Closing the Achievement Gap: How Limited Partners Can Foster Innovation in Venture Capital
Justin Fishner-Wolfson, Class 14
In 2010, I co-founded a new venture fund, 137 Ventures, with fellow Founders Fund alumnus Alex Jacobson and early Facebook employee Kathy Chan. Limited partners (LPs) of venture funds rarely invest in new managers—in fact, they are incentivized to fund the same firms regardless of returns. The practice of investing in a well-known firm is defensible because there is a precedent for success, even if that firm eventually loses money. On the other hand, investing in new firms that fail can cost an LP their job. This mindset made the founding of 137 Ventures an uphill battle.
Starting a venture fund is analogous to founding a start-up company but with even more hurdles—imagine if venture capitalists only gave money to entrepreneurs who already had five successful exits. The pace of change and innovation would be a lot slower, and newcomers would almost certainly need to be self-funded, which is precisely the handicap that LPs have inflicted on the venture industry. In the same year that 137 Ventures was founded, 51 other new firms got off the ground—20 times fewer than the 1,029 startups that raised their first round of financing.1The successful creation of 137 Ventures was due in part to the pursuit of a unique investment strategy. Over the last 10 years, the opportunities to make successful investments have required strategic shifts in strategy, and because of the structure of the venture capital (VC) industry, these opportunities are typically addressed by new managers. LPs willing to accept the risks of new managers are able to generate the outsized returns for which the venture industry is famous. This article explores the challenges we faced in starting 137 Ventures and shows how the behavior of LPs is constraining the growth of the venture industry, thereby limiting the potential for new funds.
Up and to the Right: Standing Alone Is the Best Way to Get There
Investing can often be an echo chamber of people chasing the same ideas, and once momentum picks up, investors begin ascribing to the "greater fool theory."2 Even if prices do not make sense, investors believe they can make a profit by selling to a greater fool. Therefore, great investments are often contrarian: they are made alone and only recognized once the success is obvious. In venture capital several of these opportunities have been created by gaps in the company funding cycle.
For example, after the tech crash of 2000, early-stage investing all but disappeared—but that moment was also the best opportunity to invest in companies like LinkedIn, Yelp, and Facebook at valuations less than $10 million. A new venture firm at the time, Founders Fund, took advantage of just those kinds of early-stage opportunities. Over the last few years, as those successes became more apparent and these companies came to represent billions of dollars in market capitalization, the gap in early-stage investing filled with earnest: venture funds have driven up company valuations, bidding against one another and even stirring up arguments for a bubble.On the other hand, in 2007 there was a lack of late-stage capital because companies wanted to stay private longer to maintain control, in addition to cultural and regulatory reasons, but they were having trouble accessing capital at valuations competitive to the public markets. Digital Sky Technologies (DST) and Yuri Milner capitalized on a challenging venture market by making two key insights: employees wanted liquidity and the differential in value between common stock and preferred stock had shrunk for a class of late-stage companies. This evolved the venture model and gave DST access to a group of great companies at valuations that were effectively much lower than outsiders understood.The larger fundamental problem reflected in these examples is that market opportunities stay open far longer than they should because new managers are typically the ones to take advantage of such market gaps, yet limited partners usually do not fund new managers. In the examples above, newcomers at the time—Founders Fund and DST, respectively—were able to take advantage of gaps in the market. However, unlike most new funds, they had a substantial initial capital base and therefore did not need to convince limited partners of their new and unique strategy before they began executing.
Discovering a Market Opportunity: 137 Ventures
The last few years have not been the easiest time to raise money. According to data analyzed by Bloomberg from the National Venture Capital Association and Thomson Reuters, venture capital fundraising was down 53 percent in the third quarter of 2011 from the same period a year earlier—its lowest level in eight years.3 The landscape is grim and even harder on new funds, which are always up against bigger challenges.
For 137 Ventures, we observed a gap in the marketplace that led to the basis for our investment thesis. Companies are staying private at much later stages, which has created new investment opportunities. One such opportunity is to provide liquidity to individual shareholders without forcing a stock sale, which led us to offering loans against private company stock.Many employees at later-stage technology companies want liquidity but also want to maintain more ownership than if they sold their stock, due to a continued belief in the growth of the company in which they are invested. One of my partners, who was an early Facebook employee, faced just this problem and so we began trying to find solutions for ourselves, our friends, and our larger network. We quickly discovered that no existing lenders were willing to help this group of individuals, and once we understood the size of the opportunity and our ability to obtain access to fast-growing companies that were no longer raising outside capital, our team began to meet with institutional investors about our new fund.One competitive advantage for 137 Ventures is actually due to the restrictions LPs place on managers. Limited partnership agreements (LPAs) typically restrict managers to a specific investment strategy. For instance, funds that focus on primary investments often have an LPA that prevents them from making secondary investments and vice-versa. While this structural hurdle has helped our fund, as it prevents many existing venture firms from using our investment model, it also is endemic of a larger problem within the industry of LPs limiting innovation.Despite LPs entrusting managers with billions of dollars in capital, they still refuse to allow flexibility in the strategies pursued; this protects LPs from managers making investments in things they do not understand, but it also ties their hands when they come across good opportunities. Moreover, LPs have financial allocations to specific strategies such as venture capital and venture debt, buyout funds, and long and short hedge funds, to name just a few. They want managers to stay with their initial strategy to make it easier to track and maintain those allocations, all of which leads to restrictions regardless of the impact on returns. Although LPs have given a complicit endorsement of venture fund managers' decision-making by investing money with them, the LPAs tell a different story—that LPs do not want managers to stray from the strategy they sold to investors.
