Almost one year ago I wrote a wildly popular Idiot CEOs article that highlighted my affection for the crucial role of visionary CEOs at early stage companies, and how instead they are foolishly made/forced to believe that the directives from the company’s board (mostly VCs) will guide them to success.

That article was meant to protect CEOs from making mistakes and set things right from the start. So it is now a year later in which my understanding and affection for the role of Limited Partners (LPs, the investors in Venture Capital firms) is voiced in contrast to those LPs who continue to support the dysfunctional VC arbitrage in the Venture ecosystem (see our primer).

This article is meant for those LPs who do not want to earn the adjective “idiot”.

Invest at “your own” risk

More important than the easy harping on “the money-men” is the serious realization that investing in venture by LPs, knowing how the VC arbitrage works today, is truly the definition of insanity. Simply put, the way VC works today cannot and will not lead to scalable performance the LPs are betting on and worse, implodes our ability as an economy to create sustainable innovation that can improve our lives, and will erode the dominant role of the United States in it.

Limited Partners (and their boards) and the Public markets are lulled into a false sense of security by Venture Capitalists (VCs) who primarily blame deplorable venture performance on the malaise in the macro-economy, which we have debunked many times. And so Limited Partners should heed the warnings in this article, and if they do not take deliberate action to investigate their actual deployment of risk are going to lose much more than they already have.

Change you must believe in

As many aspects of the technology sector have changed and having met as many VCs as I have over the years, you will realize they have not changed along with it.

– Market access has changed
About 30 years ago, Venture relied on a small and proprietary market model to drive insular innovations that each relied on nothing but itself to carve out a market. A lot of critical success factors have changed since then, and the Internet has all but evaporated the luxury of monolithic access to markets and a straightforward and private way of addressing it. Today’s buyers of technology have many more (often jarring) options, which has dramatically increased competition and forces VCs to understand and support the complexity of hybrid market models, unique product experiences, social economic value and a clear understanding of what drives value beyond simply being there first.

– The technology stack has evolved
Technology has become more pervasive in our lives, albeit more than 80% of the worlds population still does not use the internet for meaningful applications. Usage has evolved from the office to everyday lifestyle, with more demanding user experiences as the impetus to buy. No longer is the value of Intellectual Property (IP) simply defined by the ferocity of the many lines of proprietary software code, but by how the proposed user experience uniquely crosses (and hides) the complex boundaries of code, content, distribution, relationships, marketplaces and hardware. Simply put: no longer is the value of the spark plug more important than the value of the car. Producing code is no longer the sole testament of the ability to deliver groundbreaking value.

– Risk and returns have systemically deflated
As Paul Kedrosky (author of “Infectious Greed”) alluded to at the Milken Conference panel, “old VC brands are dead”. But not for the reason most people think. Counter to what VCs make their own investors believe, investing in Venture has become even more of a specialty and harder, not easier and certainly not cheaper. Fear and the inability of incumbent VCs to change, have forced many VCs to continue to invest using the old Venture model in a market and with technology that has fundamentally changed. Twenty years of VC resistance to change has already turned Venture investing into a subprime sector in which micro-PE (micro-Private Equity) risk deploys no more than micro-PE returns, regardless of the state of the macro economy. And worse, it has attracted developers who think of themselves as entrepreneurs when they feed the VC’s micro-PE hunger.

– The VC demi-cartel has no way to detect innovation
As technology is getting more competitive, global and evolves faster than ever before, the current demi-cartel consisting of VCs with a single (outdated) investment thesis that heavily relies on syndication (i.e. consensus) with fragmentation of dollars and deflation of risk to support innovation is counter productive to the economic indicators that are pointing the other way. With ten levels of risk diversification and deliberate price-setting, Venture has become the systemic rollover of the car business, and in need of a overhaul of standards and requirements. Real innovators do not engage with venture anymore, and leave VCs alone with their self-induced and spiraling down subprime investment malaise, patiently waiting for it to break and reset itself completely.

– The grass is not greener
When life gets harder only mediocrity walks away in search for greener pastures. I too believe in a more responsible and greener world, just not with Venture Capital as the financial instrument to drive it. Mediocre VCs are exactly those VCs who successfully sell that the Venture model founded on the fluent economics of technology, blindly applies to every other “feel-good” growth sector, which subsequently lands more LP support and therefor a longer stay in the derivatives investment business. No other asset class than technology venture provides more immediate and effective economies of scale for creation, distribution and adoption of value, that is if as a VC you can define the compass of real value.

Super Pimps

To continue the corollary from Idiot CEOs and based on the fascinating HBO documentary Pimps Up, Hoes Down referenced in the article, idiot LPs are the Super Pimps who believe that the premise of investing in venture, knowing how VCs treat and detect entrepreneurs will continue to deliver outlier returns.

For intelligent LPs, who like many smart rich people continue to write their own checks and get involved in how the rubber meets the road, a wonderful future of returns still lies ahead in technology venture. LPs need to invest in understanding the whole venture ecosystem, and be able to challenge the risk models VC deploy in order to make the smart choices that come with great returns. And today’s smart choices are not yesterday’s.

But those LPs who by virtue of the deployment of a defunct venture market model, stale VC experience, and a venture cartel treat entrepreneurs like Hoes, will get and deserve nothing more than they have for the last ten years.

[Editor’s Note: George cross posted this at VentureCompany. –mrh]