What Is Venture Capital?

European Straits #163

Mar 04, 2020

Hi, it’s Nicolas from The Family. Today, I’m answering what may appear to be the simplest question—and announcing the launch of a paid version of European Straits.

⚠️ First up, I’m launching the paid edition of this newsletter. Scroll down to the news section to learn more. Or jump on the opportunity right here and enjoy access to all forthcoming editions for an entire year 🤗👇

🎙️ In other news, you might remember that I was in Geneva a few weeks ago. One of the highlights there was recording a podcast with my friends Ben Robinson and Dan Colceriu of Aperture. I really recommend giving it a listen because our conversation absolutely resonated with the topics discussed in this newsletter—from Europe’s developing economy to the growing transatlantic rift to Brexit.

You can listen to the podcast on various platforms via this link: 🆕🎙 New Podcast! ‼
You can also read the complete transcript: Europe Is a Developing Economy. But So Is the U.S.

With regards to today’s newsletter, I recently met Johannes Lenhard, an anthropologist and the research coordinator at the Max-Cam Centre for Ethics, Economy and Social Change. Johannes is interested in venture capital, namely how it creates value and the ethics that animate the people in it. As we were sipping coffee at the De Beauvoir Deli in Hackney last week, he asked me the simplest questions: What is venture capital? And what do venture capitalists do all day? Like most simple questions, however, the answers are anything but. So read on for an expanded and documented version of my answers 👇

1/ What is venture capital? It’s a category of investing which fits two very important criteria:

Your investment target is exposed to one critical risk—that is, a risk that is either highly probable or has a significant impact, or both (criticality = probability * impact). From a business perspective, it means that this one critical risk can threaten the survival of the target. And so it is important to manage that risk by way of “assured access to cash and sufficient control of circumstances”, to quote Bill Janeway (see below). It’s also important not to be exposed to other critical risks at the same time, because there’s only so much risk a venture can manage.
If the target survives exposure to that one critical risk, everyone will enjoy returns on invested capital that are potentially infinite. And this is what makes for the unique economics of venture capital. As we often hear, a VC can afford to lose money on nine companies in their portfolio if the tenth generates such massive returns that it effectively covers all those other losses. That one win makes it possible for everyone (the firm’s general partners, its limited partners, the company’s founders, and some employees) to become very wealthy.

2/ Because of this unique profile (one critical risk + potentially infinite returns), venture capital only exists in two very specific economic worlds—tech and biotech:

In computing and networks (that is, ‘tech’), the critical risk is on the business side. A startup might fail to get a foothold on the market; it might fail to scale up; it might fail to discover a business model. On the other hand, founders don’t take much risk on the tech side (which is ironic given the ‘tech’ label): today’s tech stack is robust, available, and cheap (think: AWS, open source, Airtable, and myriad other tools). If a tech startup manages to enter the market, generate revenue, and scale up, it can then enjoy infinite returns thanks to network effects.
In biotech, the critical risk is on the tech side: you may simply never discover that new drug. On the other hand, if you succeed returns are infinite: many people need your drug; it will be prescribed by healthcare professionals; and it will all be paid for by government-sponsored health insurance. So you don’t take critical risks on the business side, just a bit on the regulatory side—and that part is usually managed by the big pharma company that acquires the startup.

3/ The “venture” part is known, and widely discussed. But what about “capitalism”? Let me remind you about what I wrote in a previous issue, Give Capitalism a Chance:

Capitalism [is] a dynamic system involving three unrelated yet mutually dependent parties—workers, consumers, and capitalists. [Instead of simply pitting] workers against consumers, capitalism brings a third party to the table: capitalists. Because those have a vested interest in expanding the pie, they can tip the balance and invite both workers and consumers to reposition themselves within the game. Like in the three-body problem in Newtonian physics, capitalism tends to be unstable, unpredictable, and in constant need of self-correction. But given proper checks and balances, it really can deliver.

And then more recently, discussing Fernand Braudel in Capitalism and the Future of Nation States:

Braudel sees within capitalism an ensemble of processes that allow one to extricate oneself from the trivialities of commerce and pursue increasing returns to scale. The market economy is the world of merchants, those who buy and sell while taking a small margin as items pass through their hands. Capitalism, on the other hand, is the world of the traders, financiers, and entrepreneurs who have understood that they can attenuate the rigorous competition in the market economy by “inserting” capital into the production process.

And so, like any other form of capitalism, VC is about inserting capital that will enable startups to pursue increasing returns to scale rather than getting mired in a vain struggle among competitors to lower prices. It’s about taking a merchant’s business and turning it into a capitalist’s business so as to generate that economic surplus that makes everyone wealthy in the end.

4/ How do venture capitalists add value? Because their business revolves about managing one critical risk (either on the business side or on the tech side), VCs often contribute in those two ways described by Bill Janeway, author of Doing Capitalism in the Innovation Economy:

When bad things happen, unequivocal access to cash buys the time required to find out what is going on [the capital per se], and sufficient control enables corrective action [the VC’s involvement in governance].

