The Lynx White Paper

Don't Go Alone; the Death of Traditional Venture Capital

American venture capital has the allure of a long and storied history, with its roots intertwined with some of the great original American families, such as the Rockefellers, the Whitneys, and the Morgans. The term “venture firm” has a nearly mythological weight behind it, and carries a sense of institutional certainty that implies it operates with godlike efficiency, combing through a massive number of startups to hand-select only the ripest and strongest companies. Some of the key players such and Sequoia and Benchmark have enjoyed long-standing returns that would back this sentiment up, but the truth is venture capital is still very much in its infancy, less than a century old in its current form and very much still operating on “well if it worked once” foundations that have not been adapted in the decades since inception. In fact, many of the adaptations to the early venture firms occurred within the past few decades. In an age where institutional money lacked a structure and an interest to facilitate these early investments in private companies, titans of industry and their families would be the largest sources of startup capital throughout the 19th and beginning of the 20th century. It wasn’t until the end ofthe second world war that we saw money being raised from institutional sources outside of large family trusts, creating what we would recognize as traditional venture capital firms. One of the first major venture players, American Research and Development Corporation (ARDC) was founded in 1947 by a then star-studded team, including both the Chairman and President of MIT, a member of the federal reserve board, and a Harvard Business School professor General Georges F. Doriot, who is often referred to as the father of venture capital. Although ARDC was founded with the modest goal of promoting private businesses run by soldiers returning from the war, it is widely recognized as the first non-family-backed fund to secure a major venture win, purchasing a whopping 77% of Digital Equipment for $70k in 1957, going on to realize a 3,905,000x return over 14 years as the company ballooned to a $355 million valuation. The scale of returns achieved by some of these early firms, along with the continued success of once family-trusts turned venture firms, such as Venrock (Rockerfeller) and J.H. Whitney (Whitney), built serious excitement for the new asset class as more and more investors were willing to accept more risk in exchange for the higher rates of return. Arthur Rock, a student of Doriot’s, was one of the first to hop on this new way of investing, and was instrumental in one of the venture capital poster moments when he secured funding to help “the traitorous 8” break away from Shockley Semiconductor Laboratory to create Fairchild Semiconductor. Despite not knowing it at the time, this turned out to be a truly monumental moment in venture capital for a variety of reasons. Firstly, and oddly least important, Fairchild Semiconductor was an absolute runaway financial success, scaling to annual revenues in the hundreds of millions of dollars within its first five years. The unintended ramifications of Fairchild would far exceed the annual revenues, however. Fairchild’s transistors were far superior to anything that existed at the time, and their decision to put four transistors on a single silicon wafer was the catalyst that drove major computing breakthroughs that would follow for decades to come. Fairchild’s success also gave its founders along with Arthur Rock a unique opportunity to invest in other technology based startups that were popping up all around them. Together, they formed Davis & Rock, California's first venture capital firm in what would become, poetically, Silicon Valley.

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The richness of Silicon Valley’s history speaks for itself, with some of the world’s largest and most innovative companies coming out of the area, such as Apple and Google. Less known however, is how the massive success shared between an almost incestuous group of players created powerful empires in the form of large venture capital firms. Sequoia Capital, still to this day one of the largest and most successful venture firms, was founded by a Fairchild salesman and is a perfect example of the amazing amount of power that was consolidated by so very few. As denoted above with ARDC’s investment for 77% of Digital Equipment, the early stages of venture capital were incredibly investor friendly. These larger players had the power to dictate terms to startups looking for capital, creating a take-it-or leave-it style of negotiating with founders. These early players consolidated much of the total available capital investment for startups and dominated the startup-investing landscape of the 1960s, 70s, and 80s, with little to no innovation occurring during that period. This slowly began to change in the 1990s as the internet became increasingly more mainstream. The internet created a massive increase in thenumber of venture firms as well as available capital for two reasons: firstly, information Lynx Ventures became much more available and transparency in early-stage investing increased, which greatly reduced the existing barriers to entry. The second and more obvious reason was the skyrocketing valuations of dot com companies created a near frenzy for investors looking to punch their ticket to fortunes previously only enjoyed by the families of the original titans of industry. Despite a large correction at the end of the decade that brought most valuations back down to earth, wiping out some of the smaller venture players, the shift in supply gave founders more avenues to capital, creating choice and giving founders more power than ever previously enjoyed.

