Skip to main content
main-content
Top

About this book

In spite of the robust development of venture capital that has occurred over the last three decades, returns from venture capital have been declining. This book focuses on a simple question: why? The answer lies in the context of multiple deformations that have occurred throughout the venture capital process. The book critically assesses the ways in which interactions between different stakeholders in the venture capital ecosystem change (or "deform") venture capital, decreasing its value. Klonowski also reveals that venture capital actually has few benefits—and some outright disadvantages—for entrepreneurs, and it can create a self-perpetuating cycle of investment and loss for the entire venture capital industry. This is especially true as corporate governance and compensation structures may create significant misalignments, incongruities, and conflicts of interest between general and limited partners.

Table of Contents

Frontmatter

Introduction to Venture Capital

Frontmatter

Chapter 1. Venture Capital: A Closer Look Behind the Curtain

Abstract
Venture capital is defined as the provision of capital and know-how by institutional investors to private entrepreneurial firms. The mainstream media tends to describe venture capitalists as a “super-breed” of financial intermediaries. Evidence, however, points to the contrary, suggesting that the benefits of venture capital may rarely materialize. In other words, the venture capital “promise” of value creation, superior assistance to entrepreneurial firms, and meaningful above-average returns appears to be false. Evidence also confirms that venture capitalists “get it right” in achieving entrepreneurial success roughly one or two times in ten (other investee firms underperform or go bankrupt). The performance of venture capital may actually resemble an “n-arc” rather than a J-curve.
Darek Klonowski

Chapter 2. Maturation, Segmentation, and Competition in the Venture Capital Industry

Abstract
An analysis of the venture capital industry, based on Michael Porter’s six force model, confirms the existence of a strong rivalry between fund managers. This competition occurs in two distinct market sub-segments: investee firms and limited partners. The interactions of the two market sub-segments are not congruent and overlapping. Each market segment operates on the basis of its own cycle, resulting in four different interaction scenarios. A number of qualitative and quantitative measures and characteristics demonstrate that the venture capital industry appears to be in the maturity stage of its life cycle.
Darek Klonowski

Venture Capital Deformations Throughout the Investment Process

Frontmatter

Chapter 3. Fund Formation: Structural and Operational Deformations in Venture Capital

Abstract
Venture capital fund structures are complex, where management of venture capital partnerships is vested in GPs. Corporate governance structures in venture capital funds may be likely to fail in a variety of areas; as a result, GPs may have abundant opportunities to exploit LPs. The key challenges relate to problems with information disclosure (i.e., weak and misleading information disclosure to LPs), poor alignment of financial incentives, and complex legal documentation (that disallows LPs effective control over GPs). Moreover, the current compensation structure in venture capital creates significant misalignment, incongruence, and conflict of interest between GPs and LPs. Lastly, venture capital firms can easily live off of fixed management fees.
Darek Klonowski

Chapter 4. Deal Generation: Optimal Modes of Entrepreneurial Value Creation

Abstract
Deal generation represents “lifeblood” of the venture capital industry and is inherently connected to the nature of deals venture capitalists pursue. Venture capitalists often embrace the “accelerated” growth pattern of entrepreneurial development, which is based on external modes of expansion, overfunding, terminating the founding CEO, bringing in external managers, and so on. Venture capitalists often wrongly assume that entrepreneurial firms’ “natural” business development can be somehow changed, accelerated, or hurried. But, achieving successful entrepreneurial growth means expanding at a rate the entrepreneurial firm can manage, control, and afford. The most successful entrepreneurial firms rely on evolutionary and incremental processes. The “natural” value growth pattern of entrepreneurial development is based on a balance between revenue generation and capital conservation. “Natural” entrepreneurial development and “accelerated” value creation may be largely incompatible.
Darek Klonowski

Chapter 5. Screening and Evaluation: Misguided Investigation of Entrepreneurial Firms

Abstract
While venture capitalists focus on some of the key areas that result in entrepreneurial success and value creation, their screening and evaluation may often be incomplete and inadequate. In addition, when processing a venture capital deal, venture capitalists often enter into erroneous compensatory mechanisms to counteract weaknesses in one area with perceived strengths in another. Such compensations rarely work in practice. Venture capital decisions are further compromised by multiple biases that enter into decision making. Venture capitalists use cognitive shortcuts, which lead to poor investment decisions. They are also overconfident investors and “poorly calibrated” decision makers who demonstrate a high probability of making a wrong decision.
Darek Klonowski

