Operations

Venture Capital Needs a Complete Reset

Only by returning to its roots can the VC industry thrive in the years ahead

Gabe Kleinman | 05/10/2020

Though I’ve worked in venture capital for the past four years, I still identify as an outsider. The majority of grand VC musings today from the industry’s most visible figures don’t align with my values. Investors have become known for funding products and services that create more systemic problems than the conveniences they provide.

But today, I’ve never been more optimistic for the future of venture capital. With high-flying valuations vanishing, we must engage earnestly with companies around resiliency, durability, and purpose. With gig workers providing for our basic life necessities, we can’t help but imagine how technology could remove them from harm’s way. With loved ones dying around us, we have no choice but to consider every aspect of our collective health, and how we care for it.

With history watching, now is the moment for our industry to step up. And if we succeed, the returns will follow like never before.

Big vision, creative thinking, and huge risks

Venture capital’s past — more creative, visionary, and risk-prone than much of what we see now — is instructive for anyone in the business today, especially given how little attention it seems to get in 2020. Much of its history is well-chronicled in the film Something Ventured, a documentary about the origins of the industry that features interviews with modern progenitors like Arthur Rock, Don Valentine, and Tom Perkins. Venture capital was far from perfect then as it is now, and was born during an even more homogenized era in business with dramatically different social norms than today. But if you listen to the words from the veteran VCs in this era, their rhetoric is all about vision, purpose, and impact. One might even mistake them for impact investors or even philanthropists today. Take this quote by legendary Silicon Valley venture capitalist Don Valentine: “I’m not interested in entrepreneurs who do it our way. I’m interested in entrepreneurs who have a vision of doing something consequential.”

Or this quote by pioneering VC Tom Perkins: “Isn’t it great if you can make money and change the world for the better at the same time?”

Until recently, VCs that focus on mission or impact have been thought of as delivering sub-par returns. And yet the industry’s founders celebrated ambitious missions and wide-reaching impact. Many of these VC legends funded society-altering, category-defining companies that billions rely on today, like Apple, Intel, and Genentech.

The story of biotech giant Genentech’s funding is also one of assertive venture dealmaking and creative financing. The venture capitalist Robert Swanson, who worked for Tom Perkins, cold-called Genentech co-founder Herbert Boyer to see if his gene splicing technology was ready for commercialization and what it would take to get there. Unable to muster the estimated $3.5 million needed for what amounted to basic scientific research, the team brainstormed how to get proof of concept more nimbly — and ended up subcontracting with two other labs for a total of $250,000. The rest is history.

As a type 1 diabetic, I have both scientific breakthroughs and creative risk-taking finance to thank for work that eventually led to the creation and commercialization of synthetic human insulin. And it also made extraordinary returns for their investors.

Where are the big returns from big bets transforming massive sectors of the economy for the better?

Diminishing vision, diminishing returns

Earlier in my career I was an agent trainee at Creative Artists Agency. Its president, Richard Lovett, was a learned student and aficionado of all fields within the entertainment industry, especially agencies and their original purpose: to enable true creative freedom for the best creative talent. He (and partners Bryan Lourd, Kevin Huvane, and David “Doc” O’Connor) took the best of agency titans’ client service practices and leveraged them to build the diversified, global powerhouse the agency is now.

Many fund managers today, by contrast, seem to overlook the roots of venture capital. Many investors seem to think venture capital began with a philosophy rooted in the belief that operators (that is, those who have been founders or early employees of a venture-backed startup) know how to build companies and can help you build yours, too. They continue to lionize this philosophy.

Venture pioneers like Arthur Rock were essential to the building of the companies in which they invested, but Rock wasn’t an operator (as it is thought of today) before becoming a venture capitalist. He was first and foremost an investor. After graduating from Harvard Business School, Rock became a securities analyst and subsequently joined Hayden, Stone & Company in corporate finance. However, it’s clear Intel wouldn’t be the company it is without his involvement in all aspects of Intel’s early growth, from sourcing key hires to building business strategy.

