Discussion: Should You Index Venture?
It’s true that most VC funds underperform, but should the response really be “spray and pray”?
Once again, AngelList has released a blog post encouraging Accredited Investors to be an active and broad early stage private company investor — citing the fact that indexing venture performs better than the median VC fund. And this is true, due to the power law nature of startup performance, it’s a feast or famine environment for VC funds — where the top performing funds end up being mind boggling better than the rest of the industry. Just as how technology companies have created “winner take all” conditions for markets, VC funds also operate on a model when the best funds are incredibly strong and the rest struggle to break even.
That said, attempting to index startups instead is a terrible idea. This is because of how the private markets operates which is very different from the public ones. Any efforts to create a broad, publicly available index fund for venture will eventually lead to chaos and underperformance for the following reasons:
- VCs add value. Unlike public markets where companies have a large number of employees, an established Board of Directors, and substantial revenues, startups are under-resourced and therefore seek out venture capital for value-added business support in areas such as sales development, executive recruiting, and strategic advisory. If a casual investor puts capital into a startup without offering additional value creation, the startup can actually be at a disadvantage compared to a competitor that raises from a venture capital firm that is able to help the company with growth.
- Financings are fixed. In public markets, equity is liquid and (in theory) an unlimited amount of capital can flow into the publicly floated shares. It would simply mean that the public companies receiving the capital will see their market capitalization rise to unforeseen heights and give existing shareholders an opportunity to sell their holdings — which also adds an element of correction that stabilizes a company value. In a private company, shareholders are only looking to raise a finite amount of capital and the market capitalization of the firm is set at a fixed amount. This means only select investors can enter each desirable round — and more often than not, it’s one of the top performing VCs that have created a strategy that enables them to be the lead investor in the best opportunities.
- Access is limited. Given the fact that generally one VC serves as the main capital provider of each round, and the best VCs add disproportionate value to each invested startup, naturally this means that the best startups will build a connection with the top VCs and the average individual will never have an opportunity to invest in these companies directly. Many of the best startups in recent years never appeared on crowdfunding platforms and managed to secure the desired amount of capital at each stage of their growth directly from a top VC. So while a retail investor can get into any public company they choose — thereby allowing for a true index of public companies, the best private companies will not be accessible to the average individual — meaning at best one can only index a sub-par selection of startups.
So what can an average investor do? The biggest challenge in the current economy is that the wealthy have an unfair access to private markets; which has also been the primary source of value created in recent years, and as capital has been pouring into the private sector, companies are staying private even longer — which is only increasing the income inequality present among those with access to the private markets and those without access.
Given what we know about VCs and startups above, the door that needs to open then is not for retail investors to have more exposure to private companies directly, but rather for individuals to have more ability to invest in approved private equity funds themselves — either through their 401k provider, an IRA, or even as a direct fund investment through brokers that can aggregate their capital and place it into funds fitting a desired strategy.
As for the power law nature of VC, unfortunately, as long as startups exhibit a power law nature in outcome, it will influence into the status quo of an indisputable spread in difference between the top funds and everyone else — including any fund that attempts to index venture (as the top startups won’t have consistent exposure from indexed VCs). Most then are better off working with a VC that holds a differentiated approach in either value discovery, value creation, or carrying a valuable thesis.
