What Drives VCs?
By Paul Graham - March 2005
A couple months ago I got an email from a recruiter asking if
I was interested in being a "technologist in residence"
at a new venture capital fund. I think the idea was to play Karl
Rove to the VCs' George Bush.
I considered it for about four seconds. Work for a VC fund? Ick.
One of my most vivid memories from our startup is going to visit
Greylock, the famous Boston VCs. They were the most arrogant people
I've met in my life. And I've met a lot of arrogant people. [1]
I'm not alone in feeling this way, of course. Even a VC friend
of mine dislikes VCs. "Assholes," he says.
But lately I've been learning more about how the VC world works,
and a few days ago it hit me that there's a reason VCs are the
way they are. It's not so much that the business attracts jerks,
or even that the power they wield corrupts them. The real problem
is the way they're paid.
The problem with VC funds is that they're funds. Like
the managers of mutual funds or hedge funds, VCs get paid a percentage
of the money they manage: about 2% a year in management fees,
plus a percentage of the gains. So they want the fund to be huge--
hundreds of millions of dollars, if possible. But that means each
partner ends up being responsible for investing a lot of money.
And since one person can only manage so many deals, each deal
has to be for multiple millions of dollars.
This turns out to explain nearly all the characteristics of VCs
that founders hate.
It explains why VCs take so agonizingly long to make up their
minds, and why their due diligence feels like a body cavity search.
[2] With so much at stake, they have to be paranoid.
It explains why they steal your ideas. Every founder knows that
VCs will tell your secrets to your competitors if they end up
investing in them. It's not unheard of for VCs to meet you when
they have no intention of funding you, just to pick your brain
for a competitor. This prospect makes naive founders clumsily
secretive. Experienced founders treat it as a cost of doing business.
Either way it sucks. But again, the only reason VCs are so sneaky
is the giant deals they do. With so much at stake, they have to
be devious.
It explains why VCs tend to interfere in the companies they invest
in. They want to be on your board not just so that they can advise
you, but so that they can watch you. Often they even install a
new CEO. Yes, he may have extensive business experience. But he's
also their man: these newly installed CEOs always play something
of the role of a political commissar in a Red Army unit. With
so much at stake, VCs can't resist micromanaging you.
The huge investments themselves are something founders would dislike,
if they realized how damaging they can be. VCs don't invest $x
million because that's the amount you need, but because that's
the amount the structure of their business requires them to invest.
Like steroids, these sudden huge investments can do more harm
than good. Google survived enormous VC funding because it could
legitimately absorb large amounts of money. They had to buy a
lot of servers and a lot of bandwidth to crawl the whole Web.
Less fortunate startups just end up hiring armies of people to
sit around having meetings.
In principle you could take a huge VC investment, put it in treasury
bills, and continue to operate frugally. You just try it.
And of course giant investments mean giant valuations. They have
to, or there's not enough stock left to keep the founders interested.
You might think a high valuation is a great thing. Many founders
do. But you can't eat paper. You can't benefit from a high valuation
unless you can somehow achieve what those in the business
call a "liquidity event," and the higher your valuation,
the narrower your options for doing that. Many a founder would
be happy to sell his company for $15 million, but VCs who've just
invested at a pre-money valuation of $8 million won't hear of
that. You're rolling the dice again, whether you like it or not.
Back in 1997, one of our competitors raised $20 million in a single
round of VC funding. This was at the time more than the valuation
of our entire company. Was I worried? Not at all: I was delighted.
It was like watching a car you're chasing turn down a street that
you know has no outlet.
Their smartest move at that point would have been to take every
penny of the $20 million and use it to buy us. We would have sold.
Their investors would have been furious of course. But I think
the main reason they never considered this was that they never
imagined we could be had so cheap. They probably assumed we were
on the same VC gravy train they were.
In fact we only spent about $2 million in our entire existence.
And that gave us flexibility. We could sell ourselves to Yahoo
for $50 million, and everyone was delighted. If our competitor
had done that, the last round of investors would presumably have
lost money. I assume they could have vetoed such a deal. But no
one those days was paying a lot more than Yahoo. So unless their
founders could pull off an IPO (which would be difficult with
Yahoo as a competitor), they had no choice but to ride the thing
down.
The puffed-up companies that went public during the Bubble didn't
do it just because they were pulled into it by unscrupulous investment
bankers. Most were pushed just as hard from the other side by
VCs who'd invested at high valuations, leaving an IPO as the only
way out. The only people dumber were retail investors. So it was
literally IPO or bust. Or rather, IPO then bust, or just bust.
Add up all the evidence of VCs' behavior, and the resulting personality
is not attractive. In fact, it's the classic villain: alternately
cowardly, greedy, sneaky, and overbearing.
I used to take it for granted that VCs were like this. Complaining
that VCs were jerks used to seem as naive to me as complaining
that users didn't read the reference manual. Of course VCs were
jerks. How could it be otherwise?
But I realize now that they're not intrinsically jerks. VCs are
like car salesmen or bureaucrats: the nature of their work turns
them into jerks.
I've met a few VCs I like. Mike Moritz seems a good guy. He even
has a sense of humor, which is almost unheard of among VCs. From
what I've read about John Doerr, he sounds like a good guy too,
almost a hacker. But they work for the very best VC funds. And
my theory explains why they'd tend to be different: just as the
very most popular kids don't have to persecute nerds, the very
best VCs don't have to act like VCs. They get the pick of all
the best deals. So they don't have to be so paranoid and sneaky,
and they can choose those rare companies, like Google, that will
actually benefit from the giant sums they're compelled to invest.
VCs often complain that in their business there's too much money
chasing too few deals. Few realize that this also describes a
flaw in the way funding works at the level of individual firms.
Perhaps this was the sort of strategic insight I was supposed
to come up with as a "technologist in residence." If
so, the good news is that they're getting it for free. The bad
news is it means that if you're not one of the very top funds,
you're condemned to be the bad guys.
Notes
[1] After Greylock booted founder Philip Greenspun out of ArsDigita,
he wrote a hilarious but also very informative essay
about it.
[2] Since most VCs aren't tech guys, the technology side of their
due diligence tends to be like a body cavity search by someone
with a faulty knowledge of human anatomy. After a while we were
quite sore from VCs attempting to probe our nonexistent database
orifice.
No, we don't use Oracle. We just store the data in files. Our
secret is to use an OS that doesn't lose our data. Which OS? FreeBSD.
Why do you use that instead of Windows NT? Because it's better
and it doesn't cost anything. What, you're using a freeware
OS?
How many times that conversation was repeated. Then when we got
to Yahoo, we found they used FreeBSD and stored their data in
files too.
Source: http://www.paulgraham.com/venturecapital.html
