Thursday, May 6, 2021

Venture Capital Isn't Working: Addendum

I didn't find Nicholas Colin's Bill Janeway on Who Should Be in Control in time, or it would have been a significant part of Venture Capital Isn't Working. So, below the fold, an addendum discussing legendary VC Bill Janeway's views, and an interesting paper that he cites, The Rise of Dual-Class Stock IPOs by Dhruv Aggarwal et al.

Janeway and Aggrawal et al are both discussing another trend that, over the last couple of decades, has also led impaired the effectiveness and the returns of startups. This is the way that founders have been able to retain control of their company even after an IPO by creating two classes of stock, one that they sell to the public and another, with vastly greater voting rights, that they retain. Successful examples include Google and Facebook, but there are many more recent contrary ones, including Theranos and WeWork.

Janeway starts by identifying four types of risk that startups encounter:
both the entrepreneur and the investor are confronted with four dimensions of risk, which have different degrees of uncertainty:
  • Technology Risk: “When I plug it in, will it light up?”
  • Market Risk: “Who will buy it if it does work?”
  • Financing Risk: “Will the capital be there to fund the venture to positive cash flow?”
  • Business (or Management) Risk: “Will the team manage the transition from startup to sustainable business, especially given the challenge of building an effective channel to the market?”
Janeway starts, as both Funk and I did, by pointing out that there is "too much money" flooding the market for startups:
Today, we happen to be in a regime where there is an overwhelming supply of risk-seeking capital, most of which is coming from so-called “unconventional investors” (private equity firms, hedge funds, mutual funds, SoftBank, etc.). ... over the last five years, more than half of the amount of venture capital deployed in the US entrepreneurial ecosystem has been coming from these unconventional investors.
Too much money from inexperienced investors chasing too few good startups has not merely reduced the returns to VC investors, but also tilted the bargaining table against them:
Such investors are accepting illiquidity and paying very high prices, all with no ability to change their minds. These are typically public market investors who tend to take liquidity for granted, and yet in this case, even though they are giving up liquidity, by and large, they are not gaining any governance rights! As a result, the balance of power between entrepreneurs and investors has shifted.

Actually the balance of power was already shifting thanks to the concept of the entrepreneur-friendly venture capital firm, of which, of course, my dear friends at Andreessen Horowitz are the most visible advocates. This trend began well before the flood of unconventional capital into venture.
When founders have the upper hand, they will choose VCs offering them the most advantageous terms, which likely include flattering their vanity by entrenching their control over "their company". To maintain their "deal flow", VCs have to become increasingly "entrepreneur-friendly". Aggarwal et al's abstract reads:
We create a novel dataset to examine the nature and determinants of dual-class IPOs. We document that dual-class firms have different types of controlling shareholders and wedges between voting and economic rights. We find that the founders' wedge is largest when founders have stronger bargaining power. The increase in founder wedge over time is due to increased willingness by venture capitalists to accommodate founder control and technological shocks that reduced firms' needs for external financing. Greater founder bargaining power is also associated with a lower likelihood of sunset provisions that eliminate dual-class structures within specified periods.
Janeway argues that the start of this process was:
Google opting for a founder-friendly governance and later a dual-class structure as a public company seems to be the foundational event that inspired others, including Mark Zuckerberg at Facebook. I wasn’t present, so I don’t know how Larry Page and Sergey Brin did it. They had no revenue, and yet they managed to negotiate their entrenchment with two of the best venture capitalists in the history of capitalism, John Doerr at Kleiner Perkins and Mike Moritz at Sequoia.
Janeway summarizes Aggrawal et al's conclusions thus:
the entrenchment of founder control all the way to the IPO is due to two things: “Increased willingness by venture capitalists to accommodate founder control”  at the earlier stages, and “technological shocks that reduced firms’ needs for external financing” (the rise of open source software and cloud computing, which reduces the amount of capital required to start and grow a company). In other words, founders raise less capital relative to previous generations, and they raise it from more accommodating venture capitalists.
How does the recent rise in founders whose control is entrenched make failure or fraud more likely? Janeway writes:
In my own 35-year experience ... the adequacy of management (Business Risk) is the dominant risk to which a startup is exposed.

I have this phrase I used to use: It’s amazing what first-class management can do with a second-class idea, but there is no idea so good that it can’t be destroyed by inadequate management. And it is the case in more than several salient examples, ... that changing management was the essential step towards creating a really successful, sustainable, valuable business.
There have been a lot of recent CEOs that should have been (e.g. Elizabeth Holmes) or belatedly were (e.g. Adam Neumann, Justin Zhu) changed. Janeway makes a point with which I completely agree, the importance of:
the experience of stress. In BEA Systems, a company we invested in and became a huge success, and where we didn’t fire the founders, all of the founders had been through a failed startup or a near-death experience of an established company.

