This essay is part of The Token Handbook.

We have met the enemy, and he is us. — Walt Kelly

My name is David Siegel. I’ve invested in three venture funds and have been an angel investor for 15 years. I believe venture capital is broken, both for LPs and entrepreneurs. While the venture-capital landscape is changing, the sales narrative remains the same: We are the smart, experienced, (generally tall, good-looking, white, male) entrepreneurs-turned-investors who can beat the market through exclusive access and careful selection of early-stage companies (“We invest in teams, not ideas”), brilliant board work, and our networks of contacts.

It’s a nice story, but that’s exactly what it is: a story. The track record of this asset class is poor. In general, venture capital funds do not outperform the public markets.They are victims of the illusion of control. After several years of study, I now believe that if there had never been a single venture capitalist (professional early-stage investor), the world would be about the same as it is today, only the logos would be different. In other words, it’s market demand that creates companies — not board meetings, brilliant plans, and road maps.

In this mini white paper, I will first argue that venture capital is truly a fool’s game and that venture investors are confusing correlation with causation. Then I’ll present a high-level description of a model that I think could work to fix this industry, and how we could get it started.

Getting Lucky

Success in new ventures is not about product-market fit (read How Brands Grow to get the evidence on that one). It’s really about getting lucky. It may look like skill, but you’re not seeing the tens of thousands of skilled entrepreneurs who fail. Most startup products for a given market are remarkably similar in functionality, but you don’t see the competitors who fail to raise funding or fail to get lucky in the market. You’re seeing the successful companies, and they have a great story to tell about how skillful they were. This is like saying The Rolling Stones and other popular music talent rose to fame because their music is so good. That has been shown to be false. The market selects. The market magnifies. The market creates the jobs. Often, the market selects randomly and for impossible-to-predict reasons, with plenty of herd behavior.

Cognitive biases like base-rate neglect affect our ability to see true cause and effect, so we think it’s about skill, when it isn’t. Looking in the rear-view mirror, timing is nothing more than luck. Looking forward, it’s a lot more difficult to tell what “good timing” is — such predictions tend to be far more wrong than right. As Jerker Denrell says:

Top performance and outcomes are often produced by things besides skill, so we shouldn’t reward them as much as we do.

Product-market fit: can you find the features that match the target customer?

Venture capitalists don’t add any value and never have. They have only sucked cash out of the system as gatekeepers, and, in aggregate, they aren’t even good at doing that.

Venture capitalists make the same classic investment mistakes most investors do:

Thinking they can pick winners ahead of time. A concentrated portfolio dials up the risk for investors. Follow-on investments are usually made at high valuations and further concentrates risk. Herd mentality — chasing popular deals reduces returns. Thinking that skill, rather than luck, drives returns.

Please keep in mind that almost all successful VCs (except Nick Hanauer) will vehemently disagree with this. Success blinds them to true cause and effect — they take credit for getting lucky, thinking what they do is important. The same with successful entrepreneurs: they have the strongest possible ANECDOTAL evidence that their smart, hard work and persistence got them where they are. Nassim Taleb disagrees. What percentage of smart, hardworking, persistent entrepreneurs make more than $5m? This is not a well-studied question, but we do have good research that shows successful business people at all levels are heavily biased to see themselves as the source of their own success.

I’m not saying they’re bad people. I’m saying venture investors, like almost all other investors, are fooling themselves about cause and effect.

Angel investors make the same mistakes

Angels cherry pick their favorites, think they can tell the future. They construct a concentrated portfolio and go to board meetings. I did that myself. I experienced the volatility first-hand. In the end, a few lucky angel investors are very happy, while the vast majority get out of the game after five years.

At the earliest stages, angels invest about four times more than VCs do. They do most of their investing based on relationships, rather than smart portfolio principles.

A special note on Angel.co and other angel platforms

The angel platforms simply continue this biased belief system, but they put it all onto a platform. The concept of syndicates, where “outstanding” investors and aggressive extroverts run the show and dictate which companies get funded and which don’t simply adds to the herd behavior and misses the vast majority of companies that go onto these companies but can’t get funded. Not only do they have to get lucky in the market, these startups now have to win the popularity lottery on the platforms to even get the chance to build anything. While it sounds progressive, the platforms are just making things worse. They are great for syndicators, who are the new professional angels, steering the herd this way and that, without adding any real value.

Limited partners are starting to figure this out

While the top-decile funds do show repeated good performance, those funds are closed to new investors. It’s likely that the value they add doesn’t come from access to and picking “the best” startups, but rather helping make introductions to customers who will buy products. The rest constitute a poor-performing and unpredictable asset class. In general, you can just as easily lose money on a venture fund as make money. I highly recommend reading We Have Met the Enemy, and He is Us, by the Kauffman Foundation.

Accelerators and incubators suffer from the same delusions.

