Epistula #8: Beyond the Hamster Wheel
Transforming the venture capital industry for sustainable, long-term growth.
Last year, we wrote about misplaced orthodoxies in the US venture capital market. That essay – “Defying Orthodoxy” – has taken on a life of its own and become a calling card for Deciens’ heretical approach. Over a year later, we continue to see the world through the same iconoclastic eyes.
In our view, there is a profound mismatch between the long-term capital that underpins venture capital and the norms and business practices that emphasize taking on short(er)-term risk. It manifests itself in a set of pernicious incentive misalignments across the entire ecosystem. This is especially true when you add in an increasingly common set of intermediaries and agents with their own motivations.
The Misalignment of Incentives
LPs are stewards of capital – typically individuals, families, organizations, and institutions. Their capital tends to be permanent, or so long term as to be functionally permanent. The best LPs embody a long-term, multidecade perspective and organize their teams, capital, and activities accordingly.
Similarly, venture capital funds are designed for long-term investments. They generally have contractually guaranteed capital for at least a decade. And, practically speaking, they tend to last much longer. By the time all of the assets are distributed and funds wound down, a venture capital fund’s actual length may very well be 15-20 years.
The Company Cycle vs. The VC Firm Cycle
The enduring nature of LP capital and the way that VC funds are structured are in stark contrast to the way that most VC-backed companies operate.
The standard operating model for VC-backed companies is to raise capital, consume it aggressively, and hope to have made enough “progress” to raise more capital before going bust. Then, like hamsters on a hamster wheel, they repeat this cycle every 12-48 months with more stakeholders and capital at risk. This model embeds existential financing risk as if it is an inevitable byproduct of innovation.
While VC funds are organized around managing long-term capital, most VC firms operate with a similar hamster-wheel dynamic to the companies that they fund. VC firms raise capital from LPs, invest that capital into companies, and then raise again. But because investing in start-ups takes 10+ years and VCs raise a new pool every two to four years, the industry has created pseudoscientific metrics and accounting practices to create the illusion of “progress.” They are known as mark-ups.
The Disconnect from Long-Term Interests
Nowhere in this nested set of hamster wheels is any assessment of what is in the best interests of portfolio companies (and their many stakeholders), LPs, or VC firms themselves on anything other than the most short term of bases.
As a European VC friend once told me: “Venture capital is like a pie-eating contest where the prize for winning is yet even more pie.” When I shared that quip with a different VC friend, she said, “Venture capital is like a pie-eating contest where the number of contests you can enter doesn't depend on how well you eat pie. Instead, it depends on performative proxies, like the number of forks and napkins you bring to the table." That is the dysfunctional state of VC, from two of its most successful practitioners.
Venture capital is like a pie-eating contest where the number of contests you can enter doesn't depend on how well you eat pie. Instead, it depends on performative proxies, like the number of forks and napkins you bring to the table.
An Alignment Paradox: LPs and Founders
LPs and founders are actually much more economically and dispositionally similar than it would seem at first glance. LPs should want their (underlying) portfolio companies to compound their equity value at high rates of return for many years in tax-advantaged structures while minimizing their capital consumption and existential risk, ideally in an uncorrelated fashion to the rest of their portfolios. This is how they can consistently meet their liabilities, exceed their goals, and endure.
Founders, with their lack of diversification, should want to operate their businesses in the same fashion, as it is the only sustainable way to build generational businesses and create associated wealth.
The crux of the problem is that from a first-principles perspective, founders and LPs should be aligned but seemingly aren’t. And we suspect the intermediation through GPs and others, with their own divergent incentives, is at the heart of our industry’s malaise.
The Short-Term Focus of VC Firms
Today, most VC firms are focused on their short-term commercial interests – doing whatever it takes to raise the next pool of capital, the next fund. And because a GP has to raise a new fund every two to four years, they will do whatever they can to help themselves do so, regardless of what's best for LPs, founders, or even themselves on a medium or long-term timeframe.
