Tag: #congress

Venture Capital is Dead – Long Live Venture Capital! Part II

Overpriced rounds, a late stage VC bubble, and Sarbanes-Oxley are killing VC, markets and founders, as well as worsening inequality by limiting middle-class access to growth investment companies.

Overpriced rounds, a late stage VC bubble, and Sarbanes-Oxley are killing VC, investors and founders, as well as worsening inequality.

Institutional Investment in Late-Stage Venture Capital: Navigating Perverse Market and Regulatory Dynamics

Institutional investors’ sustained interest in late-stage venture capital (VC) funds is shaped by a complex interplay of behavioral, economic, and regulatory factors, despite these funds often underperforming relative to benchmarks such as the S&P 500 (see part I of this series). In this part II, I’ll examine the impacts of psychological biases, economic incentives, regulatory changes, liquidity preferences, and the evolving market dynamics that drive institutional capital toward late-stage ventures regardless of cost.

Institutional investors are often drawn to late-stage funds and the companies they back due to perceived lower risk, attributable to their established business models and proximity to liquidity events like IPOs. There is a lot of bias and false beliefs built into this system, and it has become toxic. So let’s break down what’s going on, and why allocators are funding this way.

Psychological Biases and Market Dynamics

Behavioral finance principles, such as the familiarity principle, herd behavior and the sunk-cost fallacy, are extremely relevant to investment decisions and play an outsized role in decisions to invest in late vs. early stage VC funds. Let’s cover these first.

The familiarity principle ensures that the known quantities—established companies nearing an IPO—seem safer than less predictable early-stage investments, even if they don’t provide investment returns that are positive after risk adjustment relative to the S&P 500. Because you’ve heard the names Stripe, WeWork, OpenSea, Brex, you are inclined to invest in the thing you’re familiar with, and the funds that back them. That can be a bad assumption when WeWork is the one you back.

The perceived safety of herd behavior (AKA, the bandwagon effect), wherein institutions follow the investment leads of their peers, is misleading. The assumption that the crowd knows best can also be viewed as a fear of missing out on potentially profitable opportunities. No one gets fired for following the market, so playing it safe with the pack is a reasonable strategy. Unfortunately, this is how lemmings go off cliffs. 

The sunk-cost fallacy is another cognitive bias that leads many allocators to continue investing in a fund because of the time, money, or effort they have already committed, rather than cutting their losses. The rationale is often that not continuing the investment would mean that the initial resources were wasted, even though continuing does not necessarily lead to a recovery of those sunk costs.

The combined effect of these three biases are beginning to be apparent when you examine flows of capital into late-stage VC funds, with LPs going along for a “ride” that seems stuck in neutral. Moreso, it may also be that allocators have lost the ability to underwrite technology, human resource, and execution risk, and are now only willing to underwrite market risk. Consider the following charts:

Distributions are at record low for a non-recessionary period, because overpriced deals over the past four years can’t be off-loaded to public markets. After pricing SaaS deals at 20x revenue just three years ago, you have a stupid amount of growth required to reach the same valuation at 7.2x revenue. Today’s valuation multiples aren’t low either, they are average for fundamental analysis based upon discounted cash flows weighted for a reasonable cost of capital in our current rate environment, unlikely to change and more realistic than the free money of the past decade.

As a result, late stage VC funds are writing larger checks to existing portfolio companies at higher and higher valuations to keep them afloat (if they’re still losing money) or in a ponzi scheme effort to keep over-marking up the winners to offset the losers. Worst of all, by delaying exits, they are not providing exit liquidity to their LPs and thus replenishing the VC funding cycle. According to JPMorgan in the Pitchbook NVCA 2023 Venture Monitor, “for vintage years 2013 to 2019, over 50% of the total value in venture funds relies on existing positions.”

Because late-stage VCs can’t IPO today without taking losses on their portfolio after writing big checks at massively inflated valuations, “unicorn” hold times increase beyond fund timelines.

What sustains this cycle is LPs willingness to keep pumping money into the late-stage funds so they can continue their sunk-cost fallacy investing on valuations not subject to public market scrutiny. Again, no one wants to recommend the “riskier” emerging manager at a small fund when the so-called experts at name brand funds are struggling to perform. Familiarity and herd bias alert!

