Venture capital has a self-dealing problem
fusion.net
fusion.net
As an as-yet-successful entrepreneur, you should know that at any time your idea or portions of your idea may be stolen or "adopted" by anyone who hears you talk about it. And forget NDA's. No one signs those anymore...certainly not an investor.
This is why, if you have an idea, you need to bootstrap it, get customers, and generate revenue. Then let the investors come to you.
I think the entire "pitch" process is rigged and pointless. If you're going to build something, be passionate, find great partners and advisers, and bootstrap.
Let the VC's play their game. You weren't invited anyway.
Another thing in addition to this - you need to out-execute future competitors. Imagine that the idea is public anyway, and build it better than anyone else could.
This is the equivalent of insider trading among government legislators. It's a very real problem, and there is no realistic solution since it is a systemic flaw of the startup/VC model.
It's quite possible startup culture can't continue working forever, and if this is a growing trend, that eventually too much encroachment by VCs will smother and scare away everyone who isn't an insider.
As an investor in a venture capital firm, though, you would expect the firm to award funding to the best, not to the insiders. As a politician interested in fostering a successful startup environment in your district, you would expect the firm to award funding to the best, not to the insiders. As a fledgling startup yourself, you would expect the firm to award funding to the best, not to the insiders. As Simon Cowell, you would want to pick yourself. Therein lies the issue. Only Simon Cowell wants Simon Cowell to win over other, more qualified startups.
If you already have those connections, that means you have a huge leg up on the competition. You can raise more money at better valuations (meaning you can make longer term bets, build a better team), you have access to better talent, and you have access via your network to other executives that can make deals happen.
We are upset because it isn't fair, but that isn't really the point. They want to make a ton of money. Yes, they also want to change the world, but tenacity and people skills (required in the VC word) are huge indicators of executing on whatever vision you have.
1. These might not be good funding decisions. Maybe investing in Keith Rabois's new startup is a bad decision, but it is only happening because he's a partner at Khosla. If you're an LP in a VC fund, this is something you could reasonably be concerned about.
2. If you're an entrepreneur pitching to a investors, you expect that the pitch is being taken in good faith. If the investor is just taking your pitch so that they can access your proprietary information and use it to inform their own startup (funded by the firm you're pitching), that's pretty wack.
I have literally no information about these examples, so it wouldn't be meaningful for me to hold an opinion on whether or not impropriety is occurring. I also think that Keith Rabois probably has enough of a track record that he could easily raise funding for pretty much whatever he wants to do. I also suspect that most entrepreneurs aren't particularly worried about point 2.
Nonetheless, this is clearly right at the nexus of the objections that people raise about SV: that it's an old boy's network masquerading as a "meritocracy". It just smells fishy. Sometimes things smell fishy and are OK... but there's always a cost to doing things that smell fishy: the appearance of impropriety is often just as harmful as impropriety itself.
Yes, it's an old boys network, old boys networks are not illegal nor are they bad. In fact they give the younger boys a fantastic opportunity to side-step the whole thing and start their own network, that's exactly what YC has done.
Whenever you see something like this there is an opportunity.
That's not a wishy-washy "fairness" thing: it's a concern about whether the firm is fulfilling its obligations to its backers. You don't have to agree with the concern... but it isn't an unreasonable thing to be worried about.
As an LP he might take issue with this, but for that you have to be an LP first and LPs typically do not take issue with this but actually feel that their money is well spent (whether that's correct or not is another matter).
2) Even if they didn't invest in themselves, they could just as easily give your idea to a more competent entrepreneur and invest in her instead. If you're really worried about your proprietary idea being stolen, you shouldn't be in these meetings.
So yeah, you can totally have the perspective that those two points don't matter. I'm not saying that you should think that they matter. But some people do think they matter, and I don't think it is wholly unreasonable to feel that way.
My goal with my earlier comment wasn't to make you agree with the author. It was just to point out that the author's points aren't just about "fairness": they're also about whether VC firms are best delivering value to LPs.
On a nitpick point: I never said "idea". The idea that people are worried only about "ideas" is silly. There are other things to worry about: if you're raising a series B and are providing data about your business, that data potentially has concrete value beyond merely an "idea". I don't personally think it's at all unreasonable to be concerned about people misusing that data.
This is a simplistic, overly idealistic understanding of venture capital that is unfortunately constantly repeated but rarely rebutted.