Chapter 6. Deal Completion: Inequitable Agreements in Venture Capital Contracting

Abstract
Financial contracts in the venture capital ecosystem are often incomplete, imperfect, and defective. Most financial contracts aim to “overcompensate” for venture capitalists’ inabilities and lack of expertise. Venture capitalists seek disproportionate, one-sided, and asymmetric protections. Two of the most draconian clauses and provisions sought by venture capitalists include the “voting flip-over event” provision (venture capitalists terminate the founding entrepreneur as CEO) and “drag-along” rights (venture capitalists implement a forced disposal of the entrepreneurial venture). Moreover, venture capitalists often bring a “uniform” approach to financial contacting that is unlikely to reflect the actual risk profile of the unique entrepreneurial firm. This standardized approach to financial contracting may highlight venture capitalists’ inability to properly understand the strengths and weaknesses of their underlying investee firms.
Darek Klonowski

Chapter 7. Monitoring: The Venture Capital Barren Toolbox for Entrepreneurial Firms

Abstract
Contrary to widely held public perceptions, venture capitalists often “oversell and underdeliver” to entrepreneurs in terms of hands-on assistance. They can further impede entrepreneurial development by providing erroneous operational advice, ill-founded strategic guidance, and inappropriate inputs, or by imposing unsuitable and unrealistic operational constraints. Their attempts at professionalization may also generate significant negative consequences. Lastly, venture capital does not cause innovation in entrepreneurial firms. At best, venture capital perpetuates innovation that has already been discovered. Venture capital’s short-term determinism and exit orientation often result in less investment toward long-term R&D, innovation, and commercialization in entrepreneurial firms.
Darek Klonowski

Chapter 8. Exiting: Distressed Value Realization in Venture Capital

Abstract
Venture capital exiting is the complex process of monetizing venture capital’s illiquid investments. Exiting is the final phase of the venture capital process and the consequence of all decisions made by venture capitalists throughout the entire venture capital process. Exit options can be classified as preferred, compromised, or undesirable. The most attractive exit choices for venture capitalists are trade sales and IPOs, but substantial realization of value is likely to occur only in one (or maximum two) out of every ten venture capital exits. Compromised and undesirable exits account for the remaining exits. There are also numerous ways venture capitalists can use exits to their advantage. The most predominant of venture capitalists’ adverse behavioral patterns include forcing premature exits, implementing a “pump-and-dump” strategy, and engaging into “window dressing.”
Darek Klonowski

Conclusions: The Venture Capital Industry at the Crossroads

Frontmatter

Chapter 9. Venture Capital: “Subprime” Returns and the Value Chain Analysis

Abstract
It is widely accepted that LPs expect to generate at least three percent more from venture capital compared to returns generated from public equities markets; this is referred to as an “illiquidity premium.” Average venture capital returns have not been able to meet or exceed these minimum requirements of LPs in any consistent manner. For example, the 15-year-period “illiquidity premium” (between 1999 and 2013) from the United States is equal to 1.2 percent. The value chain analysis of the venture capital industry confirms that venture capitalists are likely to destroy value throughout the various phases of the venture capital process. There are numerous metrics used to evaluate venture capital performance; none of these methods are optimal for measuring venture capital performance.
Darek Klonowski

Chapter 10. Improving the Substandard Venture Capital Model

Abstract
While in the past venture capital defined itself as being “a business of building businesses,” today, it is unclear what business venture capital firms are really in now. Even though GPs generate “subprime” and declining returns, the venture capital ecosystem continues to flourish; this may be explained by LPs’ incessant appetite for risk and above-average returns, false conceptions of venture capitalism and the returns it generates, automatic allocations toward venture capital, a continuous search for investment home runs to “make up” for losses or poor returns on previous investments, and the seemingly “perpetual” interconnection between the various stakeholders in the venture capital ecosystem. There are multiple adjustments that should occur within the venture capital industry.
Darek Klonowski

Backmatter

Additional information

Premium Partner

    Image Credits