By the way, this is usually omitted in the mythic histories of Silicon Valley, but circa 1990, both Sun Microsystems and Oracle each almost went bankrupt. The truth is, building a really substantial business at a fast pace is extremely stressful, and understanding how people have been able to learn from that explains why some founders succeed against all odds.
One of the BEA founders they didn't fire was Bill Coleman, for whom I worked at Sun. The other founders were also ex-Sun, so they all had been through the near-death experience from which Sun escaped thanks to the 1987 deal with AT&T.

Among the major companies that went through the near-death experience are:
  • Intel, during the transition from making memories to making processors.
  • Nvidia, both when their first chip was a technical success but a market failure, and again before 3DFX's patent lawsuit was stymied by Nvidia's countersuit.
A striking feature of the early days at Sun was the emphasis the company's first CFO, the redoutable Bob Smith, placed on ensuring everyone was aware each quarter of the financials. Jen-Hsun Huang continued this in the early days of Nvidia, constantly repeating "cash is king"! Janeway agrees:
when you have obligations that you have to meet in cash: you can pay those obligations out of operating revenues, out of the sale of assets, or out of the issuance of new securities. And when you run out of those three alternatives, that’s when you call in the lawyers!
this is my concern with the entrenchment of founders: in my experience, unless they have previously been through a failed startup or at least the near-death experience of an established business (that is, flirted with bankruptcy), they are insensitive to those stressors. And that’s the problem in the current environment: there’s no need for them to be sensitive! But I find it extraordinarily unlikely that the current environment will last indefinitely.
It is a common misperception that now, when there is a flood of money available, is a great time to start a company. This is precisely backwards. The best time to do a startup is when no-one else is. We started Nvidia in one of Silicon Valley's periodic downturns - we were the only hardware company to get money that quarter. The downturn meant we could get to the best lawyers, the best real estate people, the best CAD software and, crucially, the best VCs. Six months later, when we knew of over 30 other companies starting to attack our market, we would have been competing for attention from these best-in-class resources. The difference between the best-in-class VCs and the rest is huge, as Janeway points out:
It’s really up to entrepreneurs to do their due diligence on the investors they get on board. Venture capitalists have track records. Some of them are ignorant or stupid, some of them are bullies, some of them behave badly. This should not be a surprise. It’s possible that a naive first-time entrepreneur might not know how or have the network to do effective due diligence. But it’s out there waiting to be done.

About that, let me just say one thing about venture capital that’s really different. It’s not the extremely skewed returns: we see that across various asset classes. Rather, it’s the persistence of a firm’s returns over several decades, as seen in the US and documented with the data provided not by venture capitalists themselves, but by their limited partners!
The Economist notices the importance of venture capital to the US economy in A bigger role for venture capital:
The first recognisable venture-capital fund, ard in Boston, was created in 1946, but its successors loom much larger. Just shy of half all listed American companies were once venture-backed. The ascent of venture capital has come, in some ways, at the expense of other financiers. Bankers are conspicuous by their absence in Silicon Valley.
They attribute this increased role to the increased proportion of investment going in to intangible assets:
Firms once mostly invested in physical stuff (“tangible capital”) like railroads, equipment, vehicles or machinery to make things.Now they increasingly invest in research, branding and software (“intangible capital”) to produce intellectual property.
The rise of intangible capital may explain several capital-market trends, including the fact that private firms are tending to stay private for longer and the popularity of mergers. Software companies find it easier to protect intellectual property in private markets. Rigid accounting rules do not cope well with intangible capital, for instance by mostly booking spending on research as an expense, discouraging it.
The prevalance of intangibles explains why startups, especially recent cloud-based "asset-light" ones, aren't financed in the traditional way, by borrowing from banks:
Lenders like collateral: whenever financiers make loans they worry about being repaid, but they can take valuable property in case of default. Most consumer lending is secured against houses or cars.But businesses that create intangible assets do not have such collateral. This can make it harder to secure debt-financing, which is often not available unsecured for new businesses at a reasonable rate.
If venture capital is increasingly important in the economy, the fact that it isn't working well, producing sub-par returns and an epidemic of fraud and unethical behavior, is a serious problem. Aggrawal et al conclude:
We show that the main factor that predicts dual-class structures and a greater wedge is the amount of available private financing for startups. The more outside opportunities the founders have, the greater their bargaining power when raising capital. Therefore, they are better able to retain control of the firm after the IPO. We also document a decrease in VC firms’ aversion to dual-class structures and attribute it–at least in part–to the reduction in the costs of doing business due to technological advances in the software and service industries. This finding is consistent with the idea that when there is a lower need for financing, founders are less likely to relinquish their power to VC firms.
The literature to date has shown that increases in private financing have led to a decrease in the number of firms in public markets, and therefore more concentrated ownership in the economy as a whole. We further show that greater private financing may also cause public markets themselves to change by allowing founders to retain greater power to pursue their visions, without keeping an economic stake in the firm.

