‘Venture Capitalism’ Makes the World a Better Place

By Barry Shisgal

Venture Partner @ NYVC

December 2020

The New Yorker article on ‘Venture Capitalism’ (pun intended, see “How Venture Capitalists Are Deforming Capitalism” by Charles Duhigg, (www.newyorker.com/magazine/2020/11/30/how-venture-capitalists-are-deforming-capitalism) (‘the article’) presents the credentials of academic trade journalism. The article was authored by a reporter who was part of the NYT team that, in 2013, won the Pulitzer Prize in Explanatory Journalism for “The iEconomy”, a series of articles that examined the global economy “Through the Lens of Apple”. He is a Yale graduate, has an MBA from Harvard Business School, and quotes no less than four professors: Steve Blank (Stanford), Josh Lerner (Harvard Business School), Nori Gerardo Lietz (Harvard Business School), and Martin Kenney (University of California).

But a professional review of the article shows that it does not approach its subject matter in the analytic manner one would expect from academic ‘experts’. Instead, the article quotes four professors expressing superficial disdain of the VC industry and uses anecdotal and out of context examples to formulate a ‘vocational villainization’ opinion hit piece, a form of stereotyping that is quite detached from reality.

The article attacks thousands of good people striving to help make the world a better place, trying to help investors preserve their assets while receiving a decent return on their investment and, if successful, turn a profit and earn a piece of this profit in exchange for putting their own investment of time and resources on the line. The article showcases a classic case of confirmation bias; it publicizes harsh accusations against a large group of professionals without giving the accused group a chance to present a counterargument, overemphasizes instances that seem to confirm the hypothesis but are out of context and atypical, and ignores or brushes-off hard facts that disprove the author’s hypothesis and claims.

The article ignores several important nuances, but we can’t really blame its author since the VC industry is rapidly evolving and often misunderstood. There are different types of venture capital funds formed for investments in different stages of a startup’s life cycle. There are Angel investors and incubators that provide seed capital, typically under $250,000, to very-early-stage startups. There are small early-stage venture capital (ESVC) funds that invest in early-stage rounds such as Series-A rounds alongside other venture capital funds and private investors. There are larger multi-stage or follow-on funds (MSVC) that invest early-on as well as in subsequent rounds, providing the portfolio startup is performing well. Then you have Growth-Equity (GE) funds, which are very large, late-stage funds. The term late-stage venture capital (LSVC) is a bit misleading and I would argue that the VC industry and institutional investors alike would benefit from using the GE category as an umbrella for two distinct approaches. This asset-class distinction would also improve the public’s understanding of the VC industry and help avoid mistaken hit pieces such as the article at hand. One asset class strategy, which I would classify as PGE, would be a category of funds that provide growth capital to startups that are further along in the implementation of their business plan. PGE investments are typically low-risk investments made by a single fund (as opposed to a syndicated round) in startups that, without the use of VC funding, have already achieved a reliable revenue stream and established a commercially viable enterprise. Such startups are typically comparable to private companies in which PE funds tend to invest. Another, which I would calssify as GEVC, is what the industry calls late-stage VC (LSVC). The problem with the current LSVC designation is that it is used too broadly, including Series-C and D investments in startups that are still far from achieving their targeted market positioning and or product development as well as pre-IPO investments. LSVC or MSVC should refer to investments in startups still years away from an IPO or other exit. GEVC funds, on the other hand, are those that invest in startups much farther along the road and are on the precipice of an exit such as an IPO or acquisition. The difference between PGE and GEVC is that PGE funds acquire a significant portion of the funded startups at valuations based primarily on the startups projected linear earnings growth, whereas GEVC funds invest in the traditional VC series syndicated round format, each acquiring a small percentage of the company at a valuation based on the startup’s projected exit track and exponential growth.

In 2013, Cambridge Associates announced (www.wsj.com/articles/BL-VCDB-13221 and www.cambridgeassociates.com/wp-content/uploads/2014/02/PR-14-Growth-Equity-a-Distinct-Asset-Class.pdf) that it will begin posting “quarterly performance benchmarks for Growth Equity, which has matured into a distinct asset class”. Cambridge’s announcement defined GE (which I classify as PGE) as follows: “On the spectrum of private investment strategies, growth equity fits between late-stage venture capital and leveraged buyouts. Growth equity portfolio companies benefit from additional capital to accelerate growth. Most are founder-owned and have typically had no prior institutional investment. They also generally have a proven business model, i.e., established products, technologies, and customers; substantial organic revenue growth, i.e., more than 10% and ideally 20% per year; and positive (or soon-to-be positive) EBITDA. Growth equity investments are typically minority stakes that use little if any leverage.”

Ashley DeLuce, a VP at Callan’s Private Equity Consulting Group, penned an informative paper on the differences between Growth Equity (which I classify as PGE) and Late-Stage VC (which I classify as GEVC), available at www.callan.com/growth-equity-late-stage-vc/ or www.callan.com/wp-content/uploads/2019/04/Callan-Growth-Equity-v-Late-Stage-VC.pdf. Venero Capital Advisors, a UK based niche investment banking firm focusing on Work-Tech, also addressed the matter in a post titled “Understanding the difference between GE & VC”, available at pulse.venerocapital.com/understanding-the-difference-between-growth-equity-and-venture-capital-a4a6adc22902.

Including PGE or GEVC funds in the VC asset class, even in the LSVC category, skews the asset-class’ risk/return statistics and makes it harder for institutional investors to make data-driven investment decisions in either class. It also creates strategic and PR obstacles for the VC industry.

