The religious aspect of venture capital is the major source of the industry's mystique; faith in their instincts imparts risk-seeking personalities with the strength to become the champions of unproven industries.
Daniel Lopez, New Media Age

Over the last decade, or so, the venture capital industry has had an impressive run.  Capital commitments to the U.S. VC industry increased from $10 billion in 1991 to a peak of $180 billion in 2000.  Venture capital (as opposed to leveraged buyout capital) outperformed the S&P 500 [1].  It's not surprising, therefore, that discussions of the industry is fraught with fundamental attribution error.  Attributing the success of the VC industry to the unique characteristics of the individuals composing the industry is problematic for at least two reasons.  First of all, it obscures the deeper truth about the critical importance of effective organizational design.  Second, attribution error slows the professionalization and spread of venture capital.

Of Pilots and Airplane Design

In the early days of aviation, pilots were lionized in a manner not unlike the recent idolatry of VCs.  But, consider the following observation:

A fundamental difference exists between an enterprise operator and an enterprise designer.  To illustrate, consider the two most important people in the successful operation of an airplane.  One is the airplane designer and the other is the airplane pilot.  The designer creates an airplane that the ordinary pilot can fly successfully.  Is not the usual manager more a pilot than designer?
Jay W. Forrester

Due to advances in airplane design, a handful of highly skilled hero-pilots have been supplanted by a vastly larger number of competent transportation professionals.  A lot of the romance has gone out of air travel, but the resulting contribution toward globalization has created opportunities for unprecedented wealth creation for millions and millions of ordinary people.

By paying closer attention to the organizational design that enables successful venture capital, we can learn how to bring profitable risk capital investing to a much, much larger audience.  The profile of the VC profession will likely fade into the business background, and VCs are likely to see a reduction in their average compensation over time.  However, total wealth creation is very likely to increase as a consequence.

The "Science of Maybe"

Because we live our lives within the context of social organizations, their structure and design tends to become invisible to us.  Organizations start looking alike; but, there is no one-size-fits-all organization:

Just as there are a great number of different structures for biological organisms, so there are a number of organizations for the social organism that is the modern institution.  Instead of searching for the right organization, management needs to learn to look for, to develop, to test The organization that fits the task.
Peter F. Drucker

So, if the modern VC firm has an organizational design that is well adapted to a certain task, what is the task?

Increasingly unpredictable and rapid change follows unavoidably from doing business in an Information Age.
Stephan H. Haeckel

In the context of unpredictability, the task confronting venture capitalists is to become adept practitioners of, as my Venture Dynamics Group colleague Don Greer calls it, the Science of Maybe.  The business horizon may be obscured by fog, but the only way to proceed is to move forward.  However, some strategies for advancing into the fog (and pushing back the fog) are better than others.  In fact, they key elements of a superior strategy are clear:

• Increase the number and frequency of experiments
• Fail early, when the cost of failure is relatively low
• Learn from your many failures

The notion of experimentation and learning is easy to embrace in concept.  It's devilishly hard to implement.  In fact, the philosophy has to be baked into the context provided by the organizational design.

The Limitations of Large Corporations

Brains and guts aren't the exclusive domain of small companies or VCs.  Consider the world changing System/360 initiative decades ago by IBM.  The first modular computer system triggered the modularization of an entire industry and the creation of immense value.  The successful launch of the System/360 was a gamble of historic proportions and required a very high level of sustained effort by large numbers of smart people to pull off.

The corporation is one of the most significant social innovations in history.  Large, publicly traded corporations are, in many ways, uniquely positioned to take advantage of operating and financial economies of scale.  On the other hand, they aren't, as a group, very good at the Science of Maybe:

The problem for many companies is that they experiment not only too late but also too little.  The quest for efficiency and cost reductions often drives out experimention and testing until small problems become disasters and missed opportunities become competitive threats.
Stefan H. Thomke

Here, too, it's easy to fall into the trap of fundamental attribution error: the technocrats who populate large corporations are timid bean counters who lack imagination.  Really?  After all, these are many of the same corporations that helped drive the post-war expansions in the U.S., Europe, Japan, and Korea.  I suspect there is a more fundamental reason.  In fact, I think there are two: rank-based hierarchies and an all-or-nothing investment philosophy.

