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Is Venture Capital Worth the Risk?

The industry shaped the past decade. It could destroy the next.

For a certain sort of nineteenth-century person—the sort with high risk tolerance and little revulsion to brutality—a natural career lay in whaling. The odds of success here were, by almost every measure, poor. An expedition first needed to find whales in the vastness of the oceans. If it succeeded, it had to approach the whales in silence, with a small craft; strike with a harpoon; stay afloat, intact, engaged, and oriented as the poor creatures thrashed about, sometimes for miles through iceberg-laden water; row back to the main ship with the carcasses; harvest the baleen and render the oil; and survive the journey home. “On the eve of a Nantucket voyage, I regarded those marble tablets, and by the murky light of that darkened, doleful day read the fate of the whalemen who had gone before me,” Ishmael says, in “Moby-Dick.” “Yes, there is death in this business of whaling—a speechlessly quick chaotic bundling of a man into Eternity. But what then?”

For those who made it through the earthly trials, there could be riches in tow. A captain’s cut of the takings ranged from five to twelve per cent; a first mate’s, three to seven per cent; and so on, down the line. A captain with some skill could spend a few years leading expeditions and retire rich. In 1853, the Times described the whaling town of New Bedford, Massachusetts, as “probably the wealthiest place” in the United States.

The people on the boat, however, weren’t the largest earners. Dispatching a whaling voyage cost between twenty and thirty thousand dollars, a small fortune in the mid-nineteenth century, and an industry emerged to get these expeditions off the dock. Specialized agents in whaling-industry towns invested their own money, pooled cash from rich investors, did due diligence, and worked with captains to develop winning strategies and to plot uncrowded routes. In most cases, their efforts were fruitless: data from a couple of whaling ports in Massachusetts in 1858 suggest that fully two-thirds of returning expeditions were unprofitable; another study found that a third of the whale ships in the New Bedford fleet never made it home. A lucky outing, though, could return with a hundred and fifty thousand dollars in goods, a fortune several times the outlay, and for many investors this was enough to justify the risk.

In “V.C.: An American History,” the Harvard Business School professor Tom Nicholas sees whaling as the first practice of what we now call venture capital: collecting large pots of money and using it to invest in young companies, while also getting involved in their management, in the hope of guiding growth and generating huge returns. Venture capitalists fill these cash pots, or funds, with money from large-scale investors—foundations, pension funds, university endowments, and other passive contributors. They take a management fee, drop a bit of their own money into the mix, and, like the whaling agents, promise expertise. They, too, make predominantly bad bets: about eighty per cent of venture investments don’t pay off. Occasionally, though, there is a wild success, and, since the nineteen-seventies, such successes have transformed American business. Venture capital backed Apple and Intel. It funded Google, Amazon, and Facebook before any of them turned a profit. In principle, venture capital is where the ordinarily conservative, cynical domain of big money touches dreamy, long-shot enterprise. In practice, it has become the distinguishing big-business engine of our time. Can it offer both returns?

Much as a private table at the Casino de Monte-Carlo is off limits to those who can’t pony up for chips, venture capital is off limits to most of us as a direct investment. Funds typically have at least a million-dollar buy-in, available only to accredited investors, so unless you’re the Monopoly Man you’ll be unable to put your daughter’s college fund into some of that. Yet most of us now have daily contact with the world of venture capital, because its sphere of influence has exploded. Once, venture capital was sought by risky startups needing lots of up-front cash, whether for research and development (Genentech had to fund academic-grade research before it had a product to bring to market) or for essential leaps in scale (Uber is appealing only if it’s big enough to get a car to you quickly). Such financing seemed especially suited to proprietary technology, which was expensive, hard to seed into the market, and yet, if things went right, extremely lucrative. That has changed. Since extending its focus to direct-to-consumer retail, venture capital has come to fund delivery services, financial services, car companies, shoe companies, office real estate, leisure real estate, coffee brewers, beer brewers, smoothies, razors, trousers, speakers, scooters, mattresses, toothbrushes, socks, and underwear.

