The VC Industry and Its Impact on Society

Written By Hayoung kim
“Would the world be a better place if there were fifty Silicon Valleys? Absolutely.”
— Marc Andreessen

To say that not everyone is a fan of VC would be an understatement. A recent piece in The New Yorker called VCs “a money-hungry mob” and compared them to “drug cartels,” while another piece in New York magazine called Silicon Valley VCs “a close-knit cabal of self-styled experts picking our economy’s winners and losers by subsidizing their favorite unprofitable firms, which then drive more efficient competitors out of business by selling products at a loss — all while substituting their judgement for the judgments of millions of investors, making decisions without proper vetting, embracing fads, spending promiscuously, ignoring warnings from impartial experts, and handing economic power to charismatic liars.” 

Well, then. 

While these comparisons feel a bit...extreme, it is true that venture capital has had an outsized impact on our economy, society and startup culture. While VC AUM almost doubled in the past decade, growing from $237B in 2010 to $444B in 2019, it still represents a small share within the private equity sector, which had a global AUM of $4T as of 2019. Yet some of the most valuable companies (by market capitalization) in the US like Alphabet, Amazon, Apple and Facebook started with VC funding. In fact, according to research from Stanford, VC-backed companies make up 43% of public US companies, 57% of market capitalization, 38% of employees, and 82% of total R&D of all public companies founded between 1979 and 2013.  

Research also suggests that VC-backed companies have had a significant contribution to innovation. For one, according to a recent working paper from HBS, VC-backed patents were 4.6 times more likely to be in the top 1% most cited patents and almost 3 times more likely to be in the top 10%, suggesting that VC-backed companies tend to file more consequential patents. Patents, of course, are not the only way to measure impact on innovation. We cannot ignore the fact that VC-backed companies like Amazon, Uber and Airbnb have completely transformed our ways of living - for consumers, workers, and the broader economy, spawning entirely new industries and job classes.

However, the outsized impact of VCs have been relatively concentrated in a few sectors, business models, and types of founders, and it is not clear whether the impact has overall been positive. What may be keeping VCs from having a further reach? What will it take for VCs to have greater and more positive impact on innovation, entrepreneurship, and as a result, on our economy and society? 

Three potential areas to discuss include:

  • One, the VC return model;

  • Two, the VC growth model; and

  • Three, diversity and representation (or the lack thereof) in VC. 

“I’ve watched the industry become a money-hungry mob. V.C.s today aren’t interested in the public good. They’re 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.”
— Steve Blank
 

1- The VC return model

“Venture capital is not even a home run business. It’s a grand slam business.”
— Bill Gurley

Marc Andreessen, one of the most well-known venture capitalists, is a prolific writer. His recent blog post titled “It’s Time to Build” made the rounds in Silicon Valley, in which Andreessen lamented our failure to address some of the most fundamental aspects of the “American dream,” such as housing, education and healthcare. Truthfully, it is a bit baffling that while we have built a computer that is small enough to fit in our hands to instantly access some 44ZB of data online (I didn’t even know this unit existed, but 1ZB is apparently 1 trillion gigabytes)  we can’t manage to provide access to sufficient affordable housing, education and healthcare. Why is it that we have had so much transformative innovation in some areas but not in others? 

Many point to the VC return model as a potential cause.

1a- The “Babe Ruth” effect

Most VC investments fail, meaning the winners need to win big. Really big. According to Chris Dixon (an entrepreneur and GP at a16z), 6% of investments or 4.5% of dollars invested generated 60% of total VC returns from 1985-2015. Even the most successful VCs lose money on almost half of their investments. Given the high failure rate, VCs only invest in what they believe could be “home runs,” which in many cases require business models with minimal marginal costs and nearly unlimited upside. Read: software not infrastructure. Unfortunately, as important as software innovations may be, they can only address a subset of issues that we may want to solve as a society. 

Of course, this is not necessarily a problem for VCs to solve. Some would argue that VCs have found a business model that works for them and their shareholders, and oh, by the way, are also creating significant positive externalities in many areas. Yet it’s not clear if the VC business model is working for VCs.    

1b- Winner-take-all, VC edition

VCs that are initially successful are more likely to be successful in the future. Research suggests that this initial success is largely determined by luck (rather than competence), which then provides the VC with better access to deal flow, which then leads to subsequent success. (“Deal flow,” of course, is “everything” according to Andreessen.) On the other hand, if you start off unsuccessful or only moderately successful, you will not get this access, and you will likely continue to be unsuccessful. This leads to an incentive structure where new / unknown funds are incentivized to “really kind of swing for the fences” since it is the only way to have a shot at being successful. 

Unfortunately, this kind of “swinging for the fences” seems to be resulting in losses for most funds. According to Jonathan Kinlay, the aggregate performance of some 1,400 VC funds over the past thirty years had a Sharpe Ratio of 0.63, which Investopedia kindly informs me is not considered “good.”(You generally need a Sharpe Ratio of 1 or greater.) Given that top VC funds can regularly have Sharpe Ratios of 3 or higher, this means most VCs are essentially losing money. Perhaps as a result, even though VC AUM has been growing, much of that has been concentrated in a few “megafunds”: in 2019, a total of 272 US VC funds raised $50.5B, of which 32% went to the top 10 largest funds. 