Venture capital today differs so dramatically from 50 years ago not just in the value-add services we now see at so many firms, such as a16z’s services-on-steroids approach, which has focused largely on industries like enterprise software, cryptocurrency, and online marketplaces. Rather, it’s the type of companies being funded, the surge of former operators funding them, and the sheer number of funds and dollars being thrown at them. In venture capital today, we now have more than double the number of funds compared to what we had just 10 years ago, and nearly 40% of all venture funding going into one thing for each of the past 10 years: software.

Considering it takes about six years to get a sense of returns, industry averages seem to be going in the wrong direction as measured by DPI (Distribution to Paid in Capital), which is a multiple that represents the limited partners’ return on their investment with a venture fund. DPI multiples of upper quartile funds from 2010 are operating at levels around the lower quartile from the mid-1990s, with a mean for 2010 at less than a third of that from the late 1980s.

So why don’t we have more Intels, Genentechs, and Apples today? Where are the big returns from big bets transforming massive sectors of the economy for the better, in more than name only?

The proliferation of “value-add” firms might suggest this operator-first approach has created an overly insular industry, plagued by an army of operators-cum-investors who often fund look-alike businesses while repeating growth hacking playbooks of how to build them — Uber-For-X, Facebook-For-X, Airbnb-For-X — rather than entirely new endeavors.

Today, facing down existential planetary and human health challenges, we need less of those types of businesses and more of the inspiring, purpose-driven operations that solve massive problems using approaches never before created. And investors willing to lose their shirts to make it happen alongside those entrepreneurs.

It’s time for every firm in our industry to get back to the basics. It’s time, using one of venture’s favorite terms, to get back to first principles and rediscover our purpose.

A purpose beyond flying cars

Peter Thiel may have wanted flying cars, but rest assured, anyone under the age of 40 is clamoring for much more. How about something more ambitious, like a fully decarbonized energy economy? Dramatically less expensive, more accessible health care aligned with healthy outcomes? Cures for diseases that don’t cost $3 billion apiece to develop? Plant-based food that is exponentially better for human and planetary health, and equally delicious? The flying cars are, at this point, a nice-to-have — and only if they’re fully electric, and accessible to more than an infinitesimal percentage of the population.

For every firm, this boils down to a fund’s purpose and how prospective opportunities are evaluated. My firm believes that the most valuable companies of our time will be solving our biggest problems, and our purpose is to support values-driven entrepreneurs building these disruptive solutions. When we evaluate founders and their companies, we have a simple rubric analyzing the systemic nature of the challenge, the disruptive nature of the solution, the values of the entrepreneur, and the potential for venture returns. We also aim to diversify our pipeline and our team because we know we’ll see better deals.

If other firms’ purpose is simply to make money, they might be leaving quite a lot of it on the table. Investors must recognize that the same rules of company-building that apply to startups and publicly traded companies apply to themselves as well, with purpose today being the “animating force” for achieving profits, in the words of Blackrock CEO Larry Fink.

Jim Gaither said of Genentech about the time it was getting started that “Nobody had a clue whether they could pull that off, but if they could, it’d be big.” Whatever a firm’s purpose, we need to hear these words more often in the halls of venture firms today, and by “big” it should mean something that matters to human potential and planetary health. For those looking for a toehold, here are five places to start:

If the business isn’t transformational, then perhaps it shouldn’t be a venture-funded business.

Transformative ideas beat incremental ones

Venture capital has been squeezing as much as possible out of incremental improvements to just about everything, from juice machines to vending machines. We should now, if we weren’t already, be looking at step-change transformations. Instead of simply treating diabetes and other chronic conditions, we should be funding solutions that reverse these conditions entirely. Instead of process improvements around the edges of drug discovery, we should be leveraging technology advancements that rapidly accelerate the development of new drugs with totally novel approaches. Instead of attempting to make animal-based proteins more humane, we should reimagine our entire food system to be plant-forward and more local, fresh, organic, and accessible. If the business isn’t transformational, then perhaps it shouldn’t be a venture-funded business.

