Silicon Valley’s Dirty Secret (Part II)

In 2015 when Medium was first getting popular I published an article titled “Silicon Valley’s Dirty Secret”. It was written as a fun, somewhat satirical view of the problems with raising seed stage investment at a startup. What follows is the evolution of that article based on the progress of AI and the stunning growth of index funds.

In this article, I will explain the current problems with seed stage venture and propose a solution.

There are six problems with venture capital at the seed stage today.

1. Deal flow is driven by networks which creates a systemic bias against geographies, minorities, women, and those who do not have credentials from prestigious universities.
2. Human beings at the funds themselves have to spend a tremendous amount of time and resources sourcing and evaluating deals. This time requirement (because the people are smart, experienced, educated, and should be well paid) creates the need for the standard 2/20 fee structure.
3. Due to the 2/20 fee structure, limited partners of funds can only realize above market returns if the fund invests in one or several extremely high-performing startups (100x returns on a single startup).
4. Due to the requirement for extremely high-performing startups, very good businesses that might achieve a 5–10x return over 5–7 years are not suited for venture capital investment.
5. The funds themselves (tend to) specialize in one or a few specific industry verticals because of the expertise required by those who have to evaluate each individual prospective investment.
6. Access to these funds is limited to high net worth individuals and institutions which limits the overall amount of venture capital that is available globally.

In the original article, I argued for a machine learning powered workflow for evaluating seed stage investments. Although I truly believe that at some point in the next 10 years that will become a reality, the true shorter term opportunity to disrupt the business of venture capital lies in a publicly traded seed stage index fund (PSIF for the sake of brevity) that invests in every deal that meets its minimum requirements.

Before you tell me that this is foolish nonsense, understand that in aggregate, all venture capital funds perform approximately the same over time. Personally, I subscribe to the theory that markets are perfectly efficient, but not for human psychology. This general concept is called behavioral finance and some investors have made billions exploiting investor psychology. In all markets, the only way that bad decisions get made is if a human being is making them. If you agree, then you may agree with my solution.

In venture capital, the psychological component comes to play in lots of ways, such as industries that the venture capitalist does not have deep knowledge of (and therefore passes on otherwise fine deals,) people who the venture capitalist does not feel a personal connection to (and therefore passes on otherwise fine deals,) or fear of missing out on deals that he/she feels are “hot” (and therefore invests in deals they should not have invested in.)

A publicly traded seed stage index fund would still require filters to evaluate potential deals, but I believe those filters could be predefined and baked into the charter. Examples of filters could be:

• Founder must be over the age of X.
• Must have at least X number of founders.
• At least one founder must have a minimum of X experience in the industry vertical.
• At least one founder must have the technical skill to build the product.
• All founders in aggregate must have started at least X companies prior to this.
• No founder may have a felony conviction.
• No founder may have been (personally) party to any lawsuit in the past X years.
• Both founders must have a minimum amount of education.
• Both founders must be in good health.
• Product must be at or beyond the prototype stage with a defined roadmap showing a v1 release within 12 months.
• The company must not have taken any prior capital or have any debt.
• The company must be a Delaware C-corporation.
• The company must meet the definition of a “qualified small business” by the IRS.
• The market that is being addressed must have a total market cap of at least X billion dollars.
• The market that is being addressed must currently be underrepresented by the existing fund startups.

Some of those may be bad, wrong, or silly, there are others that would likely be needed, the above list is not intended as a suggestion, but rather as evidence that there are lots of unbiased, fact-based filters that can be evaluated by a combination of non-expert humans and machines with a high degree of accuracy. Many of the above filters are already being used at venture funds, even if unconsciously.

At the PSIF the only way to apply for funding is through its website. There are no human interviews involved, and the names, ethnicities, and genders of the founding team are redacted when a human being does participate in the fact-checking for due diligence. Much of the diligence can be performed programmatically, thereby drastically reducing the amount of human involvement and time required to diligence a deal. Deal proposal to deal funding can happen in a matter of days.

If a company qualifies based on the requisite filters then an investment is made by the PSIF in the amount of $500,000. The terms are fixed on every deal at a $2.5M pre-money valuation and the equity documents are standardized with a 1x preferred return and pro-rata rights. Entrepreneurs can take the deal or not but there is no negotiation. Entrepreneurs are free to take additional money at a higher valuation immediately after closing and the PSIF takes no board seats.

Plenty of smaller funds, angel investors, and even some accelerators invest this way but they don’t do it at a large enough scale to really disrupt the industry itself.

“But wait, you’re going to make all sorts of bad investments!” is likely to be the primary argument against this approach. To that, I’d ask them to define “bad”. If by “bad” they mean unlikely to accomplish a 100x return, highly likely to go out of business, or potentially subject to fraud, then I would agree. For the shareholders in the PSIF though, “bad” isn’t necessarily a bad thing because of the volume of deals it invests in along with the tax benefits to be found on the first $1M of investment into any qualified small business.

The argument about being unlikely to accomplish a 100x return argument is more complicated to answer.

At a PSIF venture fund, much like a Vanguard index fund, the management fees could be obscenely low. Perhaps as low as 25 basis points (0.25%).

Further, since the limited partners would now be any individual or institution who wants to buy the stock, the carry itself would be meaningless. Shareholders (formerly LPs) don’t own stock in the companies themselves, you own stock in the fund that is investing in 1000 new startups per year. If the overall fund performs well, your stock will go up in value.

Due to the negligible management fees and the meaningless carried interest, this fund can invest in companies that are likely to return a 5x return over 5 years. Just like most venture funds, some of those investments would go under, many would muddle along, some will do fine, but a small number will turn out to be the next Facebook or Amazon.

By virtue of being publicly traded, the fund has access to massive amounts of capital, investors have a highly liquid security, and it simultaneously brings seed stage investing (in a controlled way) to every investor at home who wishes they could participate in early stage investing but don’t have the knowledge, network, or large checks that are currently required.

There you have it, a solution to seed stage investing which would massively disrupt the venture capital industry. Over time, many of the human tasks required would become automated, as the data flows in about deal outcomes, the filters would become more refined and the fund would be better able to predict outcomes.

Please tell me why I’m wrong…

If you like this article, please recommend it by applauding vigorously and by sharing it on social networks. I write for fun about topics I find interesting.

Also Read: Silicon Valley’s Dirty Secret & The Time that Tony Fadell Sold Me a Container of Hummus