There are bad actors but it’s quite unfair to compare venture capital investment with giant Ponzi schemes
NR Narayana Murthy’s comment that the venture capital (VC) model looks like a ponzi scheme has become a favourite topic of discussion in many a corporate dos these days. “Investors say they are in series B, then go to series C, and sell shares to others at a profit, but it is the series Z fellow who is left with a tin box”, the industry statesman said at a recent fireside chat. Murthy’s concern about VCs focusing too much on growing the top line while neglecting the bottom line isn’t new.
Chamath Palihapitiya, founder & CEO of Social Capital, has been saying for some time that modern VC investing is a giant Ponzi scheme and the structure of the industry is such that it creates incentives that might not be aligned with the best interests of entrepreneurs. Former Fortune columnist Stanley Bing (the pen name of Gil Schwartz) had gone a step further. In a blog (thestreet.com) quoted widely, he wrote, “Forget the occasional Ponzi scheme. Venture capitalism may be the greatest scam going.” Bing said it is something baked into the DNA of the venture capitalism game.
The Ponzi scheme, named after Chares Ponzi, who was indicted for a type of scam over a hundred years ago, continues to ensnare overeager investors. But likening VCs with Ponzi schemes is a bit much, and the three gentlemen were perhaps exaggerating to drive home a substantial point. It is difficult to deny that a perception has indeed gained ground that the only thing early-stage investors care about is whether the investee-company will grow quickly enough to be attractive for another round of funding and increase the value of their initial investment.
Therefore, the gains of previous investors are paid for by the new entrants, who are wooed by friends, promises, sometimes half-truths, and strategically crafted narratives. The reality matters less than the pitch. This of course doesn’t apply to all VCs, but the industry does get a bad name for the actions of a few.
The VC industry is one of high risk, high reward. Therefore, many VC firms have diversified portfolios of investments, knowing that two-thirds will be written off as failures. They count on the remaining third to make up for the loss and produce a profit. Therein lies the problem. For the original VC to make money, the idea and the team they have invested need to be successful or at least look to be successful.
VCs thus put a great emphasis on going after the top line to show to the world that their bet is paying off. They more often than not push the team to somehow show numbers that indicate success and often the managements bow down to this pressure and even cook up their books (there are examples galore of this). This is enough for the original VC as follow-up investment then takes place, at which point, it makes at least a partial exit to recoup some of the investment. The follow-up VCs who come in when the idea and the team are more stable and less risky, pay a premium to enter the business and they too are in to make money. So, they too follow the model of the original VC. In short, the point is that VCs care that the startup exists until the next round. But they care little about what happens to it afterward. But there is another side of the coin, too. To be fair, VCs do play an important role in fostering innovation and economic growth by providing capital and expertise to help startups grow and succeed.
After all, no one else but VCs provided funding and support to iconic companies such as Apple, Microsoft, Google, Twitter, LinkedIn, and Facebook,
which have gone on to become some of the largest and most successful technology companies in the world. Many VC-funded companies such as Uber, Airbnb, and WeWork, have transformed the way we travel, work, and live.
VC is also about mentoring and giving growth capital to young and restless talent to help them grow and succeed in a phase when nobody else is going to lend them a penny or a shoulder. Whatever Murthy and others have said should be seen from the following prism. Ponzi schemes are fraudulent investment schemes where returns are paid to earlier investors using the capital of newer investors, rather than from actual profits or returns generated by the underlying investment. The scheme relies on a constant influx of new investors to pay off earlier investors and eventually collapses when there are not enough new investors to sustain it. VCs, on the other hand, are legitimate investors who provide funding to early-stage or growing companies in exchange for a percentage of ownership in the company or potential future returns. The success of VC firms is largely based on their ability to identify promising companies, provide strategic guidance and resources to help those companies grow, and ultimately sell their ownership stakes for a profit.
While there are certainly risks associated with investing in startups, VCs do not operate in the same way as Ponzi schemes. VC firms typically invest their own capital as well as funds raised from limited partners, and returns are generated through successful exits (IPOs or acquisitions) of the companies they have invested in. VCs obviously have faults and the VC model is without doubt risky, and there have been many high-profile failures over the years, as there have been in many other asset classes.
There are bad actors who will try to inflate valuations and manipulate returns. But sweeping statements about an entire industry are patently unfair.