Felix Salmon

I read quite a lot of papers about finance and investing, but I can’t remember the last time I came across a 52-page paper which I simply devoured, avidly, reading every word, and even following the footnotes. But such is the latest publication from the Kauffman Foundation, a truly wonderful report on the foundation’s own experiences in the world of venture-capital investing. This is required reading for all institutional investors with any kind of exposure to VC, and I sincerely hope that it succeeds, at least at the margin, in forcing those institutional investors to behave a bit more like investors, and a bit less like chumps being bullied into throwing millions of dollars into a series of opaque black boxes delivering decidedly subpar returns.

The Kauffman Foundation was created to encourage entrepreneurship; its endowment currently stands at some $1.83 billion. Of that, $249 million is invested in VC and growth equity funds; the foundation has been investing in VCs for 20 years now. As a rich, long-term institutional investor devoted to the cause of early-stage companies, the Kauffman Foundation is — or should be — pretty much the perfect LP as far as VC funds are concerned. And indeed, over the years, it has invested in 100 such funds, and therefore now has a spectacular real-world backward-looking dataset of VC returns from an LP perspective.

This is the kind of dataset that money, literally, can’t buy: VC funds’ investment agreements have such tight confidentiality clauses that Kauffman and other institutional investors would never be allowed to share this information with anybody else. But by anonymizing their data, and by self-critically coming clean on their own returns from venture capital, Kauffman’s investors have managed to put together a detailed and compelling report with a very simple conclusion: venture capital is not much of an asset class, and insofar as it is an asset class, it’s very, very broken.

Over the past 20 years, net of fees, Kauffman has been paid out 1.31 times, on average, the amount that it invested in any given fund — well below the standard “venture rate of return” of twice committed capital. The payout is meant to come after no more than 10 years, but the 10-year figure is honored mainly in the breach: Kauffman alone has 23 funds more than 10 years old, and eight funds more than 15 years old. One fund, at age 19, still retains more than 20% of the capital that Kauffman committed way back in 1992.

Here’s the bigger picture: the total amount returned by all of Kauffman’s funds. The red line is at that 1.31x average multiple:

This is very much a short-head, long-tail dataset, with the short head having high returns and the long tail being decidedly disappointing. What’s more, the really high returns in this chart — the ones which achieve that “venture rate of return” of 2x committed capital — come exclusively from funds with less than $500 million committed: something which is very rare among top-tier VCs these days. What’s more, most of them also come from funds raised before 1995. If VC funds were good investments once upon a time, they’re not any more:

In reality, VC returns have been dismal for the past 15 years:

During the twelve-year period from 1997 to 2009, there have been only five vintage years in which median VC funds generated IRRs that returned investor capital, let alone doubled it. It’s notable that these poor returns have persisted through several market cycles: the Internet boom and bust, the recovery, and the financial crisis… In eight of the past twelve vintage years, the typical VC fund generated a negative IRR, and for the other four years, barely eked out a positive return.

I’m all in favor of investment strategies which display low-volatility returns, but only when those returns are actually positive; in reality, according to this report, the average VC fund returns less money to investors than they invested in the first place.

The Kauffman report makes a very strong case that the best way to look at VC returns is to benchmark them against a liquid public stock index: they like the Russell 2000 small-cap index. If you do that, you get a chart which looks a bit like this. The x-axis is PME, or public market equivalent: if a fund is lower than 1, as most of these are, then you would have been better off just investing in the Russell 2000. And while there are certainly funds which massively outperformed that index, in order to get that kind of performance you really need to invest your money before 1995, to take full advantage of the dot-com bubble.

Given the high fees and the illiquidity and the inherent risks of venture-capital investing (the Russell 2000 can’t go to zero, a venture fund can), it’s reasonable to expect a venture fund to return at least 3% per year over and above the Russell 2000. Using that metric, 78% of the funds that Kauffman invested in have failed. And remember that Kauffman has more access to the top-tier firms than most VC investors.

But the really interesting thing about the Kauffman paper is that it doesn’t blame the VCs for this underperformance. Instead, it pins the blame squarely on the LPs — the investors who irrationally invest money with VCs.

The first thing they do is have a “VC bucket”, which then turns them into “bucket fillers”. VCs love bucket fillers, because an LP with a bucket is an LP with no ability to invest in something better instead, like the Russell 2000.

