open letter to Fred Wilson

It is shocking to see someone as smart as Fred Wilson say: “The venture industry is not broken, but some of the participants in it are.”

Let’s take a look at this statement for a moment. The model of taking other people’s money and investing it into startups for 2% as a management fee and 20% as carry is not inherently broken. That’s like saying the model of selling hamburgers is broken. If everyone sold hamburgers that killed the consumers, then you could argue that selling hamburgers was broken. Similarly, the infamous “2 and 20” model breeds widespread bad behavior and poor performance, which is essentially the same as being broken. So, how is it broken?
Well, most venture capitalists have started to optimize for management fees versus carried interest, or sharing in the profits generated. It simply makes sense to raise larger funds every two or three years so that each partner can earn $2 or $3 million a year in guaranteed fees. With exits taking longer and failures rampant, praying to generate personal returns from the carry after paying back your principle is unrealistic. Returns are too uncertain, and some funds have been unable to return the principle, forget profits. And, the math is clear: a 2% management fee over 10 years generates a little less than $50 MM in fees on a $250 MM fund. Meanwhile, a 2x return on a $250 MM fund also generates $50 MM in carry, yet the carry is a lot harder to get, takes a lot longer, and is much more uncertain than the fees.
Venture capitalists pump new fund money into the “flavor of the moment” industries at a staggering rate. The goal is to quickly empty out an existing fund to make way for raising a new fund and to start earning the management fees. Firms only earn fees on invested capital, creating an incentive to invest quickly in “hot” industries without much thought. This roulette table investment strategy, where everyone bets on an industry in a short period of time, barely worked with telecom and the internet, but it looks like an abysmal failure with Web 2.0 and cleanteach. It seems like “0” and “00” have come up back-to-back. There are many analogies to justify the roulette strategy, like the “rising tide floats all boats” or “safety in numbers.” You could also use the analogy: “lambs to the slaughter.”
Caring about the entrepreneur has become an afterthought, almost a myth. What firms care about is raising their next fund and returning the principle. It’s become a game. Return some principle, then raise a new fund. As a result, great entrepreneurs rarely go into venture capital anymore. It’s financial three card monte, not entrepreneurship support. Meanwhile, all of the junior associates employed in venture capital need career mobility. These business school jockeys were brought in to identify classmates as funding targets and to run complex capitalization table analysis. The next thing you know, venture firms are populated with b-school grads as partners, who, in turn, are hiring and promoting more b-school grads. Now there are a bunch of “career venture capitalists” with no idea on how to start or grow a company besides watching others from the sidelines.
If all of this were not problematic enough, the current venture capital model requires deal syndication to justify next round valuations, ensuring that many different firms work together, whether they like it or not. The problem is that behavior in a syndicate deal can only be as good as the best investor, and is likely to be just a little better than the actions of the biggest jerk. For example, if one partner in a deal is constantly trying to oust management and take over a company, it’s difficult for all of the other investors to fight this behavior. Even good investors with good intentions often take a back seat to the jerks, and they’re quick to write off a deal, while sipping cappuccinos brewed off the fat of their fees. Preferred voting rights and shareholder politics are so complex that jerks prevail.
So, Fred Wilson said that venture capitalists need to look at the entrepreneurs “as the client.” Essentially, he is saying that the model is not broken, just everyone is doing it wrong by focusing on the fees. Maybe the model encourages people to do it wrong, Fred. Wake up.