Draper: Is the Midwestern definition of Venture Capital wrong?
During a surprisingly candid Moneyball-esque discussion in Chicago, a number of proposals on how to change venture so it better serves Midwestern startups concluded with: “but that’s not venture.” Hours later, after exhausting nearly every metaphor comparing the Oakland Athletics’ sabermetrics precision to the San Francisco Giants’ home run flash, the intriguingly unanswered question became: so what IS “venture”?
The dictionary definition of venture capital is “capital invested in a project in which there is a substantial element of risk, typically a new or expanding business.” Venture capital investment is typically deployed through a legal entity owned by investing partners that is structured to exist for 10 years or less. The VCs managing the fund will leverage their skill sets to develop an “investment thesis” that articulates what types of bets they are comfortable making. And this thesis will typically inform an investment strategy that the VCs think will yield cash returns before the end of the fund’s life. These strategies, theses and structures are (potentially surprisingly for many) designed to reduce investment risk.
It is broadly accepted that Silicon Valley, Boston and New York have developed ecosystems that can support the creation of “unicorn” startups with extremely low probabilities of attaining remarkably high financial rewards. Yet, failure rates in such environments are now so high that veteran VCs like Andrew Zalasin are opening up discussions about “what makes something ‘successful’ or a ‘great startup’ or ‘spectacular.’” And others like Mark Suster are more directly stating that VC “wrongly defines success as “unicorn outcomes” [which is] often the wrong goal.” Like their coastal colleagues, Midwestern VCs often subscribe to the notion that no fewer than 70% of early stage companies require follow on investment, and argue that what separates the Midwest from Silicon Valley, Boston and New York is our unwillingness to accept low probability, high reward events.
Yet plenty of Midwesterners are participating in commodities or equities funds that are just as risky. Plenty of Midwesterners are participating in private equity deals that could implode. Some of our most successful investors are making big returns every year betting that rockets won’t blow up. The majority of our communities are making the most unpredictable investments imaginable by betting on the weather. So, why can’t we translate that risk appetite to venture? What makes venture unique?
Venture is unique because the “commodity” we are betting on is rarely fully formed. Early stage companies are so malleable that their form on payout often won’t resemble the concept at investment. This is fundamentally different from betting on known outcomes. Corn will always be corn, a building will always be a building, a share of GE will always appear to be a share of GE. But Uber is no longer a dispatching tool for Black Cars. Slack was basically an accident. Dwolla is no longer a peer to peer payments tool. Midwesterners are typically defining venture by greater than 10x returns – the “home run” of early stage investing – when the most distinctive characteristic of ventureis change.
The reality of Silicon Valley, Bosto and New York is that less than 25% of venture capital funds routinely deliver any profit. It’s easy to look at these returns and believe that the point of “venture” is gambling. With this gambling model, ecosystems become the casinos that win when more people bet. And if we continue to chart a path where Midwestern VC follows the Silicon Valley, Boston and New York model, our effort will likely win us funds just like theirs with median Limited Partner (LP) returns of less than 1.6x across the asset class.
But what if we embraced the fact that the defining characteristic of venture is the malleability of the investment? What if we embraced the fact that Midwestern communities can facilitate different changes? What if we embraced the fact that finding businesses with a top-end upside potential of 3x could yield a 2x return more quickly? What if we focused on revenue based returns instead of equity buyouts? What if our community, which can reliably build doubles, starts seeking more doubles instead of hoping for home runs?
Many estimate the top 25% and top 10% of venture funds are currently returning between 2.5x – 3.5x and 3x – 8x, respectively, within 10 years. Yet the “bottom” 75% are rarely even returning the investment. If we look at our Midwestern skill set, partnership opportunities, and educational pedigrees, a Moneyball approach could produce funds returning 1.8x – 2.5x on average, while opening up a whole new swath of previously overlooked investments.
At the moment, the Midwest doesn’t consider hitting doubles “venture” because it’s not what they do in San Francisco. But last I checked, the Oakland Athletics are still playing baseball.
Chris Draper is the Managing Director of Trokt, and has been selected as one of 25 VC Investor Apprentices from around the world to join Venture University’s Third Cohort. Draper has been a part of the Iowa startup ecosystem since moving back to Des Moines in 2010.
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