For discussion

Are we overinvesting as a society in VC (as an asset class)? If we were to have a smaller VC sector, how would that change the types of innovations that get funded?

Alternatively, is there a different model for VC that would allow different types of innovations to be funded (potentially at lower levels of risk)? If so, what would that look like and where would that money come from? 

Resources

 

2- The VC growth model

Given the VC return model discussed above, VC-backed companies need to prioritize growth over all else. This is because a company would essentially have to consistently grow 100%+ year over year in order to achieve a 10x+ return as expected from VCs. One way to ensure that you can sustain such aggressive rates of growth is through a business model with minimal marginal cost of growth. As a result, much of today’s startup financing is “concentrated on... platform economy firms…[that] exhibit powerful network effects that often lead to WTA [winner-take-all] outcomes.”  

According to UC Davis professor Martin Kenney, “in the traditional capitalist model, the most efficient and capable company succeeds; [however,] in the new [VC-backed] model, the company with the most funding wins.” He asserts that “a startup that does not grow as quickly as possible is soon overwhelmed by the startup with more capital and more reckless investment” that can acquire a dominant market position by “undercutting” the competition. 

The counterpoint is that precisely in order to capture the market in a winner-take-all space, there will be fierce competition, resulting in greater benefits to the consumers. (Remember MoviePass?) The fact that Amazon shut down its own restaurant delivery service suggests that competition is well and alive, and not dependent solely on incumbent market power or the size of your war chest. Ultimately, this competition is good for the consumers (even if it may not be good for the counterparties like drivers or restaurants.) 

In addition, this type of focus on indefinite growth is what may allow for truly imaginative and transformative disruption, ultimately growing the size of the pie. Bill Gurley, legendary venture capitalist, writes that internet marketplaces like Uber “literally create ‘money out of nowhere’” by “connecting economic traders that would otherwise not be connected [and] unlock[ing] economic wealth that otherwise would not exist.” And indeed, despite all the controversies surrounding Uber, the US taxi and limo services industry has grown from some $15B in 2011 to almost $40B in 2019. 

For discussion

Setting the question of monopolies in the tech space aside (for a future, broader conversation), what are the broader societal costs (and benefits) of the VC growth model? How can the VC model ensure greater entrepreneurship and competition that is ultimately beneficial to the economy and society rather than creating “disruption without social benefits” as Kinney believes?  

Resources

 

3- Diversity and representation in VC  

An oft-made criticism of VC is its lack of diversity, that it is a bunch of rich white men living in the Bay Area investing millions of dollars in a product that “optimizes” how they make takeout orders on their smartphones. While we should not underestimate the social benefits generated by preventing awkward millennials from ever having to talk on the phone, there is a nagging sense that there may be segments of society with more pressing needs for disruption. 

In reality, while VCs are not particularly diverse, they are not significantly less so than other, similar industries. According to the NVCA-Deloitte Human Capital Survey, women made up 21% of investment professionals and 14% of partners among VCs in 2018, while minorities (non-Asian minorities) made up 25% (8%) of investment professionals and 20% (6%) of partners. (Interestingly, many of these women partners seem to be concentrated at firms they founded themselves; Vox reports 65% of VCs still have zero women partners.) Compare this to law firms, another industry of “professionals” where, according to research by McKinsey, women made up 44-48% of associates and 19% of equity partners; while minorities made up 19-28% of associates and 9% of equity partners in 2017. (Note that a “partner” at VC may not mean the same thing as an equity partner at a law firm due to title inflation.)  

But of course, no one ever referred to corporate lawyers as “fairy godmothers of success.” The issue is that VCs are in many ways the gatekeepers of innovation, determining what types of projects and founders will receive funding. And according to research, VCs are more likely to be favorably inclined toward founders with whom they have more in common. This may explain why 67% of VC investments by number of deals and 87% by investment dollars went to startups with all-male founders, while as of summer 2020, Black and Latinx founders have raised 2.4% of all VC raised since 2015. Rate My investor also reports that 27% of investment dollars have been invested in startups with Ivy League-educated founders (a statistic that doesn’t include Stanford, which supposedly produces the most VC-backed entrepreneurs.) For reference, Ivy-League graduates make up 12 of the 100 CEO’s in Fortune’s 100. 

Another part of the skew in investments may be due to a culture that emphasizes a “warm intro.” According to analysis by VentuRank, deals sourced through “warm” intros are 264 times more likely to get funding compared to a “cold” deal. Of course, this doesn’t necessarily mean that VCs are biased to warm deals. Warm deals have likely already gone through some form of a filter process by the person making the introduction, suggesting they are not at the same stage of a funnel. (Although, I must admit, 264x does feel like a very big differential.) However, this does mean that it is more difficult for founders who are not in the same networks or extended networks as VC to get funding. 

For discussion

What types of innovations and business models are we missing out on because of the lack of diversity within VC and their portfolios? And how can we make sure that VC’s are contributing to funding more innovations and entrepreneurs with potential to make a significant difference in our economy and society? What would need to change within VCs and outside? Whose responsibility is it to make these changes?  

Hayoung kim
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