​It’s Time to Rebuild Venture Capital

Brian Botch  |

On its surface, venture capital has never looked more verdant. Six firms raised more than $1 billion each this year, prompting analysts to predict 2016 to be VCs’ strongest fundraising year since the dot-com days. Globally, the number of corporate venture firms making first-time investments is at a record high.

But a peek beneath the industry’s surface reveals a rapacious, dysfunctional world. Although venture firms are raising funds at record rates, they’re investing significantly less. Capital investments are down approximately 30% from their peak in second-quarter 2015. And while the good times roll in VC-flush Silicon Valley, poor investing practices and scandals threaten the industry’s stability.

After being sentenced to California’s Lompoc prison in 2012 for stealing about $5 million from investors, venture capitalist Albert Hu of Asenqua Ventures was recently caught creating fraudulent LinkedIn (LNKD) accounts. Even while in federal prison — where he’s supposedly without internet access — Hu somehow brought the spurious financial firm back from its grave.

Hu’s case is hardly an anomaly. More recently, venture capitalist Mike Rothenberg of Rothenberg Ventures has come under fire for gross mismanagement of funds. After raising $50 million since the firm’s 2012 launch and investing in heavy hitters like SpaceX and Revel Systems, Rothenberg clandestinely scooped investors’ funds to fuel River Studios, his virtual reality startup. The firm is under investigation by the US Securities and Exchange Commission, which has triggered an exodus of employees — many of whom were allegedly paid wages far below market. Hoping to shed the poor press, Rothenberg recently rebranded as Frontier Tech Venture Capital.

So, while funding has ticked up steadily over the past two years, the industry’s reputation has slid noticeably downward. Returns on VC investments have been less remarkable than firms promised, and venture capital performed the worst among the California Public Employees’ Retirement System’s private-equity investments.

Pockmarked by scandals and poor returns, venture capital’s problems have never been more stark. The industry is broken, and its dark underside cannot hold.

What Wrecked the VC World?

In a word, hubris has tanked venture capital. As money pours in, investors have gotten sloppy, jeopardizing their funds’ returns by eschewing data and careful vetting. Oftentimes, fund managers rely on a single investment to carry an entire fund. Out of 100 investments, 99 underperform and one exceeds expectations. For investors and business leaders alike, that’s a dangerous approach.

How can VC firms be so casual in their investments? Well, in most cases, they don’t have much skin in the game. Most commit no more than one to five percent of their capital to any fund, minimizing their own risk at the expense of investment companies. Think of it this way: If a firm puts up $10 million of a $1 billion fund, that’s like someone risking a single dollar of a $100 bill. At a 10-figure scale, a $1 million loss is hardly missed.

In any case, one would expect more discretion, given how large funds struggle to generate returns. Research from the Ewing Marion Kauffman Foundation paints a sobering picture of venture capital investments. The Kansas City-based nonprofit organization found that out of 88 funds surveyed, 66 did not deliver on their expected return rates. Only 20% of the 100 funds included in the study outperformed public-market equivalents by more than three percent. Once adjusted for fees and carry, most firms’ returns simply can’t compete with public markets.

But rather than meticulously vet investments to improve returns, firms simply look for a star player to buoy the fund. The larger the fund, the bigger the bets it has to take — and the more spectacular a home run must be to move the needle. With huge reserves and little personal risk, venture firms are making billion-dollar decisions on gut instinct.

How Do We Rebuild Venture Capital?

If venture capital is to be repaired, firms must forgo instinct-based investing and embrace the technologies they’ve helped finance. Mint founder Aaron Patzer addressed the lack of data in investing back in 2010, and, frankly, not much has changed since then. With the advances we’ve witnessed in data and behavioral science and machine learning, VC funds should be posting far better success records than they are. A handful of firms have caught on, including Correlation Ventures and Founder Institute. But if venture capitalists are to make more informed investing decisions, then tech must become an integral part of VC investing.

Investors should use data not only to choose promising startups, but also to look beyond growth potential. VC-backed companies divert, on average, 80 to 120% of revenue to marketing and sales in the company’s first three years rather than focusing on the product. At some point, that creates a house of cards.

My firm has found that profits, more so than growth, point to which companies can expect return-generating exits. Too often, VCs bet that companies will become profitable once they’ve reached certain growth metrics. That might work for companies like Facebook (FB) and Uber, but the majority of companies fail if they emphasize growth at the expense of profitability.

Sadly, venture capital evades scrutiny because most people don’t understand it. They just know that billion-dollar brands like Snapchat and Twitter (TWTR) became fat on VC funding, so they assume the model works. Honest, conscientious, data-driven investing can prevent another dot-com collapse — but only if venture capitalists let it.

Brian Botch is a founding partner at Tricent Capital, a venture capital firm based in San Francisco, California, that makes data-driven investments to deliver frequent, consistent, and rapid returns for investors while creating life-changing economic events for founders.

Brian developed Tricent's proprietary Fundability Score, which uses statistical modeling to determine a company's potential success as an investment opportunity. As a successful angel investor, he has 16 years of experience advising senior executives at companies ranging from startups to Fortune 500 brands on technological initiatives and user experience.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
FB Facebook Inc. 183.55 -0.26 -0.14 8,411,086 Trade
TWTR Twitter Inc. 42.80 0.51 1.21 12,025,564 Trade
LNKD LinkedIn Corporation Class A n/a n/a n/a 0 Trade

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