Our findings provide critical input for evaluating policy proposals that affect the nature of public and private markets. They suggest that policies to liberalize private markets by loosening the restrictions on selling and trading in private securities (SEC, 2019) may not only make public issuances less desirable, but may also increase the likelihood that the firms that do ultimately go public will be controlled by their founders.
Who could have predicted that the flood of money would lead to looser discipline of entrepreneurs, leading to lower returns, fraud and irresponsible behavior by founders, greater inequality, and reduced influence for holders of public equity?


David. said...

Joshua Bote has more on the defenstration of Justin Zhu in A San Francisco tech CEO says he was ousted because he used LSD before a big investors' meeting:

"Quirks that are now commonplace in tech culture — casual attire during fancy meetings, drug use in the name of bolstering productivity and grandstanding, conceptual thinkers — ended up becoming a thorn in Iterable's side, per the Businessweek report, despite the company being valued at a couple billion dollars."

Only VCs desperate to throw money at something would fund jerks like this, which is why their returns suck.

Blissex2 said...

«there is "too much money" flooding the market for startups»

There is a classic Dilbert cartoon series from around 15 years ago about that:

«The prevalence of intangibles explains why startups, especially recent cloud-based "asset-light" ones, aren't financed in the traditional way, by borrowing from banks»

The idea of "intangible capital" is vastly overrated, and it is just a fancy new name for "goodwill". Anyhow the complaint that banks don't finance businesses without certain types of collateral is ancient, and it used to be expressed by saying that banks don't lend against revenue/cash flow, and for that I think there are other reasons:

* To be used as collateral something must be easy to sell for cash in case of repossession, that is it must have a liquid market, and most "goodwill", oops I mean "intangible capital", is not easy to sell for cash. Since almost all startups fail, that is a quite important detail, and also the reason why VCs tend to drive a very hard bargain on liquidation preferences.

* Political influence by owners of certain types of assets means that there are regulatory constraints on the types of collateral that regulators allow banks to accept or the ratio of those to own capital by the banks. So for example very risky and cyclical residential property is in, and business revenue/cash flow is not.

* Political influence by owners of certain types of assets means that some assets are effectively government backstopped, and that makes them a lot less risky than "goodwill".

* If the "goodwill" is software, it is a huge myth that it is very expensive to develop, and thus in that sense "valuable": in most software companies R&D expenses (which are often inflated by a very "generous" definition of R&D) are 5-15% of revenues, and often smaller than total expenses by salespersons.

* Most importantly, usually the "goodwill", oops I mean again "intangible capital" of a failed startup is worthless because it is intimately tied to and customized for the success of the startup, and if it "worked" (in a non-technical sense) the startup would usually have succeeded. Consider the potential case of Uber closing down, for example because it were to turn out that its business model can't work: what would be the value of all its software assets, designed around that business model? The "intangible capital" of a startup as a rule would be valuable only if it failed because of "accidents", so that another startup were to be willing to buy them to have another go at the same business. For a brutal example:
«"I would argue that Countrywide is insolvent. Their only asset is their pricing platform, their business algorithm, and that's not working. The next biggest asset they have is the toner for their copiers."»

Blissex2 said...

«How does the recent rise in founders whose control is entrenched make failure or fraud more likely?»

As to this I guess it is not a huge factor, because the key ingredient as Janeway says is management effectiveness and that is only partially correlated with founder control; founder control matters only if they are ineffective and at the same time unwilling to hire better executives. That does happen, but it is nothing new or easily solved. Many VCs have the attitude that effectively the founders are "hired help" paid with stock to manage "their" startups, and the "hired help" should be replaceable at whim. If they are, great for the VCs, but making sure that the "hired help" founders know that they are just "hired help" does not make so committed to the success of the startup.

«Will the team manage the transition from startup to sustainable business»
«creating a really successful, sustainable, valuable business»

Please don't make me laugh! The "duty" of a VC is to realize the best possible growth for the fund they manage and that pays to them their 2-and-20, and that is achieved at exit, not by creating "sustainable" business. In particular in periods in which "greater fool" theory applies.

«the flood of money would lead to looser discipline of entrepreneurs, leading to lower returns, fraud and irresponsible behavior by founders, greater inequality, and reduced influence for holders of public equity?»

Since "greater fool" theory currently applies, this is the real problem with venture capital: because "cash is trash", the problem is not so much too much VC money willing to invest, but too much "dumb" money willing to buy at IPO or similar exit, and this is the pull that drives the VCs and the whole "unicorn" situation.

David. said...

Dan Malven has a contrary view in Why Institutional Investors Should Double Down on VC based on:

"A working paper published by the National Bureau of Economic Research (NBER) in November 2020 ... showing that half of all VC fund managers outperform the public markets, and are therefore worthy of institutional investment."

The paper is Has Persistence Persisted in Private Equity? Evidence from Buyout and Venture Capital Funds by Robert S. Harris, Tim Jenkinson, Steven N. Kaplan and Ruediger Stucke. Once I've had time to study its 43 pages, I plan to update this post.