This realm of direct commerce could be called Venture World. You know what its businesses are like. They appear suddenly, everywhere, with chatty ad campaigns on public transit starring cool, young people who were clearly nerds in high school but who have since mastered impressive dance moves. They tell you that their products aren’t just better; they are simplifying the whole deal, changing how stuff works across society, and not a moment too soon. If you are buying an actual object and live in a major city, you might find a brick-and-mortar storefront decked with ha-ha-clever wallpaper where you can hold the toothbrush of the future or try one of five purportedly game-changing eyeglass frames. But the bulk of Venture World’s offerings are online, where they are hawked on bright, uncluttered sites that scroll down, down, and down again with charming animations, offering moving stories about one big idea that will change the industry, about community, about zero-impact supply chains, which, thanks to their backing, they can afford. In Venture World, everyone seems to be more or less on your wavelength. Its companies are geared toward unfussed people who keep their phones silenced and close. Venture capitalism is behind most of the platforms on which people lament the gaucherie of “late-stage capitalism”; it has become the chief industrial backer of the self-aware, predominantly upper-middle-class approach to life style now called woke.

A marriage between social enlightenment and manic growth defines the business of the past decade. Venture capitalists, having helped officiate the ceremony, often find themselves in awkward standing when the marriage falls apart. In the fall, WeWork, a venture-founded office-rental company, tried to enter the public markets with a forty-seven-billion-dollar valuation and the pixie dust of world-changing rhetoric, only to postpone the I.P.O. indefinitely when the valuation dropped by about seventy-five per cent and its lion-haired C.E.O. resigned amid disturbing revelations about his management style. Before that, there was Theranos, the fraudulent blood-testing company, which, despite the absence of evidence that it could do what it promised, raised a mint in venture-capital funding—then, on the basis of that, hundreds of millions more—and Juicero, which, before the company’s abrupt shutdown, in 2017, had raised a hundred and eighteen million dollars for seven-hundred-dollar Wi-Fi-enabled squeezers of juice packets. Last week, news broke that Zume—a startup whose business centered on pizza par-baked by robots, then loaded into delivery trucks filled with ovens that finished each pie en route to its destination—had been compelled to lay off more than half of its employees because SoftBank’s venture-capital arm, which had already invested three hundred and seventy-five million dollars in the company, had backed away from further funding, wanting Zume to pursue more aggressive “global domination” in its pizza craft. The startup (which, despite its robust funding, delivered pizza to only a small portion of the San Francisco Bay Area) is pivoting its business to “compostable molded-fiber packaging.”

Could there be a moral to such embarrassments? Maybe occasional high-profile mortification’s keep an essentially healthy system honest. This is what a lot of wealthy entities seem to think, given recent record-breaking growth in V.C. fund-raising: in 2018 venture capitalists, as a group, loaded more than fifty-six billion dollars into their funds.

And yet a seepage of doubt is spreading, notably among venture capitalists themselves. “It’s a venture-capital-finance boom, where, within a mile of this building, there are somewhere between five hundred and a thousand startups,” a withered specimen of the old school told me a few years back, gazing out his window, across San Francisco. “But they’re not companies.” Viewers of “Shark Tank”—the reality show on which entrepreneurs pitch to regal investors dressed in midlife-crisis clothes—could be forgiven for coming away with the impression, shared by many startup founders, that getting funded is itself proof of value. The public markets often disagree. In recent years, it has become common for venture-backed companies like Facebook and Uber to wilt in share value subsequent to their public offerings—which happens to be the period when many venture capitalists distribute their stake back to investors.

On the money tree of contemporary finance, venture capital comes off the branch of private equity: the buying and selling of shares of companies which aren’t publicly available, ostensibly to turn a profit while helping businesses thrive and grow. When people speak of “private equity,” however, they usually mean funds that move on mature companies, often with the goal of restructuring and selling them as if flipping a house. Venture capitalists are different. They buy equity from brand-new or young companies, and they generally cannot get their money out until the startup enters the public market or is acquired by a larger company, like a herring being swallowed by a tuna. This is what happened to Instagram, when it was bought by Facebook, or YouTube, upon its acquisition by Google. Acquisitions are one reason that, despite the efflorescence of new startups, power in tech flows toward the giants at the top.

Another way that venture capital is unlike private equity proper, Nicholas explains in his first-rate history, is that the venture-capital industry was itself a product of speculative funding, tamed and coddled into being by the U.S. government. It started, as most American things do, with excess. By the late nineteen-twenties, one per cent of American families earned nearly a quarter of the United States’ income and held half of its wealth. Many set up investment vehicles, some specializing in high-risk offerings. Laurance Rockefeller, a grandson of John D., began putting “venture” money into untested aviation companies. Nicholas calculates that he could have made more in the stock market, but Rockefeller was undeterred. “Venture capital endeavors are not for the impatient,” he remarked. “Nor are they for widows and orphans or people who cannot afford to lose.”

