April Fool’s! And… sorry for the clickbait. But I want to draw attention to something that most people probably don’t know: the model that most VCs use to invest in startups today, down to the “two and twenty” structure used by most fund managers, has its origins in the 1800’s whaling industry, dating back to rainy New England port towns. Boston is talked about as the next Silicon Valley — turns out it was also the first.
And here’s the thing: we’re still using the same model today, not necessarily because it’s the best structure, but because it’s how things have always been done.
And in fact, it might not be the best model at all.
(Editor’s Note: Whaling in real life is a serious environmental threat; you can learn more and help out here)
Moby Dick: The Original Unicorn
Before the dawn of electricity, cities powered their streets and lit homes with the most efficient form of energy on hand: whale oil. Long before the days of ExxonMobil, whaling was a wildly profitable industry; according to Harvard professors Tom Nicholas and Jonas Peter Akins (and this great Economist article), returns on investment for a whaling expedition regularly reached three times the return of an agriculture investment (and probably made for a better story for your friends).
Naturally, wealthy families sought to invest in whaling ships. But unlike putting up money for a new tavern or planting a crop, whaling was an expensive pastime. The typical voyage required an up-front investment of up to $30,000 — more than $750,000 today. And the voyages were risky: one in three lost money, and only a few netted huge returns.
In the 1830s, a cottage industry was born: independent agents began to pool money from multiple families, recruit a ship and a captain, and assume responsibility for the voyage. With the help of agents, families were now able to invest in multiple voyages at once. As “limited partners,” they would split any profits with other families, and they weren’t allowed to second-guess the captain’s decisions. Their capital was spread across multiple voyages, so one very lucrative tour could offset the loss of another ship.
Today’s limited partnerships in venture capital use much the same model as these early whaling expeditions, hardly changed from the 1800s.
But it doesn’t end there (bear with me for a little more history). To finance the day-to-day operations of a whaling voyage, the agents developed a structure for who got paid what, and when. At the end of a voyage, the crew would return to port with their whale fat, known as their “carry.” The crew would get 20 percent of the carry (whale meat), with investors retaining the other 80 percent.
Meanwhile, the captain would negotiate a percentage of the whole investment — say, 2 percent — to cover the cost of buying food and supplies for the crew. Investors tried many other business models, but “two and twenty” would carry the day. This “two and twenty” structure would eventually be copied and pasted for investing in startups. Two and twenty management fees are near-canonical in Silicon Valley today, and the term “carry” is still widely used.
If it ain’t broke, don’t fix it?
I’d argue that the process that worked so well for the titans of the whaling industry is causing investors to miss out on great companies today.
For instance: thanks to “two and twenty”, fund managers always make a fixed ratio in fees — two percent — on their assets under management, no matter the size of the fund they manage. The larger the fund, the more money managers make, regardless of whether the companies succeed (the median partner’s salary at the average venture capital firm in the United States is $750,000). So managers have an incentive to build as large a fund as possible.
That’s where the problem starts: if you’ve got a $1 billion fund, you need to decide how to spend large amounts of money very quickly. According to a 2013 World Economic Forum report, it takes the same amount of time to conduct “due diligence” — deep research investigating investment quality — on a $10 million investment as it does on a $100 million investment. And when there’s big money at stake, you’re more likely to go with something that resembles what has worked in the past.
So large investors will almost always go for one larger deal over a number of smaller ones — or, in the case of a tiebreaker, the deal that fits patterns that are easier to understand.
“Two and twenty” is hardly the only structural problem with venture capital today, but it’s one example of an issue that has unintentionally caused many investors to miss out on companies that don’t fit the patterns that venture capitalists like to see (the “warm introductions” from people they know, or the products with “traction” in a hot industry.) Like so much in today’s world, it relies on an unhealthy power dynamic between those with money and those without, and it ultimately hampers the imagination of our innovation economy. But the dynamic persists, because “that’s how it’s always been done.”
Winners and Losers
This 150-year-old investment model encourages massive corporate consolidation and reduces small business dynamism. Who loses? For one, smaller startups. For another, any company that doesn’t fit the traditional patterns that venture capitalists are used to seeing — which often means companies solving complicated, real-world problems in health, education and sustainable energy. It can also mean founders who come from the middle of the country, or don’t resemble the investor or the (mostly white guys) who get the majority of venture capital in the first place.
I have a few ideas about what we can do better. For one, we can explore alternate investment models. One thing that Village Capital has done is to explore alternative financing options for our investments, including revenue share, which my co-founder Victoria Fram wrote about in February — we invested in one company, a fish farming operation in Paducah Kentucky called Fin Gourmet, using this model because it made more sense for their size and their community.
Another idea is to use public policy to incentivize different forms of investment. One idea I’m excited about is “job bonds.”The government pays private investors to develop all sorts of things: stadiums, schools, housing complexes. What if private investors (individuals, foundations, institutions) were to provide upfront cash to entrepreneurs? A “job bond” would work like this: private investors take upfront risk in a company, and they are repaid by government sources out of increased tax revenue (payroll, sales, real estate) based on the company’s growth. If the company creates net new jobs, investors succeed; if it doesn’t, investors don’t.
Finally, we can explore alternative ways that companies can create wealth for their investors and team members. New Belgium Brewing, creator of Fat Tire beer, is a billion-dollar company, what investors call a “unicorn.” A pioneer of the craft brewing industry, you can buy New Belgium most places across the U.S. But founder Kim Jordan didn’t sell the company to Anheuser Busch-InBev or SAB MillerCoors — she sold it to her employees. Today, janitors and receptionists in New Belgium are going to have a comfortable retirement because they own stock in the company. The people producing value in the company are the ones who will realize it over the long term. Founders and CEOs can structure liquidity events creatively like this so if the company is successful, their investors will benefit — but so will their co-workers.
No, we’re not getting into the whaling industry at Village Capital. But in an industry that’s chasing whales and unicorns, a lot of folks are getting overlooked. We are exploring different ideas to rethink how VC works. If you have others, I’d encourage you to share them in the comments below, or get in touch with me at ross@vilcap.com.
Ross Baird is CEO of Village Capital. Learn more on our website and read our insights on Medium.