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There’s been a lot of discussion about Paul Graham’s latest essay, Why There Aren’t More Googles. I’ve been thinking a lot about something similar to what he said lately on the investing front, but I’ll save that for its own post. I’ll toss in my random two cents on a couple other topics though.

As for the titular question, it’s hard to disagree with anything he said. But I think it is often left out that Google is a company with, even now, a $140 billion market cap (previously over $225b at the peak) and companies of that size come about rather infrequently. Even the top company on the Fortune 500 (which I believe goes by revenue rather than market cap), Wal-Mart, is only at $225b. To put it in perspective, a couple weeks ago when their market cap was $127b, they were the 24^th largest company in the world.

So part of the reason there hasn’t been a next Google is just the fact that companies, for a million economic reasons, rarely get that big. So asking why there hasn’t been another Google is like asking why there hasn’t been another Wal-Mart. It just doesn’t happen frequently. Especially on the web, which is still only responsible for a small fraction of overall commerce.

PG also mentions that VCs are not bold anymore. I think that’s certainly true in general (and I wish I had read that article before seeking funding) but it’s worth noting that there are a few specific areas where VC’s are surprisingly courageous, generally because they’ve succeeded there before. Take, for example, copyright infringement. VCs seem to love nothing better than a startup that infringes copyrights. Their attitude is “do it, make it popular, deal with the recording industry later”. I think this stems from YouTube, though probably began earlier than that. They seem to recognize that helping people give away intellectual property for free, generally illegally, is one of the easiest ways to grow traffic. And the recording industry is just so beaten down that it seems to not be too difficult to manage them later.

The most interesting part to me was when PG asked “Why are VCs so conservative?” The proper answer to any question as to why people behave in a certain manner is almost always “because they are incented to”. It’s not that they are stupid or irrational, or even just missing something. It’s that the rules of the game make them. So look at a VC’s incentives and you’ll see why they behave the way they do.

VCs get generally get paid in two ways. One is a percentage of the profits their funds generate. This is called a carry, and a typical amount might be 20%. They also get a percentage of assets under management each year as a fee, much like a mutual or hedge fund. 2% might be a typical number for that.

Here’s an explanation from a blog I found:

“Let’s walk through a simple example.  Let’s say there’s a $150 million fund and the VCs are getting 2% in annual fees and 20% in carried interest.  Then, the firm takes in $3.0 million in annual revenue.  If the fund returns 2x the capital, or $300 million, over the 10-year life of the fund, then $150 million is considered capital gains and the VCs get 20% of that amount, or $30 million, to be divided up between the partners according to who has how much of the carried interest.”

So what we see is that this hypothetic fund, which raised $150 million (not a large amount for a VC fund either) made $30 million from the carry and $30 million from the management fee. And that’s assuming they return 2x capital, which is just over 7% annually and way above average for a VC fund. Supposedly the majority of VC funds lose money, meaning that over half the time, they earn the annual fees alone.

So I can’t say for sure what percentage of total VC firm profits come from the annual fees versus the carry, but it’s big. And as that ratio grows, so does the firm’s incentive to raise (and therefore deploy) large amounts of money. And that means they have to sell themselves.

We entrepreneurs look at our end of the dance and view ourselves as the salesman and VCs as the prospective customers we’re pitching to. But VCs, of course, have to turn right back around and sell themselves to their investors. They raise hundreds of millions of dollars themselves every time they start a new fund.

I suspect that’s why the established firms, the 25% that are doing well, are variance averse. They know that in a few years they’ll be back selling again. And telling the guys who run the pension funds and endowments they rely on “yeah, we tried this new way of doing things and that’s why our last fund tanked” might be fatal. They’re not comfortable taking the increased variance that comes from funding companies earlier and doing less due diligence, because it threatens their ability to keep raising funds in the future.

(Interestingly enough, if it weren’t for the sales aspect, their best long term strategy would be to pursue a higher risk, higher reward course of action. This is not only because of the general increase in EV, but also because they make the same if a fund loses 1% as they do if it loses 100%. They make the annual fee and nothing more. But they make more if the fund returns 100% than if it returns 1%. So a higher standard deviation benefits them because they gain more when their fund over-performs, but are penalized less when it underperforms.)

Also, a VC firm isn’t a spreadsheet. It’s an organization of human partners who all benefit directly from their firm’s profit. The carry and annual fees go into their pockets. It’s been shown over and over that in what are essentially gambling situations, people will take the route with less risk, even though the expectation is lower, especially when large sums are on the line. Most people would take a guaranteed $1 million over a coin flip that gave them a 50% shot at $3 million and a 50% shot at $0, even though the coin flip has a 50% higher expectation. And they’d be correct to, because the difference between having $0 and $1 million in the bank makes a great impact on their lives, whereas the difference between $1 million and $1.5 is rather slim.

So the lower-tier VC firms (which are the majority of them) make little or no money from the carry, meaning their incentive is to raise and deploy large amounts of money and collect as much as they can in management fees. One would assume they use tricks similar to those employed by the mutual fund industry to keep investors coming back even though the average grossly underperforms the market. And the Sequoias of the world, that actually do return a good rate, have a relatively low risk method that’s making the partners millions, and therefore have no incentive to rock the boat.

My guess is that PG should try selling his approach to mid-tier VC firms rather than Sequoia. Ones that aren’t on the gravy train, but are still in the black and have more incentive to try to increase the carry. I don’t really even know if such firms exist, as I don’t have much data. Perhaps for various reasons (collusion might be one) fund results don’t follow a normal curve and all VCs either generate a large return or a negative one.

The only way I can think to fix it would be to move to an all carry profit model. That, I assume, is what Y Combinator and most angels effectively use, since it is their own money on the line. They are therefore incented to be more brave. Perhaps in the early days, before the top tier firms had investors lining up to hand them money, VCs were more brave themselves, hoping to hit a few big payouts to make selling much easier in the future.

This entry was posted on April 16, 2008 at 8:11 pm and is filed under Startup . You can follow any responses to this entry through the RSS 2.0 feed Both comments and pings are currently closed.