The Traditional VC Model is Broken. Here’s How to Fix It

Over the last 20 years the VC model has changed substantially. Venture capitalists have brought some innovation to their structures, but to a large extent VCs still have important issues with their business models. These stem from misalignment, size of funds, track records, and changes in the entrepreneurial ecosystem.

Due to the success of the early tech VC funds, capital flowed into the industry. Managers were incentivized to:

1. raise more capital (make large management fees);

2. write large cheques to deploy capital quickly;

3. and swing for the fences as profit sharing becomes only meaningful (relative to management fees) if home runs are a semi-regular.

This misalignment creates poor track records and also prematurely urges entrepreneurs to exit quicker than optimal, so funds can raise more capital on the back of exits. In Canada, where a good bulk of VCs were Labour Sponsored Funds, this was especially the case.

The above forces created a flock to quality from larger institutional investors and completely shut out the smaller investors as they could not afford to invest in large funds. Further aversion grew as investors did not want to be locked up into seven-year terms with limited liquidity. Hence the VC community grew smaller in number with some very large funds. The misalignment issues were dealt to a certain extent but this left a vacuum for the financing of earlier stage companies.

The remaining large VCs simply have to deploy capital in large amounts to be manageable, making early stage companies too cumbersome to consider. Furthermore, new startups, due to many factors including cost of computing, the cloud, freelancing services (such as eLance) and teams looking to put in lots of sweat equity, require less financing to prove their models. They often only require limited capital to reach significant value creation milestones including sometimes substantial revenues.

Angel investors have slightly filled the void but they lack the diligence and structuring capabilities, often get stuck in down rounds and are unable to raise further capital. Crowdfunding has also begun to fill the gap but again diligence is limited, structuring mostly non-existent and the jury is still out on that part of the ecosytem. In Canada, government led funds have moved in to try and stimulate investment but they are only part of the answer.

The new crop of VCs is smaller in size and focused on earlier stage companies within specific geographic areas. Hybrid VC/Merchant Banks are also filling this gap. They are self funded teams investing their own capital and subsequently bringing in co-investors alongside, directly into the companies. These offer the benefit to co-investors of not being tied to a seven-year fund, a choice in investments, and increased liquidity (they get the liquidity of each company). Both these models are very focused on verticals and tech hubs enabling them to nurture and mentor the companies they work with.

There is no question that we are in a period of unprecedented innovation. Funding sources need to get organized in such a way to support this entrepreneurial boom as well as make good returns for investors. VCs must evolve to meet this challenge.