Many venture capitalists make a fortune if and when they ‘hit the jackpot’ with a good, smart, or lucky investment, but many more never or rarely hit such jackpots and are relegated to earning an income similar, for example, to that of an honest journalist. The public, however, is often not aware that behind a true venture capital fund are institutional investors, such as pension funds and insurance trusts, who are the limited partners of the VC fund and whose capital is then invested by the fund. These institutional investors inject tens or hundreds of millions of dollars into venture capital funds, knowing full well that approximately a third of their capital would be invested in startups likely, in retrospect, to fail, and that all capital invested in these startups will be lost forever. These retirement funds or insurance trusts cannot afford to lose money and have a strict mandate to preserve their capital for the benefit of their retirees or policyholders, and hopefully earn a reasonable return on their investments. So how can they let a third of the capital they have given to venture capital fund managers vanish into thin air? How can they go along with making investments in tens of companies expected to fail? Because the early-stage venture capital model is designed to account for, give or take, a third of investments being lost, fifty percent of investments yielding a small profit, and less than twenty percent of investments yielding high enough returns to cover the remaining losses and yield an acceptable overall return on the capital invested by the funds’ institutional investors. Without these few outsized winning investments, institutional investors, knowing that a third of investments made with their capital will be lost on failed startups, would not be willing or able to invest in VC funds, which in turn would have to stop funding fanciful innovative entrepreneurs with nothing but a brilliant vision!

This creates a multi-tiered champagne-glass top-down pyramid ecosystem, a ‘Gatsby Champagne-Tower’ in which outsized returns from the top 10-20%, i.e. profits from the few top performing portfolio investments, ‘overflow’ and, in retrospect, fuel the funding stream that was provided to the bottom tier, startups that were written-off, and to the middle tiers, portfolio investments that barely scrape by. Venture capitalists seeking outsized returns are not motivated by greed (as opposed to a certain degree of appropriate personal ambitions) and this is not a perversion of capitalism, as the author portrays it to be. Seeking outsized returns from one startup so that we can continue funding four or five other startups, knowing that the latter might yield a negative or low ROI, is precisely the beauty of capitalism. It’s an effective mechanism for spreading success and wealth while creating inclusive opportunities for starry-eyed entrepreneurs, and advancing innovation and technology for the benefit of humanity and the planet.

The same paradigm, where most investments fail while the outliers’ outsized returns make up for such losses, applies to investing in VC funds by institutional investors. Smart institutional investors do what smart VC fund managers do: diversify and spread their investments so that if a few VC funds lose money or under-perform, other VC funds they have invested in will likely make up for the losses or low returns of the former. But whether you are an institutional investor investing in VC funds or a VC fund manager investing your limited partner’s capital in startups, you can’t make individual ‘investments’ that are likely from the get-go to lose money or under-perform. Such ‘Impact Investments’ have to be made at the discretion of committees authorized to make donations or high-risk social or environmental impact investments and cannot be made by asset managers with a mandate to preserve and grow their AUM. Intentionally ‘investing’ in low-expectation startups would not only constitute a breach of the asset managers’ fiduciary duties to the beneficiaries of the investing entity, but it would also break the VC model and prevent future startups from obtaining access to risk capital.

The Washington State Investment Board (WSIB) knows that venture capital is the riskiest asset class of all (see www.sib.wa.gov/information/pdfs/asset_classes.pdf). Yet the WSIB and other successful institutional investors are increasingly investing tens and hundreds of millions of dollars in the VC asset class, particularly because the venture capital model helps local and global economies and populations while, in aggregate, minimizing the risk of loss to investors. VC investors and their portfolio companies are increasingly making capital available to the disenfranchised through DEI and balanced impact investing policies, while also balancing losses and wins to preserve investor capital and, ideally, yield, in aggregate, an acceptable return on investment.

Cambridge Associates finds that in the 15 years between 2004 and 2019 the best performing institutional investors (top decile) more than tripled their allocation to the VC asset class (see “Figure 2: Venture Capital Allocations Continue To Grow” www.cambridgeassociates.com/wp-content/uploads/2020/01/VC-Positively-Disrupts-Intergenerational-Investing.pdf#page=3).

Some venture capital funds fail to strike this balance and fail to preserve their investors’ capital in full. For this reason, institutional investors spread their investments across a number of asset classes such as PE buyout, PGE, hedge, equity and index, fixed income, RE, ESVC, and MSVC/LSVC funds, as well as across several funds within each asset class; here too, hoping that the returns from the better-performing funds or asset classes will outweigh loses from under-performing ones. This balancing act, on the fund level and on the portfolio investment level, is what keeps capital flowing into promising but risky startups and funds.

Venture capital funds in the seventies and eighties operated differently and were limited in size and number. They didn’t seek to invest in brilliant entrepreneurs as the article suggests but rather in strong teams with solid business plans and realistic pro-forma income and balance sheet projections, the stuff of MBA’s. ‘Cash is King’ was their ‘Holy Grail’. An old-school venture capitalist would not touch an innovative idea or look at a brilliant developer without detailed projections, budgets, marketing, and monetization plans, and a demonstrated clear path to profitability. Such prudent old-school venture capitalists disenfranchised ambitious entrepreneurs and brilliant startups who failed to demonstrate a clear path to profitability. Then the Internet came about and turned the startup landscape and the VC model on its head. Venture capitalists realized that by spreading the risk and making many more investments in innovative startups with no prudent monetization strategy but with an outrageously compelling vision for Internet-enabled or technology and Internet enabled stellar growth, they could fuel innovation, raise, and invest more capital, and become less involved in the nitty-gritty of micromanaging slow-growth businesses. But this meant that venture capital funds no longer needed or wanted small startups that aimed to crawl to low or medium profitability and stay there. In the new era, such old-school startups are best relegated to seeking funding through SBA-guaranteed loans www.sba.gov/funding-programs/loans, which provide low-interest debt financing for fixed assets and working capital, and from local business development associations.

The pattern used in the article to marginalize the entire VC industry goes as follows:

1. Identify an infamous outlier event or person (Juicero, WeWork / Neuman, Theranos).

2. Conflate your target (venture capitalists) with the infamous event or person using inaccurate, exaggerated, and or out-of-context conjectures.

3. Present non-representative atypical cases (SoftBank Vision Fund, carte blanche wielding $100 billion of Saudi Arabia and UAE commitments) and unrelated cases (Rupert Murdoch, Betsy DeVos – private investors who are not VC fund managers) as negative ‘stereotypes’, laying the groundwork for an assault on the merits and character of an entire group of thousands of loosely related individuals, on their business practices, and on capitalism.