As a result, early-stage VC is getting crowded out. The share of early-stage VC deals between $5-10mm has shrunk by 2/3. LP funds available for early-stage VCs continue to shrink. According to data from Crunchbase, 84% of capital raised by U.S. venture investors went into funds raising $250 million or more in 2018, and has increased every year since then according to Pitchbook data. As a result, VC funds managing $250m or less now account for less than half of all VC capital raised, down from over 75% in 2013. In the first two quarters of 2024, just two funds, Andresson-Horowitz and General Atlantic, raised 44% of all the venture capital raised by all VCs (Pitchbook).

While I have no data to support a hypothesis that allocators have lost the ability to underwrite technical, human resource, and execution risk, it’s clear that they are not underwriting these from the checks they’re giving VCs. Given that they only appear to be willing to invest in market risk, it seems bonkers that they do so without liquidity. You can better manage market risk in public equities with liquidity, so why do VC at all (and we’re back to part I).

This trend also shows in absolute dealmaking numbers collapsing for early-stage VC. According to AngelList, the second quarter of 2023 saw the lowest rate of early-stage startup dealmaking in the history of their dataset (dating back to 2013).

If you read part one of this series, the irony of the situation is that the VCs who continue to generate the highest returns are having the hardest trouble getting capital as late-stage VCs hoard assets and LP money. Until late-stage funds provide LPs liquidity via exits, the cash that feeds the whole ecosystem is locked up. Those exits are not likely to come soon.

Late stage VC is poisoning the well for the whole industry.

So why don’t early-stage VCs just work with founders to bypass the late-stage fiasco and encourage their portcos to go public after their series A/B rounds like we used to? Well, Congress kind of messed that up for everyone.

Impact of Regulatory Changes on IPO Timing

After the Enron scandal (which someday I’ll write a very cool post about but SoxLaw has an excellent summary here) Congress needed to show voters that they were going to do something about corporate fraud. In typical government action, they acted without fully considering the consequences of their actions. Surprise! Government is as ignorant as it is incompetent.

The resulting Sarbanes-Oxley Act of 2002 had a profound impact on the public offering landscape by dramatically increasing the cost to be a publicly traded company, imposing stricter financial reporting rules, forcing companies to hire more auditors to audit the audit (yes, that is as crazy as it sounds), and dramatically escalating governance standards for public companies.

In summary, Congress decided to stamp out fraud from corrupt auditors by adding even more auditors and creating additional byzantine governance systems for them and corrupt managers to hide in. Yes, that makes no sense.

I’ve looked at a lot of academic research to see if SOX actually reduced fraud. Without going into too much detail, it hasn’t. The best paper I can find on the topic shows that SOX only reduced the “probability” of fraud by about 1%. However, it did dramatically improve the detail of reporting provided to the public. Let’s not minimize that, and yet I’m hoping that Adam Packer will do a brilliant analysis to see if this resultes in improved investment manager performance -likely not, but surprise me!

So while SOX did dramatically improve information reporting and volume, fraud has not really decreased, valuations are down, and companies have to delay their IPOs due to increased costs and expanded public-listing responsibilities.

The average cost for SOX compliance is exploding. According to Protiviti’s annual SOX expense survey, on average, companies allocate $1–2 million for their SOX budget, with internal audit teams dedicating an additional 5,000–10,000 hours annually to SOX programs. 

According to Protiviti, the average SOX compliance cost in 2023 was:

  • Companies with more than 10 locations: $1.6 million
  • Companies with only one location: $704,000
  • Companies with $10 billion or more in annual revenue: $1.8 million
  • Companies with $500 million or less in annual revenue: $651,000 

When you have to shell out $1-2mm for one compliance cost, plus heaven-only-knows how many thousands of hours of additional internal audit time, you can’t go public until the economics make this massive cost immaterial.

As a result, since SOX passed, the average time from founding to IPO has notably increased—from about 5 years in the late 1990s to more than 10 years recently (Pitchbook data, thank you once again). This regulatory-induced delay significantly affects the liquidity of investments, particularly those made by early-stage venture funds, extending the time to potential returns.

So, getting liquid on VC investing is more expensive and takes longer than ever. These are the primary reasons late-stage VC is so attractive to LPs. Despite poor performance, institutional funds have a strong liquidity preference, even if the private markets aren’t beating the S&P 500 (again, see part I).

