Musings on Entrepreneurship and Innovation
Sunday, May 22, 2005How VCs Are Like Crack Dealers
In today's New York Times, Gary Rivlin's article (registration required) begins:
By all rights Stewart Alsop should have been a terrific venture capitalist. So why did Mr. Alsop, long considered a cyber-prophet among technology leaders, wash out in a profession in which he seemed predestined to succeed?
I know nothing of Mr. Alsop, but Rivlin's article highlights two key aspects of the venture capital business - one economic and the other psychological - that anyone involved with venture capital should understand. First, venture capital, as it is currently practiced, is a tournament with incentives that influence behavior. Second, venture capitalists, like the rest of us, are prone to self-serving attributions about themselves and others.
The VC Tournament
In Freakonomics, economist Steven Levitt and journalist Stephen Dubner answer the question, "Why do drug dealers still live with their moms?" Their answer involves analyzing drug dealing as "a game best viewed as a tournament."
In order to advance in the tournament, you must prove yourself not merely above average but spectacular...once you come to the sad realization that you will never make it to the top, you will quit the tournament.
Drug dealing, like other "glamour" professions, is an up-or-out affair. As Levitt and Dubner explained, most drug "foot soldiers" live with their moms because they make, on average, less than the minimum wage. Why? Because they want a shot at becoming a gang leader who can make 25 times as much or more. In one major gang, "just 2.2 percent of the full-fledged gang membership took home well over half the money."
So what do the economics of drug gangs have to do with the business of venture capital? Well, consider this quote by Dick Kramlich, a founding partner at New Enterprise Associates:
There are Darwinian characteristics to venture capital...Below the surface there's a huge amount of turnover.
New hires by an established venture firm are very well paid. A partner can draw a salary of $1 million or more per year. On the other hand, as Rivlin notes, the real action is in the "carried interest." That is, the big payoff comes through participation in the 20% of distributions that are allocated to the general partners on the back end. "An informal survey of venture capitalists suggested that a partner working at a top-tier firm in the 90's could pocket roughly $50 million over the life of a single fund - with venture firms typically raising a new fund every few years."
Venture capital, like dealing crack cocaine, is a winner-take-most game. That engenders some predictable behavior on behalf of those at the top of the food chain. As one successful gang leader observed:
So, you know, you try to take care of [your subordinates], but you know, you also have to show them you the boss. You always have to get yours first, or else you really ain't no leader. If you start taking losses, they see you as weak and shit.
Mr. Kramlich isn't prepared to be viewed as weak and shit:
Mr. Alsop said he left [N.E.A.] because he felt most comfortable working with nascent technology companies, and, increasingly, N.E.A. has been broadening its focus well beyond investing in very small start-ups. He described his own track record over eight years as good but not great.
But Mr. Kramlich...put it more harshly. The firm, it seemed, had simply run out of patience with Mr. Alsop, as it did with others who were not seen as pulling their weight.
Self-Serving Attributions
VCs tend to be smart, analytical, and able to place big bets in the face of high uncertainty. But, that doesn't mean that aren't susceptible to self-serving attributions. Consider the following from ChangingMinds.org:
We all have a need to explain the world, both to ourselves and to other people, attributing cause to the events around us. This gives us a greater sense of control...
When another person has erred, we will often use internal attribution, saying it is due to internal personality factors. When we have erred, we will more likely use external attribution, attributing causes to situational factors rather than blaming ourselves. And vice versa. We will attribute our successes internally and the successes of our rivals to external "luck"...
Our attributions are also significantly driven by our emotional and motivational drives. Blaming other people and avoiding personal recrimination are very real self-serving attributions...
We will even tend to blame victims (of us and others) for their fate as we seek to distance ourselves from thoughts of suffering the same plight.
It seems obvious that Mr. Kramlich views himself as a Darwinian winner (though it's not at all clear that he understands the mechanism of Darwinian selection). Steve Dow, a venture capitalist at Sevin Rosen, is of a similar mind: "Sometimes it's true that a partner left a firm over strategic differences or whatever they say, but that's the exception rather than the rule...[More typically it's] because they didn't have a good enough sense of smell about a deal." Sanford Robertson chips in, "I think what a lot of these guys learned, some the hard way, is that you're a natural athlete or you're not."
The party line is that those who win the tournament are winners; those who lose are losers. Correlation is causation. Personal success is deemed to be proportionate to one's essence - one's natural ability, one's sense of smell. Seemingly, those who leave (or are forced from) the VC tournament may cling to these beliefs the most fiercely. Mr. Alsop said, "I think I've done very well as a venture capitalist, but I'm not in the god category." David Beirne, formerly a partner at Benchmark, echoed the deification of the industry's celebrities. "'I feel at this point I'm very good at this'...It's only a matter of time, [Beirne] said, before he scores what he describes as a 'godlike hit.'" After all, who but a god could cause a return on capital of hundreds of millions, or even billions, of dollars?
Implications
Who cares? After all, it would be easy to dismiss my perspectives as the sour grapes of a washed out pretender who achieved unspectacular results in his short tenure in the private equity business. Fair enough. Nevertheless, I think there are at least three reasons to care:
- To the extent that the venture capital tournament is a closed affair, there is the prospect of oligopoly. It's at least plausible that self-serving efforts to maintain and justify oligopoly could lead to a sub-optimal level of equity risk capital in the country and the world. Unlike crack dealers, VCs, as a group, contribute to the social welfare. But, are they contributing as much as they could?
- Self-serving attributions inhibit learning. The deification of successful venture capitalists suggests an essentialist perspective that, I believe, is damaging. If one could really measure such things, I wouldn't be surprised (disappointed, but not surprised) to find that Mr. Kramlich, for example, were 10 times (100 times?) the VC I could ever become. Nevertheless, I believe I can learn to become better. And, if that's possible, then a million of me can have far, far greater impact on the world than a handful of "godlike" investors.
- If, as an entrepreneur, you choose to accept an investment from a VC who has embraced the ethos of the tournament, understand that you, too, will become a participant in the tournament. Up or out will have a very personal, specific meaning. Is it a game you really want to play?
Related: The Center for Venture Education; VC Industry Success a Function of Organizational Design