4. Ignore nuances that undermine the validity of your assault and misrepresent the action or inaction of your target group as sinister and negligent in nature.

5. Misleadingly represent that your target group is the root of all (applicable) evil – while ignoring mounds of evidence to the contrary: over a trillion dollars invested in the US alone, hundreds of thousands of startups of all stages funded, thousands of successful companies that make the world a better place, and tens of thousands of startups that were funded by the VC industry but subsequently failed to launch (something we, venture capitalists, are proud of because each failed startup is stepping stone for entrepreneurs on their path to innovation and success).

The article starts by picking on everyone involved in the WeWork fiasco.

NextSpace, a local co-lo facility, was allegedly generating a small profit and aiming for modest growth. Its founder, Jeremy Neuner, seems resentful that venture capitalists rejected his idea of building “a solid business” that would achieve “five million dollars a year in revenues” and, with that $5 million, “make money for everyone”.

Venture capitalists explained to Neuner, allegedly, that “making piddly investments in his company wasn’t worth their time” and that, if they funded his tiny co-working company, they could be excluded from buying into WeWork. But “to Neuner, this seemed nuts”. What Jeremy Neuner and the author of the article fail to understand is that when a venture capital fund invests in a startup, that investment needs to strive from the get-go to yield a high return – even at the risk of going bust – not because of greed but because of the nature of VC strategy. Venture capital funds make plenty of investments that fail unintentionally. If on top of that they settled on investments intended only to yield a small return, the fund will, in aggregate, lose money or perform significantly below par. When that happens, venture capital fund managers fail to receive a share of the profit, which may never materialize or may fall below the hurdle-rate threshold. More importantly, as I have explained earlier, the pursuit of low but steady returns is outside the purview of the mandate given to VC fund managers by their institutional investors. Venture capital fund managers follow a calculated investment strategy and deviating from it could be detrimental to the interests of their fund’s investors, to the entire VC model, and to the entire startup-funding ecosystem.

Venture capitalists are not in the business of investing in companies that seek to make “enough to earn a living and buy a house and put your kids through school”, or companies that “just made a healthy living”, as Neuner represented his goals. Neuner seems irate that venture capitalists didn’t care that WeWork “was losing millions of dollars expanding to new locations at a feverish pace”, couldn’t have been profitable at the price it was charging, and that venture capitalist kept giving WeWork capital without being “certain how WeWork would ever become profitable”. But that is exactly what venture capital funds need; startups with an untamed vision of growth by creating the best solution, a proven ability to obtain follow-on funding at increasing valuations, the ability to execute its growth plans while attracting more users and capital, and an apparent likelihood of yielding very attractive returns for the benefit of the venture capital fund.

Neuner then equates venture capitalists with drug cartels because they fly on private planes. This ludicrous analogy and the fact that it was quoted by the author of the article without reservations show that the entire argument stems from bitter disdain rather than from a logical analysis of the VC industry. Bruce Dunlevie’s quoted statement “Let’s give [WeWork founder Adam Neuman] some money, and he’ll figure it out” does not reflect an irresponsible attitude, as the article insinuates, but rather the essence of venture capital strategy. Venture capitalists focus on picking investments and strive to refrain from micromanagement. If you find a prospective investment to be in line with the objectives, theme, criteria, and risk tolerance of your fund, you have to be able to trust the CEO of the portfolio company to ‘figure out’ how to execute her plan. Benchmark’s first investment in WeWork, a $17 million investment, was a risky bet in an early startup with big dreams and no profits. No one can complain that after SoftBank dumped billions of dollars into the company, Benchmark’s investment yielded a good return, especially considering that Benchmark came dangerously close to losing all the capital it invested in WeWork.

The article focuses on SoftBank Vision Fund’s Masayoshi Son giving WeWork $4.4 billion on impulse after a twelve-minute tour of WeWork’s headquarters. But SoftBank Vision Fund isn’t a real venture capital fund. A typical venture capital fund will raise a limited amount of capital from multiple limited partners and invest the capital according to a carefully crafted strategy. SoftBank Vision Fund, a $100 billion trove fueled-by (pun intended…) Saudi Arabian and UAE commitments, is more like a multi-family office, or a multi-SWF, managed by Masayoshi Son and making proxy direct investments, carte blanche, literally on impulse.

The article then calls the venture capital industry “greedy and cynical” but the true terms would be “strategic and methodical”. The article’s subsequent claim, that the VC industry is “dominated by a few dozen firms, which, collectively, control hundreds of billions of dollars”, is technically true but also misleading. The fact is that today’s venture capital funds have across the board more capital under management than funds had a decade or two ago. The reason that the VC industry is, as the author states, “dominated by a few dozen firms, which, collectively, control hundreds of billions of dollars” is that a small number of VC firms have raised GEVC funds each intended to invest tens or hundreds of millions of dollars at a time in Series-D or later rounds in preparation for an IPO. These funds are far less risky than early-stage VC funds and give highly liquid institutional investors an opportunity to make large relatively short-term low-risk investments with the expectation of yielding a high Net-Cash-Return. Such multibillion-dollar GEVC funds should be in an asset-class category of their own and their growth does not reduce the growth of early-stage VC funds. On the contrary, these GEVC funds invest in maturing portfolio companies of early-stage funds at high valuations and help these early-stage funds increase their RVPI and obtain better returns upon exit or in the secondary market. These large funds don’t represent “greed and cynicism” nor ‘dominance’ over the VC industry but rather a solution for large institutional investors that also benefits startups and their early investors.

In fact, these GEVC funds are increasingly substituting for mezzanine capital infusions traditionally made by PE and hedge funds in pre-IPO startups. Multibillion-dollar GEVC funds are not drawing investments away from ESVC or from MSVC funds but rather from other asset classes that are exposed to a higher degree of volatility than that of, in aggregate, VC or GEVC asset classes. An Institutional Investor article explains this quite well: “”US venture capital funds have raised a combined $69.1 billion in 2020, edging past a 2018 record and defying the odds amid a pandemic-rattled economy,” PitchBook said in a blog post Friday. The record fundraising in U.S. venture capital contrasts with slower asset gathering in other alternative asset classes, including the larger private equity industry. As of the third quarter, private equity funds had raised about $400 billion globally — trailing behind the $481 billion raised over the same period in 2019, according to Preqin data. Other private capital managers, including hard-hit real estate funds, have also struggled to raise money this year, according to Preqin” (www.institutionalinvestor.com/article/b1pcv5pyp3djdj/The-Asset-Class-That-Raised-Record-Funds-This-Year). While this Institutional Investor article references a decrease in the number of VC funds closed in 2020 compared to 2018, which indicates that institutional investors are making bigger commitments to larger funds, neither early-stage funds nor GSVC funds have seen a material reduction in total assets committed to these asset classes by institutional investors.

