How Venture Capital Can Avoid the Next Silicon Valley Bank Fiasco
In the public Imagination venture capitalists are often seen as independent wealthy players using their personal money to spur start-up companies. But the vast majority of VC capital comes from “LPs” — or limited partners — including public pensions, university endowments, hospitals, and wealthy families. In other words, venture capitalists manage large sums of money from other people. This makes them the de facto gatekeepers of innovation, deciding what gets built and who benefits from it. When this system works, we end up with companies and technologies that change the world. If it fails, as in the case of Silicon Valley Bank, we risk setting ourselves up for stagnation and decline.
Historically, society has allowed venture capitalists ample 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 money managers. However, amid the collapse of SVB, many people have begun to question the wisdom of giving VC executives so much leeway.
As conflicting theories emerged about the bank’s meltdown, commentators from across the ideological spectrum seemed to agree on one thing: venture capitalists’ reactions to the crisis were woefully unprofessional. Some criticized the VC leadership for a panicked response; others have labeled the pleas for swift government action as “idiots’ talk.” The harshest critics accused VCs and startup executives of “fell asleep at the switchThey claimed 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 risky, held uninsured deposits at the bank.
DelJohnson is a venture capital investor, limited partner, business angel and author. He is a graduate of UC Berkeley and Columbia Law School.
As one of the few VCs who expressed early concerns As for the asset’s systemic risks, I wasn’t surprised by either the VC-led bank run or the week of finger pointing that followed. Venture capital investors have long prided themselves on fostering a collaborative pay-it-forward culture, guided by deep networks and personal relationships. However, as a Bay Area son who got an up-close look at VC’s reactions to the collapse of the dot-com bubble, I knew that narrative amounted to little more than slick marketing.
To understand why the industry’s panicked and erratic response has exposed flaws at the core of how they operate, we need to understand VCs’ reactions to the SVB’s failure as a result of the industry’s ingrained 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 intervention to bail SVB depositors back to health. Over 650 firms – including prominent names such as General Catalyst, Bessemer and Lux Capital –recommended their companies to keep their money or return it to the SVB, despite an ongoing public debate about the systemic risk of pooling seed capital into a single bank. Research suggests that this culture of groupthink is the result of capital consolidation in the hands of only a few very influential fund managers.
About 5 percent of VC managers control 50 percent of capital in the United States, according to the 2022 Pitchbook Venture Monitor report. A staggering 75 percent of these leaders attended an Ivy League school, Caltech, MIT, or Stanford, and 91 percent are men. Additionally, these “Big VC” firms tend to cluster geographically, with over 90 percent based in either Silicon Valley, New York, Boston, or Los Angeles, creating regional imbalances that have historically discouraged promising entrepreneurs and… Locked out investors from outside of these technology hubs.
To achieve such a skewed concentration of capital in a handful of industry players, big VC firms have done convinced herself, her colleagues and the general public of her superior investment skills. But the lack of basic financial literacy these VC executives seemed to demonstrate during the crisis underscores serious concerns about their competence. One study found that VC investment decisions show “little or no skill in the short or long term.” According to a Cornell University model, what appears to be VC skills is just a matter of a fund investing at the most opportune moments. A recent Harvard study even found evidence that investor performance degrades over time, suggesting that experienced big VC managers may actually be worse off than their inexperienced peers.
If we are to unleash the true innovation potential of our society, it has become clear that we must dilute Big VC’s undeserved influence. To achieve this goal, we must not only break the market power of large VC funds and investors, but reinvent innovation investments from scratch.
We must build structures that avoid the types of financial entanglements and conflicts of interest that permeate the current system. One way to do this is to do more research that challenges venture capital conventions, such as B. VCs’ over-reliance on personal relationships to close deals and LPs’ tendency to overvalue branded funds. This could be done through new structures such as publicly funded innovation labs or through private institutions that do not invest in VC and are not anchored in this ecosystem. The work done at such institutions would have the added benefit of reforming many of our public innovation programs, the rules of which are often driven by the same flawed logic, conventional dogma, and untested assumptions as traditional VC.
As we develop new models, we can use legal and policy tools to reduce the influence of big VC managers and stop the behaviors that contributed to the meltdown. For example, to limit the extent to which the most powerful players can dominate the market, lawmakers should consider legislation that tax VC compensation as personal income or limit the number of funds or assets that are subject to preferential tax treatment. To curb the cozy relationship between startup banks and VCs, lawmakers should also consider closing VC-specific loopholes that allow banks to invest massive amounts of capital in these structures. On the LP side, we can – through regulation or legislation – encourage more investment outside of the enmeshed Big VC system. This could include removing the cap 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 run by unengaged outsiders were launched.
If society has now decided that Silicon Valley VC is structurally important, as many argued during the SVB collapse, lawmakers must also ensure that the VCs, which have an overwhelming impact on the sector, are subject to professional standards and accountability rules. In numerous other fields – such as medicine, law or investment advice – professionals must demonstrate basic knowledge, especially where incompetence could pose a danger to the public if left unchecked. VCs should be no different given the immense control they hold over innovation in vital sectors like AI, national security and defense.
Ultimately, it is up to us to fundamentally rethink the power we have given to VCs and push for meaningful reforms to ensure the industry fulfills its fiduciary and societal responsibilities. We must learn the lessons of this moment and break the market power of established big VCs to both save the innovation ecosystem and ensure economic prosperity.
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https://www.wired.com/story/to-save-the-innovation-economy-break-big-venture-capital/ How Venture Capital Can Avoid the Next Silicon Valley Bank Fiasco