Liquidity Preferences of Institutional Investors

Given the extended timelines to IPOs, late-stage VC funds have become more attractive due to their shorter duration from investment to exit. While I can complain all day about extended unicorn hold times, the hold times are still longer if you invested earlier. Institutional investors, including pension funds and endowments, prefer investments that align with their liquidity timelines. Late-stage investments generally offer a quicker path to liquidity, matching the large pools of capital that institutional investors need to deploy efficiently.

So when average VC hold time is approaching ten years AFTER becoming a unicorn, who wants to invest in the early stage VC who backed them six to seven years before then (CB Insights, State of Venture 2023). Seventeen to twenty years is a very long time for an institutional LP to hold a private security, so who can blame them!

While I can find no solid economic research to explain why institutional investors would favor late stage VC on the basis of liquidity preferences alone, it stands to reason that a 17-year hold period is not acceptable for most funds of any size to get liquidity at any cost.

The Necessity of Large Capital Pools and the Impact on Founders

The growing average market cap of companies at IPO—from around $500 million in the early 1990s to over $2.5 billion today—requires larger rounds of late-stage funding. As companies grow larger and remain private longer, they need substantial capital to scale up to absorb the costs of a public offering post-SOX. This need makes large late-stage funds particularly appealing, as they are capable of mobilizing the capital required for continued growth. However, this trend has profound implications for startup founders, who often endure increased dilution and a loss of control as they raise more capital under increasingly stringent terms. The loss of control has real impact, as TechCrunch recently reported that VCs are using this power to block IPOs and prevent founders from liquidity. This leads to strategic misalignments that might endanger long-term success.

The assumption here by VCs justifying their control provisions is that the late-stage VC funds provide better oversight and governance and will better protect investor interests on behalf of their LPs. Really? Are VCs better and smarter than public markets and their oversight? I doubt it.

Again, I have no research (and I doubt you could put together a credible quantitative analysis), but I think it stands to reason that thousands of public investors and a public board of directors do a better job of oversight than a handful of privileged insiders who fundamentally share the same world-view as VCs. Yes, we have group-think and bias too, so better off if more eyes can see the business.

The closest thing I have to a benchmark on this is to see how company valuations change post-IPO, when public scrutiny provides the best check to the opinions of private company valuations and the ability of VCs to provide good oversight and valuation guidance. And yes, when you look at the sheer number of unicorns falling from grace since 2022, it would appear that the private markets overpriced and misgoverned significantly (see Techcrunch and Hurun).

A final note on this, if you want to nerd out on great IPO data, check out Jay Ritter’s recently updated data here. It rocks.

Diseconomies of Scale and Risks to the Ecosystem

The preference for large funds and substantial capital injections can lead to diseconomies of scale, where the size of the investments begins to detrimentally affect fund performance. As suitable investment opportunities become scarcer, funds may end up deploying capital in less optimal ventures, with more funds bidding up the price for available assets. This, in turn, can dilute returns. Moreover, as founders lose equity and control, the risk of misaligned interests increases, potentially affecting the company’s strategic decisions and long-term viability.

The larger the fund, the greater the challenge in deploying capital efficiently, which often results in decreased returns and increased risk of strategic misalignment within funded companies. Ouch.

Conclusion

Institutional investors’ preference for late-stage venture capital funding is dictated by a blend of psychological biases, regulatory impacts, liquidity preferences, the loss of their ability to underwrite anything except market risk, and the structural requirements of modern IPOs. While these investments may offer the perceived safety of shorter time horizons and reduced risk, they come with their own set of challenges, including potential misalignments and increased founder dilution.

The situation was made worse when the 2021-22 market bubble caused late-stage funds to overprice investments, and now extend exit periods so that they can avoid going public at a loss. Without exits, no new liquidity is flowing back into institutional and large family office LP investors, so early-stage VC funds are getting squeezed with fundraising for new funds that have ever elongating exit strategies. This, in-turn, creates less companies getting funded to their series A/B, and further restricting deal flow for late-stage funds, thus exacerbating their crisis to allocate capital and double down on their already overpriced, current portfolio companies.

So how do we break this doom-cycle? Part III coming soon…

For Crypto to Live, It First Must Die

Governments hate stuff they can’t control.

