It’s official: the world of Silicon Valley and startups has reached crazy times.
Techstars, one of the most prominent accelerators in the world, announced yesterday that it was introducing what it called “an equity back guarantee.” The idea is that founders who join the program can ask for their equity to be returned (or a percentage of it) shortly after their Techstars batch ends if they feel that the accelerator didn’t provide them with sufficient value.
David Cohen, one of the founders of Techstars, believes that founders nearly always see the value of Techstars in hindsight, but often have concerns about its impact before the program. A return policy is designed to ameliorate those early concerns and ensure that founders never have to worry about wasting their time and losing equity in the process.
It’s an awesome and smart move for Techstars in what is becoming a very competitive accelerator market. But it’s also crazy.
Think about it: a living, warm-bodied venture capitalist has just offered his equity stake back to any founder who dislikes his investment. That violates pretty much every sacrosanct principle that the VC industry has, and I can almost imagine the amount of coffee spit out on Sand Hill Road by VCs first reading about the concept. It’s as if your friends Peter and Tom are getting married and the Pope suddenly shows up to officiate. You almost have to do a double-take just to be sure you really are seeing properly and your Burning Man brownie has stopped coursing through your brain.
If this were a one-off deal, we could simply chalk it up to the eccentricities and benevolence of a single investor and continue our belief in the grand normality of everything going on in the startup world these days. But David Cohen isn’t the only investor crazy enough to give back equity to his founders.
It’s as if your friends Peter and Tom are getting married and the Pope suddenly shows up to officiate.
Kent Goldman, who recently launched a new seed-stage fund called Upside, is offering a chunk of the carry (or upside — get it?!) of the fund to the founders he invests in. Carry is the profit made on the investments of a deal, and is usually distributed to the partners of the fund as a performance incentive. Goldman wants to encourage more community among his founders, and thus, he believes that providing a bit of carry to his founders will foster a culture of collaboration across Upside’s portfolio.
And that’s not all, folks! Upside isn’t the only new fund giving up carry, as Binary Capital, a recently launched fund started by Jonathan Teo and Justin Caldbeck, intends to donate a portion of its carry to charitable organizations, mirroring a similar commitment by Andreessen Horowitz a few years ago to donate half of A16Z’s partner income to charity. Binary argues that it focuses on the missions of founders rather than purely metrics, and thus, their carry donation aligns their incentives with this commitment.
Look, innovation here is good, and venture capitalists can and should always be working to improve their relationships with founders. An equity return policy is a nice way to ensure that there is accountability from investors, since they can’t just disappear after the term sheet is signed. Giving founders a chunk of carry provides a monetary incentive for founders to cooperate with each other and develop community within a portfolio. And no one can argue against charitable giving and connecting venture gains with those much less well-off.
But together, these programs are starting to make me a little concerned about the health of the venture industry. If capital has become so plentiful that the only way to distinguish a fund in a competitive market is through these sorts of programs, are we reaching a point of oversaturation?
In short, aren’t we looking at something of a bubble here?
I continue to have mixed opinions. Private valuations of startups have run ahead of the public markets in many cases, which became most evident in the IPO and IPO rumors swirling around Box and Square. But I have also argued that we should be cautious about running to our bubble bunkers, since these steep valuations also come at a time when technology adoption is faster than ever, and startups can thus grow exponentially in heretofore impossible periods of time.
If capital has become so plentiful that the only way to distinguish a fund in a competitive market is through these sorts of programs, are we reaching a point of oversaturation?
While these new programs would definitely seem to indicate that the market has become frothy, what I haven’t seen is venture capitalists giving up as much on the size of their equity chunk, something that Y Combinator’s president Sam Altman has discussed before. Series A investors are still largely determined to net a large slice of equity, often approaching 20 percent or even 33 percent of a business, and that focus on the percentage ownership has driven up the size of rounds. If a startup only needs $2 million, but is valued at $50 million, the vast majority of VCs are going to argue for a larger capital infusion in order to get their equity stake more in line with their investment strategy.
This sort of dynamic is also evident at many top accelerators, which continue to take a mid-single-digits percentage of equity (usually around 7 percent). Greater competition from corporate accelerators and nonprofits that take no equity would seem to be putting pricing pressure on the market.
If these are the signs of the apocalypse, the good news for founders is that the only people truly being harmed here are the VCs themselves. Founders are huge beneficiaries, and most of these new practices don’t affect the limited partners of venture funds, since these programs are coming out of management fees, carry, or both. Even an equity return policy isn’t likely to skew results much, since the assumption is that the worst companies are probably the ones most likely to return their equity since they didn’t grow and thus don’t see the value of the investment.
This is why competition in the capital markets is good. VCs have traditionally been able to work with poor performance for years while getting paid millions of dollars in management fees, a view heavily espoused by the entrepreneurship-focused Kauffman Foundation. With greater competition in the capital markets for startups, being a VC is no longer the cushy and instantly-profitable job it once was. The bar has been raised through these new founder-friendly programs, and the worst VCs are facing a tougher battle everyday not just for returns, but for their paychecks as well.