Getting Off the Ground: Relationship Capital
Most limited partners do not take risks on new funds or new managers, which begs the question of how 137 Ventures was able to buck this trend. The simple explanation is that the venture industry is fundamentally a people business, and we are fortunate to have many limited partners who are willing to bet on us, as people. These limited partners are willing to take risks because they have known us for many years and are investing in part because of these relationships.
However, the simple answer is not the entire story, and the actual answer is much more complex. My previous experience from having joined Founders Fund (FF) just as they began raising their first institutional fund (FF II) was tremendously useful to starting 137 Ventures. I was very involved in the Founders Fund fundraising process—including negotiating the limited partnership agreement. I also had a preexisting relationship with the limited partner that anchored FF II.These opportunities to form relationships with limited partners arose from my joining Founders Fund while they were still a startup, which later allowed the same limited partners to take a risk on 137 Ventures given our many years of having worked together. Mine is not a common experience, though, and it never would have happened at an established firm.So, while the easy answer is to say that 137 Ventures was able to raise a new fund against all odds because of our extraordinary personal network of limited partners, the real explanation is that I had the opportunity to develop such a network after having previously played an integral role in the raising of an inaugural venture fund. Yet most people in the venture industry today have never helped raise a first institutional fund and do not have the opportunity to develop relationships with LPs.Therefore, it is unsurprising that most first-time funds do not succeed given that their partners do not have the experience of ever having started a fund. Since there are very few new funds created (figure 1), this creates a vicious cycle. As an industry, we need to take steps to create more opportunities for new funds to succeed. The venture industry seeds many new entrepreneurs and start-up companies every year, yet LPs are not doing the same with new venture funds.
Figure 1. New and Follow-on Funds by Year.4
The Difficulty of Rewarding LPs to Take Smart Risks
From the perspective of a limited partner, there are a lot of start-up costs for new funds, which are a real deterrent for investors. A new fund has no infrastructure and no processes in place, in addition to new interpersonal dynamics and often a new investment strategy. Even in high-profile firms like Andreessen Horowitz and Founders Fund, the partners invested their own capital to prove their strategy before being able to raise institutional capital. In raising 137 Ventures, I spoke to many investors that categorically do not invest in new funds until they are proven to be at the very least stable, but preferably successful.
One major reason for this policy is the compensation structure for limited partners, which does not offer financial rewards for investing in funds that are ultimately successful. The time horizon for success is generally aligned with the lifetime of a fund—typically 10 years. So, if a limited partner invests in an unknown firm that may not appear to be immediately profitable, they might lose their jobs in the short-term. All that downside and no upside is a recipe for keeping limited partners from taking risks, even smart risks.Unfortunately, it is not realistic to treat limited partners like hedge fund managers and give them a piece of the returns their portfolios generate. Venture capital operates on an institutional time horizon, not an individual time horizon: The lifetime of a fund is 10 years, but as exits take longer, that lifespan can stretch even more. Successful companies take a long time to build: For instance, Benchmark Capital invested in the Series B for OpenTable in 2000, but that investment required a nearly 10-year wait before they went public in 2009 with a market capitalization of close to $1 billion.5 If limited partners' only bonuses were paid that far into the future, they would have no incentive to change their present behavior, especially given the uncertainty.On the other hand, if limited partners are rewarded based on a marked-up value of their portfolio on a shorter time horizon, there is a real risk that those returns will never be realized. Further, most of these assets are controlled by nonprofits like foundations and university endowments or pension funds; for political and perception reasons, such organizations will not pay their employees substantial bonuses regardless of the value a person brings to the organization.Despite all these obstacles, innovative and thoughtful limited partners who are willing to take smart risks do exist. The problem is that they are currently the minority, and the challenge is turning them into the majority.
History Repeats Itself: The Cyclical Nature of the Venture Industry
Looking at 10-year returns for the venture industry and these misaligned incentives, it is easy to conclude that the industry is broken—that without change, it will become harder and harder to make outsized returns by investing in small private tech companies. However, change is unlikely to come from within the venture industry. Instead, change should come from the consumers of venture: the limited partners who provide the capital. The general agreement is that there is too much money in the venture industry, but if limited partners keep funding venture capitalists, general partners at venture funds will obviously keep accepting their money.