The beauty and promise of cryptocurrency is that Bitcoin and Etherium truly became the worlds first fiat monies divorced from any government backing. Yes, use of fiat is blasphemy to crypto die-hards, but for crypto currency to succeed as a global currency, we need to have an honest conversation about what fiat really means, and how crypto must kill off it’s government independence if it wants to truly reach its full potential.

Fiat currency is a medium of exchange that has no intrinsic value, unlike gold and other precious metals, that have industrial and artistic use with value apart from its circulation as money. Fiat currency has value because we believe it has value, and thus becomes a store of value and medium of exchange. Fiat currency to an economist is money that only has value because we have faith in it, and it has no use otherwise.

In this way, crypto currencies are true Fiat monetary systems in a pure way. Divorced from any government backing, and with an alternative use case of zippo, they truly are a medium of exchange that is divorced from everything. And therein lies the rub.

Governments hate stuff they can’t control. And Bitcoin/Etherium are far from their reach. The Satoshi’s and Buterin’s of crypto built their systems in such a way that governments can never, ever control them. And that is beautiful when it comes to creating the perfect fiat currency. No more printing money when you need it (looking at you Zimbabwe), and all the other money mischief devised by central banks that protect governments and hurt everyday people (for a good read on the various ways governments have done this, Milton Friedman has a great read by the same title if you click the link).

Governments have thus far reacted to crypto with what John Gottman recognized as one of the ultimate forms of rejection and contempt: stonewalling. This is when you just go quiet. Say nothing. Sit still. Ignore. The epic lack of regulatory interest in crypto is accomplishing its purpose: killing crypto silently.

Crypto currency’s promise, to have a stable system of exchanging stuff divorced from government mayhem, will never be realized until governments learn to accept that the future of currency is out of their control, but within their regulation. And this is where crypto lovers weep: regulation must happen for crypto to reach its full potential. In this way, crypto dies so that it can live.

In a world where we buy stuff and pay our taxes in Bitcoin and Ethereum, governments need to have rules around how money can be used. These rules include how to get paid back if you’re ripped off, how to track money to protect us from dark forces, and how to make sure people aren’t manipulating crypto markets and hurting consumers by restricting supply and demand. The public benefits of crypto currency are many, but only if the beast is trained to avoid destroying our freedom with its own.

And here lies the root cause of our current dilemma. A US Congress so old it might as well be a nursing home, led the way with the oldest White House leader ever, means that US leaders are too far removed in history to address modern problems they do not understand. Joe Biden remembers world war two as a kid. Ponder that and honestly ask yourself if he’s ready to suggest ways government can adopt the future of money. Yeah, I didn’t think he was doing anything either.

What the world needs right now is visionary leadership from a new generation of forward-thinking monetary leaders. Sadly, I’m not sure we have them right now, at least not outside of the developer community. Ouch.

Tax Facts – What Government Doesn’t Want You to Know

Warning: this blog post is about taxes. Taxes are an inherently boring topic, but useful if you want to understand something that will seriously impact your life. So, please read on if you want to learn the economics of what takes 40%-50% of your income. Otherwise, stop here and remain blissfully unaware.

There is a lot in the press these days complaining about the tax cut package passed by congress and signed by the President. Almost universally, the comments in the mainstream media have an agenda that appears to be almost perfectly tailored for the echo chamber created on each side of the aisle for the major news outlets’ political sponsors. However, a careful scrutiny of the history of US tax law (and tax rates) paints a very different picture of how these tax cuts will impact the United States insofar as its impact on the tax base and the demand-side of the economy.

While US tax law goes back to the very founding of the Republic and the tariff system created by Congress to fund it, personal income tax is a relatively new idea.  Although there was a brief period from 1861 to 1872 where a personal income tax existed to help pay for the civil war,  it wasn’t until the 16th Amendment was passed in 1913 that the government actually got the right to tax our incomes for the first time.

From 1913 until 1931 at the start of the great depression, the federal tax rate hovered at around 1.1% for the poorest families and while progressive (meaning wealthier families paid more than this), it was not punitive for rich people either, with 7% as the top bracket for people earning over $12mm a year in today’s dollars (adjusted for inflation).

