The core mission of venture capital (VC) is to fund incredible ideas, so that those ideas may one day become realities. In many ways venture capitalists (VCs) are the most benevolent agents of the financial system: They are the ones who most directly channel money from those who have it to those who can put it to use. Venture capitalists allow young entrepreneurs to secure funding to cover the early losses that are typical to any business model before it can later become profitable. The VCs themselves also join the boards of these young companies and provide invaluable counsel on how to transform a start-up into a long-term success story. That’s the goal, at least.
The VC industry is changing, and not for the better. Market dynamics are evolving and shifting power away from venture capitalists and toward entrepreneurs. This is bad for business, bad for stock-holding employees, and certainly bad for investors.
Changing Market Dynamics
Simple supply and demand dynamics in the market for capital have resulted in the greatest shift the VC industry has experienced so far. In the past two decades, there has been a massive increase in ‘dry powder,’ or capital that is ready to be invested. At the same time, the number of quality start-ups searching for funding has sharply declined. The supply side has been driven somewhat by a period of overwhelming economic expansion since 2008. In the past few years, shifting wealth distribution, where the top one percent who constitute the institutional investor base behind venture capital have amassed more and more wealth, has played an equally important role. The demand side is driven by a changing business model in the tech industry. Professor Rafael La Porta at Brown University notes that the business model when General Motors, for example, was founded in 1908 required vastly more capital than it does for a Mark Zuckerberg to design a website today. Because this new business model requires less capital, tech start-ups experience fewer losses prior to reaching profitability. Therefore, modern tech firms don’t need to sell as much ownership in order to reach the breakeven cash flow. As a result, there is more VC money looking for quality start-ups today than there are quality start-ups looking for VC money.
Another major shift has been the increasing dominance of the mega fund: a VC-organized pool of capital that raises over $500 million for a prospective batch of investments. In the ‘70s and ‘80s, a plethora of venture firms would invest across a body of start-ups at the Seed and Series A stage, so that the one-in-three chance that one of them went public would make them quite rich when they sold their shares in an IPO. In 2020, we saw 21 mega funds raised across the industry. Prior to 2017, the most mega funds raised in one year had been six. While only five percent of all VC firms have ever raised a mega fund, these funds account for more than 62 percent of total capital under management. This drastic consolidation of control in the VC market naturally lowers the barriers to collusion between big funds. Unsurprisingly, it has led to the dominance of syndicated funding rounds in all of the biggest VC deals. This means that several large VC firms will work with each other in a round of funding, coordinating their current and future investment plans.
A third shift in the industry has been the compositional movement toward ex-entrepreneurs in VC firms. Until recently, the vast majority of partners in VC firms had a history in finance – and probably an MBA. Today we are witnessing VC firms hiring more ex-founders as partners in their funds. In 2009, two ex-entrepreneurs co-founded Andreessen Horowitz, which has since become one of the biggest and most successful VC firms in the world. They represent the burgeoning philosophy that founders are essential to a start-up’s growth story, and that VC firms should be less restrictive regarding how founders run their companies.
Finally, we’ve seen a growing obsession with late-stage VC. Big names like Softbank, TPG, and Tiger Global Management – private equity firms, really – are moving into the pre-IPO space and engaging in the funding rounds of private companies with several stages of VC funding already under their belt. These firms naturally have a much shorter exit horizon than those who got in at Series A. Consequently, they are less concerned with the exact valuation of companies and fostering sustainable, long-term growth, and more concerned with just getting a piece of the pie so they can make bank when the company goes public in a year or two.
How This Changes Boardrooms
All these market transformations result in a monumental transfer of power away from traditional venture capitalists and toward founders, who now have an endless line of capital knocking on their door, willing to accept any terms in order to get a piece of the equity.
The first result is that VC and private equity guys sitting on the board are far less likely to raise issues when they see red flags in CEO behaviour. Firms like Founders Fund proclaim on their website that they have “never removed a single founder.” Nowadays, this proclamation of founder loyalty is essentially expected if a VC firm wants to get a founder to agree to take their funding in return for equity. Once a VC firm has made this declaration, it’s difficult for them to pressure the founder to change his or her practices or make room for a new CEO with more experience running a public company. Not only will this lower the likelihood of other start-ups engaging in future funding with the first, but other VCs will be unlikely to want to bring that firm into a syndicated deal in the future. Increasingly, the implicit terms of syndication are that if you want to join in on a Series D, E, or F raise, you have to agree to not rock the boat. If you do, you won’t be brought on to other late-stage deals in the future.
A second change in the modern VC industry is that founders get to exercise an incredible amount of boardroom control, even when they don’t have majority equity stakes. Founders do this using dual-class common stock, which can give Class A owners 10 times the voting power of Class B owners. This leads to situations where founders own less than 10 percent of the company, but sit in a boardroom with a set of empty chairs and a few loyal members who ensure that there is no one in the way of whatever it is the founder wants. In 2004, Google was the first tech company to implement dual-class ownership at IPO. Since then, a long list of companies including Snap, Facebook, Workday, and Square have done the same. In past decades, tech founders have gone even further, establishing dual-class ownership structures before they even go public. This gives them far more power in the boardroom to outvote the preferred stockholders (typically VCs).
What This Means for Stakeholders
The implications are pretty obvious: a lack of VC board member jurisdiction and willingness to act have led to serious corporate misgovernance, particularly in the tech space. Uber is a classic example. CEO Travis Kalanick owned only 10 percent of the company but had negotiated to pick three directors on the board. This allowed him to stay in power even as his company was caught up in a series of scandals, including stealing Lyft drivers and creating a fake app to evade regulatory authorities. Theranos is another example, where board members were unwilling to scrutinize CEO Elizabeth Holmes, who held over 99 percent of voting shares even after raising $700 million, until it became glaringly apparent that the whole business model was a scam. More recently, WeWork blew up. Softbank’s CEO wrote a $4.4 billion check for the start-up after a 12-minute tour of its headquarters. The investor was blind to the unscrupulous behaviour of CEO Adam Neumann and everyone on the board was too scared to say anything for fear the other VCs wouldn’t bring them into another syndicated deal.
These cases are rare in that we know about them. But the vast majority of boardroom negligence is going unnoticed, and it’s employees who get hurt when their CEO isn’t running a company properly. In the long term, companies with real potential are going to keep imploding because the VC industry is blindly chasing massive returns. As a result of corporate misgovernance, employees lose their jobs, workplace abuse gets ignored, consumers get hurt, future growth possibilities get squandered, etc. All of these things happened at WeWork, Uber, and Theranos. Rest assured, they’re going on elsewhere too.
This article is not about the solutions, but I will offer a few to consider. (1) Outlaw the creation of dual-class shares; they are inimical to the meaning of democracy and harmful to business. Without dual-class shares, founders will be forced to listen to investors who are backing the company. (2) Pass bills that legally empower shareholders to sue board members who fail to report unethical behaviour. (3) Increase oversight into the process of deal syndication, to ensure these partnerships look less like cartels. (4) Start regulating anti-trust again. The new age of data-advertising business models requires a new definition of monopoly that looks at harm to other firms, not just to consumers. If regulators started breaking up giants like Amazon that cripple competition, then VCs would stop attempting to back the next Amazon. Anti-trust enforcement at the top would see more diversified start-up funding at the bottom. (5) Bring back the 500 shareholder threshold that mandated a company be liable to public reporting requirements after it reached 500 distinct shareholders. This would force highly successful companies to raise public capital and live up to higher regulatory standards once they reach the 500 threshold.
Photo: Image via Unsplash (Matthew Henry)