One of the pillars of capital markets is integrity, as it underpins assurance of investors’ ability to price, invest, and trade in securities at fair value and with timely execution. In the venture capital market segment, no set of standards has yet been widely adopted to guide VC professionals in their conduct, and this is resulting in foundation-eroding doubts about the true value of venture-backed businesses. This session highlights ways investment partners can identify and root out unethical behaviors in their venture capital holdings. Learn more at https://www.ascendstl.com/ethics
TRANSCRIPT
Welcome to the show! We’re going to go fast here because by my calculations, I figure I only have about ten minutes to capture your attention when talking about anything with the word ethics in it.
Summary Disclosure here - super important so be sure to come back to it.
A quick slide on Ascend - we are Data-Centric Tech investors, which means we invest in the Data Economy. We see industries being transformed by the widespread expectation that all decisions should be made based on data, and we back early stage companies that are set to power the data-centric future state of those industries.
How’s it going so far? Well, it’s been a wild summer in the markets. The talk at the beginning of the summer was inflation, then it was no inflation, then transitory inflation, then catastrophic inflation, then back to normal healthy inflation again.
Over the same time period, for retail figures it was all about No COVID and COVID all over again, sadly. Bafflingly this sent the demand for shipping containers and hospital beds soaring at the very same time.
All the while, the US market has been almost invariably up, now up more than 6% for just the summer. It’s crazy! It’s like the S&P got vaccinated against uncertainty.
What I’d like to highlight today that’s a symptom of recent market behavior is the social contract and sadly how it’s failing in a quiet corner of the capital markets. And what I mean by the Social Contract is, after we transact with one another, that I won’t then kill the transacting partner and take their stuff. And what I mean by a quiet corner of the capital markets is Venture Capital.
As if you weren’t already aware, venture capital is experiencing a banner year, capping off a decade of growth at CAGR of 25.9%. Think about that – the market doubled every 3 years for more than a decade.
The space is continually setting and exceeding records:
Assets Under Management surpassed $1.2 trillion in 2020, up 11.6% yoy and is set to exceed that in just the 3rd Quarter this year
The average VC Fund Size surpassed $157 million, up 26% yoy and it already exceeded that in the 2nd quarter of 2021
It’s a great time to be investing in new ventures, with allocations increasing from family offices, corporate investors, foundations, endowments...even hedge funds ...and the rowdy ones, too! You can ask me all about this later.
And because of this booming period, where social contract markets are supposed to be self-policing, where aberrant behavior is rooted out by people who realize it’s not worth it to transact with an unreliable partner – things are different in the venture capital world.
Venture capital has an ethics problem.
Think about how much you rely on the social contract in your day to day as an investor:
When you invest in a stock, you assume the company and/or subsequent investors won’t devalue your stake materially
When you invest in a manager with a unique focus, you expect that you won't end up holding the very same assets as everyone else
When you evaluate a transaction, you expect the transacting partner to conduct themselves professionally and not degrade you in meetings or vanish altogether
And I know what you’re saying to yourself now, because my wife tells me all the time: stop being such a crybaby!
But you know what, we’ve all studied the same materials and passed the same tests. We all know what the standards of professional conduct mean and why they’re important.
Standards like Independence & Objectivity, which assures everyone that our work and our opinions aren’t afflicted with circumstance or bias. Here’s the thing – this isn’t a thing in Venture Capital.
I'll give you an example: startups with female leaders have been found to perform 63% better than others in both returns and time to exit. Everyone knows this in the venture capital world
Given that fact pattern, what % would you expect the funding level for female founders to be in comparison to the overall VC capital market? 60%? 40%? 50%?
It’s 13. 13% of companies with VC funding have a female leader, despite proof of better returns borne out from the data. And the situation is the same for diverse founders, by the way.
How is it possible that so few dollars make it to these promising companies? The answer: demographics. If that doesn’t highlight widespread bias in venture capital, then I don’t know what to tell you.
Here’s another example – Misrepresentation. In Venture Capital we have a problem that’s known as Fund Creep. And I’m not even scratching the surface of the Elizabeth Holmes & Theranos level...yet. That type of creep comes next.
The type of creep I am talking about is scope creep - how later stage funds consistently pluck companies from earlier and earlier stages for their portfolios. This is why what used to constitute a series A deal in 2005 looks very different from a Series A deal in 2021. Here’s an illustration, and stick with me here:
Median angel and seed valuations, the very earliest stages, are around $5-7m right now (to the right of this chart). Moving one stage later, to the Series A stage, we see that a $7m round used to be the median early-stage valuation in 2011 (to the left of this chart). What used to constitute a Series A deal ten years ago is now an angel deal. Now check out the early stage valuations today, at a median of $42m (to the right of this same chart). Compare that to median late stage valuations in 2011, which used to ring the same register. (to the left of this chart) What used to constitute a series C deal is now a Series A deal.