GPs we interviewed are very aware of “bucket filling” behavior, and said LPs with VC mandates act like the money is “burning a hole in their pockets.” They just need to spend it. Institutional investors governed by mandates presumably attempt to get into the ten to twenty top-tier VC funds; but if they can’t, they’re left to choose from second- and third-tier funds—a strategy that nearly guarantees returns unlikely to exceed a low-cost, liquid, small cap public index.

If you look at the performance of VC funds during the golden years of 1986-1999, it turns out that once you strip out the top-performing 29 funds, the rest — more than 500 — collectively invested $160 billion, and managed to return $85 billion to investors. If you can’t get into one of the best funds — and everybody knows which funds those are — then there’s really no point investing in venture capital at all. But what happens is that some investment board looks at VC returns inclusive of the best funds’ returns, and then mandate a certain investment in VC which assumes they’ll have some kind of access to those top-tier funds. And that’s an extremely dangerous assumption to make, because most of the time it won’t be true.

The second thing that LPs do is that they pay VCs to raise lots of money, rather than pay them for returns. Most of the income in the VC industry comes from the 2 bit of 2-and-20, rather than the 20 bit. Which means, as the report puts it, that “while a select group of VCs remain focused on delivering great investment performance to their investors, too many are compensated like highly-paid asset managers.”

As such, these GPs have every incentive to exaggerate early-year returns in their funds, despite the fact that the whole point of the way the funds are structured is to allow long-term investments which don’t pay off until many years down the line. Here’s the most astonishing chart from the report:

What you’re looking at here is the self-reported returns from all 100 of the Kauffman foundation’s funds, plotted on a time zero axis. In theory, if you believe the VC industry’s hype, the returns should look a bit like the green line: negative in early years, as you make investments which won’t pay off for a long time, and then positive by year 10.

In reality, reported returns peak very early on, in month 16 — which just happens to coincide with the point at which the GPs tend to start going out on sales calls, trying to raise their next fund. (The blue line shows total fund returns, while the red line shows returns net of fees — the money which actually goes to LPs.) Of course, at month 16, none of the returns are realized: they’re driven instead by increases in portfolio-company valuations, and those valuations are set by the GPs themselves.

If GPs were incentivized mainly by their 20% performance fee, then you’d expect something like the green line, or at the very least you’d expect the performance to rise over time, as the fund’s illiquidity premium manifested itself. If GPs were incentivized mainly by their 2% management fee, however, then you’d expect something much more like the real-world red and blue lines, where performance figures are used more to raise new funds than to make money.

Here’s how the report explains GP math:

Data from the Foundation’s portfolio indicate that the median time to the first capital call of a subsequent fund is 26.6 months. As a thought experiment, assume a VC partnership raises a $250 million fund. Early in year three, exhibiting early positive IRRs, the firm raises a subsequent $350 million fund. Demand for Fund III remains strong, and the GPs raise another $500 million fund later in year five. Each new fund adds a fresh income stream to the residual fees older funds continue to generate over the ten-year life. Without visibility into the firm financials, LPs don’t see the total cumulative management fees the firm receives, and, more importantly, don’t know where those fees go. In this theoretical example, a moderately successful VC firm raises three smaller-sized funds within the investment period of the first fund; and the operating income climbs to more than $19 million by year five. Our experience would indicate that VCs may somewhat increase fixed costs like additional staff with subsequent funds, but in most cases expand very conservatively.

The Kauffman foundation has lots of bright ideas about how this misalignment of incentives could be fixed: for instance, investors in VC funds could ask for much more transparency on the costs of running those funds, pay a budget-based management fee instead, and then pay a performance fee which rises sharply when the fund genuinely outperforms the public markets. For instance, it could be 20% when the public markets are outperformed by 3%, 25% if the outperformance is 5%, and 30% if the outperformance is 7%.

Ian Charles ran an intriguing experiment in 2008, when he asked LPs how much of a performance fee they would be willing to pay to get into a top-performing, $250 million fund. He got bids as high as 72.5%, and a market-clearing level of 42.5%. Clearly it’s possible, in theory, for top VCs to charge much higher performance fees than they’re charging right now, and some of them are OK with budget-based management fees, too.

But here’s the weird thing: it’s the LPs, much more than the VCs, who are averse to any change on the compensation front. Investors, it turns out, are extremely conservative, and don’t want change even if it’s in their best interest.

One startling fact from the report explains why that might be the case:

Our own casual review of institutional private equity investors reveals median job tenure of around three years. There is much turnover at the LP investor level, which creates little incentive for any one investor to fight hard on behalf of their institution for better economic terms, especially if they are not getting paid for that outcome and views such behavior as harmful to industry ‘relationships,’ which the investor likely will find beneficial in landing their next job.

