Jan 14, 2022
VC and the “Real” Economy: Growing Fast or Growing Strong?
Sequoia, one of the most illustrious VC firms, recently announced a momentous change to how they structure their fund(s) and their business. Some claim that “Sequoia Capital will no longer be a venture capital firm,” others claim that it is “blowing up the VC fund structure,” and of course no 21st-century reporting is complete without that tired but ubiquitous metaphor of the “game-changer.” These effusive reports are right for the wrong reason.
The big change at Sequoia is actually two changes:
- Whereas most VC funds run for ten years before the limited partners (LPs, read: investors) get their money back, Sequoia is packing all their funds into one big continuous fund. They’ll be constantly investing, paying out, and reinvesting.
- Whereas most VC funds chase the “exit,” when they sell the equity of their portfolio companies — often in an IPO — , Sequoia is going to remain invested after the IPO and perhaps even help organize the IPO like a traditional investment bank.
These changes do bring a few benefits. For example, they’ll add firepower to a firm trying to compete with private equity operations with hundreds of billions under management. They might also help institutional investors to invest for longer periods — perhaps over generations — without incurring a capital gains tax hit. Reinvestment becomes a more obvious choice.
But it’s easy to overstate the magnitude of these changes. Sure, Sequoia is going to have to write up new terms for their LPs and collect a lot of signatures. But these new changes deviate little from VCs’ actual practice.
The new fund’s unlimited duration is not revolutionary because all VCs already think and act as if their funds were continuous. We’re always watching for potential LPs because that’s how we raise money, and we’re always watching for potential investments because that’s how we make money. As one fund’s ten-year run draws to a close, we’re already busy convincing our LPs to reinvest a portion of their return on the next fund. And that next fund is likely to include many of the same companies.
As professional athletes know, there is no off season, just a break to prepare for the next game.
The same applies to Sequoia’s shift into the public markets. Thanks to the rapidly maturing secondary markets, private companies’ equity is far more liquid than it used to be, and VCs can acquire it right up until the IPO. And thanks to SPACs, VCs can also help their portfolio companies go public with a reverse merger and profit from it. Even if a portfolio company wants to go public without a SPAC, companies like Roblox and Coinbase have proven that direct listings, which largely obviate investment banks, can be wildly successful.
So Sequoia is going to invest perpetually and manage exits. So what? Capable VCs do that all the time and have been for decades.
Less Velocity, Stronger Foundations?
Chips are in short supply and have been for months. The global chip shortage now has its own Wikipedia entry. Beyond chips, there is a global supply-chain crisis across a range of industries.
Any bright teenager knows that prices rise when supplies diminish. There is big money to be made in fixing supply chains and chip production. But you won’t find any VCs biting. Why not? Why is venture capital leaving this money on the table?
What’s keeping VC at bay is the same reason that software is eating the world: software’s unparalleled ROI, which is another way of saying it has negligible marginal costs.
The beautiful thing about software is that it might only cost a few million to develop a great app, a few million more to prime the marketing engine, and then network effects take care of the rest. Producing another copy or another billion copies of an app costs effectively nothing. The marginal cost is asymptotic.
Industries that rely on physical plant and materials can also be very lucrative. Despite some recent difficulty, Intel is worth four times as much as Klarna, a unicorn and secondary-market darling. A.P. Moeller Maersk, a leading global shipping company, is worth about twice as much as Epic Games, the studio behind the wildly profitable Fortnite.
From the perspective of traditional VC fund structure, the difference between the software companies and the ones that rely on real hardware, like silicon foundries and ships, is the velocity of their growth, which is itself a function of those asymptotic marginal costs. Even though Facebook wouldn’t exist without Intel’s chips, Facebook grew to Intel’s $200 billion market cap in about a decade (the 10-year fund run!), but Intel needed closer to 50 years. Building a shipping company worth $55 billion took about 120 years. Reproducing ships, containers, and factories is much harder than recopying an app.
Like velocity, most indicators of VCs’ performance capture a change over time. The change is the growth in the market cap, user base, profitability, revenue, or whatever, and the most relevant time interval is ten years.
By abandoning the ten-year cycle, Sequoia is omitting the denominator, they’re freeing themselves from standard indicators. Sure, in order to do this, a VC firm would need a global brand that allows them to evade the comparison with other funds using standard indicators. Only a handful of VCs can pull that off. Sequoia has that freedom, and it could be put to good use. A continuous fund could help to profitably retrofit the “real” economy, on which the digital economy and its financial infrastructure depend.
The Real Wake-Up Call
It’s easy to overstate the import of Sequoia’s move. They remain venture capitalists doing venture capital. It does, however, give us all an impetus to reconsider our investment strategies, to think strategically about the economic conditions for our success rather than just maximizing each investment’s return. By omitting the temporal denominator from the equation, Sequoia is shifting the focus from how fast they’re moving to how far they can travel.