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The next innovation in the venture world came in the following decade after the dotcom collapse. On the back of increased power and choices for founders, venture funds began adapting their “take-it-or-leave-it” strategy in favor of pitching their “unique” value-add to founders. These original value-add pitches were largely based around the previous success of the venture firm, or the ability of some of the key players at the firm to offer guidance and support to founders. This strategy was inherently more successful for the long-standing power players in the industry, with proven track records in companies that had since IPO’d at insanely high multiples. Newer venture funds without this track record needed to innovate or be forced to take second and third pick of the hot new startups looking for capital. Their solution was to bring talent in-house for the sole purpose of leveraging that talent in their pitches to startups. These venture studios now had the potential to offer full services to their prospective startups, and cover any of the services not able to be covered by an employee of the startup. Cost structure of these studios prohibits the accumulation of talent needed to satisfy every need in the very niche startups fields that exist, but it was enough to be able to compete with some of the large players who were limited to offering general advice along with their capital. Later these studios, especially those targeting very early stage companies, began offering incubators. Giving startups with little more than an idea an office and a framework to take their idea from the back of the napkin to a fully fledged company. These incubators, later rebranded to accelerators, helped create some of the most successful startups of the 2000s and 2010s, such as Airbnb, Coinbase, and Reddit.

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Despite being the vehicle that is used to fund disruption, there has been little advancement in the venture capital industry since the introduction of the venture studio, Lynx Ventures especially that meaningfully improving founders power. The notable exception to this came out of the wildly successful accelerator Y Combinator, whose startups have generated over 2000 successful exits. Early stage companies are notoriously hard to price, with no generally accepted method existing, especially for startups that are pre-revenue. Arguing the valuation of what is essentially just a PowerPoint was an incredibly subjective process, with investors being wary off the back of the dot com collapse. Y Combinator found an ingenious way to solve this problem by launching the SAFE (Simple Agreement for Future Equity) Note, which deferred agreeing to a valuation until it was decided by investors in a later fundraising round, compensating investors for this delay by giving discounts on the future valuation or agreeing to cap the valuation at certain levels. The current fundraising landscape for founders still functions in a largely inefficient way, with the core process relatively unchanged in the almost 100 years since traditional venture funds came into existence. Changes to laws, especially those concerning crowdfunding, have created a few additional channels for founders to raise capital, but crowdfunding in general is still largely impractical with startups needing to have extremely proficient marketing capabilities to even entertain the idea of attracting hundreds if not thousands of retail investors. The core issues of traditional fundraising can be boiled down to a few overarching points. Firstly, founders, who often excel at creating a product or service, usually are not the best capital allocators. So not only are founders forced to take a massive amount of time away from creating their product to fundraise, they are then forced to spend an equivalent amount of time finding service providers to hire that can help deliver on the aspects of their business not covered by their in-house team. Secondly, those service providers they find have misaligned incentives right fromthe start. The highest quality service providers have already been priced out by 99% of startups, with their rates being far above the budgeted level. Startups can only elect to work with these providers at the serious detriment of their runway. The service providers left are also in a position where it is economical to take as much out of a startup up front as possible, as statistically they will not be around in a year’s time. In addition to the high cash cost the vendor does not have any material benefit in seeing the startup succeed outside of continued revenue. The summation of these issues means going above and beyond is not feasible for most providers. Lastly, investors lose a massive amount of potential returns to markups on services. If a startup raises a million dollars it will likely Lynx Ventures spent around 600k on external service providers. On the extremely conservative side these providers are marking up their services only 30% from cost, meaning that investors are spending 18% of their total investment supporting the bottom line for external service providers.

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In light of these issues, there is an opportunity to create a more efficient and successful system for fundraising by leveraging stakeholder interests in a way that aligns everyone's interests with those of the startups. The SWEAT (Simple Work for Equity under Agreed Terms) Note expands on the innovation of the SAFE Note by creating a structure for service providers to share in the investment and upside at the point of fundraising. Although work for equity is not a new idea, there has been no framework to streamline and govern the process of these deals under generally accepted terms. This lack of structure has handicapped the wide stream adoption of this type of investment vehicle. Following the protocols outlined by the SWEAT note and the supporting documents provided by Lynx, venture investments can take a radical step forward to improve the existing levels of efficiency. The SWEAT Note gives vendors the opportunity to share in the upside they help create, and more importantly puts a premium on service providers finding unique ways to drive value in the startups they partner with. Eliminating venture capital firms as the single source of capital will drastically reduce the barrier to entry associated with starting a business. More importantly, these strong partnerships will increase the chance of success for startups which is beneficial for all parties involved. Investors not only get to take advantage of these higher percentage opportunities, but get to take an immediate win by creating ROI at the time of investment due to the elimination of markups on services.

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