Rethinking the VC Unicorn culture

March 18, 2024

If you are a capitalist it is an article of faith that growth is good. Growth creates wealth, jobs, innovation and social progress. If you do not believe that then this essay will not interest you.

This essay is about Venture Capitalists’ quest for “unicorns” and what it does to young companies and the investors who back them.

A unicorn is a one-in-a-thousand investment that delivers hypergrowth to investors. Unicorns are rare in mythology. They are rare in the VC world, too.

And still it s not uncommon for VC firms to promise an internal rate of return of 25 percent. A unicorn hunter might ask why anyone wouldn’t trade that for the 7 percent that personal investment portfolios average. The answer is because VCs seldom hit their targeted returns.

This belief in higher returns turns out to be closer to a theology than a true reflection of financial-market history. As an asset class over the past 20 years, venture-capital investing has not performed significantly better than any number of well-constructed index funds. Only 5 percent of all VC investments achieve target returns, let alone unicorn status.

Money is how the score is kept, as they say on Wall Street. Assuming you believe that, the National Venture Capital Association estimate that 25 percent to 30 percent of startups backed by VC funding go on to fail. Would you put your retirement funds in an investment that has a 25 to 30 percent chance of not even returning your initial investment?

This is not the way to build long-term wealth. If we were organizing a capitalist economy from scratch and desired the efficient application of capital would unicorn hunting be the way we would do it?

The Big Score

The Big Score is part of the American psyche. We love stories of making it rich by building a better widget, or anyway by buying stock in the widget maker when shares are cheap.

Markets are often more emotional than wise. We all know this. Even sophisticated investors are entranced by tales of the Big Score. All the data in the world is not going to change their minds.

But remember that venture capitalists are financial people, not operating managers. The first question they ask themselves is not about how to achieve sustainable growth but how to accelerate their returns in the companies in which they invest.

This distinction is important if you are a CEO who takes VC money. A VC’s high-growth agenda may not suit a company’s long-term strategy. The consequence may include an abrupt end to the ambitions of the startup and its employees.

This is somehow portrayed as the market’s efficient winnowing. Meanwhile, society is deprived of the contributions of new businesses that might not have been unicorns but were promising and would have been profitable.

Instead of ruthless pruning of the garden, allowing companies with slow but sustainable growth would be better. We might have more rather than fewer solutions to hard problems. (If you want a poster child for the virtues of measured growth, look at Pal’s Sudden Service.)

For the pension funds, college endowments and foundations that fuel venture investing it is fair to ask if promises of higher returns are worth the risk relative not just to the damage the current system causes but to their own return on invested capital.

If you believe this is an anti-VC diatribe you would be mistaken. Investment capital in early-stage companies is a source of growth and vitality. VCs themselves have invaluable experience that help entrepreneurs see around corners and navigate growth.

But would it be crazy to ask VCs to prioritize a higher rate of “survive and thrive” among their portfolio companies? What would it take to make that happen?

Change the score keeping

VCs feel they need to promise outsized returns to continue attracting new capital. Grand slams and home runs, in otherwords, versus singles and doubles. They may be right. But the universities, foundations, pension funds and other institutions that invest with VCs are under no obligation to play along.

The beginning of a change to investor culture can start with the way financial journalists cover markets. Reporters are also addicted to stories of the Big Score, an addiction reflected in their choice of stories. They tend to write as if they assume an investment horizon of no more than the next six months. If your intention is long-term growth this perspective is not in the service of your interests. That is true whether you are an investor or a business builder.

Institutions that invest with VCs and private-equity firms can play an even bigger role in changing the game.

One way is to bring a different value framework to their deployment of capital, one that seeks more survivors, more employment, more innovation. Or they can set all that aside and prioritize stable growth for their invested assets. Either way, the data makes it clear that VCs and private equity are usually not their best choice.

Challenging an article of faith is never easy, but it can inspire monumental change. Isn’t it time to begin this conversation?

This essay is written in collaboration with Kevin McDermott ofCollective Intelligence in New York.

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