Currently, there are two major economic drags on fund returns. First, because management fees are paid out of the capital committed to a fund, only about 80 cents6 of every dollar is ultimately invested in a company. Second and more significant, many older firms do not have to net losing investments against winning investments, a practice known as "clawbacks."7 Imagine a casino where you make bets with someone else's money: when you win, you take 20 percent of the profits; but when you lose, you just make another bet. These seemingly backward economics were put in place when the industry was still young and general partners had leverage, and although neither is the case today, history and momentum are powerful forces.While these economic terms hurt the net internal rate of return (IRR) for the venture industry, the real problem is that returns will always be cyclical if limited partners continue to behave as they have. In private equity, just like in the stock market, investors are chasing returns. Investors want to fund things that historically have been successful, because (a) they believe such things will continue to be successful and (b) not taking on risk in their investments does not threaten their continued employment. This shortsightedness means that limited partners will come into the market when results are good and leave when results are bad, which is why general partners who were successful ten years ago are still able to raise funds—that is, until this class of LPs decides that venture does not generate returns and gets out of the market again.A cycle is created: less money going into venture capital means fewer active funds, which leads to less competition for deals, which means fewer companies get funded at lower prices, which means there is less competition for talent, which means companies are likely to be more successful and generate even better returns. Of course, once the returns get better, the limited partners who are chasing returns will come back into the market, and the cycle starts anew.
Looking Ahead: A Different Investment Cycle
What differentiates great limited partners is their willingness to invest alone, with the possibility of being right, rather than being wrong with the crowd. However, it often feels like there is safety in numbers as the wisdom of crowds8 has borne out time and time again. Truthfully, having additional partners does reduce risk. For venture investors, having multiple stakeholders who can help guide and mentor entrepreneurs increases the likelihood that a new startup succeeds. The same holds true for a new venture fund that has multiple LP stakeholders who can help the fund get off the ground.
The LP community should take a page from successful angel investors when they find a good investment—commit capital first and then find others who will co-invest alongside them. This ensures that a new fund has enough capital to be successful. If LPs actively worked with one another to ensure that new managers are able to raise capital, no individual LP would disproportionately shoulder the risk of new investment strategies and new managers. This approach also would ensure that a new fund has enough capital to be successful.Moreover, just as companies fail for reasons unrelated to their products, like interpersonal conflicts, funds also fail for reasons unrelated to their investments. If LPs work together, they can help one another shoulder the responsibility of mentoring new managers to build successful organizations and learn from the mistakes and accomplishments of others. This would create a chain reaction and a constant source of innovation, increasing the pace of that innovation and improving returns for the entire industry.A major impediment to this level of cooperation is that LP compensation is often based on performance relative to peer institutions. In order to improve the incentives of the industry, LPs should redesign their compensation plans by changing the benchmarks against which they are evaluated. This would be a good first step at encouraging cooperation and creating an environment in which LPs reap the benefits from working together.The key is to start a conversation about how LPs can positively impact the industry and the metrics the industry uses to define its own success. Venture capital is an industry that thrives on creative destruction based on the premise that innovation comes from new entrants. We should judge the health of the industry not just by the total dollars raised each year, but also by the number of new funds, new managers, and new strategies developed. This approach will ensure that venture capital is as diverse and innovative as the companies it funds.
Justin Fishner-Wolfson
Justin is a co-founder and managing partner of 137 Ventures, an investment firm focused on private technology companies. Previously, he worked at Founders Fund, a venture capital firm, where he was responsible for all aspects of the investment process and led the financial and operations functions. Prior to that, Justin was the CEO of SSE, a conglomerate of businesses at Stanford University. Earlier in his career, he was the director of sales at Cellfire and worked as an engineer at Raytheon/Texas Instruments. Justin also served under Alan Larson, the Undersecretary for Economic, Business, and Agricultural Affairs at the U.S. State Department. He holds a bachelor's degree with honors in management science and engineering and a master's degree in computer science from Stanford University.
1 PricewaterhouseCoopers and National Venture Capital Association, "Overview of Venture Capital Investments Third Quarter 2011," MoneyTree Report, http://www.nvca.org/index.php?option=com_docman&task=doc_download&gid=803.2 See, e.g., Tim Hartford, "The Herd Instinct," FT Magazine, June 3/4, 2006, 2. http://www.gqq10.dial.pipex.com/PressArticles/HerdInstinct.pdf.3 Ari Levy, "U.S. Venture Capital Fundraising Falls to Lowest in Eight Years," Bloomberg, 2011 October 10, http://www.bloomberg.com/news/2011-10-10/u-s-venture-capital-fundraising-falls-to-lowest-in-eight-years.html.4 Author's image; data from Thomson Reuters and National Venture Capital Association, "Venture Capital Fundraising Declines Further in 2010," 17 January 2011, http://www.nvca.org/index.php?option=com_docman&task=doc_download&gid=687&Itemid=93.5 CrunchBase, "OpenTable: CrunchBase Profile," 2011, http://www.crunchbase.com/company/opentable.6 Assuming a 2-percent management fee on a 10-year fund.7 For a full definition, see the VC Experts glossary: https://vcexperts.com/encyclopedia/glossary/clawback.8 James Surowiecki, The Wisdom of Crowds (New York: Anchor Books, 2004).
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