Every other day, the media is bombarding us with news about venture funded startups for their downsizing of teams, markdowns by investors, abysmal revenue numbers or founders being replaced by professional management. Venture capital was supposed to benefit these new age companies with economies of scale to achieve nonlinear growth. The investment model seems to be clearly breaking down. The temptation for VC firms is to blame market headwinds. Limited partners entrust the general partners to create most productive returns for their money.
VC firms lose investment discipline, get carried away to follow trends and surf bubbles. Selfish focus for quick returns, unfocussed aggression to play to the gallery, reckless risk taking, poor economics, incompetence to measure potential outcomes are the expressions which can define the fall of the capital business. Something must have gone horribly wrong, someone must be made responsible for these failures. For a long time, limited partners have accepted the VC firms’ appraisal of its own worth, ignoring their investment blow-ups.
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It’s time for the general partners to start valuing business fundamentals rather than chasing growth metric mindlessly. It’s time to make crucial changes in the venture capital investment thesis.
By applying the below mentioned back to basic principles for strategy, execution and business practices can help uplift, the current performance challenges at the VC firms.
Back To Basics
- The first step is to slow down investments: It helps VCs take time out to practice business fundamentals with all the invested portfolio companies & build close relationships with founders. It will be good to have reminders with the help of posters in offices that simply read “Slow Down.” Investors are quick learners, their behaviour, actions reflect a lot from how the funds higher up in the value chain operates. If the top few leading funds act responsibly, rest of the industry will see & learn. People in the venture capital industry are forever apprentices.
- It is time to realise that funding just out of college founders taking a moonshot is like tossing darts. It is the general partners’ job to make founders realise that capital is always to be treated as a scarce resource. When you see an interesting deal, just because you can afford the price don’t just do it. It’s better to be discerning, become immune to fear of missing out which results in over commitment of capital. VCs need to be more in the market than in office feeling the pulse of the business themselves. First-hand, ground level knowledge of VCs is a million times powerful than the numerical data evidence by flawed funding models. All funds have their sweet spots with their set of domain expertise, investment themes, they should adhere to those fundamentals. Stop investing in symbols, make paradigm shift and go for domain expertise.
- It is more important to have clear metrics within the venture fund on what they know, what they don’t know rather than whom they know. The funds working behind the scene,s with detailed understanding of the sector they are investing with consensus driven investments decisions is more likely to produce winners than a fund with a star culture, celebrity fund managers chasing hot sector deals.
- A VC firm’s belief that liquidation preferences will justify their chase to subscribe higher valuations will mean that they miss out looking at the hard business numbers. These overvalued companies have a problem with their anti-dilution terms equally, which can sink them if there are significant down rounds due to their burn rates, poor unit economics resulting into losses. By overvaluing growth VC firms end up with inflated deals having no profitability imperative. VCs taking a cue from unprofitable unicorns’ journey forget that not all entrepreneurs are Jeff Bezos or Travis Kalanick. It is time to course correct by favouring companies with a clear path to profits and be valuation sensitive.
- When there is a large success and a winner is identified, it creates a lot of noise in the market. This creates thousands of startup clones with incremental innovation around that winning theme. VC firms try to look additional opportunities or alternatives in that space. Many sectors need not be where it’s winner take all, but once a pole position is achieved by the first one then it’s difficult for the second or third entry to break out. It is extremely difficult to find that one signal to fund out of the market noise. Venture firms hence need to attract the young team, best technocrats, and highly motivated professionals who can find & help fund the signal.
- Fund managers with a couple of successes think themselves as mavericks and set themselves up in an ivory tower. They get out of the continuous learning mode and build up a flawed ego with self-aggrandising claim of Midas touch in startup investments. These obnoxious fund managers end up intimidating founders and even their peers. Being humble, modest and accessible helps fund managers create valuable relationships great source of information & deal flow.
- Focussing on investments in great products, fast growing market or charismatic founders instead of a company’s business as whole is a recipe for disaster. Investors, rather than looking at accurate indicators of business success, tend to have a bias towards the idea, market or team they believe can make disproportionately big. They take decisions then try to make that decision right. These are control freaks. VCs in the driving seat doing micro management, the last stop is a definite shut down of business. A VC’s experience breadth counts but they don’t have the depths of domain expertise. They should stay at the strategy board level & keep away from fixing their product, team or market.
- Fail fast, fail often is about experimenting with growth hacks & not about blowing up capital, take pride in business failures. Celebrations of failure have gone too far with founders because of the VC firms high tolerance for failures. VC firms need to more responsible, vigilant in what they invest, and create accountability with introductions of tighter controls and transparency, having in missionary zeal with their portfolio to be successful.
- VC firms can easily lose their way when they on board an investment committee that works like a rubber stamp by blindly approving risky deals with no questions asked. It’s the end of compliance, internal checks and balances when general partners believe rules are for fools. A proper investment memorandum needs to be pitched to the investment committee which captures investment rationale, valuation, exit scenarios, and key risk factors. An upright investment committee which is competent enough to contradict & does not get intimidated is an asset to the VC firm.
The ideas VCs finance are revolutionary, no one has attempted anything like it before. This high-risk, collateral-free model of finance helps creates new business opportunities, employment & growth with improved efficiency. Venture capital is the best form of productive capital for an emerging country’s economic growth. We need VC firms’ investments to perform successfully for macroeconomic reasons.
Given the code of secrecy that VC firms impose, it is difficult to get them to speak openly about what they do. Being a full-time angel investor, working with many of the VC firms closely these are my personal views & observations.
[This post by Sanjay Mehta first appeared on LinkedIn and has been reproduced with permission.]