
VC Insanity, Explained - xyzzyrz
http://www.danshapiro.com/blog/2010/08/vc-insanity-economics/
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lionhearted
It's an insightful explanation - the structure of funds, expectations of LPs,
common practices in the industry, and reputation concerns lead to some
incentives that are logical for a VC to follow, but perhaps inoptimum.

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einhverfr
So it also explains why so many VC's do not want businesses to bootstrap.

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jonmrodriguez
Why is there no recycling? It seems like a no-brainer to for the LP to allow
recycling, so maybe I'm failing to see some perverse incentive that would
exist if recycling were allowed?

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danshapiro
There is actually some recycling allowed, as described in the "disclaimer"
section. But the reason is interesting:

Many organizations that invest in VCs are extremely efficient, analytical
operations. They model each investment in their portfolio carefully.

Imagine you are considering playing blackjack at a $1-per-bet table. You start
with $100. You play well, so you expect to end up with about $97, since with
good play, the house edge is about 3%. Two hours later, all your money is
gone!

Did you lose every time? No. But you re-invested the proceeds of each game,
and that modified your return expectations.

Similarly, when VCs have unlimited re-investment, it plays havoc with their
investors' return calculations. Also - separate issue - if you re-invest late
in a fund's life, you increase the odds that the fund closes up shop while it
still has a bunch of active companies in its portfolio.

So while it's not prohibited outright, it's often restricted, and knowing that
can help you understand certain behaviors.

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draggnar
> It’s 10x return on what they reserved to invest – a bigger number that takes
> in to account the total amount they predicted you’d need over the course of
> your company’s future

Does anyone know of any examples where a VC did not allow a sale to happen
because they were going to do another round? The argument here makes logical
sense but I have never actually seen an example of this.

~~~
apenwarr
It's not "because they want to do another round." They don't necessarily want
to give you the extra money, but the final amount of their return _does_ need
to be a multiple of the number they could have invested, not the number they
did invest.

Thus they need your company to grow more than you might think they do, and
they could block a sale in the hopes that will happen. If you end up needing
more investment after the sale has been blocked, that's fine, because they
have money in reserve, but actually giving you the money is not the
overwhelming motivation.

~~~
draggnar
That makes sense. Is sales being blocked by investors a common thing?

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pge
Articles like this, which paint VCs with perjorative stereotypes (e.g. "Golf
games get abbreviated.") are not helpful. As long as you consider the VC an
"other" - a different species from you, you won't be able to work
constructively with one. Anytime we paint another group of people as an
"other" whether because of race or culture or whatever, we do our selves a
disservice and encourage conflict and misunderstanding. We're all people, and
we're all pretty much the same.

A VC is just an entrepreneur whose line of business is money management
instead of software development. If you want to understand the differences
between money management and software development and what that means for how
VCs try to build a successful business in that industry, go talk to VCs. But
approach the conversation as a peer and fellow entrepreneur, not as someone
trying to understand an alien.

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patio11
I'm hearing echoes of my liberal arts education in that first paragraph. For
what it's worth, if you otherize the VC but understand what 2 and 20 means,
you will successfully predict the behavior of a VC much, much, much more often
than someone who has a deep personal relationship on a human level with his VC
but who does not understand the math in this post.

This is not a hypothetical. Many entrepreneurs have become friends with
entrepreneurs-specializing-in-money-management before. Then their friend e.g.
blocks a sale (want to hear a story about that? Find any five experienced
people in the Valley -- I think you'll hear about three) and the entrepreneur
is dumbfounded. This was not dumbfounding behavior -- it is predictable like
the sun rising in the east.

~~~
pge
Totally agree- I didnt mean not to understand the incentives, I just meant
don't paint all VCs as a group as having a certain set of values or goals.
Everyone, whether VC or entrepreneur, acts in response to a combination of the
incentives in front of them and the rewards they value. If you understand a
person's goals and the incentives in front of them, you can often predict what
they are going to do reasonably accurately. Whether entrepreneur or VC, some
people want a lifestyle business; some people want fame; some people want
fortune; some people want to solve hard problems; some people want to create
meaningful change in the world; etc. Different industries offer different ways
to achieve any of those goals with varying levels of risk.

By all means, do everything you can with any business partner, whether a
colleague, a VC, or a potential acquirer to understand what their goals are,
and what behavior they are incentivized towards in their effort to reach that
goal.

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alok-g
Previous discussion:

<http://news.ycombinator.com/item?id=1598728>