The goal in venture capital is to be able to continue to raise funds. On a $500 million fund, a venture firm locks in $100 million in management fees over the life of the fund (assuming the standard 2% annual management fee and 10 year fund life) regardless of performance. Not a bad deal.
But it gets better. Because of the nature of venture investments, it's all but impossible to declare a fund a winner or a loser a few years into a fund. But a firm won't wait 10 years to raise its next fund. It's going to raise its next fund not more than a few years in, and in a hot market like this one, that fund is likely to be bigger, so the firm gets to lock in another 10 years of management fees on an even bigger pile of money.
Carried interest (your "return on investment") is icing on the cake for venture capitalists. Because most LPs are muppets who will continue buying the same inferior product, the real imperative for a venture firm is to make sure its funds are not total dogs. Given historical venture capital returns, that basically equates to not blowing up your fund.
As a LP, I would actually think that my GPs have a fiduciary duty to fund companies started by their partners if they thought it is a great investment opportunity (and ultimately VC partners are only beholden to their LPs and their own performance. Goodwill and good faith are valuable for achieving that end, not in itself)
Also,
>Now, in the most competitive start-up environment in history, these founders no longer just have to worry about being beaten by other start-ups in their space. They have to worry about potential investors picking off their ideas and using them for personal gain.
You've always had to vet your investors like this. Nothing has really changed.
I get your point, but you should pick a contest that isn't hit driven like VC money is. Starting a company isn't like the Olympics, for sure.
If the people funding these VC's are unhappy about it they can pull their money out.
VCs with partners capable of executing on their own ideas are pretty rare, but when it does happen it is usually because someone had a side project (possibly even before joining the VC) that got legs (either unexpectedly or belatedly) and this person then uses his excellent VC contacts to secure a deal. And of course he/she does not go to a competing VC, that would be a harder pitch and it would be strange not to offer your partners a shot at the deal first.
All in all I can't see much wrong with this and if you think that it is 'unfair' you have to remember that VCs are not under any obligation to invest in outsiders at all (private funds exist).
Situations involving conflicts of interests are not inherently unethical, but greater care is needed.
It's not as if VCs are distributing public funds and those VCs that have taken public funds (or pension funds) would likely never engage in a deal like this.
If you think you're 'in competition' with the VCs partners for capital you have it backwards, they have the capital and they can dispense it at their discretion, or even not at all.
Do you agree that there exist hypothetical situations in which a company and a VC firm investing in said company might have differing interests? Doesn't it follow that someone with responsibilities to both parties has a conflict of interest situation?
We're in agreement here.
Because this comes up in practice there are a slew of reasonable ways to deal with these sorts of scenarios. I think the original article's "what do we do about it" section falls nicely into this discussion.
I think the extent of my position here is that VC firms are at a heightened risk of dealing with this type of conflict of interest problem, and would be well served by having clear policies on how they resolve them.
edit:grammar
Beware of who you accept money from, especially if that money comes with strings attached (board seats, various preferences and so on).
This is the distinction my initial comment sought to clarify -- in bootstrapping (as I understand it) a company is funding itself so there is only one party and hence no conflict of interest. When a VC firm funds one of the partners, there might be. Given the particular circumstances this may or may not be problematic.
Would you agree further that it might be wise for VC firms to have clear conflict of interest policies in the same ways it is wise for VC firms and companies in general to have clear HR policies?
I have no particular knowledge of the frequency with which VC firms have sensible conflict of interest policies, but my naive assumption would be that this is again similar to having good HR policies. (Which is to say I am not particularly suprised when a company gets into public trouble in this regard.)
It seems perfectly reasonable, however, for the article author or anyone else to opine on how they'd prefer to see the VC industry run. For comparison, though I am not a resident of Texas it's perfectly reasonable for me to have an opinion about Texas's education policy, especially when the secondary effects impact the entire country.
I am somewhat frustrated and dismayed by (what I perceive as) an inability on your part to respond to my points or questions and a tendency to assign to me ideas I don't hold. As such, I'm tapping out of this discussion here.
i) bootstrapping is different from self-funding. All of them might start with self-funding, but bootstrapping is getting revenue to fund the startup. Not the founder's money to fund it.
ii) VC's money are not their own money in totality. They raise funds with outside investors and they decide where to invest other people's money too.