During the Depression and the Second World War, patient, deep-pocketed investors were in short supply. “The 1930s brought more progressive taxation,” and it “was frequently argued that this diminished the supply of entrepreneurial finance,” Nicholas writes, sounding as scrupulously objective as the butler at a swingers’ party. Put more baldly, Franklin D. Roosevelt soaked the rich. In 1935, his Administration imposed a seventy-five-per-cent tax—then widely known as the “wealth tax”—on incomes greater than five million dollars. A year later, it instituted a tax on undistributed corporate profits, in theory giving businesses an incentive to disburse more earnings to workers. Such policies helped rebuild the American middle class in the depths of the Depression; they also pinched super-rich parties trying to grow their wealth. Nicholas quotes the then head of the Investment Bankers Association of America: “No one in the high income tax brackets is going to provide the venture capital and take the risk which new enterprises and expansion require, and thereby help create new jobs, if heavy taxes take most of the profit when the transaction is successful.”

This was and remains a standard plea for tax breaks for the rich. Yet, during the Second World War, the government raised taxes further while plowing taxpayers’ money into business growth. Prospective innovators were paid four hundred and fifty million dollars—about five billion dollars in today’s money, by Nicholas’s calculations—in government contracts. When the war ended, the G.I. Bill helped talented people get technical training and social access, expanding the pool of potential entrepreneurs. The war and its aftermath, which saw the growth and reimagining of such companies as I.B.M. and Hewlett-Packard—plus the first programmable digital computers, the jet engine, mass-produced antibiotics, and oodles more—was by most measures a golden age of American innovation. It happened largely on the government’s tab.

Venture capital itself was a beneficiary of such support. In 1958, Congress passed an act designed to encourage small-business investments and loans. If a small-business investment company could raise a hundred and fifty thousand dollars, the government would match those funds and lend more at a low rate, bringing the fund to at least four hundred and fifty thousand dollars (nearly four million in current dollars). These investors received tax advantages, too. The lure invited fraud, and the fund-matching program was brought to an end.

By then, however, the friendly financial loopholes were on the books, and a pool of interested parties had assembled. Nicholas quotes early venture capitalists saying that they wouldn’t have got into the game if it hadn’t been for federal incentives; venture capital transformed from the pursuit of a few ultra-wealthy scions into a true profession. In the seventies, the government relaxed certain regulations—allowing pension funds to make high-risk investments, for instance—and lowered capital-gains taxes. These changes, plus firms’ embrace of limited partnerships, a legal structure that offered further tax shelters and protected passive investors, brought financial growth to the community that the incentives had founded. For the first time, a few venture-capital portfolios began to outperform the public markets. Many prominent venture capitalists now decry government controls and say they favor market meritocracy. That’s ironic, given that their industry exists as such only because of a sequence of supportive actions taken by the government.

Did the government’s investment pay off? Yes, venture capital in the seventies helped bring us Apple, Atari, Genentech, and the like. And, yes, in the nineties it was crucial to the launch of Netscape Navigator, Hotmail, and Google. Now consider a few entities that got off the blocks without a penny from Papa V.C.: Microsoft (Bill Gates sold a five-per-cent share of his already profitable company in 1981, solely to bring an old hand onto the board); the Mosaic browser (federally funded and released free of charge); and Craigslist (which diverted an existing advertising market into its coffers). Subtract venture capital from the landscape of late-twentieth-century innovation, and we would have reached the new millennium with roughly the same technological capacities.

Does this mean that the venture-capital industry itself was the ultimate frothy startup—a solution that we didn’t really need to a problem that we didn’t have? Not only venture capitalists would disagree with such a claim, because the case for venture capital is the case for ambitious risk-taking. Sure, maybe we would still have ended up with a personal computer, a visual Web browser, and even an affordable cell phone without venture capital. But we would have lost the big-risk-big-reward ethos that made these devices totemic innovations and inducements to further invention. A thriving society needs moon shots, and, in the absence of a literal space race, only venture capitalists have the mandate to throw cash at an improbable success.

Traditionally, venture capitalists have calculated that about two in ten investments will generate most of a fund’s profits. A strong fund hopes to achieve a twenty-per-cent return, and so those two in ten winning bets must hit between twenty and thirty times the money invested in them. Usually, returns do not come close. As a whole, the venture-capital industry has significantly outperformed the public markets only in the nineties—a decade that, you will remember, ended with the so-called dot-com bubble bursting, a crisis that Nicholas attributes largely to venture-capitalist profligacy. A chastening study by the Ewing Marion Kauffman Foundation in 2012 found that the average venture-capital fund in the previous two decades, far from delivering its promised returns, had scarcely broken even.

