Venture Capital's Hidden Leverage Problem
What's more leveraged than a leveraged buyout?
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This article is about how venture capital is actually more leveraged than private equity. If you don’t like simplified financial analysis, broad definitions of leverage, and analogies about being impaled, this post is not for you.
Like every venture capitalist in history, from pioneering Arthur Rock in 1961 to your slightly-less-pioneering crypto trading nephew exactly 60 years later, I have an “unconventional path” into venture capital.
Specifically, before venture capital, I was working in private equity. It might not sound that unconventional, but there are surprisingly few people who’ve done both.
I sometimes reflect on the differences between private equity and venture capital:
Suit and loafers vs. Patagonia and Allbirds
Crippling Excel addiction vs. crippling Twitter addiction
Due diligence and analysis vs. “vibes”
Today we focus on perhaps an even more important difference: leverage in private equity is visible, while leverage in venture capital is hidden: most VCs don’t even recognise it.
This, I argue, makes venture capital’s leverage dramatically more dangerous.
Leverage in private equity
In private equity, the leverage is out in the open. The clue is in the name: “leveraged buyouts”.
The leveraged buyout model is pretty simple: buy a company for $100. Pay $50 in equity, and borrow the other $50. If you can eventually sell it for $200, twice the original price, you have to pay back the original $50 (plus some interest, but we’ll forget that), so you get $150 back. Meaning:
The company’s value doubled from $100 to $200
Your equity’s value tripled from $50 to $150
You effectively magnified your return, using leverage.
Now, what happens if things go wrong?
The company’s value halved from $100 to $50
Your equity’s value collapsed from $50 to $0
Clearly, the leverage introduces risk. But importantly, the risk is mostly clear for anyone to see. The CEO, their management team, and most importantly the private equity investor can all see the leverage from a mile away: they initiated it.
This visible leverage acts like a proverbial spike in the investor’s steering wheel: it ensures that accidents are avoided at all costs. Diligence focuses on downside risks, market defensibility, margin sustainability, cash flow yield and other factors to prevent the downside case.
So yes, private equity uses leverage, of course it does. But it is carefully quantified and managed around. It’s a known unknown.
Now let’s turn to venture capital.
Leverage in venture capital
Ask most VCs if they use leverage to inform their investment decisions and you might get a combination of (i) blank stares and (ii) vociferous denials.
Financially, they might be correct to deny this. VC-funded companies don’t take out (shock horror!) leverage. Any VC or VC-backed CEO worth their salt knows that leverage is far too dangerous to include in venture capital.
But I would argue that venture capital is leveraged. Dramatically so. Just with a slightly different definition of the term.
Leverage is, in my view, better defined more broadly than just as balance sheet debt. A broader definition of leverage is that it exists in conditions where, with a given set of inputs, the outputs (positive and negative) are magnified. Financial leverage does this; as we saw in the private equity example above, the addition of financial leverage makes the good case better, and the bad case a lot worse. But other forms of leverage can also exist that have the same impact.
So how does this relate to venture capital? Because there are many, very sizeable, points of leverage, all through the venture capital asset class.
Preference stack: later investors get paid out first, wiping out value of common shares and early-stage investors in downside cases.
Operating leverage: high gross margins and large fixed cost means slower or negative growth has high cash cost.
Momentum investors: investors deploy faster in good markets, meaning funding dries up in poor macro environments.
IPO window: IPO window only opens in good macro conditions, eliminating one of only exit options in bad markets.
Macro impact: Both demand (enterprise and consumer spend) and markets (later funding and exit) deteriorate at same time.
Founder incentives: Founders hold common stock only, creating incentives for additional risk in a downside scenario.
In short, when times are good, businesses tend to grow, momentum investors invest, IPOs bloom, founders shoot for the stars, and preference stacks are laughed off. But when times are bad, they all hit at once.
This is partly why the VC world has been so sensitive to marking down their early-stage investments appropriately. If a company has raised $1b of preferred shares, and its enterprise value is $500m, then the common shares are worthless, no matter how high the last fundraising valuation was. We’re not talking haircuts, we’re talking annihilation.
But there is another important aspect of the points of leverage in venture capital: the fact that nobody recognises it.
Remember our steering-wheel spike analogy about how financial leverage acts to make drivers careful, avoiding hard turns and bumps? This does not apply when the leverage is hidden: in the good times VCs are cruising around the roads with great abandon, with a giant, but invisible, spike pointed towards their chests.
So where does this leave us?
The takeaway here is not that VCs should try to minimise leverage, or reduce their risk exposure. As we established, leverage is a great way to generate returns. To underline the point further, caution is the worst possible strategy in venture capital. Ample history has shown that venture capital funds can only work by generating “upside-volatility”: a VC fund that carefully avoids risk at every turn would be the worst (and riskiest!) strategy of all.
Instead, perhaps the antidote is simply to recognise the risk. When a pre-product market fit portfolio company gets a term sheet for $200m at $1b pre-money, that needs to be understood as adding leverage. When they hire 20 engineers while below $1m ARR, that adds leverage. If an AI company needs to spend $10m training a model, that adds leverage. Expenditures create liabilities. Liabilities create leverage.
None of these are bad things, quite the opposite! They might be absolutely necessary.
But still, when there’s an enormous leverage spike pointing at your chest, it’s probably wise to remember that it’s there.