An increase in experimentation generates lots of information.  As Duncan Watts at Columbia University and others have demonstrated, social hierarchies quickly succumb to information overload.  Information that doesn't lead to changed perspectives, different decision rules, and new actions doesn't, by definition, translate into learning.

Furthermore, a rank-based hierarchy tends to screen out the most useful information: contrary data, surprises, and news about failure.  When you are the low man on the totem pole, there is too often little incentive to spotlight failure.  After all, messengers do get shot.  As a consequence, small failures quietly grow into major disasters, which reinforces institutional caution and a hunger for "certainty."  Information systems get clogged with data, but learning is constricted.

The all-or-nothing syndrome, curiously enough, may derive from some of the most virtuous aspects of the modern, publicly traded corporation: relative transparency and accountability to the capital markets.  Transparency has a cost, which can lead to what Adrian Slywotzky calls "the Big Opportunity" trap.  The effort to make big investments in sure things can crowd out the chance to make smaller investments in maybe experiments.  (Consider the growth in mergers relative to R&D expenditures.  Could the billions squandered in the merger of AOL and Time Warner been more productively deployed in a larger number of smaller investments?)

A Better Design for an Uncertain Environment

I don't believe that VCs, on average, are any smarter, prescient, or ethical than their corporate counterparts.  However, I do believe that VCs benefit from an organizational design that is better suited for navigating in the fog.  First of all, the standard VC engages in staged investing.  Second, VC firms are, more or less, peer organizations.

At a macro level, VC firms, themselves, are funded in stages.  Funds provided by institutional limited partners are finite in amount and duration.  If the general partners do well, they get to raise another fund.  At the micro level, VCs (versus private equity investors) don't engage in all-or-nothing investing.  They purchase convertible preferred shares that give them the right, but not the obligation, to invest in the follow-on round.  Staged investing at the firm level and the portfolio company level encourages experimentation, the identification of failure early and (relatively) inexpensively, and reduces the risk of putting good money after bad.  It's not necessary that VCs see the future better than the rest of us (though that always helps), it's that they operate in a context that allows for an effective strategy of ready-fire-aim.

The aiming/learning part is important.  VCs will be competitive to the extent that they engage in just enough experimentation, but no more.

The trust engendered by a peer-based structure is a much better environment for real learning than is a rank-based hierarchy.  An environment that supports productive failure is bolstered by two additional organizational design features.  First of all, limited partners don't get to intervene in fund operations after they've signed on the dotted line.  Consequently, GPs are shielded from the risk of getting fired when early failure becomes apparent.  Secondly, LPs are contractually obligated to pay a management fee, which means that the GPs can't be starved out.

Last, but not least, most of a VC's compensation is in the form of a back-ended share of the profits (i.e., the carried interest).  The VC's interests are aligned with the GPs' in as much as he or she gets paid by engaging in an interative ready-fire-aim strategy that results in a hit.  Effective experimentation is what counts in the VC industry, as was true with Thomas Edison an his innovative lab a century ago.

Conclusions

Economies of scale, communication and coordination costs, self-interest, and cultural inertia ensure that rank-based hierarchies are likely to be with us for a long time to come.  Nevertheless, it's also true that in an Information Age, the pace of change and uncertainty are increasing, to the disadvantage of such organizations.  The virtues of staged investment, systematic experimentation, and peer organizations have been well known in the context of research and product development.  The venture capital industry's gift to us is the legacy of one class of business organization that persuasively demonstrates that such concepts can be applied successfully at the more abstract level of venture creation.  Consequently, the VC experience is fertile ground for insight into adaptations of organizational design that can be applied in other sectors of the economy, including economic development, advisory services, and other, related, forms of finance.

[1] Source: Private Equity Performance: Returns, Persistence and Capital Flows by Steve Kaplan and Antoinette Schoar.