The New Yorker article then quotes an adjunct professor at Stanford claiming that venture capitalists are “a money-hungry mob” who are “not interested in anything except optimizing their own profits and chasing the herd, and so they waste billions of dollars that could have gone to innovation that actually helps people”. One problem with this statement is that venture capitalists have a fiduciary duty to investors in their fund to optimize their returns, and doing so doesn’t make them “a money hungry mob” but rather trustworthy asset managers. Another is the fact the most venture capital fund managers don’t have the discretion to spend millions or billions of institutional investor capital on “innovation that actually helps people” – unless that “innovation that actually helps people” also fits the risk/return profile and investment strategy to which institutional investors of the fund have agreed. There are some VC funds established with an Impact Mandate and these funds have secured capital from investors, typically foundations and corporations, willing to take on a higher risk of loss associated with making Impact Investments. But most institutional investors, especially pension funds and insurance companies, require fund managers to balance environmental and social impact investing without increasing risks to invested capital and without adversely affecting the fund’s returns.

The article implies that venture capital strategy is “a clubby, self-serving approach [that] has made many VCs rich” but what makes venture capitalists rich is only their ability to successfully provide institutional investors, such as state-run pension funds, with an acceptable return on their investment in the fund. VC funds are expensive to run and operate and fund managers do not earn a profit from fund investments unless their institutional investors have earned a minimum rate of return, typically an 8% IRR hurdle rate. The article disparagingly quotes the NVCA’s account of a “record decade” of “hyper growth” in which its member VC funds had invested “nearly eight hundred billion dollars”, implying that this growth represents “a self-serving approach” when it merely indicates that more startups are being funded, more startups are failing (which is in retrospect a good thing), that more capital is available for growing companies, and that institutional investors are comfortable enough with the VC strategy of ‘high loses offset by higher gains’ that they are willing to allocate more assets to the VC fund asset class, to the benefit of the startup economy, which supports other local economies too.

The article mistakenly suggests that “A million-dollar investment in a thriving young company might yield ten million dollars in profits. A fifty-million-dollar investment in the same startup could deliver half a billion dollars”. Implying that the MOIC (Multiple of Invested Capital) on a large late-stage investment is the same as the MOIC on an early stage investment (10x in the article’s examples). But that is typically not the case. Smaller early stages investments are made at low PMVs (Pre Money Valuations) of a few million dollars, whereas larger LSVC or GEVC investments are made at PMVs in the hundreds of millions of dollars or even in the billion-dollar range. This means that an early investor paid, per share of the same portfolio company, a small fraction of what the LSVC or GEVC investor pays and, as a result, early stage investors typically receive a significantly higher MOIC. For example, according to Eric Newcomer, Sequoia’s 15.3% share of DoorDash stock was obtained with investments totaling $217 million, compared to SoftBank’s 18.6% (www.newcomer.co/p/the-story-of-a-cap-table-doordash) for which it paid $600 million (www.wsj.com/articles/doordash-is-set-to-deliver-softbank-a-big-hit-11606906803).

The venture capitalist quoted in the article as saying that “it stopped making sense to look at investments that were smaller than thirty or forty million. It’s the same amount of due diligence, the same amount of time going to board meetings, the same amount of work, regardless of how much you invest.” isn’t saying that the MOIC is the same. The economics of LSVC or GEVC funds are different; they yield lower MOICs than smaller funds do but their strategy is to raise larger funds and make larger short term low risk investments in startups exhibiting stellar success. An entrepreneur seeking a $1 million Series-A investment should approach an ESVC fund, not a LSVC or GEVC fund looking to invest tens of millions of dollars in Series D+ rounds. If ESVC funds, who are seeking to place $1 million investments in promising startups, still don’t find such entrepreneur’s startup attractive, the fault is not in the VC fund, the venture capitalist, the industry, or in capitalism. In such case, the problem might lie in the startup’s business model or in the entrepreneur’s lack of understanding of the fundraising process. For such entrepreneurs, www.TheCapitalNetwork.org provides an excelent fundraising education and valuable networking opportunities.

The article then brings Theranos as an example of a “dubious startup” that received a “gigantic infusion of money”, $700 million to be precise, from investors “including Rupert Murdoch and Betsy DeVos, before it was revealed as a fraud”. But Thernos was a con that duped Walgreens into investing $140 million in the company and to deploy fake blood-testing machines in dozens of Walgreens pharmacies. Theranos also duped Partner Fund (PFM) to invest $96 million dollars in Theranos at an approximate valuation of $9 billion. PFM, which is a hedge fund rather than a VC fund, sued Theranos for fraudulent inducement and settled for an undisclosed amount. According to Forbes (www.forbes.com/sites/petercohan/2018/05/04/theranos-losses-a-drop-in-the-bucket-for-devos-murdoch-waltons-and-kraft/), Theranos duped eight billionaires out of $528 million, including DeVos, Murdoch, Cox, Walton, Carlos Slim, and more. The only venture capitalist that invested in Theranos was Tim Draper. Draper invested early-on a small amount and mostly because Theranos’ founder, Elizabeth Holmes, was a childhood friend of Tim Draper’s daughter. Tim was duped too and believed that criticism of Elizabeth Holmes was no different than when “taxi companies attacked Uber, hotels attacked Airbnb, car companies attacked Tesla, or telecoms attacked Skype”.