More generally, VCs simply add value by being capitalists. Most VCs I know would feel ashamed and disappointed at the idea that they’re only here to sign big checks. But really, that’s exactly their main contribution to the game—and that’s already a LOT. Simply by being the third party at the table (together with the company’s employees and its customers) and inserting that precious capital, VCs literally shift the company’s direction. Deploying venture capital in a given company changes the incentives for its founding team and triggers that virtuous pursuit of increasing returns to scale.

5/ Many people criticize venture capital because it inspires founders to aim higher, go faster, and burn more cash in the process, often missing the mark of generating positive cash flows. Here’s Tim O’Reilly criticizing Reid Hoffman’s concept of VC-fueled “blitzscaling”:

To too many investors and entrepreneurs, [value] means building companies that achieve massive financial exits, either by being sold or going public. And as long as the company can keep getting financing, either from private or public investors, the growth can go on. But is a business really a business if it can’t pay its own way?

I understand the critique of VC-backed excesses, especially following the Softbank debacle. But we need to recognize VC’s contribution to raising the bar when it comes to returns on invested capital in the presence of a critical risk. Without these capitalists’ money, a founder who is confronted with competition can really only go with one option: lowering the price, thus participating in a war of attrition that eventually ends up with everyone going bankrupt.

If, however, a startup welcomes venture capitalists in its cap table, and those capitalists are counting on the startup for infinite returns should it survive, then the founders are bound to do better than being a mere merchant competing with other merchants. Raising venture capital is a powerful incentive to switch from doing trade to doing capitalism, and to thus contribute more to creating value.

6/ Today, venture capital is changing—a lot:

VC is financing businesses that don’t really fit. Some entrepreneurs take risks that are not that critical, and the potential returns from their venture are not that high, and yet we still refer to that funding as “venture capital”. I don’t really know why. Maybe it’s a cool label that people have gotten used to. Maybe it’s because all those businesses that are more predictable (SaaS) and less scalable (consumer goods) are part of the current techno-economic transition that was so heavily influenced by VC over the past few decades. In any case, many people who call themselves venture capitalists these days seem in fact to be doing something else.
VC is diversifying its mode of investment. The characteristics of venture capital (one critical risk, potentially infinite returns) long called for financing businesses with equity. In my 2016 article A Brief History of the World (of Venture Capital), I explained that the rise of equity financing was made possible by upgrading information systems, in turn enabling financiers to back riskier businesses. But, as explained by Alex Danco in his brilliant Debt Is Coming, VC is now diversifying well beyond equity.
You might think VC is a passing phenomenon, but that’s not the case. In the current Entrepreneurial Age, more and more businesses will resemble tech startups because computing and networks are widely used across the entire economy. This means more markets will be driven by (more or less) increasing returns to scale. For every business, it means that entering the market and maintaining one’s position will be more difficult. As a result, the entire financial services industry will have to transform to emulate what is known as venture capital.

7/ Now on to Johannes’s second question: What do VCs do all day? The common view is that everyone in the industry meets founders they might back, negotiates with them, argues in favor of a company they like in front of their firm’s investment committee, and then interacts with the founders to help them steer the business, notably during board meetings. However, it doesn’t work like that anymore.

I’ve long been a student of the history of Goldman Sachs, and I think there are lessons to be drawn from it when it comes to forecasting the future of VC. There used to be a time, back when legendary Sidney Weinberg was Goldman Sachs’s senior managing partner, when investment banking was akin to craftsmanship. Like this typical venture capitalist you have in mind, investment bankers at the time were seemingly doing everything themselves (designing financial services, governing the firm along their peers, and dealing with clients). And this came with a heavy price:

It made it difficult to design new services: investment banks like Goldman Sachs were limited by the senior partners’ (low) level of sophistication and reluctance to rely on others’ expertise when it came to innovating.
It made it impossible to scale, because the firm’s business depended on that small group of people, their mastery of a rough financial craft, and above all the magic they performed with clients.

8/ Then John C. Whitehead, took over (alongside Weinberg’s own son John), and he came up with the idea of applying scientific management to investment banking. Here’s what I wrote back in 2017:

From his early days as a young partner, [Whitehead] advocated putting an end to the traditional approach of investment bankers delivering the services they sold and selling only the services they themselves delivered. After years of careful maneuvering against old investment banking customs, he ended up imposing the separation of the sales and service function from the production function, triggering powerful innovation dynamics on both ends of the business and positioning the firm to make the most of the enormous growth of the investment banking business that was about to come.

