500 Startups Founder: Venture Capitalists Are Lazy and Don't Innovate

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As LinkedIn’s New Economy Editor, I talk to a lot of people who love venture capital. A lot.

The investing class known for backing hyper-successful startups like Uber, Airbnb, Dropbox and more, VC is almost deified in Silicon Valley. People working in startupland follow the moves of their favorite venture capitalists like fans follow their favorite celebrity. What these guys (and a few gals) tweet is revered. What they write is seemingly immortalized. 

Dave McClure is not one of those people.

The founder of 500 Startups, McClure runs a seed fund and startup accelerator with $250 million in assets. Unlike traditional VCs who only make a handful of big bets a year, McClure makes lots of small ones. He aims for 500 investments a year and in total has backed more than 1,500 startups with funding.

McClure thinks this model of investing will not only yield better results over time, but he also thinks it’s the model that everyone will follow in the future. In his mind, if the private investing markets are going to survive, they have to diversify their investing portfolio just like McClure has.

Rather than deify the strategy of the big-name VC firms on Sand Hill Road, McClure has a different opinion entirely – and he isn’t afraid to voice it.

“Most venture capitalists are lazy and not innovative,” McClure said last week on a panel discussion at the Milken Institute Global Conference. “They take meetings, play golf, and make two investments a year. We are surrounded by entrepreneurs who are innovating, and we are this shitty little asset class that is not changing.” 

After the panel, I caught up with Dave to get the story behind this explosive comment and the many others he made on stage.

Edited excerpts:

Caroline Fairchild: You said on stage that venture capitalists can’t really innovate. Do you really think that?

Dave McClure: There are not too many innovators in venture capital. What is maybe the myth is that VC is doing fine, but it is actually pretty shitty in its level of maturity and expansion, and there is going to be a lot of disruption in venture as people scale other models faster and better. As much as I think Sequoia, Benchmark, and Accel will have 20 more years before their models are questioned, there are a bunch of other firms on Sand Hill Road, which will have shitty performances because they are doing the same old, same old. As much opportunity is going on in the industry, we are still pretty poor at our craft. The reason the asset class hasn’t gotten bigger is because three out of four VCs do not beat the market. It is a structural problem around how people think about building portfolios and structuring VC. There are better ways to structure the asset class that will perform better. We are getting there, but it will take some time to scale.

CF: What’s the biggest problem with how venture capitalists structure their portfolios?

DM: Mostly portfolio construction is too concentrated. The industry thinks that 30 companies is proper portfolio construction, but they are absolutely wrong. Just because some outliers are successful does not mean that the rest of the industry is full of shit. If you increase portfolio size by five to 10 times, your portfolio will perform better. In five to 10 years we will realize that we are right. It will be the minority of funds that have concentrated portfolios, not the majority. People are saying we are doing “spray and pray” and say that is kind of funny and crazy. It is mathematically quantitative. You are the losers who are doing the non-mathematical model, but they haven't realized it yet.

DM: What opportunities does your investment strategy open up for you?

CF: It gives us a lot more flexibility. We pioneered a different model. When I started investing as an angel and at Founder’s Fund, I made a lot of little bets. Most of them didn’t work, but some of them worked really well. We wanted to scale that strategy. That generally is working very well. Between 2 to 3% of our portfolio will become really big, another 5 to 7% will become modestly big. It is basic math. If I only find the unicorns 2% of the time, the portfolio should be a minimum of 50 to 100 companies. For more statistically significant results, the portfolio should have 200 to 500 companies.

CF: So why is everyone so obsessed with venture capital?

DM: People have seen some pretty big wins. Those wins are capturing more and more of the value chain by not going public. Companies would go public at $200 million dollars, now companies at $2 billion or $5 billion are not going public. Private markets are capturing all the value creation. People talk about companies not going public as the problem. That is not the problem. Pricing is the problem. Those companies are kept private because private capital is greedy to invest in those companies and capture that value creation. They will definitely figure out how to price it because they will make money. 

CF: What’s going on with the funding market right now?

DM: People are trying to compare right now to 2000 and 2001, which is absolutely not what is happening. They are also trying to compare it to 2008 and 2009, which isn’t really what is happening either. There are people who are pulling back on capital deployment. They are going to be more specific and stingy on valuation, but 2008 and 2009 wasn’t a problem for companies producing interesting products. There was a lack of capital access and some companies that had been structured for growth had to figure out how to get back on a budget. The metrics changed to breakeven and cash flow positive as opposed to growth. There wasn’t a problem with the industry’s approach to growing companies then and there isn’t a problem now except that some companies were gorging themselves on easy money and they won’t be able to diet themselves quickly enough. 

CF: You said on the panel that you wished the economy was as bad as it was in 2008-2009. Why did you say that?

DM: We still would have funded Twilo and Credit Karma if the economy was doing well, but they would have been more competitive deals at twice the price. We might not have gotten in or gotten our returns cut in half because of the price. The market right now is not falling down around our ears. Yes, there are going to be some tough times around the corner as companies try to raise money at valuations that they probably can’t sustain. There will be down rounds and people running out of company and broken unicorns. That is part of the process, that is us just figuring out pricing.

CF: Theranos famously had no big venture capitalist backers. Do you think the company would be in such a tough spot if it did?

DM: People are criticizing Theranos as a venture capital mistake when it wasn’t. I can’t predict the past, but I would guess that with venture capitalists on the deal, it wouldn’t have been a $9 billion mistake; it would have been a $90 million mistake. Zenefits or WeWork potentially are things I am more worried about than Theranos. Theranos in my mind is an outlier and a bad outlier. Zenefits was a company that has an interesting business model, but got a little ahead of itself. They had to make a bunch of changes, but they still have an interesting business. The question is can Sacks [David Sacks, Zenefits’ new CEO] execute that business so they can raise money at the current valuation or better.

CF: Half of your team is female and non-white, and a third of your investment team is female. Why is diversity important to your investment strategy?

DM: I am a greedy bastard. We are arbitraging racism and sexism for our own selfish benefit everywhere we possibly can. Where people are foolish racist or sexist, we are taking advantage of investing in those opportunities as much as we can. People are mis-pricing the market. I think Sequoia and [other big VC firms] will still be successful, but I am not waiting around for them to hire a black female founder. It is not going to happen anytime soon. We have to solve these problems out of greed, not guilt. Yes, I want to do the right thing too, but that is not my strategy for building the fund. It is stupidly basic. It is an opportunity for us. If the rest of the market takes their time figuring it out, great, I am going to take more of that market before they realize it.

Update: This post has been updated to reflect the growth in 500 Startups' assets under management.