As originally appears on Progress Report.
It is instructive, when thinking about venture capital, to consider a venture firm as a two-sided marketplace.
On the one side, the firm is selling its capital to entrepreneurs. It has to demonstrate that the brand, services, and relationships that come along with an investment will have a greater material impact on the business than another firm at a similar (and in some cases worse) price. And so they will build platforms, blog, sit on boards of directors, and serve as formal advisers to startups. At Collaborative Fund, we do all of these things to serve our customers on this side of the marketplaces: the entrepreneurs.
The other-side of the marketplace is very important for entrepreneurs to understand as well. Limited Partnerships are structures where everybody, including the General Partnership, invests in a fund, and the Limited Partners hope that at the end of the fund, they will be returned their capital with some gain.
Many, but not all, limited partnerships consist of institutional investors — endowments, pension funds, fund of funds, foundations, et cetera. For these institutions, there are a number of asset classes where they invest, and venture capital tends to fall under the “alternative investments” asset class. That is, we are lumped alongside hedge funds and later stage private equity. Alternative investments, for most portfolios, are the highest risk in the portfolio, and so often represent only a small percentage of the total assets the institution has under management — usually less than 10%, and often less than 5%. As an institutional investor, the hope in this allocation is that the high-risk nature of the category will result in a commensurate high-yield. The most successful venture capital investments, then, are those where the yield was abnormally high – and the risk was abnormally high.
These two sides of the equation should inform each other. Smart institutional investors look for venture capitalists who create a support system for their founders, so that they will drive returns by better serving their portfolio companies. And entrepreneurs should seek venture capital when they are building “high-beta” concepts.
These are concepts that, in the early stages, have a very high risk of failure, but by their nature have the ability to become so big as to transform culture.
Software and internet businesses have served as excellent venture capital investments because the barrier to entry for millions (and today billions) of users is incredibly low. The likelihood for the winners to become truly extraordinary, is astronomically low, but far higher than in any other type of company.
To be honest, entrepreneurs (and venture capitalists), in the spirit of mitigating risk in the very early stages, often aim too low in dreaming up their products, or making investments. While there are many ways to make substantial revenue in the medium term, there are fewer ways to change culture through technology. And it is only the culture-changing products — the Googles, Oracles, Facebooks — that will keep this industry in balance the way it is today.**
VC associates are trained to ask: Can a scaled-up version of this vision change culture? Because those are the companies that drive the necessary returns.
The moral of the story, for both the founders and the venture capitalists, is dream big. Make bets. When Josh Tetrick decided that he could invent a solution to replace all eggs in food with Hampton Creek Foods; when John Zimmer heard his urban studies professor at Cornell describe a transportation future that was truly, completely revolutionary, they were making bets.
They had no idea if they were crazy, and were likely told along the way that their ideas were unlikely to succeed, but they were compelled by their conviction in wanting to change the culture.
And as venture capitalists, we ought to do the same in backing entrepreneurs such as these. Most of the best early stage venture investments aren’t speculative, small, “risk-adjusted” bets, but significant investments, with real allocations. And most of the best early stage venture investments happen when the investor sees an idea that’s “so crazy it might work”.
**It is worth noting that as an asset class, the venture industry doesn’t perform better than the public stock market, so there is a question as to whether the industry’s balance today does make sense.