All things being roughly equal, we don’t see any difference between accelerated and unaccelerated companies that get the same amount of capital. Accelerators suffer from a bias called reverse causality — it’s likely that successful startups gather the advice and coaching they need to continue to succeed, rather than the advice and coaching causing the success. I’m serious — we could just leave companies unaccelerated and help them get cash to go to market, and I don’t think the world would be any worse off. How many “insanely great” companies can you think of that didn’t go through an accelerator program? To take it one step further, I believe that 99% of the value any accelerator adds is signaling to investors that their companies are worth investing in. And, since they only cherry pick companies that are worth investing in to go into their programs, I will change that 99% to 100%.

Summary

Venture capital is a disaster. As we have seen with every other asset class, an unmanaged portfolio beats a managed portfolio. The sooner we blow up the dysfunctional model we have, the sooner more startups will be able to move into nice offices on Sand Hill Road.

Fixing Venture Capital

There are a few investors building smart venture portfolios:

What do these funds have in common? Diversification. They all have hundreds of early-stage companies in their portfolios, making sure that no single company has more than 0.5% of the bankroll. Of these, I believe the smartest is Right Side Capital, because they don’t cherry pick — they don’t think they can pick the winners ahead of time. They know they can’t. This is the world of “smart beta” — finding inefficient markets and investing in the entire market, letting the law of large numbers work for you.

Right Side’s return calculation using Wiltbank’s US angel data

With any portfolio of at least 100 early-stage investments, it’s extremely unlikely to lose money. How many are in your portfolio?

Here’s the key: not only do VCs not know what they are doing, they are missing the market entirely. According to Robert Wiltbank, angel investors as a group generate returns above 25% IRR. To achieve that, Right Side Capital invests in capital-efficient companies that don’t even talk to venture capitalists:

Not cherry picking produces better returns than thinking you can tell the winners from the losers

Crowdfunding the Solution

Now we can start to see the proper solution to this disaster: get rid of all the professional investors. Create an investable index of early-stage startups. Then create indexes for each stage of company, as they go from concept to growth to become profitable and eventually graduate to future crowdfunded private-equity markets, or to go public.

I’ll describe it in terms of funds and phases. Funds are investments in a given risk/reward profile (early, formation, acceleration, growth, maturity), and phases are funding phases within each stage. Here’s how that would work.

Imagine that each September and March, we 1) magically select a cohort of startups to invest in, 2) each startup gets a reasonable amount of capital to build their first product and go try to get traction, and 3) the public gets to invest in a large basket of hundreds of startups, rather than cherry picking their favorites.

Let me unpack that. There are three parts. It will help if you first read my essay on blockchain and its power to decentralize markets. When you have a chance, you should also read Vitalik Buterin’s piece on DAOs, DOs, and other new forms of corporate e-governance. As e-governance becomes more popular, I expect the legal frameworks will bend to make them more possible.

First, the magic. Our early stage fund wouldn’t have companies — it would be a large pool of people filing project plans and getting a certain amount to show they can do something within 90 days. To match groups and individuals with money, we can apply some simple heuristics. We could use a “selection committee,” but that’s the exact problem we’re trying to solve. So instead, we use a set of heuristics to set our intake criteria. An example set would be groups and individuals that:

Have a reasonable plan for how they will spend the next three months and what metrics they will achieve.

Have rounded up commitments from other investors for at least $30k (or whatever we find to be a good hurdle, to make sure they are serious).

Have several reasons why they will be able to engage with the market and get buy/no-buy signals from it.

Have had no more than two previous attempts.

I’m actually making those criteria up off the top of my head. We can probably do better than that. Since the entire asset class of legitimate startups does well in aggregate, we don’t need to be very restrictive. And we can use the blockchain to watch how they spend the money. I have a few ideas on how to improve these criteria, but let’s move on.

Next, we use volunteers (or AI) to vet the projects against the intake criteria. Companies would be allowed into the cohort if a consensus of volunteers is reached, sort of Loomio style. Note that a prediction market here is useless, since no one can tell ahead of time which companies will win, and it would be overkill for vetting. We do this 90% via software and 10% using people to check certain things to make sure they aren’t scammers. We are interested in vetting a large number of companies (thousands), and if a few of them are scammers we’ll adjust our system and keep improving. As the infrastructure for decentralized companies and reputations on the blockchain evolves, all this will become more possible and more efficient. Eventually, giving someone equity in your company should be as easy as voting and sending them Ether.

Second, the allocation. We want to get the right amount of money to each company. Ideally, each company would get just enough for a 90-day sprint, get their product into the market, and then report back to the community, showing what they have achieved. If it hasn’t worked, which is most of the time, that’s okay — just go back around and apply again. So it’s sprint based, and we could provide a lot of common back-office services online, so they don’t have to recreate those things inefficiently. Again, I have ideas on this. Once a company reaches traction, they go to the next fund.

Doing it this way allows investors to mix their level of risk/reward and put together an overall portfolio that works best for them.

