Reading time: 6 – 10 minutes

I have to admit that Umair Haque’s recent two part series of posts on venture capital really made me want to start writing on this blog again.  His posts, entitled “Asleep at the Wheel of Creative Destruction” and “Five Problems Venture Capitalists Should Have Solved (But Didn’t)” really got me thinking.  In the words of my friend and partner in TECH cocktail crime, Frank Gruber, Haque got me “fired up!”

At a high level Haque is calling for VCs to step up their game and push innovation forward rather than sitting back, like some have been, and making a lot of “me too” investments that, even if they play out, don’t really move the needle much for the world in terms of meaningful change, job creation, etc. Here, here! I am with him 100% on changing the world for the better.  That’s why a lot of us got into VC and entrepreneurship in the first place.

I agree with Haque on a number of the points in the “Asleep at the Wheel” piece.  It certainly seems that the VC industry is flooded with too much capital looking for homes that don’t exist (however, some places, the Midwest for example, don’t have nearly enough capital to fund the great entrepreneurs, ideas and technologies they have) and that, as Haque puts it, a culture of imitation, rather than innovation, has started to permeate venture capital.  I also agree that “transparency, disclosure and discussion” can help venture capital by allowing it to become more participative and open.

Haque closes “Asleep at the Wheel” with this statement:

Unfortunately, today’s venture investors are about as interested in reform as yesterday’s bankers were. So it just might take a venture crash – just like Wall St’s financial crash – to wake up the guys and gals asleep at the wheel of creative destruction.

Ouch!  He may be right about some folks but, as long time readers know, I have been a big fan of innovation in the VC business for some time now (and have written about some innovative ideas in detail) and there are many other forward thinking VCs that are interested in improving their business too.

That said, we need to figure out a way to innovate that can also provide great returns for our investors.  One of the main issues is that we hold illiquid investments for a relatively long period of time before we can either sell them or, hold on to your hats people, IPO them (haven’t seen one of those in a while).  Once we put money into a company the clock starts ticking and, when the investment is finally exited, that clock allows VCs and their investors to calculate the efficiency or quality of an investment, which comes in the form of an IRR or Internal Rate of Return.

The IRR allows different investments to be compared to each other directly to help asses if the VC investment was a good one as compraed to, say, putting money in an S&P 500 index fund (i.e. just because you received 5x your money, for example, doesn’t mean the investment was the best one you could have made – the time your money was locked up in that investment needs to factor in).  Here is an example:

Say you invest $1,000,000 in a startup right now and you get $10,000,000 back at some point.  Either way you look at it you got 10 times your money back.  A huge home run right?  Not necessarily.  Let’s take a look at your IRRs at different periods of elapsed time:

$10,000,000 returned at 5 years: IRR = 58%

$10,000,000 returned at 10 years: IRR = 26%

$10,000,000 returned at 15 years: IRR = 17%

$10,000,000 returned at 20 years: IRR = 12%

Interesting isn’t it.  You wouldn’t have done much better than the long term market return if you couldn’t exit your deal before 20 years of hold time.  That means, at 20 years, you and your investors didn’t get a great return especially considering that, generally, the startup you invested in was inherently more risky than the overall market and, therefore, should have had a far better return than the market to account for the excess risk you took (more risk needs to equal more return to make things work – see alpha).

This is why VCs have specific hold time targets (usually about 5 -7 years and sometimes less) and limit their funds’ life to 10 years (if you have to hold investments longer than that the IRRs, even at 10x your money, start to degrade and the folks investing in your VC fund become unhappy).

The folks that invest in venture capital funds (i.e. the big institutions) want returns that make it worth the risk they took and those returns are affected by investment hold time.  Some of the things that Haque suggests VCs should have fixed or innovated on and the markets we should have created don’t appear to have the profiles that would make for good investment where good equals what LPs want in terms of IRRs.  Therefore, even if VCs did dive into this harder-to-solve stuff they may have done a lot of good but the returns may not have been there and, thus, these VCs would not be able to raise a new fund and continue to innovate since their investors would have been unhappy.

Bottom line: if the VC business wants to start moving in the direction of some of the issues Haque puts forth and suggests VCs should have solved than VCs need to figure out how to get the returns their investors demand while pushing forward on harder to solve problems.

At the end of the day venture capital still needs to be sustainable and that means driving good returns to LPs. Good returns enable VCs to continue to raise new money to invest in innovate young companies and to perpetuate the innovation the cycle.  Returns are our constraint as VCs and we need to find creative ways to work within that constraint while still taking on the big risks that help to create new industries and completely revitalize old industries.

This is the challenge and it is a big one but one that will be exciting to work on.

At the end of Haque’s “Five Problems Post” he suggests that if VCs can’t solve problems like:

• Reinventing communications
• Reconceiving capital markets
• Business models for public goods
• Business models for radical responsibility
• Discovering new sources of advantage

than VCs are obsolete.  In fact, he says VCs are obsolete as of right now since we didn’t solve those issues.  I am not sure that he correct when he says that and I do think he trivializes the issues the VC business faces by ignoring the fact that VCs do need to provide returns that make sense to their investors.

However, I tend to look at Haque’s two recent posts as inspiration.  He’s right.  VCs can do better and VCs need to continue to strive to do better and to foster meaningful innovation.

I am not sure what the answers are in terms of working to reshape the VC business into one that address what Haque suggests VCs should be addressing. That said, I am willing to investigate the issues and to try to find some solutions that can get venture capital to the next level and I am sure many others are as well.  I am really glad that Haque and others continue to challenge the VC business.  It is too easy to become complacent and posts like Haque’s can really kick people into gear.

If a number of people heed Haque’s call some really exciting new ideas, businesses and industries will no doubt emerge and we (VCs and entrepreneurs) will continue to be able to combat the world’s largest, and most nagging, issues.