The VC Model Is Broken — Here’s How to Fix It

By November 14, 2014


How can you fix a model that nearly everyone agrees is in need of some drastic retooling?

Claims of excessive fees, too much meddling, and poor returns to investors are common complaints about the current VC model. Some of these issues might be caused by miscommunication or a misconception about what VCs can offer, but many current concerns are caused by the following factors:

Unnecessarily high management fees: These fees are tied to the size of a fund. Because VCs receive them regardless, they’re incentivized to raise larger funds (and subsequently receive higher fees) even if they can’t find enough quality investments.

• Excessive capital streaming into VC funds: With seemingly endless money flowing into VC funds from large investors using ’90s VC returns as their benchmarks, there aren’t enough attractive startups to invest in. This situation prompts VCs to allocate more funds toward fewer startups and pass up good investments just because they’re too small.

• A rush toward liquidity: To monetize their assets, VCs often push startups into liquidity events instead of maximizing their long-term expected value.

• The need to over-borrow: Businesses used to require a lot more capital than they do today. Cloud services, software-as-a-service, and great outsourcing options have made startups less capital-intensive. Almost all the money businesses raise now is for covering salaries. Businesses would prefer to spread these funds out, but the high cost of a round of fundraising means most startups raise $2 million just to let it all sit in the bank from payroll check to payroll check.

These problems are hurting startups with every deal and are constraining the VC industry. The need for change is urgent. If VCs don’t adapt their model, they’ll continue to be overtaken by incubators that offer more services and angels that charge no fees and offer more flexibility.

The key to fixing the VC model is recognizing how many of the problems are liquidity problems. Startups need a pile of cash just to feel comfortable hiring employees. Some VC partners need to earn a salary, while others don’t. VC funds need to find a way to avoid sacrificing long-term value creation just to create quick exits that generate cash for their investors. Here are some steps that would increase liquidity at crucial points and improve the VC model:

1. Encourage VCs to Offer Wage Insurance to Startup Employees

Startups would need considerably less capital if they didn’t have to raise extra funds just to reassure employees that they can make their payrolls. VC firms could directly provide startup employees with wage replacement insurance or purchase it from other firms to offset these initial cash needs. This would make the initial raise requirement smaller, which is good for the founders.

LPs are giving up a 20 percent carry and 2 percent-per-year management fees to have startups turn around and pay recruiters and then let most of the year’s payroll sit in the bank earning no interest. VCs providing wage insurance might take more active roles in the hiring process, recruiting and reassuring potential employees directly instead of encouraging founders to give up equity and hoard cash.

2. Create a Way for VCs to Sell Options on the Carry

By allowing VCs to sell options based on their future share of profits in the firm, VCs could select their own balance points between current compensation and future reward. The carry could be increased from 20 to 25 or even 30 percent. The management fees could be reduced to 0 percent, and the investors would still come out on top.

The cash earned from selling carry options would replace the VCs’ annual salary and allow them to have liquidity in the short run. It would provide flexibility for partners of different means to take varying risk levels in the same fund, giving VCs more flexibility in choosing partners.

VC firms could also customize their levels of service. They could give up more of the carry, obtain more cash, and spend more on associates that help portfolio companies any time it would maximize the long-term value of the fund.

Most importantly, they could adjust these preferences at any time by selling their options, and there would be transparency for investors concerning how much confidence the VC partners had in their investments and strategy.

3. Give LPs Liquidity Options, Too

VCs should utilize secondary markets such as SecondMarket to extract value from nonpublic portfolio companies. Selling individual companies or shares in entire funds would create liquidity for LPs. Funds could be bundled into super-funds with more diversification and more predictable cash flows.

Investments are intended to help companies grow, explore new ideas, and get on a secure path to profitability. And while a select few are benefitting from the current VC model, it’s not tailored to the financial realities of small businesses, limiting the startup pool that’s eligible for VC funds and the potential returns venture capitalists can generate. Just imagine the number of small businesses that could get off the ground with a more inclusive approach.