by In public In the imagination, venture capitalists are often seen as independent, wealthy actors who seed startup companies with their personal money. But the vast majority of VC capital comes from “LPs” — or limited partners — which include public pensions, university endowments, hospitals, and wealthy families. In other words, venture capitalists manage large sums of other people’s money. This makes them de facto gatekeepers of innovation, deciding what gets built and who benefits from it. If this system works, we will end up with world-changing companies and technologies. If it fails, as in the case of Silicon Valley Bank, we risk becoming stagnant and regressing.
Historically, society has given venture capitalists a lot of leeway to shape and influence the innovation economy. Our laws and policies exempt VC investors from many of the rules and regulations that apply to other asset managers. However, amid the collapse of the SVB, many people began to question the wisdom of granting so much leeway to VC leaders.
As conflicting theories about the bank’s collapse circulated, commentators across the ideological spectrum seemed to agree on one thing: Venture capital funds’ responses to the crisis were shockingly unprofessional. Some criticized VC’s leadership for a panicked response; others characterized the pleas for swift government action as the “raiding of idiots.” The harshest critics accused VCs and startup executives of “asleep at the switch.” They alleged that SVB depositors were financially negligent, citing reports that some VCs and startup founders had received personal benefits, such as 50-year mortgages, in exchange for holding high-risk uninsured deposits with the bank .
Del Johnson is a venture capital investor, limited partner, angel investor and author. He is a graduate of UC Berkeley and Columbia Law School.
As one of the few VCs to expressed concerns early on the asset’s systemic risks, I was not surprised by the VC-led bank run, nor by the week of finger-pointing that followed. Venture capital investors have long prided themselves on promoting a culture of collaboration and “pay it forward,” guided by close-knit networks and personal relationships. However, as a Bay Area son who has closely watched VC responses to the dot-com bubble collapse, I knew this story was little more than slick marketing.
To understand why the industry’s panicked and erratic response revealed flaws at the core of how it operates, we need to understand VCs’ reactions to the SVB’s bankruptcy as an outgrowth of the industry’s entrenched cultural norms. VCs are notorious for being ‘herd animals’, behavior reflected in both the bank run and their response two days after the government’s extraordinary interventions to make SVB depositors healthy. More than 650 companies – including prominent names such as General Catalyst, Bessemer and Lux Capital –advised their companies to keep their money or return it to the SVB, despite an ongoing public conversation about the systemic risk of pooling seed capital into a single bank. Research suggests that this culture of groupthink is the result of consolidating capital in the hands of just a few hugely influential fund managers.
According to the 2022 Pitchbook Venture Monitor report, about 5 percent of VC executives own 50 percent of capital in the United States. A whopping 75 percent of those in power went to an Ivy League school, Caltech, MIT, or Stanford, and 91 percent are male. In addition, these “Big VC” firms tend to cluster geographically, with more than 90 percent based in Silicon Valley, New York, Boston or Los Angeles, creating regional imbalances that have historically discouraged promising entrepreneurs and outside investors. these tech hubs have ruled out.
To achieve such a skewed concentration of capital among a handful of industry players, Big VC firms have convinced themselves, their peers and the general public of their superior investment acumen. But the lack of basic financial literacy these VC leaders seemed to demonstrate during the crisis underlines the serious concern about their competence. One study found that VC investment decisions show “little or no short- or long-term skill”. According to a Cornell University model, what appears to be VC proficiency is simply a matter of a fund that can invest at the most opportune times. In fact, a recent Harvard study found evidence that investor performance degrades over time, suggesting that veteran Big VC managers may be even worse than their novice counterparts.
If we are to unlock our society’s true innovative potential, it has become clear that we need to downplay the undeserved clout of Big VC. To achieve this goal, we not only need to break the market power of Big VC funds and investors, but we need to reshape innovation investing from the ground up.
We will need to build structures that avoid the kinds of financial entanglements and conflicts of interest that permeate the current system. One way to achieve this is by doing more research that challenges venture capital conventions, such as venture capital funds’ over-reliance on personal relationships for closing deals and LPs’ tendency to overvalue branded funds. This can be done through new structures, such as publicly funded innovation laboratories, or through private institutions that do not invest in venture capital and are not anchored in that ecosystem. The work being done at such institutions would have the added benefit of helping to reshape many of our public innovation programs, the rules of which are often governed by the same faulty logic, conventional dogmas and untested assumptions as traditional VC.
As we build new models, we can use legal and policy tools to reduce the influence of Big VC managers and halt the behaviors that contributed to the meltdown. For example, to limit the extent to which the most powerful actors can dominate the market, lawmakers should consider laws that tax VC compensation as personal income, or limit the number of funds or assets subject to preferential tax treatment. To stop the cozy relationship between startup banks and VCs, lawmakers should also consider closing VC-specific loopholes that would allow banks to invest massive amounts of capital in these structures. On the LP side, through regulation or legislation, we can encourage more investment outside of the entangled Big VC system. This may include removing the limit on the number of non-VC-limited partners a small emerging fund can have, or creating tax incentives to encourage LPs to invest in new or smaller funds raised by non-VCs. entangled outsiders.
Finally, if society has now decided that Silicon Valley VC is structurally important, as many argued during the collapse of the SVB, then lawmakers should also ensure that the VCs that have overwhelming influence over the industry are subject to professional standards and rules of responsibility. In many other fields, such as medicine, law or investment advice, professionals must demonstrate basic proficiency, especially when incompetence can pose a danger to the public if left unchecked. VCs should be no different given the immense control they have over innovation in vital sectors such as AI, national security and defense.
Ultimately, it’s up to us to fundamentally rethink the power we’ve given VCs and push for meaningful reforms to ensure the industry fulfills its fiduciary and civic duties. We must take the lessons of the moment and break the market power of incumbent Big VCs, both to save the innovation ecosystem and to ensure economic prosperity.
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