Tim Draper, the only VC and a very minor investor in Theranos, had nothing to do with the Elizabeth Holmes’ con. Blaming Draper, let alone the VC industry, for a con perpetrated by a company that was mostly funded by duped family offices doesn’t hold water. But even if VCs would have been duped and bilked by Theranos, a conned investor is a victim, not a perpetrator, and not a “co-conspirator” as the article claims elsewhere. Coincidently, Draper’s VC firm, DFJ, was also the first VC to invest in Tesla, which endured ridicule from traditional investors and analysts for years before Elon Musk’s vision and penchant for excellence quelled skepticism and quashed naysayers.

Then the article ridicules Google’s investment in Juicero. But Google, despite calling its investment arm ‘Google Ventures’, is more of a corporate investor, like those of Intel, Microsoft, Facebook, Samsung, Walgreens, etc. Google, an Internet company that in 2015 had $75 billion in revenue, didn’t invest $100 million in Juicero because it was a juice maker. It invested an eighths of one percent of its revenue in Juicero because the latter was a startup experimenting with early implementation of Smart Home / Connect Devices / IoT / Retail Metadata / Direct to Consumer (DTC) / Edge Computing technology, a tech-set expected to develop into a multi trillion dollar marketplace across multiple verticals within a few short years. Juicero could have achieved success had it substituted the mechanical presser for a mobile app and offered urban health-conscious consumers automated stock management and reordering, calorie tracking, social product research and ratings, and integration with an open platform supplier marketplace. But rather than focusing on Smart Kitchen technology, Doug Evans, Juicero’s CEO, was fixated on the mechanics of pressing a cup of juice at home. When Bloomberg exposed the uselessness of the (expensive) mechanical juice pressing hardware, Juicero became a laughingstock – and folded.

After Juicero, the article scrutinizes a $300 million investment in a dog-walking app named Wag!. But here again, the investor that threw $300 million at Wag!, which was only asking for $75 million, was the same Saudi Arabia and UAE backed SoftBank Vision Fund that tossed $4.4 billion at WeWork, and not a strategic VC fund. It’s worth mentioning that Rover, a competitor of Wag! did raise hundreds of millions of dollars from real VC investors but the article isn’t criticizing those investments because Rover is a widely used app. The differences between Wag! and Rover seem to boil down to management quality, see www.cnn.com/2019/09/27/tech/wag-dog-walking-softbank/index.html.

The article continues to lament, this time about ‘unicorns’ which is a nickname for startups that have reached a valuation exceeding the billion-dollar threshold. First, it challenges scandal-plagued Uber, in which the same SoftBank Vision Fund invested $7.7 billion dollars, and Zenefits. The article then complains about VC firms throwing money at startups that “never seemed to have a realistic plan for turning a profit” and quotes another professor arguing that “money-losing firms can continue operating and undercutting incumbents for far longer than previously”. Aside from the fact that many “money-losing firms can continue operating and undercutting incumbents”, whether those firms are private firms with strong financial backing (such as PE buyout), public firms with access to capital via secondary offerings, or firms with strong lines of credit, both those points of contention; “startups that never seemed to have a realistic plan for turning a profit” and “money-losing firms can continue operating and undercutting incumbents for far longer than previously” – reflect a part and parcel of business development in the global connected marketplace for innovation. Google, Facebook, Twitter, YouTube, Instagram and many more stellar startups “never seemed to have a realistic plan for turning a profit” – until they did. Amazon, Tesla, and many other lucrative startups were heavily-funded “money-losing firms [that] can continue operating and undercutting incumbents for far longer than previously” – and that’s why they were able to focus on improving the services and products they offer to their end users and secure their position as number-one in their fields, before becoming profitable. The article complains that this means that “the company with the most funding wins”, but that is not necessarily true.

In fact, the same SoftBank Vision Fund that invested $7.7 billion in Uber, which operates UberEats, also invested $600 million in Door Dash, a competitor of Uber Eats. But Uber was unable to grow its Uber Eats division as fast as DoorDash, which used SoftBank’s investment to beat out larger and competitors with better funding, including publicly traded GrubHub (see secondmeasure.com/datapoints/food-delivery-services-grubhub-uber-eats-doordash-postmates/). Many startups received tens or hundreds of millions of dollars only to fail miserably, while many other startups managed to succeed on a shoestring budget, and vice versa. See “189 of the Biggest, Costliest Startup Failures of All Time” at www.cbinsights.com/research/biggest-startup-failures. For example, search engines were launched with unlimited funding yet failed to gain traction, while Google organically climbed to number-one without outside funding. See also “Invisible unicorns: 35 big companies that started with little or no money”www.techcrunch.com/2017/07/01/invisible-unicorns-35-big-companies-that-started-with-little-or-no-money/.

The article claims that heavily funded startups are “destroying economic value” or “undermining sound rivals” and creating “disruption without social benefit”. This can happen whether the startup is self funded or funded by the VC industry, but a startup creating “disruption without social benefit” will not survive and no VC investor seeks to intentionally invest in a startup doomed to fail. The market is fickle and disloyal and if there’s an opening for ‘disruption WITH social benefit’ – such disrupter will step up, receive funding, and obliterate any startup creating “disruption without social benefit”. The same can also happen with companies that started without much funding, used their success to undercut competitors, then started to disappoint end users. Amazon, Tesla, DoorDash, and InstaCart are examples of ambitious well-funded startups with a viable business model that have the potential of creating true paradigm shifts that benefit the end user and change the world, mostly for the better, but not without a cost to less innovative or less agile competitors. Less ambitious and less funded startups can find niches in which they can establish a small but strong local presence. Capital could help but it doesen’t guarantee sucess. Case in point: RIM, with hundreds of millions of dollars in the bank and no debt, failed to adapt to market changes and its market-share was devoured by its competitors. If the author had made a serious attempt to criticize VC valuations, he would have taken a jab at Essential Products, which reached unicorn status based on a pitch deck, received hundreds of millions of dollars from Chinese investors, from Amazon, and from VC investors, only to disintegrate without selling any “essential products”.

