Venture Capital is Broken

Understanding the Current Venture Capital Model

To make sure everyone is on the same page, here is a very high-level overview of how it typically works. Please understand, it is very difficult to illustrate deals as they can be structured in all kinds of ways. There isn’t an exact model to follow, but here is a simplified general idea. 

Here are a few types of investment models:

Individual / Angel Investors – these are typically high net worth individuals, past entrepreneurs, or others that are accredited investors. These are typically run by one decision maker or a small team that makes investments at a fairly early-stage in Startups.

Investment Networks – these are typically a group of accredited investors that follow the model of putting money into a hat until enough is contributed for a raise. If they don’t contribute enough, the network typically doesn’t invest.

Investment Funds – this is what most people think of when they discuss Venture Capital. Outside investors contribute capital to be managed by the fund. A common approach is to raise a 10-year fund. This means the fund will try and get all of their investments made within 5 years with the hope that one of them will pay back the entire fund plus substantial profit.

Accelerator and other Program Investments – programs like Y Combinator, Techstars, etc. typically invest an initial amount into the companies they bring into their programs. In this article, we will not be considering these types of programs, Kickstarters, etc.

Here is Why Venture Capital is Broken:

In these last few years of COVID-19, every industry has realized the importance of technology. Schools were massively unprepared to go entirely remote, our nation’s unemployment system was immediately overloaded because of 1970s software, and the IRS is still backlogged years after the pandemic. Non-chain restaurants had to figure out e-gift cards, online ordering, and delivery while also figuring out how to connect their websites.

Overall, every single consumer facing industry and government entity had to heavily invest in the technology infrastructure they had been neglecting for decades. And now, there is an even bigger problem. Who is going to build it?

Over the last couple of years, the surge in need for software and technology workers already compounded the previously existing need for these workers. Now, everyone is trying to hire software developers and tech workers. But for those very few that identify problems in the world and have a strong desire to fix them, who will invest in them?

Currently, less than 1% (and I’m being generous in this estimate) of companies get funded. These are almost always high-growth startups.

If a tech worker decides to work on a new idea for their state’s unemployment software, they are not considered investable.

If a new startup wants to focus on software for a school, they have to focus on all schools around the world or… they aren’t investable.

If an aspiring founder decides they want to build a Software as a Service solution to fix a new problem, they often aren’t considered investable.

Of course, in specific cases, these types of businesses might be able to get investment. But each of them must focus on “changing the world”, “being first to market”, etc. What this really means is that each of these companies must be able to be sold for $30M-$40M at a minimum.

Why the Exits Must Be So High

As discussed, the goal of the fund is to have at least 1 big return. In reality, the hope is that some of the investments make an even return, a couple investments return enough for profit, and the rest are written of as failed startups.

However, the often not discussed reality is the overall failure rate of venture funds. It’s estimated by SaaStr that 70% of funds fail to deliver a 2x or greater return to their investors. For micro funds (often < $20M), the result is often just enough money to pay two to three partners a full salary. Instead of these numbers, we hear about how 75% of Venture Back startups fail, when almost as many funds fail to return the ideal return to their investors.

Of course, we always hear about Andreessen Horowitz and other famous billion-dollar funds. Clearly, there are top tier funds that have found success across the Startup world. But why does the standard VC model require such big exits?

First, let’s break down a theoretical Startup’s pre-money valuation.

Say Widget Maker Inc. lands a seed fund of $250,000 for 25% of the company. This sets the pre-money valuation to be $1M.

• • • An investor is looking at this company and asking if they believe the company is worth $1M today.
    • The same investor is also looking at the company and considering if the company can grow and be sold for $40M, or another type of exit will happen for the investor within 5-years.

The reason for this large of an exit is based on the capitalization table (cap table) and the required return

Initially, the cap table may be:

• • • Founders: 75% of Shares
    • Seed Investor: 25% of Shares

However, a Startup rarely exits after their initial round. After even one more round of investment, the cap table continues to evolve:

• • • Founders: 35%
    • Seed Investor: 25%
    • Next Investor: 40%

Now, let’s imagine an exit occurs (although it would likely be after multiple rounds of investment). The initial seed investor retained their 25% ownership and the founders diluted to make room for the new investor.

If the business exits at $1M, the investor will receive $250k (25% of $1M). This is a break even result for that venture fund. Now imagine the startup made a $20M exit. The initial return is  now at $5M. This might sound great but imagine that the fund invested $10M in 40 companies at $250k each. This means they have only earned 50% of their initial fund in this one exit. Still no profits are to be had and they must be successful in their other investments to see a full return. Now imagine the exist is at $40M, $50M, $100M and the numbers start to make much more sense for the fund.

