Venture Capital and the Mixed Blessing of Exclusivity

As in dining, there is great variety in equity investing. Big institutional investors, like university endowment and pension funds, sometimes have their own investment staff. These are like live-in chefs. Every gigayacht should have three. Then there are the financial advisors in strip-malls hocking mass-market investment products on commission. They help keep the public markets liquid, and the world needs them. But in the dining metaphor, these guys are microwaving lasagne at a chain restaurant.

In between those extremes are those whose services are exclusive, but not restricted. These are the Michelin-star chefs, whose restaurants are open to anyone with the disposable income and connections. The investment equivalent is venture capital. VCs don’t typically accept money from the masses, but we don’t serve single clients either; we serve classes of clients who meet our criteria.

In short, VC is exclusive, and that exclusivity is a mixed blessing.

Mixed, yes, but I cannot stress “blessing” enough. (Image: Michael Heuser)

Is that a fact?

To understand why exclusivity is a double-edged sword, consider two kinds of facts. The first, brute facts, are independent of any person or community. For example, hydrogen is the lightest element, and it would be regardless of whether anyone ever measured it. The second kind, institutional facts, are only true because people believe them to be. For example, there are 50 states in the USA. That’s indisputable, but it’s only true as long as we believe it and act accordingly. If all life vanished, languages and baseball teams would go with us, but lightspeed would remain constant.

Although many of us in the VC community like to consider ourselves calculating, analytical, dispassionate types, brute facts are virtually irrelevant to our business. Our livelihood relies almost entirely on institutional facts, on what we believe everyone else believes.

And like most people, we VCs pay the most attention to the people closest to us. The other VCs, LPs, and founders we interact with shape our world and beliefs. We consider the latest announcement to be important because our peers do too, we know how to behave at a pitch meeting because of our community’s implicit rules, and a startup is worth as much as we collectively agree it is.

Each maverick more individual than the last. (Image: Brian McGowan)

It’s a small world after all

Institutional facts depend on communities, but those communities can be very large (e.g. the whole world agrees that Canada exists) or just two people (e.g. an inside joke with your BFF that nobody else would understand).

The VC community consists of only a few thousand firms, which is orders of magnitude smaller than the hundreds of millions who own publicly traded stock. Being effectively a small, distributed, single-purpose town has its advantages:

• Perhaps the biggest advantage is quick, efficient communication. Like air traffic controllers, we have our own jargon. We know that most LPs care more about IRR than AUM and that a good SAFE can prevent a recap.
• As in a small town, news travels fast. Everyone in the community will know about the down rounds and new post-money unicorns before they happen.
• We establish and change consensus fast. Good ideas can become standard doctrine in months, and bad ones can be dropped within weeks.
• We can afford to be selective. There is broad agreement about what qualifies candidates to join our community, and we can keep those standards high and restrictive. We admit few fools, and those few don’t last long.

But as anyone who’s lived in a small town knows, such dense social networks bear costs, and VC is no exception.

Venture Cultists

The first disadvantage of being such a small, tight community is unavoidable: VC is pretty insular. Sure, VCs can be cosmopolitan; many travel the world regularly, speak other languages, and maybe even be (im)migrants ourselves. Still, we spend most of our time with other VCs, founders, LPs, and people who generally went to the same schools and see the world in roughly the same way. And sometimes our beliefs about what other people believe can suffer as a result. Is anybody out there clamoring for Web3?

The second disadvantage is a special case of the first: groupthink. Everyone lives in their own reality of institutional facts, and the smaller that reality is, the more the world outside can contradict it. Our portfolio companies are worth as much as we say they are until some external force says otherwise. Theranos was a decacorn, and many of us believed it. It was an accepted institutional fact … until it wasn’t.

There’s another kind of insular community with their own institutional facts that don’t always jibe with the outside world: cults. It’s only after centuries that the rest of the world agrees to respect their weird, particular facts and call them “religions.” Cults can be innocuous (e.g. Trekkies, crossfitters), bad (e.g. terrorists), or — theoretically — good (TM devotees? cyberutopians?).

Giving VC the benefit of the doubt, I’d say that our cult is fundamentally benign. We and the beliefs we act on are as good or bad as our investments’ effects.

The catch, however, is that our investments can multiply effects in both directions dramatically. At some threshold, quantity can swamp quality. Love or hate Facebook, Google, and Spotify, we built those with relatively modest means.

Behold: the entrance to the secret society. (Just kidding: it’s really the walk-in cooler in a juice bar in Palo Alto) (Image: Stefan Steinbauer)

The Take Home

If VC is a small community with its own institutional facts, there are three take home messages to consider:

1. If you’re on the outside, lurk more. As with any community, you must learn the language and customs before you’ll be accepted.
2. If you’re on the inside, don’t fall in too deep. Check your intuitions against the outside world regularly. Talk to people outside Silicon Valley once in a while.
3. We must all think twice. The magnitude of our actions is inescapable. As it says in the Bhagavad Gita, “A person does not attain freedom from action by abstaining from action; nor does he attain fulfillment merely through renunciation.” We must act, and our actions will have effects. Let us be wise and the effects mild.