The article’s claim that successful startups are able to demand more funds and command higher valuations, is true indeed. But the same ‘problem’, so to speak, lies within any asset class – investors typically have to choose between investing in value or in growth, and growth opportunities come with higher valuations or premiums on projected future earnings. Venture capital funds, unlike PE buyout or PGE funds, invest alongside many other investors, including angel investors and other venture capital funds, and are only minority shareholders in each portfolio company. It would be counterproductive for an individual venture capital investor to attempt to micromanage its portfolio companies as a backseat driver without real control, especially since it shares the same backseat with many other investors and shareholders. As a group, numerous investors with seats on the board of directors have some control over the portfolio company, but exercising such control requires a forum and a consensus and is often reserved for situations requiring extreme measures. With rare exception, instead of control, VC investors offer strategic assistance at the discretion of the portfolio company. As a result, VC firms must engage in enough due diligence before investing in a startup – and only invest in startups with business models and founders the VC fund manager can trust to execute on their visions and promises.

Previous generations of VC firms operated in a different world. Talent and capital were scarce, technology was limited, development and user acquisition required significant time and resources, and exit routs were limited and uncertain. Today, talent, capital, and technology building-blocks are abundant, development and user acquisition can be achieved rapidly and on a shoestring budget, and exit options are robust.

The article’s criticism of SoftBank is legit, but the author’s projection of SoftBank’s reckless investment style on the VC industry is far from it.

In 2019, “SoftBank faced criticism when its strategy of pouring billions of dollars into highly unprofitable startups became bogged down by some high-profile flops” and “SoftBank Chief Executive Masayoshi Son acknowledged some flaws in his judgment and began to publicly emphasize the importance of profitability” (www.wsj.com/articles/doordash-is-set-to-deliver-softbank-a-big-hit-11606906803). The article describes how Masayoshi Son lost $70 billion on bad investments in Internet startups back in the nineties and only one small investment brought him back from the brink when his $20 million investment in then-tiny Alibaba became worth over $100 billion years later.

The difference between investment and gambling is that investment relies on strategy that is expected to yield predictable and repeatable performance, while gambling relies entirely on luck. SoftBank does not seem to have an investment strategy but rather a gambling strategy, that of spreading money across the roulette table hoping that when the wheel stops spinning one of the randomly placed bets will cover all other losses. The venture capitalists I know rely on investment strategies supported by data and analyses, not on “buying more lottery tickets than anyone else” as the article portrays SoftBank’s strategy. On a small scale, making hundreds of random investments is a valuable VC strategy because it creates a pipeline for future investments, allowing a MSVC fund to cull the herd through a process of eliminating failing portfolio companies that received small investments and making large follow-on investments in well-managed viable and growing startups. This strategy is somewhat akin to first investing in a broad index fund then investing larger amounts in the most promising companies on the index. But SoftBank Vision Fund, itself flush with too much capital for its mandate, has been dumping truckloads of capital on a large number of startups without bothering first to research the startups’ needs or ability to adequately convert these funds into growth or value. A clear example of this, one not presented by the author of the NY article, would be SoftBank’s $240 million 2018 investment (according to BusinessInsider) in Brandless, which shut down a year and a half later.

The article continues to try to tie venture capitalists with WeWork’s shenanigans. An “unprofessional atmosphere” and weed smoking could be just part of the culture in many startups, including failing startups like WeWork and successful startups like Tesla. The problems at WeWork ran much deeper than “an unprofessional atmosphere” and involved rumors of sexual harassment, rowdy behavior, and self-dealing. The WeWork frenzy of runaway valuations stemmed from the unique combination of Adam Neuman’s personal charisma and SoftBank’s risky strategy of going all-in pre-flop, or betting on exciting startups too big, too early. The lessons to be learned from the SoftBank Vision Fund are 1) that institutional investors should diversify their allocations even within an asset class, i.e. rather than put all your eggs in one basket or $100 billion in the hands of a single VC fund manager, they should invest in multiple VC funds, 2) that they should be able to understand and agree with the strategy behind each fund manager’s investment thesis, and 3) that ‘past performance does not guarantee future results’, especially when such past performance was stemmed from a single stroke of luck.

Claiming that by funding Facebook and Uber (as mentioned earlier, SoftBank invested $7.7 billion in UBER) VCs have “enabled” Mark Zuckerberg and Travis Kalanick who “have become public villains” is a far stretch. VCs invest in tens of thousands of startups by acquiring a minority stake in each portfolio company and it is beyond their purview to police thousands of founders. Directors owe a duty of loyalty to the corporation, which is a duty to act in the best interests of the corporation and its collective shareholders. VCs also owe a fiduciary duty to the institutional investors, the limited partners of the fund, whose capital the VC has invested in the portfolio company. As such, unless they suspect a crime that should be reported to the authorities, or have been made aware of malfeasance by the startup’s executive staff, directors are in fact obligated to refrain from publicly airing comments that could have a detrimental effect on the valuation or prospects of the company. No VC wants to be stuck with an irrational founder but, once in that position and powerless to solve the problem, VCs tend to distance themselves from it as best they can. However, VCs are increasingly conditioning investments on prospective portfolio companies establishing and implementing internal Environmental, Social, and Governance (ESG) Diversity, Equity, and Inclusion (DEI) Employee Rights, and other Corporate Responsibility policies and procedures conforming to standards promulgated by organizations such as the National Venture Capital Association (NVCA) and the UNPRI (www.unpri.org).

The article rightfully ridicules WeWork’s IPO Registration Statement (S-1), but S-1s are written by the investment banks underwriting the IPO, who are subject to disclosure and reporting rules and regulations governed by the SEC and FINRA. Other than providing shareholder information to the lawyers and auditors preparing the S-1, VCs have almost no involvement in its preparation. In reliance on the underwriters’ skills and responsibilities, VCs often do not even read the entire S-1.