This is why VC firms are so focused on the Startup’s revenue, early customer success, and why they want to pour fuel on an already brightly lit fire instead of lighting the first match. The risk simply won’t return a high end result for a company that exits for only a few million.

Why This Matters

Because of the required return, a culture of limited investment opportunities results. New Startups that we so badly need to fix the world become un-investable because this model of investment. A cultural focus on large funds investing only in the most revolutionary startups becomes the norm.

This also leads to startups focusing on raising capital, creating ridiculous strategies, and now we even have a term Unicorn Farming. This is when a startup raises money from a well-known investor or fund and uses this connection to focus on raising more money through their notoriety multiple times until they become a Unicorn Startup (worth $1B early on in their business). 

This VC driven culture incentivizes Startups focusing on capital and not on building a phenomenal product, connecting with customers, and building the best companies they can possibly be, within the constraints of their markets. This also causes Startups to focus on telling a bigger story, posturing to seem investable, and focusing too much attention on fund raising that is unlikely to succeed even if they raise the money.

However, it’s not just the Startup culture that is suffering. The fund model is also incentivizing raising large funds and if they can hit the hundreds of millions or the $1B mark, the fees alone will create a profitable entity. When the total fund size increases, the 2-2.5% management fees become a serious revenue driving force. This can result in $20M+ in profits on top of any level of success they may make on their investments for a billion dollar fund. If they lose everything the fund still profits $20M+ with this standard model.

However, not all funds are simply in it for the money, and many funds have achieved incredible success. The point of this article isn’t to point fingers at individuals but to reconsider the overall model to highlight that this traditional model of investment is holding our country ‘s innovation and technical development back. Simply relying on this model is not going to build a brighter future for us all and a huge opportunity is being missed.

Surely, there has to be a better way…

A Better Future for Venture Capital

Luckily, different alternatives already exist. Even for a medical device company, such as Winter Innovations, alternative methods exist for initial funding. The founders of this company, Lia and Preston Winter, raised almost $100k pitching in competitions across Tennessee. ActionVFX.com did an initial Kickstarter campaign, and The Cookie Crate simply started selling cookies to anyone that would buy them. Alternatives exist for every industry.

For those that need true investment to grow their Startup, a new model already exists. TinySeed.com is a fund that operates in a unique way. Tiny Seed is a year-long accelerator program that invests $120k-$220k for 10%-12% of the company in equity. The founder must be full-time in their business and are able to use the investment money to pay their own salary. This is often unheard of in traditional VC since investors typically want to pay for marketing, not for a founder to live. Founders’ salaries are capped at $250k per year and anything paid out afterwards is considered a dividend split based on ownership for the life of the company (or until an exit event). Any exit by the startup is also handled by % ownership.

The Tiny Seed model focuses on programming, mentorship, and accountability. They connect your company to the most experienced mentors in your field and consistently provide a community of support. The money earned from Startup exits helps create new funds and the revenue split also helps create ways to pay for the operations, mentors, and other future opportunities.

This is a hands-on model that currently focuses on Software as a Service (SaaS) Startups with revenue growth sometimes as low as $2k MRR. Many of the companies Tiny Seed has invested in would typically be considered lifestyle (i.e., un-fundable) Startups. This is a model that can help us build the future. Currently, this model is a very focused approach, but there clearly is room to expand this approach for many industries.

How Do We Fix Venture Capital?

First, we need to change the culture of talking about investment. Most Startups should focus on bootstrapping the business as far as they can. This includes building their MVP, finding an incredible team, and getting their product in customer’s hands as fast as possible so they can learn how to build a great company from them. Traditional, early-stage investment should be reserved for companies that require it immediately (e.g., medical device, aerospace, green energy, etc.).

Ecosystem builders need to stress this new focus and push alternative forms of early-stage capital to create a realistic culture of growth instead of always working on capital formation. Create competitions, partner with universities, and interlink the ecosystem to provide non-dilutive funding that moves the needle for your Startup community. In our region alone, you can compete in The Pitch by FoundersForge, iBucs, and the MADE Gala for up to $30k in prize money if you win at each competition.

Next, we need to start building alternative funding models to the traditional VC one. I understand this is an easy model to duplicate because it’s been around for a long time. But unless you have a very good fund manager and you raise a substantial amount of money for the fund, you are unlikely to be much more successful than the Startups you invest in. But these alternative models create a unique way to bring together entire communities of various industries together.

And last, we need to tap into the incredible opportunity of funding the un-fundable.

Baremetrics, Dripp, and the surge of private equity buying up these un- fundable Startups is proof of the opportunity our traditional funding models are missing out on.

The rapidly growing need for a better tomorrow is not just great for humanity, it will also be a great business opportunity for those who seize it.

Yes, traditional Venture Capital is broken.

The exciting part is that we now have the opportunity to fix it.