Third, the public invests at the fund level in an entire cohort. In the US software business, that would be a few thousand startups every six months. Obviously, we have to overhaul the way capital and equity are allocated, and this is exactly what the blockchain is good at, so I think we’re at a point where we could architect that system and start to test it. The key here is many-to-many (M2M) allocation: many investors create a pool, and that pool is divided among many start-ups. There would be rules for closing each pool and how many startups would get the money (we may need a lottery system if there’s too much demand). But all this is now doable on the blockchain using Ethereum and smart contracts. Even the eventual exits and managing returns and tax liabilities can all be done using smart contracts and cryptocurrency — no paperwork required. All this machinery is necessary to do this at scale, which would eventually be worldwide.

Obviously, some things would have to change to enable this. Different state and federal levels have different laws and roadblocks. We’ve already gotten over many hurdles with the JOBS act, and disruptive companies are pushing the boundaries of what’s possible. I think we can incrementally work our way there, first with accredited investors and a smart KYC platform — much of this is being done in other areas of cryptofinance at the moment anyway. We’re about at the point where we could hack it together.

Investing in Unmanaged Funds

So there would be two “batches” each year, with somewhere between 1,000 and 5,000 per batch in the US, and each company would get, say, three chances to develop something and get traction. The funds would be run entirely by software, using people to help validate and move companies through the progression. The first two are a single fund, the second two could also be a single fund, and the third would be a separate fund:

Early stage 1: 90-day sprints until you have market signal. No companies. Just people and ideas and enough cash from outsiders to make sure they are legitimate. It’s all about getting early adopters to try your product. And, of course, we would build verifiable ways to prove that you have real market traction, not fake customers. Once you get traction, you go to the next stage. Early stage 2: Form a company, allocate equity, bring in more outside investors, gets more funding, still on a sprint basis: enough cash for two 90-day sprints, with a presentation to the community after each one. Keep the back office lean and focus on customer acquisition. Acceleration: Now they will be getting enough money to continue to improve the product and build a sales organization for a full year. Growth: Traditional VC stage: Enough to get to profitability in most cases. Stability: A fund for companies who are close to or at profitability.

After these stages, we can apply a similar approach to private equity, disintermediating the entire professional PE investor class. Oh, I can’t wait. Once we build an XBRL-style reporting system for private companies, all companies should be findable and acquirers can use heuristics and models, rather than gut feel and bravado. This has the added benefit of wiping out the investment bankers — another inefficient layer skimming billions of dollars out of the system.

This can be scaled to investments in new companies around the world, as regulations loosen and crowdfunding becomes more prevalent. Imagine investing in a composite portfolio of 2,000 startups around the globe, and allocate to each cohort as you receive returns from previous batches — the returns would be remarkably predictable from year to year!

Then we are essentially done. Once the public can invest in a large basket of private companies, it’s the same as taking those companies public. The good news is that no one gets to cherry pick — it’s all based on cohorts and an index-like approach that preserves capital via the law of large numbers. In the same way the ETF industry got started, a few smart people could create this software-driven ecosystem. If it succeeds, software will eat Marc Andreeson’s job and keep more money in the system for new entrepreneurs. Technological unemployment will come to venture capital — it’s a matter of when, not if.

Given how many new entities are raising money through equity crowdsales and raising millions, I think it’s entirely feasible to put this together using regular token sales, publicize the plan, and issue “Venture Coins,” which would be securities and need a special exchange (working on it). That would be the crypto-equivalent of “going public” in a world where investors and companies both get what they are looking for (subject to regulatory approval, of course). It’s not impossible. If you’re interested in starting this company with me, please get in touch. We have a team of six working on it now.

Summary

This is an antifragile (convexity) strategy that combines high risk and high payoff with low exposure, to produce consistent returns with low volatility. The system I envisage would give public investors access to a broad portfolio of private companies that would be far safer than investing in a handful of public stocks today. It’s just a vision, but you can see plenty of signs that we are heading in this direction.

To get this working at scale, I think we need some kind of transition strategy, going from what we have today to what we want tomorrow. If I had the money, I would partner with the guys at Right Side Capital to build this system. They understand the process of building an unmanaged venture portfolio better than anyone. I would want to build on their foundation. Ten years from now, the pie would be much bigger, but the margins would be much smaller. Eventually, it would simply be software with no added fees, creating a friction-free M2M market for private-company equity.

By that time, the brokers and capital markets will be similar, and most hedge funds will be gone. A new day will dawn for investors, powered by smart contracts powering smart-beta strategies that harness the engine of market pull, rather than salesman push. And this is just a small part of the financial-services disintermediation party we’re starting now. Wait ’til you see what’s coming to the mortgage market.

If you want to do some further study, here are the links I mentioned:

I hope this gives food for thought. Anyone with the money and interest could get this started. It will take ten years to overhaul private investing, but the end result would be more entrepreneurs, more ideas reaching market, and perhaps even a level playing field where women and minorities could win in business without fighting stereotypes. We have started building it. Come join us.

Contact

On LinkedIn (please connect)

Everything I have ever written: dsiegel.com

Did I mention the MBA is broken?

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