An old saying goes: “in Silicon Valley, you’re never on your way up or down, you’re always coming around . . . “
It’s a great phrase because it captures the energetic movement of people around this sunny and magical land. With enough success to give folks a sense of possibility — and just the right amount of failure to keep people moving — the dynamic system that is Silicon Valley nurtures a “pay it forward” culture that’s part long-standing way of life and part necessity. It’s a place where people are urged to count the number of additional years they wish to work and divide by four (the number of years in a typical vesting schedule) to determine their remaining “shots on goal.” And everyone seems to believe that favors today pay dividends tomorrow.
This virtuous circle also applies to capital. VCs shower money on startups, hoping that each dollar that goes out comes home with a bunch of its friends. Of course, the cash that VC funds invest comes from limited partners, the endowments, foundations, pensions, and individuals that are the money behind the money. The distributions to these folks from liquidity events then fund subsequent capital calls that allow VCs to invest in the next round of startups. It’s circular: just as cows feed on grasses and their, ahem, deposits replenish the soil with essential nutrients and encourage more growth, the startup cycle looks similar from my seat.
Indeed, understanding this circularity and assessing the role of tomorrow’s distributions in today’s capital commitments is critical; most LPs spend considerable time and effort modeling these flows. Anyone who wants the inside baseball on this particular brand of voodoo that we do should check out the seminal paper, Illiquid Alternative Asset Fund Modeling, by my buddies Dean and Seth.
But today, there’s some sand in the flywheel relationship between yesterday’s capital calls and tomorrow’s commitment. As companies stay private longer, the duration (to use the term from bond math) of venture has been extended. An already long-dated, out of the money option has gotten even longer-dated and seemingly further out of the money. According to the good folks at Cambridge Associates, venture capital funds called $149 billion from investors during the last decade and returned $143.5 billion during that time (and those tallies don’t include public and crossover funds). The numbers don’t lie: for most investors, VC has been a negative cashflow experience over this period. The counter argument to the cashflow complaint, of course, is that there’s incredible undistributed value associated with the investments made during this time. And I do believe that there are some amazing companies in fund portfolios, but until the wired cash hits accounts, the dollars available for new fund investments are getting scarcer and the flow of funds is in danger of interruption. It’s always been tough to manage the disconnect between 7 year liquidity cycles and 4 year fundraising cycles. As the former gets longer and the latter gets shorter, something’s got to give.
Meanwhile, the galloping valuations of so-called unicorns – some of which are little more than donkeys in party hats (h/t Bryce) – has put considerable stress on LP allocations, compounding the cashflow problem. One LP with whom I was speaking the other day said that their institution – one with a long, long history in VC – had never seen such an asset price run-up without correspondingly lavish liquidity. But it’s creation of liquidity that’s always marked the “going pro” in VC-land. Staying private for extended periods is like redshirting; you can’t do it forever. Now, don’t get me wrong: I like big fundraising rounds as much as the next guy; they’re great validator of value. It just seems that startups have a lot of cash on their balance sheets relative to burn rates right now. Raising money without plans for growth or acquisition is just creating a blockage in the system and worsening the velocity-of-capital problem.
It seems that today, we fetishize the deal, celebrate the closed round, high-five the fundraise. But isn’t that when the work really starts? All this activity without exit creates capital constipation.
At the risk of sounding like Ben Horowitz, being an LP today can feel like being a character in the seminal 1993 rap opus Torture/Method Man by Wu Tang Clan. I’ll spare you, dear reader, the particulars of the lyrics, other than to say that two rappers are comparing how they might torture an enemy. As the skit ends, one of the rappers offers his worst: “I’m going to sew your [bottom] shut and keep feeding you and feeding you and feeding you.” The terminal bloat portended by this taunt is the pain that many LPs feel today.
So, entrepreneurs with visions of staying private forever: for the good of the ecosystem, let’s take a laxative and loosen that exit sphincter; let’s put the moolah in da coolah so that it can be recycled back into the startup world. Don’t just do it for us, the LPs, do it for your next company. Your future self is counting on you. After all, you’re never heading up or down, you’re just coming around.