Laurance Rockefeller was right, then: what venture capital as a field provides is something other than a great way for investors to make money. But, even if they didn’t prosper, you and I probably did. We might lament the hegemonic power of Amazon or chortle at, the dog-and-cat-supply startup whose insanely capitalized launch ended in abrupt liquidation two years later. But what about Groupon, which brought your family a nice dinner in hard times, or the popular vegan Impossible Burger, which purports to reduce animal cruelty but which also, somehow, bleeds? Try making that sales pitch to a government funder or a mainstream investor. Venture capital has offered a path into the market for unsmooth operators and bizarre ideas.

For most of the late twentieth century, V.C.’s realm, like the Tiffany necklace, was a bauble that symbolized the capacities of the entrepreneurial whole. Good value? No, not really. And yet a life of total prudence is no life: let’s have it. Then, recently, something changed. The bauble started to become the bank.

The Times journalist Mike Isaac, in his buoyant and well-reported new book, “Super Pumped: The Battle for Uber,” points to the advent of the iPhone as a crucial turning point in venture investment. “The App Store changed the model for software development entirely,” he writes. What used to require distribution infrastructure could now be served at a click. What used to be trapped at your desk could be in your pocket, a huge scaling-up of market opportunity that paved the way for companies like Uber. “Venture funds began throwing money at twentysomethings, hoping to stumble into funding the next killer app,” Isaac writes. “But the real winning apps were backed by top-tier venture capitalists, who made connections to potential partnerships with large companies, built pipelines to faster recruiting, offered strategic advice and, of course, turbocharged growth and marketing with millions of dollars in funding.” Spewing cash across the consumer market in pursuit of “unicorns,” venture capital expanded beyond a small corner of the finance world. It became an option for anybody with a flashy-seeming new business who wanted—promised—to grow fast.

The pressure of scale fell hardest on startup founders. When venture capitalists take board seats, they are supposed to help guide a company in the best direction. By sheer necessity, though, their most immediate interest is seeing the company grow quickly enough that their equity can reach their own targets. For a young startup, getting bigger faster is not always the best directive. (A thirtyfold return on an investment of several million dollars, we might think, is a lot to ask of a company that specializes in delivering underpants through the mail.) One trend in Venture World has been growing valuations, which in median last year reached a five-year high. Another has been undesirable treatment of employees, who may find themselves overworked, underpaid, or verbally abused. You’re unlikely to be a great boss if the people who invested millions in your company are pressuring you to grow, grow, grow or deliver ever-greater efficiencies—or be fired yourself. It doesn’t even take a hard-nosed venture capitalist to whip a startup into such a state, because pressure is built into the system itself. Valuations and the economics of dilution (the portion of ownership that entrepreneurs must sell in order to bring more money on board) are spurs to faster growth.

Hence WeWork: a company that absorbed billions of dollars of capital for the purpose of subletting office space, had to bail on its I.P.O., and cut loose its offending C.E.O. with a severance package of more than a billion dollars. The WeWork debacle is illustrative not because it’s a case of foolish investment and unchecked mismanagement (life at sea!) but because the company gained value during these shenanigans, at least until it filed for I.P.O.—which startups are doing less often than they once did.

To understand why, we can return to the high-stakes room at the Casino de Monte-Carlo. If you’re a venture capitalist, you are, like James Bond, playing mostly with other people’s money. Unlike James Bond, you’re taking a fee to do it: the more money you start out with on the table (the larger the fund), the more gets slipped into your pocket—and that’s before you play your hand. Now imagine that there are two ways to turn your chips back into cash: either you can go to the guy at the window, who will carefully tally and value them (like a startup readied for an I.P.O.), or you can rake all your chips into your hat and sell the whole lot to another player, who may overpay a bit to sweeten the deal and get that lucky je ne sais quoi (like a startup’s being acquired). Occasionally, venture capitalists sell shares in a secondary market, too.

Two things should be clear. First, it can be less appealing to cash out at the window: an I.P.O. entails financial scrutiny, regulatory hoops, and other requirements that are designed to protect investors like you and me from the WeWorks of the world. Why go that route if you’ve got other options? (In the case of WeWork, the push to I.P.O. seems to have been a financial necessity.) Startups hoping to be acquired have less incentive to plan for a lifetime as healthy businesses; like the playboy burning through his savings on fast living and gorgeous suits, they have to keep it appealingly together only long enough to seduce a prosperous spouse-patron.