Not all VCs take outside investors, but plenty do.
I'm not sure I would think the LPs would be all that concerned with this. After all, a VC firm is going to live and die by its performance reputation, so if their funds fail to return gains, it will haunt their firm for a long time.
What I do buy though is Kevin's other point in the conflict of interest of potential entrepreneurs walking into VC offices and pitching a great product (editing out the word "idea" for clarity) that gets rejected. At that point you've given up a lot of information with little recourse, and having a partner at a firm run with the idea themselves, with strong funding and a powerful network, would pretty much be a death sentence.
I have never seen this happen myself (although I do confess Seattle can be pretty far removed from the daily dealings in VC world), and I do choose to believe that most VCs operate with a moral compass, but it's still a terrifying thought.
Let's not forget every day some entrepreneur goes in to pitch an idea, and a VC picks up the phone and calls a portfolio company and says "hey I have an idea for you."
"VCs will steal your idea and launch it themselves" is not a real risk, especially relative to existing risks.
The issue of VCs launching their own ideas is purely between them and their LPs - if CALPERS is ok with it, then there's no issue.
there is 3rd component - money. You may have good idea and be executing it well. The VC has money, has your idea and in this situation hey have choice - your execution or to implement their own. Due to money asymmetry, even having somewhat worse execution, they may still do better than you.
The best ideas are often borne out of the conviction of the founders and their ability to spot an untapped need.
Because of this, founders (and progenitors of the original idea) are often true believers... and they will execute harder and with more conviction (even if less effectively at first), because it was their idea in the first place.
They'll often have better reactions and can better see where the market is going, because it was their idea in the first place.
Depending on their personality, they may also be better able to conceive of and implement improvements, because it was their idea in the first place.
Execution is critically important, but one cannot exist without the other.
Your value proposition as a founder should never be as minimal as "It's my idea".
Unless you make an SMS based concierge service and call it Magic
...even if the rest of us think it's a tad silly.
There's this myth that VCs are evil and out to devour young and fragile start-ups. Maybe it's due to the nature of my work (and quite possibly due to who pays me so there's my conflict of interest) but I've seen more start-ups and later stage companies trying to scam VCs than that I've seen VCs trying to scam/rip off (potential) port-folio companies (0).
Maybe this is a local affair and the EU VC scene is different in this respect, there is some confusion in this thread about angel investors being mixed up with VCs but in general VCs tend to be fairly honorable people. To balance that a bit more: there are VCs that have a bad reputation, typically these are smaller funds that are non-transparent wrt the source and destination of their capital, those are probably best avoided but I don't think they're representative of the segment as a whole.
The example given here - as far as I'm concerned - is a fairly typical affair given that capital providers will part with their money more easily when there is a basis of trust between them and the person or entity receiving the capital. Whether that's an optimal allocation strategy or not is debatable but it does not in any way require the measures advocated for in the article.
VCs are very image conscious, if they lost their influx of potentials because their reputation took a hit because of a real or perceived hi-jack of someone else's idea then they would suffer immensely so they are very protective of this channel.
I'm not sure if it would be an existential issue but I'm definitely sure that it would hurt badly to be known as 'the VC that you can't pitch to because they'll rip your idea'.
~Upton Sinclair
I don't feel suspicious of family's investing in their kid's venture -- wow how unfair! so biased, they should have given the kid next door a fair listening to as well!
The problem only arrises if bad decisions are then publicly de-risked (as is the case in banks, etc -- don't know specifically if this happens in an indirect way with VC's). But in and of itself -- "people you know" is one of many possibly good or bad metrics you can use to invest your own money (or the money interested to you by funders that know how you operate).
someone a while back made the case that SV is an offset economy where instead of CEOs you have VCs, and instead of Managers you have Startup CEOs.
Keeping the vague analogy in mind, how is flooding your kids with easy credit not available to other people not a form of nepotism?
Should I think it's unfair you spend nothing on me?
I run a VC backed bitcoin startup myself and more then one of the investors we pitched to as early back as two years ago have gone on to create their own bitcoin-related companies in suspiciously similar product verticals to ours.
In a private company, like Andreessen Horowitz, they are effectively spending their own money. If they choose to invest in a company founded by one of their partners, I do not see the conflict of interest. From the outside we may question whether or not the startup is really worthy of being funded, but it really isn't our call to make.