Likewise, these days, many people boast that they work in venture capital (“I am a VC”, “Dad, Husband, VC”), but in fact they barely belong to a homogeneous category because the Taylorization of venture capital has begun. Now there’s marketing (notably content); research and analysis; operational support for portfolio companies (notably HR); fundraising; financial engineering that involves debt financing; co-investment with limited partners; developing relationships with early-stage investors and large corporations, etc. This is all part of venture capital indeed, but nobody in the space has exactly the same job anymore, and everyone is more focused on specific tasks rather than being involved across the whole business.

9/ Thus the direction in which VC is headed is the same as investment banking. Most venture capital firms don’t seek to scale up. Or rather, the power law that is the mark of venture capital has made it possible for the best firms to enjoy some increasing returns to scale without the need to convert to a more Taylorized approach: they enjoy increasing returns to scale when they deal with limited partners (who only want to invest in the best firms with a proven track record) and when they deal with founders (who all would like that term sheet from Benchmark).

But things are changing, and there are signs that suggest that soon VCs might leave the world of merchants to enter that of capitalists:

There are new, large players in town, including hedge funds like Two Sigma, Tiger Global, and Coatue; private equity firms like KKR and Blackstone; investment banks like Goldman Sachs; institutional investors seeking to invest directly; and up-and-coming new players that don’t fit in any box. Good luck competing with all of them if you stick with the old craftsmanship approach.
Businesses themselves need more than what traditional VC has to offer. It’s not only about diversifying the ways of deploying capital (as discussed by Alex Danco in the article linked above), it’s also adapting to different regions and ecosystems, as well as keeping pace with software eating industries that are more tangible and markets that are more regulated.

10/ In conclusion, there will still be a part of the VC world that sticks to the old ways. But my view is that VC, like investment banking 50 years ago, will end up being dominated by big corporations ruled by scientific management and able to generate increasing returns at a much larger scale. VC will still be about one critical risk + potentially infinite returns, but as for what VCs do, the gist will be:

Some traditional firms will stay as they are. Benchmark might keep on functioning as they always have: they have the brand, the clout, the connections, the know-how for them not to have to bother with the John Whiteheads that are currently taking over and reinventing venture capital.
Other traditional firms will evolve from the old, small-scale model to a more Taylorized, scalable one, just like Goldman Sachs back in the day. I think Andreessen Horowitz is headed that way, and this is also what Chamath Palihapitiya had in mind when building Social Capital.
Established players from outside the VC world will expand into venture capital, just like large retail banks once expanded into investment banking when the regulations inherited from the old Glass-Steagall Act had been removed.
And then there are organizations that don’t fit in any of the boxes above but are betting on VC becoming more of a capitalist business (as opposed to a merchant one). Those are the most difficult to decipher, but they’re playing a very long game (we know, because we’re The Family).

🔥 Now let me say a few words about why and how I’m upgrading European Straits—adding two additional weekly editions which you can enjoy starting on Friday if you subscribe without waiting 👇

First, the “why”. Quite simply, we need more research covering European startups as an asset class:

I admire the many efforts in the media world, including by Sifted, where I’m a columnist, Reflexive, and Tech.eu, as well as in some parts of the VC world, like with Tom Wehmeier’s remarkable work at Atomico and some by the likes of Pitchbook, CB Insights, and Dealroom. All of these are very good when it comes to tech insiders learning about other tech insiders.
However I don’t find that these provide the content that fits the needs of investors outside the tech ecosystem and people working in the financial services industry in general. If you’re in that category, you need more insights, opinions, and perspectives on European tech so as to reach sound investment decisions, and my upgraded newsletter aims to provide just that.

What should you expect? For those who are happy with what I already send, things will stay mostly as they are. European Straits’s main edition will still be sent every Wednesday morning (CET) to its 7,800+ recipients. It will still include a 10-point essay, as well as pieces of news related to me and my firm The Family. I’ll still be available for anyone who is kind enough to reply with feedback, encouragement, and critiques. Only the comprehensive reading list (the “Go Further” section at the end) will be moved to the Friday edition, which will be for paying subscribers only.

In addition to the main weekly edition, those who subscribe to the paid version of European Straits will receive two additional editions each week:

Every Monday morning, a (rather) short Monday Note focused on two things: my opinion on a big piece of news that happened the previous week, and some additional short morsels. The goal is to provide a clear update as your work week is about to start.
Every Friday morning, a longer Friday Reads that will dive into interesting topics that I think are relevant for the longer term, as well as ample reading for your weekend. The goal is to provide ammunition so that you can dig deeper in whichever direction you want.

Mais encore? The overall goal is to have more room to cover different topics and angles such as:

Examining the big tech-related news of the day and adding my opinion.
Discussing the growth and diversification of venture capital.
Introducing you to investors that we like and explaining their thesis and approach to investing.
Focusing on a given industry and how it’s being impacted by tech startups.
Analyzing a given company’s strategy in detail and drawing lessons for investors.
Discussing Europe and where it stands on the global tech scene.
More clearly understanding where European startups stand as compared to other asset classes.