What this says to me is that the VC industry, as a whole, is being incredibly successful at extracting rents from dumb institutional investors. These investors wouldn’t dream of investing in a public company where there was no transparency as to basic questions like how much money the principals were being paid, but they happily invest in venture capital funds where the founders cream off so much of the income that younger top performers end up leaving the firm. And in general, VCs are incredibly good at playing fear off against greed: would-be investors really want massive VC returns, and they really don’t want to be left out in the cold. Even Kauffman does that: “We have chosen to stand down on terms,” they write, “when faced with an investment decision in a top-tier fund.”

The big picture, here, is that an enormous number of institutional investors are still chasing VC returns which haven’t really existed in the industry since the mid-90s. So long as all that money is chasing a relatively small number of opportunities, and especially now that valuations for early-stage tech companies are going through the roof, the chances that the average LP will make any money at all in VC are slim indeed. Venture capital is sexy, and it makes a lot of money for GPs. But investors need to take a very hard look at the asset class, and ask whether it’s worth it from an LP perspective. After reading this report, they should probably conclude that it isn’t.

Investor Chamath Palihapitiya wrote a strongly-worded letter to Airbnb CEO Brian Chesky yesterday, which promptly got leaked to Kara Swisher.

Palihapitiya was given the opportunity to invest in Airbnb’s latest round, but declined, partly because of the way it’s structured. Airbnb’s executives are taking $31 million in cash as part of the deal, and Palihapitiya was actually OK with that. But his problem was that $22.5 million of that is coming in the form of a dividend — which makes it look pretty evil, in an early-stage company where many employees only have options.

“If you want liquidity, that’s fine, but you should make it available to everyone,” wrote Palihapitiya, adding that “dividends are an approach used by cash rich operations to distribute excess earnings”.

In case Palihapitiya’s point isn’t clear, let me explain with a much simpler company, with just two founders and one new shareholder.

Adam and Bill set up a company — let’s call it Bubbl. The way the structure is set up, Adam has 1 million shares in Bubbl, while Bill has 1 million options to buy Bubbl stock at $1 per share. Bubbl is successful enough that potential investors start circling, and eventually a deal is done whereby Charles will pay $1 million to buy 200,000 shares at $5 per share.

Historically, such a deal would be pretty simple. Bubbl issues 200,000 new shares, which are sold to Charles for $5 each. And so after the investment, Adam still has his 1 million shares, Bill has his 1 million options, and Bubbl has $1 million of cash in the bank. Working on the assumption that at some point Bill will exercise all of his options, Adam’s stake in the company has gone down from 50% to 45.45%, since the total number of fully-diluted shares outstanding has risen from 2 million to 2.2 million.

Adam’s now worth $5 million on paper: he owns 1 million shares which are worth $5 apiece. And he owns 45% of a company with $1 million in the bank, so in a sense he has $450,000 in cash. But he can’t spend that cash — it belongs to Bubbl, not to Adam. The problem is, Adam wants to buy a nice house. And Bill, too, likes the idea of making some fast cash. So instead of doing this kind of old-fashioned deal, Adam and Bill decide that they’re going to do a cash-out deal instead.

Charles still buys 200,000 shares at $5 each, but Bubbl doesn’t issue any new shares this time. Instead, Adam simply sells Charles 100,000 of his 1 million shares. And Bill exercises 100,000 of his 1 million options, buying 100,000 shares at $1 each and immediately selling them to Charles for $5 each.

At the end of all this, there are still only 2 million fully-diluted shares outstanding. Adam owns 900,000 of them, which gives him the same 45% stake. But he also has $500,000 in cash. Bill has 900,000 options, and $400,000 in cash. And Bubbl has $100,000 in cash, which it got paid by Bill when Bill exercised his options.

Now, let’s take our first step into the world of evil, and suppose that Adam doesn’t feel any particular need to look out for Bill’s interests. Bill isn’t a shareholder yet: he just has options. So instead of letting Bill exercise some of his options, Adam decides to sell the full stake to Charles himself. His shareholding drops to 800,000 shares, he gets $1 million from Charles, and he ends up with a 40% fully-diluted stake in the company, compared to the 50% stake that Bill will have when he exercises his options.