Second, if you’re a venture capitalist you know that you will not be the one to go broke. You might lose all your investors’ chips, but you still have fee money pooling in your pocket, and that’s more than most people involved in the deal get. Startup founders make big money only if their efforts succeed. End investors get rich—or richer—if the funds in which they have invested yield a good return. Venture capitalists, on the other hand, now make good money regardless, and some firms purporting to prosper through their “carries”—their share of returns—are swelling up mostly on fees. A few successful venture capitalists get ribbed for their grandstanding, dubious blog pontifications, and general “Shark Tank”-ing. But who can blame them? If your business depends on bringing in more and more investment, isn’t your first priority burnishing your public image for having special skills and insight? In venture capital, as in a growing number of enterprises, reputation is what pays today.

A looming question is whether venture capital has become too large for its own good. In his book, Nicholas quotes a prominent venture capitalist saying, “This business is just not set up for big bucks.” As funds grow, successful venture-capital firms have been moving outside their traditional province. Andreessen Horowitz (which, admirably, reinvested much of its fees to support services for entrepreneurs) last year expanded its range of investment, and announced that its largest new fund would be directed toward “late-stage venture”—that is, mature startups with some proven success—creeping up on the work of mainstream private equity. First financings across the field have been declining since 2014. Big risk capital, with more money in the balance, is quietly stepping away from risk.

What does this make it? Chiefly, a great business for some venture capitalists—especially those in firm control of startups being sent toward cash harvests in the pre-dawn of the private markets. Champions of regulating the sphere of private equity, most prominently Elizabeth Warren, have suggested that such models are “rigged.” Purely on the basis of risk-reward odds—who is bearing the risk and who is reliably extracting significant wealth—this is a hard claim to dispute. One might wonder why entrepreneurs and investors keep lining up for the privilege of being channelled into what has become a vast financial threshing machine.

They do it in part from competitive pressure: if your rivals are growing wildly at an early stage, and with good hookups, you’re obliged to play the game in order to keep up. But they also do it for the chance at the lottery. Jackpots have only become bigger as venture capital has grown overcapitalized; last year exit values, the proceeds from selling shares, topped two hundred billion dollars for the first time.

Institutionalizing venture capital has had good effects. For all its swagger about finding diamonds in the rough, the industry has always been largely about whom you know and what narrative you fit, with firms notoriously favoring socially maladapted young white men. This tendency has begun to change as its costs, financial and social, come to mainstream attention. In 2016, four women in tech—Jennifer Brandel, Mara Zepeda, Astrid Scholz, and Aniyia Williams—put up a widely cited blog post called “Sex & Startups.” “Startups, like the male anatomy, are designed for liquidity events,” they wrote, suggesting that women—at that point the recipient of only three per cent of venture funding—fight the tyranny of venture capitalists’ hockey-stick growth drive and work to fund companies whose successes were more sustainable. A year later, they formalized the idea in a manifesto supporting multicolored and mutualistic “zebra” companies. (“Unlike unicorns, zebras are real.”) A new generation of smaller-scale venture capitalists are indeed focussing resources on startups led by people underrepresented in tech leadership, and, for the first time, Venture World is starting to pay attention to the interests of everyone it serves.

Other perils remain unaddressed. It’s nice that we’re able to get cheap or free stuff from wildly scaled-up unprofitable startups with venture backing. (Recall the brief, bright age of MoviePass.) But how healthy is this norm? Thirty years ago, it was widely understood that, if you wanted to get quality news on your doorstep, you had to send a subscription check through the mail; if you wanted to see a great new movie, you had to fork some bills across the box-office window or the video counter; and if you wanted to take a cab uptown you had to pay the driver the standard fee, plus tip. Venture World has weaned us off these habits of direct exchange. Now we expect certain things to be free, because surely a wealthy, ambitious funder somewhere will be picking up the tab. It is true that we get goods and services on the cheap thanks to venture capitalists pouring money into “pre-revenue” companies. But we also learn to value them less.

The American whaling industry ended largely because the most valuable of those creatures were hunted almost to extinction. In the venture-capital realm today, the risks of fishing out the sea are no less real. Nicholas writes of early venture capitalists’ sense of “social responsibility,” by which he means that they didn’t regard growth toward profit as their primary goal. Making the planet a better place gets a lot of discussion in Venture World, but it is sometimes as simple as constructing a company that is useful and sustainable, and that treats its employees well. Venture capital, once a small and chancy field, is now a profit machine for its managers, with all that entails. Poorly designed for its scale, rote and entrenched at the higher echelons, it has become vulnerable to a particular sort of change: disruption by a bright, daring idea.