What drives venture capital?

Gord_geckothumbGordon Gekko would answer that with one word: "Greed"

Is it true?  I honestly don’t think that it is the primary factor.  However, there is one phenomenon that makes me believe that it is a significant component.

Imagine a business that would create an equity portfolio of minority shares of start-ups.  Once it identifies a promising business, it takes a minority share in exchange for participation in the fund – in effect the entrepreneurs give up equity in their ventures for participation in a "basket" of equity in a similar set of ventures (becoming "limited partners").  For this hypothetical business to be profitable, it would value the ventures at a discount, compared to the rest of the portfolio, therefore creating shareholder value.

A set up like this would make an interesting risk-management product for entrepreneurs, who are typically extremely exposed to risks associated with their ventures.

Could such a business work?

The response I get from the VC community has been negative.  A common objection is that the VC’s smartly take advantage of the drive (or "hunger") of the entrepreneurs.  If the entrepreneur is able to hedge that risk, theoretically she is less driven to succeed, therefore hurting the VC fund’s portfolio’s performance.

This does not make sense to me.  If this argument had much merit, Jim Clark (founder of Netscape and SGI), a billionaire, would have no VCs interested in backing him.

I think the real objection lies in management fees, the typically 2% fee that a VC fund charges its LPs as compensation for managing the fund.  In the hypothetical set up described above, there is no fund, hence no management fee.

As the early stage funding market gets more efficient, I predict that the management fees would be under pressure.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s