Venture Capital is Broken

aka The Venture Funding Bubble

This is a collection of thoughts that have been floating around in my head for some time. It’s a bit rough around the edges and not necessarily my finest work but I’d really like to hear the opinions of others, so I bit the bullet and hit publish.
WARNING: WHAT FOLLOWS IS A SERIES OF OPINIONS WITH MINIMAL SUPPORTING DATA. If that kind of thing makes you angry please stop now.

Before jumping in, yes, the title is a little clickbaity so let me frame it as a question instead…

If there was an infinite amount of capital available to be deployed by what are currently referred to as Venture Capital Funds, would they continue to invest in the same kinds of companies and in the same ways, and would they manage their portfolio companies in the ways we have become accustomed to?

If the answer to the above is “no”, then it must follow that there is some amount of capital, were it to be made available to venture funds, that would fundamentally change the nature of the established venture model.
And if the answer to the above question is “yes”, then who is to say that we haven’t reached that tipping point already?

My assertion is that we have passed the tipping point, and as a result Venture Capital has already changed in ways that are likely to have far reaching outcomes for the entire ecosystem.

Preamble expanded

TL:DR As I mentioned above, too much venture capital chasing too few venture opportunities.
The meat of the article deals with the potential consequences if the above statement is true. Feel free to skip ahead to the next section if you are happy to take the assumption at face value. Otherwise...

We all know that venture funds succeed by seeking out businesses that have the potential to provide them with outsized returns. This is not a matter of vanity, just a reflection of the fact that ~70% of companies who receive venture funding will not exit or be acquired ie 70% of venture investments are failures (to be clear, the investments are failures, not necessarily the companies themselves).
Unless the average startup needs proportionately more capital to achieve successful outcomes, or the overall pool of startups has increased in proportion to the available capital, or the 30/70 success/failure split coincidentally changed at the same time as more capital became available to investors then we have an out trade somewhere.
I’d love to have the access to the detailed data required to make a more thorough analysis, but at a very high level I don’t see any relevant metrics that indicate potential returns from venture backed companies can come close to the (at least) 4x increase in available venture capital in the last ten years. Eg global GDP increased from $57.86T (2007) to $75.8T (2016), global market cap of all listed domestic companies increased from $60.3T (2007) to $64.8T in 2016, and there were 213 IPOs in the USA in 2007 versus 160 in 2017.
Even if you assume that the pool of available venture capital had to double to accommodate the explosive growth of venture funding in emerging economies like China and India you still fall well short of ways to explain how the larger pool can generate the same level of returns.

So, investment opportunities have not scaled in proportion with available capital. How will that impact the venture ecosystem?

• At later stages, might larger fund sizes impact investor risk profiles? Does writing larger cheques exacerbate a herd mentality, meaning investors are less likely to look at what are perceived to be riskier options, or those that don’t fit the current perceived wisdom? The best (venture) investors are often heralded as the bravest, the most contrarian, but most investors don’t fall into “the best” category. The long time horizons in venture exaggerate this problem — why swing for the fences and risk a chalking up an early loss when you can earn a good living for about ten years by following the crowd?
  And if behaviour does change at the bottom of the funnel, how will it impact early stage investors at the top of the funnel? Will they be compelled to take similar steps to maximise their chances of investing in startups that are more likely to receive follow on rounds of funding versus focusing on the fundamentals of each opportunity? Changes in approach at the “top” of the ecosystem have the potential to filter down to the “lower levels”. What Softbank does can impact the three people in their garage working on a mobile app and trying to secure their first round of funding.
• “Delayed IPOs”. Outside of the bleak post-crash years of ’08 and ’09 2016 saw the fewest US IPOs since 2003 (itself a victim of the dot com hangover). The resultant tech IPO log jam has received plenty of coverage but is finally showing signs of loosening up with a 2018 off to a very promising start. That said, the fact remains that the proliferation of late stage funding opportunities has given many late stage startups the luxury of being more selective with their IPO timing. Some of the potential impacts are as follows: 1) The IPO process can be painful, but these are necessary pains, growing pains. The bigger a company gets before IPOing the harder it will likely be for them to make the necessary changes. Worse still, if they fail to apply the necessary rigour to their IPO they run the risk of going public with significant structural issues (like inadequate governance) that could poison the well for IPOs that come in their wake, to the detriment of the entire VC ecosystem.
  2) Delayed IPOs keep employee capital locked up for longer. Employees from successful IPO candidates are a vital to the functioning of the ecosystem as they recycle their intellectual and financial capital post exit as new founders or angel investors.
  3) Companies used to IPO to get access to public capital in exchange for giving the public access to potentially high growth businesses. That seemed like a fair trade to me. Now late stage startups don’t need to IPO to get capital, the main driver is to provide founders, employees, and venture investors with liquidity, and the risk of the trade is now asymmetrical. Companies who delay their IPOs have been squeezed longer and harder by VCs, lessening the potential upside for the public without necessarily reducing the risk.
• Business models are changing, notably becoming even more aggressive. How much of that is due to the new funding paradigm and is this new approach good for the society as a whole? As an example, would ridesharing in the US have been able to displace municipally licensed taxi operators so quickly without receiving generous funding from their VC benefactors? Will the public be any better off once the legacy competition is eradicated, ridesharing firms go public, and the venture capital being used to subsidise fares vanishes?
• How much funding is enough for a given startup? Softbank aren’t necessarily fighting with other VCs over taking the lion’s share of a round, they are fighting with founders over the size of the round. If founders accept more capital than they initially thought they wanted/needed who is really running the business at that point? Who controls the business plan?
• How does this impact earlier stage funding trends? I’ve already used the word “ecosystem” five times in this article, so it’s pretty clear that I believe late stage behaviour can impact earlier stages and vice versa. For example, perhaps more patient earlier stage VCs will have to push their founders more aggressively to meet tougher requirements imposed by follow-on round investors? One possible antidote to this for early to mid stage startups might come in the shape of corporate VCs who typically can afford to be more patient due to extended time horizons and a split focus on strategic in addition to purely financial returns. I’m pretty sure Fred Wilson would disagree, but could these changes herald a new golden age for corporate venture capital in the 2020s?
• If my underlying point is correct, that too much venture capital is chasing too few venture opportunities I expect the high performing funds will still do well, but as an asset class venture will suffer. Will that led to a dearth of available capital in ten or fifteen years’ time when these chickens come home to roost?

But it’s not all doom and gloom

Some mid and late stage venture funds probably aren’t venture funds at all any more, more growth equity firms. That said, there are still a large number of insanely talented, incredibly helpful investors for founders to chose from at all stages of the venture lifecycle. Picking your investors has always been an incredibly important part of a founder’s job, and that remains the case, now more than ever.
And on a lighter note, if all else fails, founders should make hay while the sun shines. Play the game, take advantage of what I’m convinced is a surplus of funding capital and get yourself a piece of it.

Regardless of whether “Venture Capital is Broken” or not, whether it is capable of scaling as an asset class, what remains the case is that venture capital continues to provide founder’s of certain types of company with the opportunity to fulfil their dreams and those of their employees. It really can provide once in a lifetime opportunity, and as long as that remains the case I expect there’ll be no shortage of brave individuals queueing up to take their turn.

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