing but are also investing at a smaller scale in various businesses.

So my fund would give them a chance to invest in something they knew about, could actively help with selecting what businesses to invest in, and could help make those companies a success (e.g. with finding good people for them). So they're not just bringing their cash to the table, but their expertise and contacts. And I'd think they'd enjoy it. They'd also have the networking benefits of knowing/meeting their co-investors who are people like them.

I'm imagining the scale of investment would be in the £50k-£1m sort of range. So less than VCs typically. But the risk would also be less. The fund could invest in smaller businesses, or existing business who just wanted to go to the next level. I know loads of agencies, for example, at the moment in the digital sector which I think have loads of potential and where there's a lot of M&A activity at exit values around £5m-£15m. Perhaps less exciting for VCs but a huge potential return on investment for early investors.

So the risk/return profile wouldn't be nearly so highly geared as VCs. But investing in property isn't looking so good at the moment; and leaving your money in a high interest internet-only savings account isn't that exciting. And there are probably tax advantages to be had in investing in this way. Quite apart from wanting to be "part of building the industry".

The fund might only be £10m in size which, with a 2% management fee, gives only £200k a year to the management company. But surely you could a decent investment manager for this (with the carry upside), supported by the industry 'on the ground' expertise of the investors? Do you need more than 1 person with some admin support?

'Deal Flow' would be easy (given E-consultancy's contacts in the market place) and the investors should be in a very good position to spot what is likely to work or not.

So where's the catch?

Ashley Friedlein

about 10 years ago

Drama 2.0

Drama 2.0, Chief Connoisseur at The Drama 2.0 Show

Ashley: your fund concept is markedly different from the traditional VC model. In essence, you're creating a fund for angels.

1. The total size of the fund is small (relatively speaking) so the economics of your investing strategy is quite different (you can invest in smaller chunks).

2. The fund is focused on very specific markets which you have intimate knowledge of and experience in and your partners (be they "limited" or "general") are also "industry veterans."

3. While you're more familiar with M&A activity in these markets, it sounds like it exists and that your exit expectations are aligned with that activity (as opposed to VCs who are investing in the hottest Web 2.0 startups at 9-figure+ valuations despite the dearth of acquisitions in that range).

Will your model work? Who knows. It seems more sensible than the traditional VC model and even if you don't go on to fund a future Fortune 1000 company, so long as you and your partners are realistic and have the same expectations, you could all very well walk away satisfied with the results.

That said, there are always risks. A downturn in the digital marketing and ecommerce markets could devastate the fund and if you're relying on the expertise, experience and relationships of the partners to aid the businesses you invest in and the partners don't follow through with their involvement, that could negatively impact your portfolio companies. So like anything else, timing and execution play a huge role.

In regards to your question: "In theory, at least, if you are unsuccessful in running a fund then presumably it is much harder to raise money for the next one?"

In theory, sure. But there is so much money out there that needs to be parked *somewhere* that in actuality VCs have not (yet) had much difficulty raising capital.

Remember - not all big money is smart money and there are still lots of people who believe that the venture capital asset class is worth having exposure to.

That said, I do think the traditional VC model is flawed and uncompelling and if the VC industry's woes continue, you just might see second and third-tier firms going out of business at some point as less people and institutions feel the need to have exposure to the venture capital asset class.

about 10 years ago

Ashley Friedlein

Ashley Friedlein, Founder, Econsultancy & President, Centaur Marketing at EconsultancyStaff

Hi Drama 2.0

Thanks for your reply. Agree with your points. Two follow up points which you reminded me of:

1. No 'exit'. Unlike most funds I was also wondering why there needed to be any 'exit' which risks forcing "valuation events" which might not be sensible. If the fund were investing in businesses which were, or became, profitable, then could the fund not return money to its investors every year? e.g. from dividends it received, or possibly loan repayments if the money was given as a loan rather than equity?

2. Angels. Yes, the investors would be like angels except that I'd imagine that it would be the fund investing and not individuals. In fact, there would have to be a clear understanding that though the investors would be encouraged to be "involved" with the fund, ultimately the fund (investment manager) would have to make the final calls. Otherwise it could end up a right mess - entrepreneurs tend to be pretty opinionated people...

I think the main challenge is *how the investments* would be made. It is all very well being small and flexible enough to be able to give out smaller chunks of money but that doesn't necessarily make it *easier* or *less time consuming* to do so. And there might come a point where the hassle isn't worth it.

Unless there are different financial constructs/vehicles which the fund could apply relatively quickly and easily depending on the likely nature of the investment. That could work. Which is why I'd need someone who really understood all these aspects if I have half a hope of turning this into any kind of reality!

about 10 years ago

Drama 2.0

Drama 2.0, Chief Connoisseur at The Drama 2.0 Show

1. Bingo! The desire for a big "exit," because it happens so rarely, is often detrimental. If you have a group of investors who are patient and not necessarily focused on a "big hit," you could conceivably structure your investments to provide for a dividend stream if and when your portfolio companies have the earnings to support it.