However, from 1932 to 1941, Hoover and FDR had tax policies that, by any survey of the most liberal-minded economists, had disastrous results on the economy.  Tax revenue in 1931 was 834mm USD.  In June of 1932, Hoover decided that the worsening economy required government to start collecting more taxes to balance the budget.  Hoover almost tripled the top rate from 25% to 63%, and the low rate increased from 1.1% to 4%.

The amazing result was that tax revenue fell from $834mm to $427mm in 1932.  Why?  Well, when you take money from people’s pockets, they have less to spend.  Less spending results in less profits, and lower corporate tax collections (if companies are losing money, they don’t have profits to tax).  This fell further by 1933, with a mere $353mm in taxes collected as the economy continued to shrink and the government took more and more of the pie for itself (a concept economists call crowding out).  FDR raised them up to 76% when he took office (he raised the top rates to 76% by 1936) and unemployment spiked to 20%.  By 1937, FDR realized that his efforts to spend money to lower unemployment were only partially successful.  Unemployment was down to 15% but the government was spending huge amounts of money and creating large debts in the process.  

So why did this happen?  This has to do with the impact of taxes on the overall economy and the velocity of money. Since the government can only tax profits on money in circulation, the speed with which money moves around between firms in an economy have a major impact on taxes.  For example, if our economy only had four companies, and each company has $100 a year in profit on $200 in sales, then the economy would have $800 in sales, and $400 in profit to share. However, if the government taxes 50% of that profit, there is $200 less money for the companies to share with the economy, and the economy will shrink.  Now, think about how many times a single dollar is exchanged in a year between consumers and companies, and how each time the dollar is exchanged it creates a taxable event. More exchanges equals more taxes.

So if the government raises taxes very high, they reduce the number of taxable exchanges by the amount they took in taxes multiplied by the number of times those dollars would have been spent in a transaction. In short, the government is taking money so that it can’t be spent and then taxed.  While I’m not calling for the abolition of taxes so that we’ll have economic stimulus, it is a good idea to understand that when taxes go up, the economy goes down by a multiple of that tax collected.

However, at the time of these tax increases during the great depression, some Keynesian economists (those who believe that government expenditure is key to stimulating the economy) were shocked because these New Deal tax increases were increasing unemployment and New Deal spending wasn’t improving the economy to compensate.

Government spending was just helping us to limp along while incurring huge debts in the process since demand for government program spending far outstripped taxes collected.  Governments are like us, if they borrow a lot of money today, they will need more income in the future to pay off the debt and maintain their standard of living.  Sadly for us, when governments need to increase their income, they must raise taxes (taxes are the only way they get money legitimately).  So FDR decided to raise taxes again and again.  By 1940, the upper rate for wage earners was 94% for upper income earners, and 23% for anyone earning more than $500 a year.  Needless to say, the economy was so bad by this point, it took World War II to force dramatic changes in production and labor and end the depression.  At the end of WWII, Truman decided to start cutting government spending and lower taxes beginning in 1945.  Economists complained at the time that Truman was going to guarantee another depression, after all government spending is what they believed saved them from the depression getting worse, right?  Actually, Truman’s decision restored accountability in the economy and the nation grew to full employment in very short order.  Needless to say, the corporate tax rate was dropped from 90% to 38%, providing companies plenty of additional cash to grow and hire new workers.  In a recent survey, 2/3 of all economists agree that FDRs policies made the great depression worse and enabled it to stick around for a long time.

What does that mean for us today? Well, during the Obama administration taxes went up, and so did regulation (a quiet form of taxation because it raises the cost of doing business). So despite the Federal Reserve pumping unprecidented amounts of money into the economy through quantitative easing, the velocity of money (over 10 before Obama was elected) fell to just over 5 when he left office.

So, if we are to fix this, we need to have policies that would lower taxes and lower regulation to a sensible level. Both would be good ideas, if your goal is to grow the US economy. So when I hear people opposed to both of these, regardless of their intentions, we need to recognize that they are advocating policies that hurt the financial future of America’s families.

That is why it is all the more important to have sensible people in government who can not only enact policies that help working class families, but are able to explain these policies in a way that unites the American people behind them. Alas, that last part is what both parties appear to be lacking these days: leadership.

 

Note: some nut job out there may construe (how, I don’t know) this article as some sort of tax advice and then think about suing me. I’m not a tax adviser, this is not tax advice, so don’t make any tax decisions from my article.  And yes, this is proof positive that attorney’s can ruin our lives.