Adam’s choices here are pretty clear. He can make sure that Charles’s $1 million stays in the company, take no cash for himself, and end up with a 45.45% stake. He can put just $100,000 of Charles’s money in the company, take $500,000 of it for himself, and still end up with a very similar 45% stake. Or, he can take all of Charles’s $1 million in cash for himself, and end up with just 40% of Bubbl.

Or, Adam could get really evil. This time, Bubbl issues 200,000 shares to Charles in return for $1.2 million. Bubbl then has $1.2 million in the bank, and distributes all of that money to its shareholders, as a dividend. Now remember that Bill only has options: he doesn’t have any shares. The only shareholders, right now, are Adam, with 1 million, and Charles, with 200,000. So Adam gets $1 million of the dividend, while Charles gets $200,000 of his own money back.

The net result for Charles is the same: he’s spent $1 million in total, and received 200,000 shares. But Adam is sitting pretty: he has 45.45% of the company, plus $1 million in cash.

This is a much better option, for Adam, than the other three: he manages to maximize his fully-diluted shareholding in the company, and get $1 million in cash. Adam has cashed out, here, but has also kept all of his shares: a classic case of having his cake and eating it. And Bill, of course, gets nothing: no cash, and no cash in Bubbl’s bank account, either. In fact, he’s been diluted. If Adam just sold some of his shares to Charles, then Bill would retain his 50% stake in the company after he exercised his options. But this way, Bill gets diluted down to a 45.45% stake.

Essentially, Adam is taking money from Charles, and he’s taking equity from Bill. At least Charles is getting something in return: Bill isn’t.

Which explains what Palihapitiya was thinking when he wrote this:

I would implore you to not take the easy way out. Treat your employees the same as you’d treat yourself. Do things that you will be proud of and can defend to anyone including your Board, employees, prospective hires etc. In such a competitive hiring market, you are competing with not just your obvious competitors, but also any successful tech company who is also looking for great talent. A principle that treats your employees as well as you’d treat yourself is a huge strategy for differentiation, retention and long term happiness of the exact types of people you will need to be successful. In contrast, if you are viewed as self-dealing and shady, it will only hurt your long term prospects.

It was only two months ago that Chesky was forced to grovel to the public, admitting that he had “really screwed things up” when a woman’s apartment was ransacked by Airbnb guests. He’d learned, he said, that “you should always uphold your values and trust your instincts”. One’s forced to wonder, given the structure of this latest round, just how long that lesson lasted.

Update: Palihapitiya has now written a follow-up letter to Kara Swisher, “prepared in discussion with Chesky and Airbnb’s board”, in which he says that he will participate in the round after all, in return for promises from Chesky to allow employees to cash out in future. In contrast to the original letter, it’s full of jargon (“strategic intent to balance employee and founder liquidity which will align long term interests”) and seems to represent the triumph of greed over principle.

Steven Davidoff has published two recent columns on l’affaire Skype. The first takes a familiar position: that Silver Lake isn’t evil, it’s just a private-equity shop. I would however take issue with this:

The easy lesson here is the need to carefully read contracts before you agree to them and hire a lawyer if you don’t understand them. The language Mr. Lee complains about was certainly legalese but heralded caution.

Remember the language he’s talking about here. It’s one sentence of an 11-page stock option grant agreement, buried in a paragraph about IPOs:

If, in connection with the termination of a Participant’s Employment, the Ordinary Shares issued to such Participant pursuant to the exercise of the Option or issuable to such Participant pursuant to any portion of the Option that is then vested are to be repurchased, the Participant shall be required to exercise his or her vested Option and any Ordinary Shares issued in connection with such exercise shall be subject to the repurchase and other provisions in the Management Partnership agreement.

Yes, this is legalese. And what’s more, it doesn’t actually explain what Skype is doing; it just refers to some other, presumably equally unreadable, agreement. But here’s the thing: if you did read this sentence carefully, it still wouldn’t raise any red flags. Because it looks very much like something which is standard practice in Silicon Valley: when you leave a company, you need to exercise your vested options very quickly — normally within three months. If you don’t, then the company can claw them back.

So when Davidoff says that Lee’s failure to carefully read his contract is “baffling,” he’s being too harsh. Even a careful reader would have missed this one. And that’s why Skype was evil. If they’re going to have aggressive clawback provisions in their contract, they shouldn’t bury them in incomprehensible legalese: they should be open about what they’re doing.

