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.