Now I ask you, when you invest in a Late stage manager with a 10 year horizon, do you expect you’ll hold early stage companies in the Series A stage? No way – that would be crazy. But it happens, mostly because it’s been a buyer’s market for so long. In those situations, scope creep is a common problem.
And my final example is Misconduct. And setting aside the malignant behavior that passes for professionality in venture capital, VC is one of the only capital markets in which early investors are segregated from later investors by preferred share classes. The delineation of classes is by stage, and it opens the doors to integrity eroding behavior. For example:
Retail investors, who are typically involved at the angel stage, are segregated from professional investors who typically negotiate later stage, preferred share classes. This means that they can set the deal terms, and because their check sizes are orders of magnitude bigger than retail investors’, they also hold way more voting rights.
One of the ways this plays out is the elimination of pro-rata rights. If an investor purchases 10% of a company’s stock in the angel round, then they may have the right to maintain that 10% ownership stake in later stages to prevent dilution ...and late stage investors hate this because they want to maximize their ownership as a company is de-risked on a company's path to global domination. So what they do is they vote to strike pro-rata rights of earlier-stage investors and dilute them as they please. They squeeze out the smaller, earlier investors.
Does that sound like behavior of a grown up capital market set to thrive in the long term?
By engaging in behavior like this, they’re eroding the integrity of the venture capital market, which is underpinned by the ability for early stage companies to raise capital in the first place. If companies can’t raise money in earlier stages because angel investors have been burned too many times, they simply can’t reach later stages, and there won't be anything for later stage managers to invest in. Moreover, late stage managers often rely on the diligence of earlier stage managers, which is how we ended up with the Theranos debacle in the first place. Want an entertaining moment – look up Elizabeth Holmes’ ted talk and think to yourself how it would factor into your diligence process.
So, venture capital has some growing up to do before it acts like a mature capital market. And you know what? Grown up behavior outperforms. For Ascend, just by treating founders as a professional, maintaining a standard of care for other investors & practitioners, and by doing what we say we’re going to do - we’ve forged ironclad relationships with our founders, earning our way onto the cap table of winning companies, and giving us and our partners access to rarified air and 33% returns since 2015. Taking a stand to conduct ourselves professionally actually helps us outperform. And, we’re still Ascending.
So, venture capital is at a crossroads. On one path, we do nothing and risk:
social backlash
dislocating fundamentals from market value, and
destabilizing the foundation of venture capital market integrity
On the other hand, we do...something. We can choose to act like professionals. Here’s how we can do that. If you're on a team that invests in venture capital fund managers, you can do a number of things – you can hold them accountable. You can hold me accountable! Like:
Having CFAs review the funds in diligence.
Also, you can select venture capital managers who employ CFAs and who encourage their investment team to pursue the CFA charter
Having passed the tests, CFAs know what constitutes an ethical standard for professional conduct. We should be applying this standard to hold Venture capitalists accountable
For insiders, here's what I'm working to promote in the industry: A voluntary commitment to professionality and ethicality. Such a code would provide a framework of what constitutes ethical investing, all while promoting professional behavior throughout the industry. These are the key tenets I propose, which you can also find at ascendstl.com/ethics
If you’re an adjacent practitioner, you’re not off the hook! Here’s what you can do – you can promote the practice of ethical venture capital by:
Following Ascend Venture Capital on LinkedIn
You can learn more on my website ascendstl.com/ethics or by googling “Ethical Venture Capital”
Or you can find a time to talk shop and hold me personally accountable over coffee. Let's just make sure it’s a strong coffee
So, in summary, the venture capital market has an ethics problem. And the key thing to remember here is, we can fix it simply by choosing to act like professionals. And you know what - it outperforms. Thank you for your time. I'm happy to answer any questions.
ABOUT THE SPEAKER
Dan Conner, CFA is the founder and general partner at Ascend Venture Capital, an early stage data-centric tech focused venture capital firm located in St. Louis, MO and the world’s leading proponent of ethical venture capital practices. Dan founded Ascend out of a relentless passion for innovation and entrepreneurship. As a c-level operator at disruptive startups, as a quantamental management consultant, and as an investor in big ideas, Dan has cultivated a career in enabling the future states of industries. Dan is an Olin Business School MBA graduate and holds an undergraduate degree from Yale in mechanical engineering; he also holds a master’s in advanced renewable technologies from Washington University in St. Louis.
Image by Matthew Kosloski