The article then attacks the Board of WeWork, but WeWork’s directors followed their mandate. When the company was growing and heading toward becoming a publicly traded company, they stayed out of its way. When Neuman became an impediment to the company’s prospects, they pressured him into leaving. Claiming that “the board could have assumed strong oversight of the company and started the hard work of rebuilding [it]” is not necessarily correct. A board of directors does not mange or operate the company. It hired a replacement CEO who fired problem employees but WeWork needed more than just new management, it needed capital, and a lot of it. You can rest assured that the VCs on the board investigated the prospect of investing additional capital into the company but concluded that such an investment would not be in the interest of the limited partners of their respective funds and would amount to throwing good money after bad. With proceeds of an IPO off the table, selling their WeWork shares to SoftBank, which was flush with cash and willing to throw good OPM after bad, was the best way for these early VC investors to prevent WeWork from collapsing and recoup the funds they have invested on behalf of their respective investors in WeWork. Buying out Neuman was not a choice; he was a major shareholder and legally entitled to proceeds from the sale of his shares to SoftBank.

For a VC fund manager, who only gets paid after the institutional investors that invested in the fund achieve a preferred return, or a hurdle rate, of, typically, 8%, “a fine investment on a cash-on-cash basis”, as described by the author of the article, is far from a profit. It means that the fund did not lose cash on the deal and made a relatively small cash profit, but in terms of a compounded profit reflecting the number of years the capital was invested, the return would be very low and below the VC fund manager’s hurdle rate. It will also fail to offset losses from other fund investments, preventing the VC fund manager from earning a carry, a profit from the fund’s aggregate investments.

SoftBank, or more accurately, Saudi Arabia and UAE by-proxy, dumped tens of billions into WeWork. They might be able to recover some of it but it’s unlikely this ‘investment’ will ever yield lucrative returns. Ironically, the only real ‘winners’ in the WeWork saga were Adam Neuman and the scores of entrepreneurs around the world, including myself, that got to enjoy WeWork’s beautiful colocation facilities at prices subsidized by SoftBank’s billions.

WeWork was a colossal catastrophe in terms of ROI but life isn’t fair and, in this case, those who least deserved to benefit from the ordeal walked away with fortunes. The WeWork saga was an anomaly and funding to other startups may have been affected by other factors but not by WeWork’s troubles. Venture capitalists make mistakes, and such mistakes are baked into their business model, but investing in WeWork was not one of them. WeWork would have progressed comfortably toward an IPO if SoftBank would have invested in it $1 billion instead of $3 billion. It was the easy money and the over abondance of it that exacerbated Neuman’s mismanagement style and transformed it from visionary to reckless. WeWork could have been a success and anyone who rented a spot at one of its locations can attest that WeWork offers entrepreneurs and office-less workers a much-needed service.

Venture capital funds are not charities. They invest in innovators and help them grow but only if doing so is likely to yield the funds’ investors a reasonable return on investment. Much like with startups, some VC funds manage to yield outstanding IRRs, others succeed in providing their limited partner investors an acceptable MOIC, while other funds may lose money over the life of the fund or yield low returns.

Calling venture capital strategy “greedy impulses” is misleading, to say the least. Even SoftBank’s clearly impulsive decision-making was far from “greedy”; throwing $4 billion at an entrepreneur asking for just $1 billon is more ‘generous’ or ‘charitable’ than “greedy”. Institutional investors make various types of investments which, in aggregate, tend to achieve results not much better than returns achieved through index fund investments. But institutional investors are required to diversify across asset classes to mitigate or hedge against volatility risks and VC, being a long-term illiquid asset class, provides a hedge against short term financial markets volatility, (See “Volatility and Venture Capital”, Peters, 2018, www.rsm.nl/fileadmin/home/Department_of_Finance__VG5_/PAM2018/Final_Papers/Ryan_Peters.pdf), along with attractive returns. Institutional investors only allocate 10-15% of their investments to venture capital funds because investing in venture capital funds is perceived (not necessarily accurately) as risky; VC funds sometimes experience loses, sometimes yield minor gains, and sometimes yield far better returns than index funds. But all VC funds, even the best performing ones, lose money or barely break even on nearly half their investments (see Benedict Evans’ post of Horsley Bridge’s analysis of 7,000 portfolio investments www.ben-evans.com/benedictevans/2016/4/28/winning-and-losing).

Without the handful of portfolio investments that provide their VC investors extremely high returns – the entire VC investment model will collapse. Without the super returns from a few homerun or grand-slam portfolio investments – funding for thousands of startups would dry up. Without venture capitalists and without the venture capital investment strategy, where many investments lose money and a few investments yield outsized returns that make up for such loses, the ecosystem that provides funding to tens of thousands of aspiring innovators – would never exist.

People called Elon Musk ‘crazy’ and some still do, but that’s because they can’t tell the difference between crazy and genius. Visionaries are crazy when they fail but geniuses when they succeed. Saying that “It was clear to everyone [that Neuman] was selling something too good to be true” is itself untrue. Just as it was far from clear that Elizabeth Holmes or Theranos were selling a lie, investors believed Neuman and believed in-him, as did his employees, the same employees that are now complaining that they were robbed of a piece of the pie. If they never believed in the pie, they can’t complain about not getting a piece of it. Neuman, fueled by unfathomable riches and drunk with success and power, turned out in hindsight to be a bad manager and a major liability. But at the time, his vision, plan, and strategy, until just prior to the failed IPO, were compelling.

There are indeed villains in this world, but venture capitalists (in general) are not among them.
In the hit-piece article, the academic author seems to be weaponizing SoftBank out of context against the VC industry with help from fellow academics. But the VC industry targeted in the article further serves the author as collateral damage in yet a broader assault, similarly out of context, against capitalism itself.

Looking a bit deeper, one might recall that the VC industry and the startup universe often exhibit an aversion to business school grads. Billionaire Elon Musk, founder of Tesla, SpaceX, Solar City, and PayPal, made it clear by saying that “As much as possible, avoid hiring MBA’s. MBA programs don’t teach people how to create companies … our position is that we hire someone in spite of an MBA, not because of one”. Billionaire founder and venture capitalist Peter Thiel stated that MBA’s are “high-extrovert, low-conviction people” and even “never ever hire an MBA; they will ruin your company”. Billionaire founder Scott Cook, a Harvard Business School MBA himself, stated that “When MBA’s come to us, we have to fundamentally retrain them. Nothing they learned (at Business School) will help them succeed at innovation” (https://stvp.stanford.edu/blog/tag/value). In a December 2020 interview with Matt Murray, Editor in Chief of the WSJ, Elon Musk remarked that “I think there might be too many MBAs running companies. There’s the MBA-ization of America, which I think is maybe not that great” (www.wsj.com/articles/elon-musk-decries-m-b-a-ization-of-america-11607548589).

