The latest move announced by Sequoia Capital, one of the world’s largest venture capital firms, whereby it will be transformed into a new fund based on an open-ended liquid and evergreen super-fund model - is a necessary step, and provides a solution to what so many venture capital investors have said: the accepted model, which has existed for so many years, of a closed fund, with no tradability and with a pre-set end date - is a complicated and limited model. Entrepreneurs and investors in Israel have also seen the need for the new model, and searched for ways to solve existing restrictions, and some say they beat Sequoia to a potential new model.
The limited liquidity and short-term nature of funds using the classic VC structure have become major disadvantages. As the high-tech market matures, we have witnessed the growth of unicorns and exits by companies that sometimes required more time to mature than planned. The fund’s time limit becomes more and more problematic and forces these considerations to sometimes override companies’ business judgement. Now more than ever, the move to the evergreen model seems to make sense: a model in which fund managers can invest and accompany successful companies over time, based on each company's performance, and not according to the predetermined life span of the fund, which is very difficult to change.
As both Sequoia and we ourselves see things, the best current model for managing venture capital funds is that of a dynamic fund, which manages to adapt itself to a changing world and offers transparency to investors.
The basis of the structure of the traditional venture capital funds is the fund’s set life cycle, which is usually 7-10 years, and this has become a limiting factor. The Sequoia Fund addressed this directly in the article in which it unveiled the new structure of the planned fund: "Ironically, innovations in venture capital haven’t kept pace with the companies we serve. Our industry is still beholden to a rigid 10-year fund cycle pioneered in the 1970s... Once upon a time the 10-year fund cycle made sense. But the assumptions it’s based on no longer hold true, curtailing meaningful relationships prematurely and misaligning companies and their investment partners. The best founders want to make a lasting impact in the world. Their ambition isn’t confined to a 10-year period. Neither is ours."
Ultimately, an organically maturing industry needs yield cycles that are longer than a decade. Investors need to build their relationship with companies and founders based on investment maturing timetables, and not to be dependent on the limitations of a no longer relevant fund structure.
In effect, the global venture capital industry has continued to rely on the basic assumptions of the traditional fund structure that was first outlined in the 1970s, and which has remained unchanged since. Roelof Botha, a partner at Sequoia, put it well: "As chips shrank and software flew to the cloud, venture capital kept operating on the business equivalent of floppy disks"
The solution - and some challenges
One of the solutions to the conflict of interests between founders and fund managers regarding the fund’s life span is the creation of an evergreen liquid venture capital fund. This is exactly the model developed last year at the Tel Aviv Stock Exchange in conjunction with the Israel Securities Authority for the issue of public R&D partnerships, effectively constituting the next generation of venture capital funds. The Tel Aviv model of public R&D partnerships effectively creates an evergreen fund, which improves on the traditional VC structure and also generates liquidity for investors, as the partnership is traded on the Tel Aviv Stock Exchange. Being a public company goes hand in hand with transparency and strict supervision of the fund’s activity, which is another important benefit for the investors. As the fund’s shares are liquid, investors can buy or sell shares at any time, and so the fund managers have no pressure to exit an investment after a predefined period of time in order to repay the investors.
In the old model, when, for example, there is a negative market when the fund needs to return money to investors, the fund must realize its holdings at a time that is not optimal for its investors in terms of potential financial returns, and sometimes pushes a portfolio company into a sale or public offering at an inopportune time.
An additional advantage of an evergreen fund is that it creates an investor with deep pockets, one who can continue raising money into the same fund and repeatedly invest in the successful companies from the portfolio as they grow (unlike the model of the old funds, which in many cases does not allow two funds to be invested in the same portfolio company).
The new structure of partnerships creates new challenges: the traditional calculation of carry fees, the fund managers’ (the general partners, or GP) success commissions, which are traditionally calculated at 20% of the fund’s surplus gross profits, need to be adapted to the new evergreen model, as the size of the fund continues to change when fund managers raise more and more money. In addition, the fact that limited partners (LP) can invest and sell their shares on the stock exchange daily makes calculations even more challenging.
Undoubtedly, the R&D partnerships model needs to mature further and prove itself to investors - but it’s a step in the right direction in terms of the investment fund operating model. It presents a material change to the venture capital fund model, and offers greater compatibility with the new generation of founders seeking smarter long-term investors, and in effect, expresses the new model that Sequoia Capital was talking about: an open super-fund, liquid and open ended, which creates full transparency for investors.
It’s gratifying to see that the venture capital industry is attempting to reexamine the right model for its activity after years of inaction. The model needs to be improved further and investors need to be protected, while preserving the funds’ ability to invest in successful companies and provide the financing needed for the growth of significant and impactful companies.
Eran Savir is CEO and Co-Founder of Manara Ventures
Published by Globes, Israel business news - en.globes.co.il - on January 4, 2022.
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