Large VC complexes, with their expansive teams, need larger and larger funds to support massive overhead. In turn, they promote capital-consuming industries and companies to justify their own fund size. Burning lots of capital advances their business model, even if it is to the detriment of their own ecosystem.
The Decline of Profit-Sharing Incentives
Nowhere is the short-termism clearer than in how VC firms treat profit sharing – aka carry. To be explicit, the behavior of most GPs and non-GP investors today suggests that they have all but stopped caring about generating carry. For most, all they seem to focus on is keeping the gravy train of fees running, getting deals done regardless of quality in order to get “points on the board,” and investing in hype-driven opportunities that a greater fool will “mark up” – all to get more assets under management, get a “bigger” job at their current firm, or get a job at a more “prestigious” firm. And who can blame them, given bloated fund sizes, anemic carry allocations stretched across big partnerships, European waterfalls, extremely long liquidity cycles, ten-plus-year carry vesting, and a business culture that increasingly promotes job hopping?
LPs and founders, of course, respond to the incentives placed on them. If it is good for an individual’s career to allocate to a “prestigious” firm, they will do so, even if it is not in the best interest of the capital they manage. If large pools of capital want to deploy larger and larger amounts of capital, VC firms will grow to accommodate, even if it is bad for their returns and, because of the need to deploy larger and larger amounts of capital faster and faster, bad for founders.
The Consequences of Unsustainable Growth
A VC focused on putting out double the capital this year as they did last year will back the most capital-consuming companies and/or push existing portfolio companies to burn more faster, so they need more capital even if it is unsustainable. Founders, in the boardroom, are pushed harder and harder to scale, with the attendant operational, organizational, and technological debt that comes with a growth-at-all-costs mindset.
Tragically, as we are now experiencing, capital can dry up as quickly as it appears, leaving everyone wondering how they got themselves into such a morass.
Breaking the Cycle: A Long-Term Approach
From where we sit, GPs must utilize the long-term nature of their capital partnerships to their advantage. If we have capital for around 15 years, then we should invest in and help founders build businesses that can compound for all 15 years. This is simply a more prudent, risk-adjusted strategy than burning brightly and hoping that every time a company rolls the fundraising dice, it comes up with double sixes (which is a lot easier in a once-in-a-lifetime financing environment). While the latter is commercially tempting, it is truly a red herring.
Our strategy is to go long duration by investing in businesses that create value through financing optionality, rather than going short duration through buying short-term, embedded, existential financing risk.
Rethinking Capital Returns
One way to break free of the cycle is to reframe how we think about returning capital. VCs have historically only sought to return capital by exiting their positions. This means selling a portfolio company in whole to a strategic or financial buyer, selling a VC’s specific position to another buyer (also known as exiting on the secondary market), or taking a company public and handing a VC firm’s shares back to their LPs (what's known as distributing the stock).
If a business can grow at high rates of return while generating liquidity (or at the very least not consuming capital) and one has permanent or long-dated capital with which to enjoy the benefits of compounding, we don’t fully understand why one would want to sell such a company. The GP can use the liquidity a company generates to furnish distributions to LPs and crystallize carry, without needing to exit a position and permanently extinguish the potential for future appreciation and/or liquidity generation. Furthermore, companies like this can take advantage of dividends, tender offers, stock buybacks, dividend recapitalizations, and other ways to return capital.
Conclusion: True Alignment and Partnership
“Alignment” and “partnership” are the most overused words in venture capital. To live these values, we need LPs to partner with GPs that actually align the timelines of their capital, people, and investments. We need GPs that build and invest in the future rather than another hype cycle, that fight for carry as it truly aligns them with their LPs, and that organize their firms, teams, time, and personal lives for longevity and compounding.
By embracing these principles, we can create a venture capital ecosystem that truly serves innovation, investors, and entrepreneurs for the long haul. It's time to move beyond talking the talk and start walking the walk of true alignment and partnership in venture capital.