Improve non-digitized industries

Technologies historically kept within the confines of Silicon Valley’s sandbox are now available much more widely, especially to a range of legacy industries that have, until today, been concentrated in companies like Google. Data science, machine learning, robotics, distributed services, automation, and software-defined operations are just beginning to transform many more “traditional” industries like construction, logistics, manufacturing, and agriculture. It’s time to ask questions like: How might we dramatically reduce costs and improve efficiencies for the entire homebuilding sector (hint: manufacturing techniques)? How might we finally develop and deploy robots with human-like dexterity that can handle novel objects and materials? How might we totally eliminate more dull, dirty, dangerous jobs, from weeding to drywalling?

Create durable brands, not ephemeral companies

Consumer spending makes up roughly 70% of America’s GDP, and while the category isn’t going anywhere, it is changing dramatically, and we can do better to produce in healthier, less wasteful ways. Besides, consumers now appreciate the connection between products, their personal well-being, and that of the planet — and they are shifting their behavior accordingly. We know consumers are rewarding brands that commit to and deliver more sustainable, healthier, “good for you goods.” Here, more than most other categories, we need durable, built-to-last, purpose-driven brands and marketplaces to show us the way forward.

We need more resilient networks

This is clearly top-of-mind given the havoc Covid-19 is wreaking on everything from supply chains to retail environments, and, worst of all, access to critical materials like compounds in medications. This moment in time has revealed just how deeply dependent we have become on systems with single points of failure. We need to find ways for companies to produce and distribute all manner of products across all channels. We need more active clinical trial sites, unlocking their potential, exponentially growing their accessibility, and strengthening their resiliency for times just like this. We need to reimagine our workspaces from the ground up across all geographies. We need homeowners and businesses to control their own energy destinies, regardless of what happens at the grid level. With distance learning temporarily the norm at all levels of education, it is now apparent how wide the digital divide actually is and how we must build more resilient, antifragile systems as we face more potential school shutdowns in the future. These were already burning questions before the onset of the coronavirus; now, they’re existential to our economy and civil society itself.

Earth is more important than Mars

While this may seem obvious, it’s also not. The solvable challenges here on planet Earth far outweigh the potential for tourism in space, or life on Mars. We have the technology and the know-how; let’s now find (and fund) ways to truly scale the electrification of all transportation modes, especially infrastructure. We have so many solutions to our energy challenges; let’s take the obvious steps to fully decarbonize, and explore all options. We have clear and demonstrable evidence that animal-based protein and mono-cropping are destructive to our personal health, the planet’s, and often both simultaneously. Let’s not just have a conversation about it — let’s accelerate the transformation of our food system like never before.

Private enterprise is not the solution to all our ills, just as government isn’t the inhibitor to all our innovations.

Redefining hard problems

There are a number of firms already embracing this mindset, and they have been for years. Data Collective (DCVC), Collaborative Fund, Lux Capital, Atomico, Fifty Years, Generation IM, The Engine, and DBL are just a few taking big risks on big problems. And I’d love to see media, often hyper-critical of venture capital as a field and in search of what’s ahead, look to funds like these instead of falling back on the same players for coverage and comment.

I hope more entrepreneurs start asking harder questions of their investors, too, especially around the firm’s raison d’etre.

In 2014, as Head of People Operations at Medium, I painfully remember losing software engineering recruiting battles to Uber and Airbnb, the defining startup rocket ships of the era. I quickly learned that engineers wanted to “solve hard problems,” and I couldn’t understand why that didn’t seem to extend beyond the actual, day-to-day engineering challenges to the broader purpose of the company. I’m hoping candidates like these across all disciplines now see, more than ever, what a truly “hard problem” is that they can help address.

The same goes for VCs, with an even higher standard. It’s not enough to say we can solve these challenges alone, as many in the venture industry believe. Private enterprise is not the solution to all our ills, just as government isn’t the inhibitor to all our innovations. We tend to forget that touch-screen technology, wireless communication, and the internet were all government-borne technologies. And let’s not sleep on the social sector, which has delivered extraordinary societal returns in the past 20 years (see, for example, Khan Academy or Wikimedia).

As an industry, we have no excuses left not to forge ahead by embracing the best of our roots and moving forward with clear purpose. Technology is more readily available to positively transform industries for the better. We’re more aware and capable than ever to build ambitious, diverse investment teams and back the same in our entrepreneurs — ones that are pursuing the great challenges of our time.

If we succeed, the returns will follow like never before.

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