Are venture capital investors and governments missing the same trick? Johannes Lenhard sees opportunities.
Venture capital has had deep involvement in the rise of the digital age. Many of the most important technologies were originally funded by venture capital: microchips (from Fairchild Semiconductor to Intel), personal computers (from IBM to Xerox to Hewlett Packard) and more recently the smartphone (Apple), internet communication (Skype, Zoom, Slack), online shopping (Amazon, Shopify, Zalando) and the gig economy (Uber, AirBnB, Delivery Hero).
The so-called general partners or GPs in a venture capital firm (VC) usually only invest a small amount of their own money but they invest capital provided by limited partners such as university endowments, pension funds, family offices and high net-worth individuals. And unlike the state, which has provided the majority of funding for the basic research and innovation underlying the digital technologies, VCs excel at pushing ideas that last mile into the market. They are the financiers of risky start-up commercialisations where banks and other financial institutions take a pass. And they have done so quite successfully since their inception in the 1940s, in terms of creating both employment and innovation despite certain caveats.
“Covid-19 exposed a “monumental failure of institutional effectiveness”.”
Enter Covid-19. In mid-April, when the full extent of pandemic had not yet fully arrived in the US, world-famous venture capitalist Marc Andreessen (one half of Andreessen Horowitz or, as it is known, A16Z) published a call to action. He argued that Covid-19 exposed a “monumental failure of institutional effectiveness”. This failure is not a question of politics, but of a much more widespread “inability to build”. From coronavirus tests, cotton swabs and vaccines that are still so urgently needed, to much more fundamental things like (affordable) housing and education as well as manufacturing capacity – society hasn’t had the right focus on “building things” recently.
Andreessen really only implicitly – if at all – sees his own industry as part of the problem. He doesn’t address the incentive systems and limited and general partner structure common to most VCs as producing a culture of short-termism – at least when it comes to structural projects such as housing. Back in 2011 he wrote an opinion piece for the Wall Street Journal titled: Why Software is Eating the World in which he claimed that software applications would be able to replace and improve many processes we had become accustomed to in the pre-digital world. But it appears that there are limits to what the software industry, often backed by VC funding, can do. Software can’t eat everything, it turns out. Besides not addressing the limitations of what VC can achieve, Andreessen also doesn’t address the widespread sentiment among VCs that the state is incompetent and shouldn’t be involved in building (new) institutions.
But how have VCs reacted immediately to the changes the pandemic brought about? Have they still been driving employment and innovation – and will they be able to do so again in the future, building back better?
What has happened with venture capital investment during the first phase of the pandemic earlier this year, is first and foremost a story of slowdown rather than accelerated building activity. Overall, first and second quarter data from Crunchbase shows a slump of investment from VCs into startups, particularly for Series A and other early stage companies. Asia was particularly badly hit and so was the “push for new unicorns” according to a CB Insights report.
This slowdown is overall not surprising given that the core processes venture investors use to invest in start-ups suddenly had to be re-thought and crafted from scratch. From deal flow and due diligence to pitch meetings and investment committees – everything was moved from the conference room and café to digital platforms. Not only did this shift take a while to perform, it also came with added uncertainty: did you really want to write a first cheque, possibly worth several million pounds, having never personally met the founders of the company you are investing in?
Not everyone was immediately comfortable with “vetting people” via Zoom, a fact that also led to funding rounds taking longer to close. Possibly as a result of this uncertainty and new processes, some VCs have also been behaving badly. Instances include lowering pre-approved valuations retrospectively or quitting rounds altogether, for instance as Entrepreneurs First’s Matt Clifford observed. Female founders were struggling particularly hard, as is so often the case.
So overall, the atmosphere in the industry was not exactly pleasant, while stay-at-home orders were being rolled out everywhere. If, as many commentators fear, a recession indeed prevails, historical data shows that VC activity will in fact remain very slow for a while.
“How can society profit from the potential that VCs offer in the process of building back better?”
How then are we going to address the issue of building more and better, from the perspective of VCs and start-ups in the longer term? How can society profit from the potential that VCs offer in the process of building back better? One source that could contribute to the shift in focus and culture that Andreessen is suggesting, a culture that puts at the fore the “ability to build”, is in fact the state.
In many (Western) economies, government bailout funds have been put into action not only for big corporates but also for start-ups. From the £250bn Future Fund in the UK to a so-called two-pillar strategy in Germany, these funds in fact look (almost) like venture capital funds in themselves. With these vehicles, the state and its various national and local agencies take equity stakes in young companies in return for emergency funding – in principle just like VCs. Unlike in Germany, the large fund in the UK will also continue post-Covid and could act as a catalyst for VC activity. But so far it unfortunately isn’t exactly designed to contribute to a general movement of “building more and better”.
In a recent article UCL economist, Marianna Mazzucatto, pointed at flaws in the government bailouts more generally that also apply to the start-up funds. To foster “inclusive, sustainable growth”, it will be necessary to ban share buybacks and dividend payments, while requiring rules for worker representation and more inclusive boards or even “green clauses” such as zero-carbon emissions within a given number of years. Giving away money for free to – more or less – whoever is asking for it, without any conditionality won’t make anyone fundamentally change direction.
“The state needs to be the one setting the scene, and getting the incentives right to push VCs quickly into the direction of inclusive and sustainable innovations. ”
While conditions for start-ups would need to be adapted, and there is an argument to be made that overall more flexibility is needed early in a company’s life, I believe the state is in the process of missing an opportunity. It could do a better job of setting the scene for commercial VCs with its bailouts. For example, in the UK funds, only start-ups that have attracted prior investments are supported. As Diversity VC co-founder Check Warner pointed out, when the fund was first announced, this will probably further disadvantage under-represented founders such as women and black founders for instance. The German strategy does this slightly better already. Particularly, given the recent push for more racial justice in the light of the Black Lives Matter movement in the US (which has already ricocheted strongly through the VC ecosystem), why does the state not take a more proactive stance on diversity and inclusion?
Similarly, why does the state not push a movement to build more sustainably and green? A precedent was set pre-Covid among some high-ranking European VCs that signed up to the leaders for climate action clause. Funds like Acton Capital, Northzone, Holtzbrinck and Cherry Ventures committed to measure carbon dioxide emissions and to agree on reduction goals with all portfolio companies. This is a starting point that could have been further reinforced and incentivised through state action to push VCs in the direction of stakeholder rather than shareholder capitalism.
Don’t get me wrong; unlike Mazzucatto I do believe in the value that VCs can bring to the economy by commercialising risky ideas. But unlike Marc Andreessen I don’t see them set up to, by themselves, build back essential pieces of our lives including housing, education and sustainable industry post-Covid. The state needs to be the one setting the scene, and getting the incentives right to push VCs quickly into the direction of inclusive and sustainable innovations. But it is so far not thinking its push into the start-up financing world through to this end. I am not sure how we can achieve a fundamental change of direction quickly if even the state does not feel secure enough to set a different standard in such a moment of opportunity.