Sweeping changes on Wall Street will dramatically reform the business models under which such leading financial institutions as Goldman Sachs and Morgan Stanley have operated for decades.

In parallel, many believe the traditional venture capital model also needs to be reformed. The fixed term, limited partnership structure currently deployed by most VC funds is a relic from the industry’s inception when Eugene Kleiner and Tom Perkins formed Kleiner Perkins. The model architected by Kleiner Perkins served the firm and industry well for many years.

However, severe market volatility since the late ‘90s has exposed certain weaknesses.

The primary drawback of the existing VC model is its short-term focus. The model is based on generally unrealistic expectations of an IPO or sale within three to five years. Venture capital funds should instead be motivated to lead their portfolio companies toward sustainable, profitable growth.

Peter Ueberroth, Managing Director of the Contrarian Group, a highly successful investment firm, recently told Seattle’s Zino Society that “we don’t believe in exits.” His point is “you shouldn’t enter a business thinking about your exit strategy; you should enter a business to profit, grow and expand. If you get it right, exit strategies will emerge.”

With the doors to the IPO market shut, and the dollar volume of acquisitions of venture-backed companies significantly down, hoards of medium and late-stage portfolio companies are left unprofitable and struggling for support. Of the 31 venture-backed companies that pulled their IPOs in the last year, 90 percent had not yet reached breakeven (and these represent the cream of the crop.)

Many VC funds currently do not have enough capital to fund the needs of their older portfolio companies. Moreover, the general partners have frequently moved on to successor funds with new, sexier investments. The current model encourages spending large dollar amounts early to achieve quick exits, and, if that does not occur, venture-backed companies risk being orphaned. Investors’ rose-colored glasses quickly turn into green eyeshades.

Aside from highlighting that the traditional VC model is broken, few have offered specific ideas to fix it. One alternative is to broadly adopt an evergreen structure. Unlike traditional VC funds, evergreen funds do not have fixed time frames and they reinvest realized proceeds into new businesses. An evergreen fund offers three key advantages over the existing model.

First, as its name suggests, it invests regularly and for long periods of time. Traditional VC funds generally make new investments only during the first five years and are structured to terminate after 10 to 12 years. With a potentially endless horizon, evergreen funds foster investment decisions based on long-term growth and profitability versus quick flips. The nature of an evergreen fund also reduces the temptation to invest heavily in new companies during periods of market exuberance.

Second, evergreen funds relieve fund managers from the conflicts and distractions of periodic fund raising. Because realized proceeds are promptly returned to investors in a traditional VC fund, rather than being reinvested as in an evergreen fund, traditional VC fund managers are raising successor funds every three to five years in order to invest in new businesses.

This pattern is not necessarily in everyone’s best interest. It opens the possibility that investment decisions (the timing of a decision to pursue an exit, for example) are made to optimize fund raising objectives rather than maximize long-term returns. It is also a distraction of time and effort, not only during the fund raising process, but also after a new fund has been formed. Mid to late-stage venture-backed companies often note that the attention of their investors (particularly as it relates to attendance at board meetings) diminishes as successor funds are established.

The third advantage of an evergreen fund is that it accommodates investment returns not only through an IPO or sale, but also from dividends. An evergreen fund is not dependent upon a strong IPO or M&A market. Evergreen fund managers are afforded the flexibility to optimize returns from a variety of sources based on the unique circumstances of a given portfolio company and market conditions.

Warren Buffet’s Berkshire Hathaway is probably the best example of an evergreen fund. Although a public company, Berkshire Hathaway has the flexibility to invest for the long term, adhere to a buy and hold strategy, not worry about raising new funds and generate returns from both capital gains and dividends.

The common criticism of an evergreen fund is that of illiquidity. If realized proceeds are reinvested, how do limited partners ever get their money back?

The solution is to provide investors with the option to receive all or a portion of any realized gains or received dividends. Since many limited partners regularly “re-up” with successful funds, a re-investment mechanism would ensure sustainability of funds that are performing well. The current debacle in the financial industry was largely created because originators of mortgages generally were not motivated to hold the securities to maturity.

They were motivated and rewarded to sell existing mortgages quickly and to originate new ones. This is not dissimilar to the mindset that traditional VC funds foster. Perhaps Sand Hill Road can learn from the mistakes of Wall Street and proactively adopt a new operating model without being forced to do so by external forces.

Tom Simpson is Managing Partner of Northwest Venture Associates. He is also on the board of WIN Partners, an angel fund, an Adjunct Professor at Gonzaga University and co-founder of www.greencupboards.com.

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