In Praise of Professional Venture Capital

It’s become fashionable among some entrepreneurs, and even some venture capitalists, to badmouth the venture capital industry. The industry certainly has many flaws. But to paraphrase Winston Churchill, venture capital is the worst method for financing scaling startups except for all the others.

One of the conversations I had with Wences Casares (founder and CEO of Xapo), during this trip to Patagonia, reinforced my belief in the necessity of venture capital.

The problem with many critiques of professional venture capital is the fact that the true alternative to VC is not some utopian world in which deserving entrepreneurs quickly and easily obtain the capital they need to grow. While venture capital may be a flawed industry, the alternatives are even worse.

Option 1: the government

One option is to put the government in charge of capital allocation. The world’s history of five year plans and great leaps forward suggest that this strategy is seldom successful and often disastrous. Capital allocation decisions are based more on political concerns, such as ideological purity or connections, rather than merit. This isn’t necessarily the fault of individual government officials; many civil servants are intelligent and dedicated. But unlike a pure financial investor, any governmental body making investment decisions is forced to take on additional, massive political risk. The failure of a government investment results in not just the loss of risk capital, but also what is likely a much larger loss of reputational and political capital (a classic example of this is the Department of Energy’s involvement in the solar panel startup Solyndra). This additional risk (which financial investors do not face) makes it almost impossible for any government to successfully provide venture capital.

(Note that this is different from the government funding scientific research, or being an important early customer, where there is a much better track record of success.)

Option 2: wealthy individuals & families

The other option is to leave capital allocation decisions to wealthy individuals or families. Since I’ve spent my career in Silicon Valley, it’s hard for me to envision this, but Wences points out that this is the reality in many parts of the world. As Wences put it, “You're begging the 15 families who have the capital to see if they will give you capital. And if you haven't gone to private school with one of their kids, you won't get it.” Risk capital should always be available to entrepreneurs who didn't have the privilege of growing up wealthy or attending an elite university. Venture capital, for all of its challenges, opens up the decisions for capital allocations beyond the wealthy families. Indeed, because venture capitalists are incented to invest and then distribute, they can only create wealth for themselves by creating wealth for others — including the entrepreneurs.

At the end of the day, the results of the venture capital process speak for themselves (both positively and negatively). At the end of the third quarter of 2019, seven of the world’s 10 most valuable publicly traded companies were technology companies: Microsoft, Apple, Amazon, Alphabet [Google], Facebook, Alibaba, and Tencent (the non-tech companies were Berkshire Hathaway, Visa, and JPMorgan Chase). All seven raised venture capital.

Many people forget that Microsoft raised venture capital ($1 million from Technology Venture Investors). Bill Gates decided to raise the money, which Microsoft didn’t need, and apparently never spent, because he wanted the venture capitalist Dave Marquardt on his team. Bill told an audience at Harvard:

We eventually gave away, or sold, 5 percent of the company for a million dollars at a 20 million dollar valuation, just to get a venture capital company to join our board and give us some adult advice about various things, which was quite helpful. We picked one in the Valley, a guy named Dave Marquardt came on our board and did a fantastic job. That money sat in the bank, and it’s still in the bank today, so it was not for anything to do with capital, but rather just to join the team.

As is often the case, Bill thought deeper about the subject than most. He realized that a venture capitalist is not a banker or moneylender; she or he is a “financial co-founder” that the startup “hires” by accepting an investment. And like any co-founder decision, the decision to bring in a venture capitalist involves risk. Pick the wrong co-founder — financial or otherwise — and you’ll end up destroying value, and possibly your company. Even if you pick well, you have to be able to handle the inevitable conflicts and disagreements that will arise along the way. On the other hand, while it is possible to build a company without co-founders, it’s a much more difficult journey.

Good venture capitalists are essentially networks in human form. They bring a unique network that provide the essentials of start-up growth — follow-on capital, talent, industry knowledge and access — in ways that a government agency or a wealthy family do not.

The problem with bootstrapping is that you’re going it alone. It’s much harder to build a network around you if no one else shares your financial incentives.

You can hear Wences talk about the value his investors brought him, the great work that Endeavor.org is doing around the world to build startup ecosystems, and how difficult it is to raise money in a market without venture capital in the first podcast episode from my Patagonia trip.