However, the disdain for MBAs expressed by such prominent billionaire founders and venture capitalists needs to be put in its proper context. It does not mean that venture capitalists refrain from investing in startups led by MBAs. The derision of MBAs by prominent billionaire tech founders stems from their frustration with MBA perceived-insubordination and strongheaded opinions, which could be out of line for employees of brilliant founders with a razor-sharp vision for their respective baby-unicorns. MBAs can and do succeed as founders or as executives at startups with a flexible or a conventional business model where standard procedures and business-as-usual adds value to the company. Blue Apron, Compass, Diapers.com, DoorDash, HomeLight, Hulu, JUUL, OpenTable, Peloton, Plenty, Rent The Runway, SanDisk, Stitch Fix, Stub Hub, Warby Parker, and Zoom are examples of successful startups with at least one MBA co-founder or founder. Top business school networks also help their MBA graduates raise billions in funding, giving them a leg up when it comes to raising capital and launching startups. Yet with all this “MBA privilege”, there are far fewer MBA at the helm of the most successful startups.

In the VC industry itself, where innovative decision making is less crucial than in the management of a startup portfolio company, some of the leading and best performing venture capitalists are indeed MBA grads. VC firms also hire analysts and associates with MBAs, which may later become partners. But in the startup world the situation is different. BSchools.org looked into the number of unicorn founders garnishing an MBA (www.bschools.org/blog/mba-unicorn-startup-founders). Of 496 unicorns listed by TechCrunch (www.techcrunch.com/2019/05/29/the-crunchbase-unicorn-leaderboard-is-back-now-with-a-record-herd-of-452-unicorns), they picked 49 unicorns with the highest valuations, worldwide, (One of the top 50, Jiedaibao, has no founders listed). Globally, 12 unicorns, or 24% of the 49, were started by at least one MBA founder, 42 unicorns, or 86% of the 49, were started by at least one non-MBA founder (five unicorns were started by mixed teams), and 26 unicorns, or 53% of the 49, had no founders with and MBA. There are 7 unicorns on the list with all-MBA founders, 5 from China, one from Singapore, and one from Brazil; none from the USA.

But looking at the USA-based unicorns on that list, the percentage of MBA founders is much lower. Of the 22 USA-based unicorns, none had an all-MBA team of founders, 4 unicorns (18%) had mixed teams with 5 MBA and 8 non-MBA founders between them, and 18 unicorns (82%) had no MBA founders on board. In aggregate, the 22 USA-based unicorns had 52 founders, 5 founders (less than 10%) with an MBA, and 47 founders (90%) had no MBA. This data comes from a small sample set (22 top US-based unicorns) and does not suggest any definitive assumptions except that individuals with an MBA are far from dominating the startup scene.

MBAs are predictable, often arriving at the scene after extensive training in well-researched Best Practices, armed with lofty BSchool nomenclature and Golden Rules, and believing in the supremacy of their Ivy League BSchool degree and skill-set. On the other hand, the strength of non-MBA founders is their ability to, as the Apple slogan goes, ‘Think Different’. Innovation does not come from doing what you were trained to do, it comes from questioning or even pushing back against conventional wisdom, pondering out of the box, and not being afraid to try something unconventional, a.k.a. ‘crazy’. Non-MBA founders typically seek constructive criticism and feedback from any source but are also able to ignore superficial criticism and ad hominem attacks from prominent experts. MBAs, being trained and skilled management professionals, typically have a harder time being told by ‘academically inferior’ colleagues or even bosses that there seems to be a better way of doing something or that an action proposed by the MBA might backfire. MBAs often tend to be more sensitive to criticism from prominent experts, peers with greater esteem than their own. The knowledge and skills taught in BSchools are indeed powerful tools in the right hands but without an open-mind these tools can be misapplied and have a detrimental effect on a rapidly evolving startup navigating in uncharted territory.

Statistics show that MBAs are not necessarily better CEOs even in traditional enterprises. A study by Dan Rasmussen and Haonan Li published in Institutional Investor states the following: “MBA programs simply do not produce CEOs who are better at running companies, if performance is measured by stock price return. We ran similar regressions controlling for industry and found that — even after controlling for industry — elite MBAs did not produce positive statistically significant alpha. Elite MBAs did perform relatively well as CEOs in healthcare and consumer staples, but relatively poorly in energy and materials businesses, though those results were not statistically significant. Our study is not the only one to come to this conclusion. A study by economists at the University of Hawaii asked similar questions and found that firm performance is not predicted by the educational background of the CEOs.” (www.institutionalinvestor.com/article/b1db3jy3201d38/The-MBA-Myth-and-the-Cult-of-the-CEO).

The New Yorker article is a perfect example of academia attempting to assert dominance vis-à-vis real-life experts in a field where hands-on data analysis and a more-than-superficial understanding of the elements far outweigh regurgitated scholastic rhetoric. That said, plenty of academic researchers provide VC professionals with important and practical insight. For example, VC fund managers and their limited partners could gain such valuable insight by reviewing “What Can Venture Capitalists Learn from Academics?”, an excellent summary by Eric Ball, a senior partner at Impact VC with an extensive leadership and investment experience in the technology arena and a PhD in management, of data-backed academic research papers examining deeply held strategy assumptions prevalent in the VC industry (www.kauffmanfellows.org/journal_posts/what-can-venture-capitalists-learn-from-academics). VC fund managers might be interested in one particular thesis addressed in Eric’s summary, a substantive academic research paper titled “Should Investors Bet on the Jockey or the Horse? Evidence from the Evolution of Firms from Early Business Plans to Public Companies” by Steven N. Kaplan, Berk A. Sensoy, and Per Strömberg, published in the AFA Journal of Finance, 2009, 64(1), 75-115 (https://econpapers.repec.org/RePEc:bla:jfinan:v:64:y:2009:i:1:p:75-115).