But what if it was our call to make? Did they make a bad decision by funding one of their own? Looking at his track record he already has experience as a co-founder and a CTO. On top of having prior experience, he has worked as a partner at Andreessen Horowitz for over a year. The people making the decision whether or not to fund his startup have experience working with him. They probably have a good idea of whether this person can or cannot deliver.
I think most people object to this, because they imagine a situation where a better startup is not funded because the partners decided to fund their buddy instead. Let us say that is true. For the sake of argument, assume this guy is incompetent and should not be given funding. Imagine this guy worked at Andreessen Horowitz for over a year and everyone knew he was incompetent, but decided to fund him anyways just because they were BFFs.
I guess it is possible something like this happened, but I doubt it. I recently finished reading Horowitz’s book The Hard Thing about Hard Things and he doesn’t seem like the type of person who keeps incompetent people around just because likes them.
The only valid objection I see is if they are using information provided to them under a non-disclosure agreement to gain unfair advantage. But is this a valid concern? As others have pointed out, most ideas are cheap. Even if that information provides some short-term advantage, it won’t help in the long-term as the market changes.
The corollary is that the crony's company did fail, his reputation would suffer, and he'd lose business!
My first company actually had a situation where the same firm represented both us and the investor during our seed round AT THE SAME TIME. To be fair, this was the investor's idea, not the law firm (and the law firm made sign all sorts of waivers), and we ultimately saved a small amount in transaction fees and I can't say we would've gotten much better terms with independent counsel. But the entire affair makes me cringe a little every time I look back on it.
In case you're wondering, yes, there are rules against all of this. But you can waive a lot of the rules by providing written consent (and many clients don't think twice about this).
It's a conflict of interest and any publicly traded companies will fire you for it because it's stealing from the (other) shareholders.
Why? Well in information technology (IT) venture capital, in recent years a strong theme has developed: The VCs want the founders to be technical, e.g., design and write software. As I recall, the firm A16Z is an especially strong supporter of this theme.
Well, then: For my startup, I've read a lot of VC bios: My conclusion is that only a tiny fraction of VCs are in any very significant sense technical in anything in or very close to IT. E.g., when was the last time they designed and wrote 10,000 lines of code? Invented a new algorithm? Did some technical work prior to the software, e.g., the applied math of machine learning or data science, e.g., some applied math for ad targeting? How about some applied math for computer and network security via anomaly detection? How many VCs are qualified to direct a major IT development project with planning, hiring, training, software project management, server farm planning and implementation including performance, reliability, security, growth potential? Gee, let's keep it simple: How many VCs could step into to a slot as database administrator of, say, a major site of SQL Server, Oracle, DB/2?
So, in an IT startup at the seed or Series A level, why would a founder want to hire a VC, and why would a VC want to invest in a VC as a founder or a founder who would hire a VC? How 'bout they wouldn't?
Sure, at the Series B, C, ..., maybe some VCs could do business development, marketing, setting up the sales channels, running the sales organization.
Net, bottom line-wise, the goal of the VCs and their limited partners (LPs) is to make money, and a VC firm that doesn't make money will have a tough time raising more. And, LPs may look with surprise and even concern at losing bets on VCs within the firm. Or, such a VC darned better make money!
There's lots of other unfair things in the Valley when it comes to privilege like this.
Investors (specifically LPs) might not know that it's happening.
A. You went to the same ivy league schools as VCs
B. You have a certain look
C. They give you the opportunity to work with them & you take advantage/work the opportunity to get funded.
Case in point, while I was participating in an incubator, there was a 20 year old mentor. He was mentoring a 40 something first time female founder. He had millions in funding and he went to sell his company for millions.
How did that happen when he had no previous experience. Well for one he graduated from the same top school as his VC (one of the biggest), who in which gave him a job working at the firm, who then funded his company and steered it to a huge sale using his huge/immense network.
Start-ups can be very unfair if you don't look the part, gone to the same ivy league school, given an opportunity to work with X huge VC & make the most of it and or struck gold/got lucky by publishing the next big thing you had no idea would take off.
VC is definitely a boys club filled with all the popular people from your high school who left you out & talked trash about everyone who didn't fit their part.
There is an argument for prescreening, but having been part of the interview process for a high profile YC company in its early days, I can say that the weight placed on "likeness" is very high.
The correlation between likeness and competence, not so much.