Why VCs deserve more credit than criticisms
One of the neglected truth when making an investment decision is that your trade opponent almost always believes the opposite of what you want to believe in. For instance, when you are buying Tesla shares thinking that it is a good investment that will continue its upward trajectory for many months/years to come, the seller is selling the shares to you because he/she thinks that the share is too expansive and might take a downward turn sooner than later.
It's also true when you are selling. As you can see from Figure 1, the equity market took a nosedive at the beginning of the pandemic and investors were throwing away their investments, thinking that the world is about to collapse. But the reality was that there were investors on the other side of those trades and were buying all those shares from the sellers thinking that its a bargain (and it just so happened that the buyers were correct). And such behaviour happened in the past too. During the 2007/08 global financial crisis, a banker (then my colleague) saw his Bloomberg screen in all red for days and told me that EVERYONE was selling. My question to him was ‘Well, who’s buying then?’
We can also see it happening in the options market, which is more popular in 2020 than ever with about 26.9 million contracts executed on an average day of 2020 or the highest it has ever been in the entire history of the options market (thanks to the market volatility and Robinhood traders). The buyer of a call option enters the trade thinking he/she can make a quick ‘geared’ profit by betting a relatively small amount of premium but what he/she neglects is to question why the option seller is thinking the opposite? On the opposite side, when an investor is selling a call option (a covered call) thinking that he/she is earning the option premium in exchange for a limited upside, he/she rarely question what the motive might be for the counterpart.
This is why some academics call the public capital market (especially the options market) a zero-sum game for the participants and claim that the act of buying/selling alone doesn’t create any economic value to our society. I agree with this and would also argue that the case where a value is created in the capital market is when both the buyer and a seller are entering a trade with the same directional bet. But wait, how can a buyer and a seller have the same directional bet? Seems counter-intuitive right? In fact, however, that’s what happens in many of the private market trades, especially in the early stage of the venture capital market.
In the VC industry, the buyers are the VCs (or GPs acting on behalf of LPs) and the sellers are the existing equity owners (mostly the founders). When a VC makes an investment in a company, in effect, they are buying equity of the company from the founders and both sides are entering the trade with and intention to make the equity value go up. In other words, the interest of the buyer and a seller are aligned and both sides are making the same directional bet. In fact, it is this alignment of interest/direction, along with strong growth prospect, that justifies what seems like (to the public) an outrageous valuation. To me, this is why a large portion of value will be created in the private market for a foreseeable future and the core contribution that the industry makes to our society.
There is however a potential conflict to this and that is when the VCs, more specifically GPs, need to return their funds to their LPs. In other words, there comes a time when even the VCs need to make an exit and realise their gains. One option is to enter the public equity market through an IPO and this is where many critics to the VC industry makes their argument of ‘conflict of interest’ and ‘irresponsibility’ to the public and other minor stakeholders such as employees. To their eyes, VCs are pumping up their portfolio company’s value and ‘dump’ it to the public (or to other investors), pocketing a large profit to themselves. A recent article from The New Yorker: How Venture Capitalists Are Deforming Capitalism points out some truth that many VCs would not want to admit to.
Since I am not a current practitioner in the industry my perspective/opinion should be taken with a pinch of a salt but the problems outlined in the article shouldn’t dismiss the truth of the industry’s role of creating an economic value in the capital market where millions are profiting from a zero-sum game. Sure, it has its problems but so do almost all other industries that exist on earth and as long as the vast majority of the practitioners recognise the problem without forgetting its core contribution and role for the society, it is an industry worth more credit than criticism.