Time to Rethink Venture Capital: Why the Industry’s Investment Paradigm Could Shift from Unicorns to ‘Rhinos’

Nowadays, venture capitalists like to follow a ‘grow-at-any-cost’ approach to create the next unicorn — while this approach can help VCs realize exceptional returns, it can also be counterproductive not only for VC firms but also for the industries in which their portfolio companies operate

Photo credits: San Diego Zoo

Common venture capital wisdom suggests that most portfolio companies will not yield the returns required for VCs to make money. The usual return distribution is the following:

• 50+% of a VC’s portfolio yields a return that is below the invested amount (i.e., cash is burned)
• 30–40% of the portfolio yields a return that is above the invested amount but rather negligible (i.e., “1x-3x” in VC lingo)
• Less than 10% of the portfolio yields an exceptional return (i.e., 10x, 100x, 1000x)

Even without doing the math, we can see that, on average, 90+% of portfolio companies do not yield exceptional returns. Therefore, VCs have always sought to invest in unicorns — companies which are valued at $1bn and not yet publicly traded — that generate exceptional returns to offset the losses of failing portfolio companies. The strong focus on unicorns is logical, but the quest for finding unicorns has developed into an unhealthy competition that could rather harm many industries instead of reshaping them for the better.

Why so? Since the emergence of the dotcom bubble in the late 1990s, the recipe for success for new ventures has been market dominance. Especially in the tech industry, network effects are the main drivers of profitable growth and the emergence of unicorns, such as Google, Facebook, and Amazon. Hence, a winner-takes-it-all attitude has become the synonym for success among founders and VCs alike. However, this paradigm implies that ventures which have the best idea and operate most efficiently will not necessarily prevail. Instead, “the company with the most funding wins” (Duhigg, 2020, para. 19). Recent studies highlighted the consequences: “Money-losing firms can continue operating and undercutting incumbents for far longer than previously [and] are destroying economic value [by undermining sound rivals and creating] disruption without social benefit” (Kenney & Zysman, 2018, p. 5).

“The more that rumors spread about WeWork’s predatory tactics and odd culture, the more [WeWork] was courted by venture capitalists” — Charles Duhigg (2020)

Let us consider a concrete example: WeWork. In his recent article, Charles Duhigg not only described the predatory practices of and the lack of good governance at WeWork but also outlined how VCs played a crucial role in nurturing the company and its questionable business practices. “The more that rumors spread about WeWork’s predatory tactics and odd culture, the more [WeWork] was courted by venture capitalists” (Duhigg, 2020, para. 22). This example shows that Silicon Valley VCs and investors from abroad — most notably Softbank’s Masayoshi Son — “decided to deliberately inject cocaine into the bloodstream” (Duhigg, 2020, para. 21) of WeWork and other high-risk companies that had no sustainable business model. This investment strategy increasingly diverges from the principles of early-day VC investors, such as Tom Perkins (founder of the VC firm Kleiner Perkins), who focused on well-run, innovative young firms that had the potential to change industries and society for the better.

Are VCs becoming increasingly greedy? Do not get me wrong: Achieving a sufficiently high return is critical for any VC fund. In fact, 95% of VC funds are not even profitable. VCs are under enormous pressure as they must achieve a decent return for their investors — the LPs — even before the end of a fund’s life (typically: 10 years) to be able to raise cash for future funds. Furthermore, the increase in the number and size of funds has led to declining returns as “all [VC firms are] looking at the same deals and trying to persuade the same coveted entrepreneurs to accept their investment dollars” (Duhigg, 2020, para. 19), putting additional pressure on VCs to find high-return investments. Yet, by injecting enormous sums of cash into their ventures to make these the dominant companies in their field, VCs increasingly run the risk of promoting eccentric and undisciplined behaviors of entrepreneurs, creating precedents like WeWork.

Therefore, it is time to rethink venture capital. One way of doing so could involve shifting the investment paradigm from creating unicorns to spotting ‘rhinos’ — a term coined by Nick Nash and Oliver Rippel, founding partners of Singapore-based Asia Partners. Rhinos are humble young companies with sustainable business models that are highly robust and create long-term value. Three trends support this paradigm shift. First, VCs are increasingly looking for resilient business models as “the fear of missing out [FOMO] on that next Facebook rocket ship is starting to be replaced by actual fear of losing money” (Accel Venture’s Rich Wong in USA Today, 2016, para. 5). Second, the current pandemic will likely weed out business models that have little/no substance, serving as a strong call for VCs to focus on more sustainable ventures. Third, investment research has shown that companies with sustainable business models often outperform their peers in the long run. While paradigm shifts do not happen overnight, this new approach could help VCs rediscover their roots: Providing funds, advice, and a network to startups with innovative and resilient business models that not only yield high returns but also make society better off.

A personal note: I would like to thank Frédéric Herold for his outstanding support and the valuable insights that he provided for this article.

References and further reads:

• Antler VC Cast, Episode 3 (2020). “Navigating through crisis with Nick Nash & Oliver Rippel”.
• Asia Partners (2020). “Winter has Come — The Rise of the Snow Rhinos”.
• Carson, Biz (2016). “’The great reset’: Venture capitalists and startups have shifted from greed to fear”. Business Insider.
• CNCB Interview with Nick Nash (2019). “We don’t look for unicorns, we look for rhinoceroses: Asia Partners”.
• Dean, Tomer (2017). “The meeting that showed me the truth about VCs”. Techcrunch.com.
• Duhigg, Charles (2020). “How venture capitalists are deforming capitalism”. The New Yorker (November 30, 2020 issue).
• International Monetary Fund (2019). “Global Financial Stability Report: Lower for Longer”.
• Harris, Aaron (n.d.). “Why VCs push companies to burn too fast”. Y Combinator.
• Kenney, Martin & Zysman, John (2018). “Unicorns, Cheshire Cats, and the new dilemmas of entrepreneurial finance”. Venture Capital — An International Journal of Entrepreneurial Finance, Vol. 21, Issue 1, 2019, pp. 35–50.
• Kleiner Perkins — Mission & Ethos (2020).
• Mandano, Laura (2016). “This is the ‘great reset’ in tech valuations, says Accel’s Rich Wong”. USA Today.
• Mulcahy, Diane (2013). “Six myths about Venture capitalists”. Harvard Business Review (May 2013 edition).
• Simon, Morgan (2019). “Greedy VC doesn’t pay: But impact does”. Forbes.