Davidoff followed up his first column with a second one which only served to make everything worse. The headline: “Skype Not Alone When It Comes to Options.” And here’s the little summary you get in your RSS feed:

Silver Lake may have imposed a greater penalty, but LinkedIn, Google and others in Silicon Valley have similar requirements for vested options.

Um, what? This is simply not true. Silicon Valley standard practice is clear: you have every opportunity to exercise your vested options when you leave a company. Skype took that opportunity away. That’s not “similar” at all. Being able to exercise your options when you leave is always better than not being able to exercise your options when you leave. It has, if you’ll excuse me, option value. But Davidoff contrives to believe that standard Silicon Valley options language “is no worse than the legalese in the Skype documents that Mr. Lee complained about”.

He’s doubly wrong here. For one thing, standard Silicon Valley options language, while not exactly plain English, is still vaguely comprehensible. It gives a clear deadline of three months after you stop being employed at a company, and says that options expire at that point. On the saying-what-they-mean front alone, Silicon Valley companies win here.

And more substantively, those companies are giving exiting employees the opportunity to share in some of the growth they’ve helped to achieve.

Davidoff is underwhelmed:

This provision forces former employees to exercise their options while the company is still private and the true value unknown. In addition, the fair market value of the option may be very low and at or near the exercise price. It certainly isn’t at the initial public offering price.

Given the risks involved, employees are likely not to want to pay the exercise price out of their own pocket.

It’s hard to know where to start here. Silicon Valley companies might be private, but that doesn’t mean they’re unvalued. They tend to raise multiple rounds of capital at steadily increasing valuations; if you’ve stayed at the company long enough to see a new fundraising round, then automatically your options are in the money. And increasingly equity in these companies is priced on private markets like SecondMarket and SharesPost. It’s true that the price of the equity isn’t the IPO price, but then again the price of a company’s equity is almost never the IPO price. (Employees in Pandora, for instance, are unlikely to get the IPO price for their options, even after it has gone public.)

And certainly options are risky assets. Everybody in Silicon Valley knows that. When you leave a company, you have a 3-month-long opportunity to buy stock in a private company at a level which is probably a very good price. Many people in Silicon Valley would jump at that opportunity, especially if they’re senior enough that they have a bunch of cash lying around. Certainly some employees will pass. But that’s the employee’s choice. It’s clearly better to have the choice than to not have the choice.

Yee Lee thought he had the choice — and decided he wanted to exercise his options. He knew the rules, knew he had to make his choice quickly, and made that choice. He informed Skype’s HR department of what he wanted to do, in a more than timely manner — and then spent a month going back and forth with them, before learning that Skype was refusing to let him exercise his options at all.

Davidoff’s second column seems to be aimed at unnamed “commentators” who don’t understand Silicon Valley standard practice, and who think that vested options can be held in perpetuity after you’ve left the company. That’s not the case. But that hardly makes Google as bad as Skype. Not even close.

One of the least convincing and most annoying arguments against investing in index funds is the idea that if everybody did it, then the stock market wouldn’t be able to efficiently allocate capital any more. Well, yes — but there will always be people picking and buying individual stocks and funds. That doesn’t mean that you and I should count ourselves among their number.

Mike Arrington, today, repeats a very similar argument when it comes to angel funds:

Very few angel funded startups end up very big or interesting. “An entire generation of entrepreneurs are building dipshit companies and hoping that they sell to Google for $25 million,” lamented a venture capitalist to me recently. He believes that angel investors are pushing entrepreneurs to think small, and avoid the home run swings. And you don’t get a home run unless you swing hard, he says. When you play it safe you nearly always lose…

Some venture capitalists think that this “think small” attitude is driving entrepreneurs who may otherwise build the next Google or Microsoft to create something much less interesting instead, and then everyone loses. No IPO. No 20,000 tech jobs. No new buyer out there for the startups that don’t quite make it.

And without those occasional but huge exits, the entire ecosystem can fail. Venture firms need big returns to raise new funds. Without venture money a lot of the innovation in Silicon Valley would end.

So in effect, the argument goes, the angel investors are like a quickly growing cancer. Without radically invasive surgery, Silicon Valley will eventually flatline.

All of this doom-mongering is based on the existence of angel funds adding up to $200 million, tops, when you put them all together: chump change compared to the kind of money that the big VC firms control.

It is true that as barriers to entry in the tech space get lower, that reduces the amount of money that entrepreneurs need, and can result in venture capitalists being left out of the funding equation altogether. Doesn’t your heart just bleed.

