Entrepreneurs sell equity, VCs buy call options. This explains so much of the mutual disgruntlement.
It has been fashionable among many, entrepreneurs and VCs alike, to beat up on the venture model – in blogs, on websites, in discussion panels – so frequent and oft-quoted that I won’t even bother to provide links. Entrepreneurs complain about VC control, about the VC’s lack of concern for founders, about the VC’s push for exits, about liquidation preferences, and so much more. Venture capitalists and their close observers complain about the economics, and how on earth to generate a compelling return when only one out of ten investments really delivers when all is said and done.
But no wonder, really. How can the economics be truly compelling in any other than an unusual bubble environment, when call options are being acquired for full equity value or worse? And how can entrepreneurs expect VCs to relax their attitudes and structures when the margin for error is beyond slim?
Would any hedge fund buy IBM calls for the full IBM stock price? Would anyone pay the full IBM market equity value just for the right to buy that same equity at the same price or higher in the future? But this is in many ways what venture capital investing has become, driven largely by the staggering sums that have for some 10-15 years been pushed into the sector. The VC writes a check to an entrepreneur for, say, $2-3 million in a Series A round, knowing that the business which he/she has just bought into will, almost by definition, become a different business altogether before it’s time for the second (Series B) round. And worse, nobody, not even the founding entrepreneur, truly knows what that future business will be. What’s being bought, then, by that $2-3 million (at some way higher post-money value), is the right to double up later on, or pull the plug and let the option expire.
So when the VC is buying these very expensive call options, and when a portfolio consists of, say, 10-15 such positions – which is not much diversification at all for an option pool predicated on a 1-in-10 hit rate – how can the portfolio economics be compelling in any normal market environment, and how can the investor not be cranky? How can this investor possibly structure a deal without a liquidation preference? And how can this investor not be counting the seconds to an exit? In the meantime, how can entrepreneurs who have sold call options for at least the full equity value, not expect to be monitored and watched and structured all day long? Really now.
In the last analysis, the fix is not at the VC or the founder’s level. The fix is at the root, the capital source: the LPs. That these are reportedly cutting back on their venture capital allocations is probably a good thing for VCs and entrepreneurs both. It may not seem like it in the immediate term to many, but the future should improve all around.