Of course, some would argue that high-growth companies should funnel any earnings back into the business, so this is a consideration but for companies in certain markets, I think a stream of dividends is viable provided that the entrepreneurs you're funding find this acceptable.

2. Yes you'd probably set up a limited partnership or limited liability partnership (I'm not as familiar with legal structures in the UK) and for your "limited partners" you could, for instance, structure some sort of advisory arrangement that enables them to participate in some more formal manner with portfolio companies but that would not give them any additional rights to "control" the investment in the portfolio companies itself.

You are absolutely correct in stating that smaller investments do not demand less time and effort than larger investments. While angel investors obviously want to make a decent return, it's worth considering that many become angels because they truly love being involved with new businesses. Even if they don't make money on an investment, they get a return in the form of satisfaction.

Is that an acceptable outcome when you're running a "fund" for a handful of angels? Good question.

about 10 years ago


Blake Southwood

I solve hard problems. I'm an engineer at heart.
Raising funding is more difficult then solving
problems that take me years to figure out through
trial and error. I am persistent. i am stubborn and I think
outside the box. Not one VC has expressed any interest
in the problems I've solved becuase I'm not in the network
and they don't know me. I wish that there was an easier
way to get investment but it boils down to the fear
of VCs to take the risk and to them the risk is the money
and time. Nothing is a sure thing. There will always
be uncertainty. I really enjoyed "Founders At Work"
and "Fire In The Valley" and "Dreaming in Code" but
what's so amazing to me is that some ideas are funded
based on the school that the founder(s) attended and
they have ZERO work experience. Zero. Unreal.

about 10 years ago


sofia Panagi

I have been studying the online advertising market for some time. Research indicates that adspend in the UK will pass £1bn in 2008. However, looking at all these investors, venture capitalist and financial institutions wishing to capture that small percent of the market all seem to be missing a very vital point.

There are over 23million broadband users in the UK and rising. However, although most of these people use the internet on 40% buy online. This is due to the fact that they find searching a minefield. So many search engines, shopping portals and website make it very confusing and infuriating. Most people like to use the internet but they are not tech savvy.

I think people need a simple way to find what they are looking for and navigate to with in a few clicks. Virtual worlds were created for this reason, but how many of us have a few hours each day to walk around a virtual world like second life. It seems meaningless and with no purpsoe. Sorry 2ndlife fans but i am expressing my honest opinion here.

Lets face it Google reported record profits in the UK last year. Most adspend online goes on search engines.

No one seems to be targeting those 60% of DSL users in the UK who do not buy online.

http://www.mymall.at formerly known as http://www.themall.tv is the first concept that allows advertisers to cost effectively brand themselves and allows users a fast,easy and fun experience via their 3d interface. They do this via a 3d virtual shopping mall that has the best quality of graphics and speed i have ever seen. They recently launched their site with over 500 major brands, 1500 stores in 36 categories hosting over 25 million products…WOW.

Their model is simple…

Having studied them they have a great business model too. They claim each mall holds 5000 stores. They charge at £100 per month rent per store. Peanuts compared to the 4 figure weekly adcampaign by Google Adwords.

Anyway thats £6million per year per mall. They are planning at least 20 malls in different countries and in 12 languages. They have also considered regional malls if the demand is there.

That makes it £6m x 20 = £120m a year.

They are targeting 1 million users in the UK and 4 million in 4 years. Their CPA income should work out to at least £1 per registered user per month. I know my figures and guys… im a size 8. They are expecting 50million users globally in 5 years. That makes my calculation at £50m x 12 months = £600m a year in year 5

so far that is £720m a year.

With ad revenues at £1 per person per month you can add another £600m making a total revenue of £1,320,000,000.00 a year.

Try IPOing that…

That is without their virtual social network income, and their free mobile phone platform said to be better than skype for quality.

They have set this up with no investors, using their own funds, see today’s lancashire evening post article. i interviewed Ishmael Bahadur the Founder and CEO of MyMall, he said he has been to government grant innitiatives, banks they all thought it wasnt possible. So he invested everything he has to get to this point. he quoted ” great minds have always encountered opposition form mediocre minds” a quote originally from Albert Einstein.

Why arnt any venture capitlaists or investors looking at this instead of throwing millions at virtual worlds that all do the same and other daft internet concepts.

sofia panagi now a mymall fan.

almost 10 years ago


Stock Market Trading

You ar eabsolutely right. VC's have a big chance of overfundingand falling into the herd mentality trap. Tht is why , I do not trust my money on VC's.

almost 9 years ago


Grant Oliver

I am looking to set up a Fund for software companies.  I have just raised £6m for two software companies and now have access to funds.  Is this viable as I am a software and e-commerce CEO rather tha a VC?

over 8 years ago



You guys have it all wrong. Investors do not care about average returns. What they care about is ego. They want to be able to brag to their friends that they were in on the next Google or Twitter early on. A VC prefers a lower average return with one big name in their portfolio over a higher average return, but no big names to brag about. They're already rich, they aren't gambling with their own money, so what they care about is status among their investor friends.

about 8 years ago

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