But the idea that an uptick in angel-backed companies will result in fewer huge successes is just silly. Yes, it’s possible that angel-backed companies are happier with smaller exits than their VC counterparts. But if the VCs see an opportunity there to become the next Google, they’re more than welcome to buy the company themselves: they certainly have $25 million lying around to do just that. More realistically, VCs can certainly take over as and when original investors feel like cashing out, just as public stockholders take over when VCs cash out in an IPO.

Reading columns like this, though, does make me a bit more hopeful when it comes to the tech startup scene in second-tier cities like New York. In California, it seems, the funding architecture is incredibly rigid and inflexible, and any threat to that architecture is met with wails of pain. The rest of us, I think, are lucky to live in a world with a bit more optionality when it comes to funding. And who knows — maybe in the future starting an online company will be so cheap that it can be done entirely on debt, with no equity investment at all. That won’t help the people dreaming of getting rich through getting lucky with tech investments. But it might well help company founders avoid a lot of the poisonous funding politics that Arrington talks about.

I just found Tony Hsieh’s astonishing book excerpt in Inc, entitled “Why I Sold Zappos“. It makes for very sad reading. Hsieh starts by explaining that he never wanted to sell to Amazon:

Our hope was that we’d eventually go into all sorts of other businesses. We saw Zappos as a global brand like Virgin — except whereas Virgin was about being hip and cool, Zappos would be about offering the best service. The plan was to grow sales to $1 billion by 2010 and eventually go public.

But then Amazon came calling again:

As before, our plan was to stay independent and eventually go public.

But our board of directors had other ideas. Although I’d financed much of Zappos myself during its early days, we’d eventually raised tens of millions of dollars from outside investors, including $48 million from Sequoia Capital…

By early 2009, we were at a stalemate. Because of a complicated legal structure, I effectively controlled the majority of the common shares, so that the board couldn’t force a sale of the company. But on the five-person board, only two of us — Alfred Lin, our CFO and COO, and myself — were completely committed to Zappos’s culture. This made it likely that if the economy didn’t improve, the board would fire me and hire a new CEO who was concerned only with maximizing profits. The threat was never made overtly, but I could tell that was the direction things were going…

I left Seattle pretty sure that Amazon would be a better partner for Zappos than our current board of directors.

Essentially, Hsieh never wanted to sell, but Amazon was a less-bad option than sticking with the bean-counters at Sequoia, who never really signed on to Hsieh’s philosophy:

Some board members had always viewed our company culture as a pet project — “Tony’s social experiments,” they called it… The board’s attitude was that my “social experiments” might make for good PR but that they didn’t move the overall business forward. The board wanted me, or whoever was CEO, to spend less time on worrying about employee happiness and more time selling shoes.

The tensions between Hsieh and his board (for which read Sequoia GP Mike Moritz) were reported by PE Hub at the time, and then dismissed by the NYT; it seems PE Hub was right. This is a lesson for anybody who takes VC gold: VCs always have an eye on their exit, and they usually want it more quickly than the founders do.

Still the tensions can’t have been all that bad. After Zappos was sold to Amazon for $1.2 billion in Amazon stock, the team which had fought to keep it independent — Tony Hsieh and Alfred Lin — stayed on at the company. Until, in April, Lin announced that he was leaving. To go to Sequoia Capital. I wonder how closely he’ll be working with Moritz?

(Via)

This is where the blogosphere comes into its own: Gerry Langeler, a venture capitalist, takes to Dealbook to try to defend the crazy way in which most of his income is taxed at the 15% capital gains rate. And then James Kwak reads his piece, comes down with an acute case of Siwoti, and delivers a textbook fisking of what passes for Langeler’s argument.

This might be the first point at which I’ve actually seen an MBA put to good use:

Langeler can’t tell the difference between a founder and an investor. To start off, what does it mean to say that founders are “leveraging our money”? The concept of leverage only applies to debt. VCs invest by buying convertible preferred shares, which are a form of equity, not debt.*** They are buying a share of the company, and they get all the upside on that share. That’s not leverage. Seen purely from the standpoint of the capital structure, VC investments dilute the founders. Granted, the company is getting something valuable — cash — in exchange for that dilution. But it’s giving up some of the upside. That’s the opposite of leverage.

There’s much, much more where that came from: go read the whole thing. It’s overwhelmingly probable that you agree with Kwak already: I have yet to find a non-VC who thinks that VC incomes should be taxed at 15%. But you’ll still learn a lot, both about the economics of financing startups, and about the art of putting together a great blog post.