I recently relocated to San Francisco full-time and I wanted to understand the venture capital ecosystem better. Here is an overview sparked by conversations with industry friends and other interesting resources linked throughout and at the bottom for the restless and curious.
Business model basics
All venture capital funds have one value proposition in common: partnering with entrepreneurs and helping them to build high growth companies. Beyond providing access to capital, funds offer a range of unique value propositions based on the combination of their management style, expertise, data analytics capabilities, and network. This concept is referred to as the platform model.
Pioneered by Andreessen Horowitz, the platform model brings in value-added services that help entrepreneurs access the resources they need to make their venture succeed. Venture capital funds may, for example, provide human resources and recruiting services to help startups scale faster. The diversification of services is a result of an increasingly competitive venture capital market. Funders and founders expect much more than access to capital, and venture capital funds have taken different approaches to attract the best ideas and talent.
Funds also lean on expertise differentiation, claiming a niche that defines their investment strategy and makes them a go-to for specific types of ideas and funding needs. Some examples include:
- Industry-specific versus industry-agnostic
- Geographic market focus
- Investment stage focus: seed, grow, build
The Venture Studio Model
A variation of the venture capital fund model worth mentioning is the venture studio model. The term was coined to define the combination of a venture capital fund with an incubator/accelerator studio. Like venture capital funds, venture studios also come in very different shapes and sizes. Most of the industry sees the venture studio as a model in the making, although early players have been around since the dotcom era. There is little to no standardization in terms of how venture studios go about their operations, but from a high-level perspective, all venture studios are similar in that they position themselves as a co-founder. Some venture studios conceive the idea and form the team entirely from scratch, while others take existing ideas and teams and insert their team into the startup and act as an extension.
In spite of the uncertainty about which variation of the venture studio model is best, according to David Cohen at Techstars, 11% of startups that secured Series A funding in 2018 came from a venture studio. This stat shows that venture studios are adding value to the venture capital ecosystem by derisking early-stage investing. On the flip side, the overhead cost from talent needed to incubate and accelerate startups brings critique and questions about the model’s sustainability and best practices for funds allocation.
The Investors Behind Venture Capital Funds
The appeal of investing in venture capital funds versus directly in startups comes down to diversification. Venture capital funds offer access to portfolios of startups that diversify risk for investors. The Power Law of Venture Capital says that ten percent of investments return the entire value of the fund. In other words, one out of ten startups succeeds in making enough money to pay off the cost of all ten investments.
There are two categories of institutional investors.
- Big institutions: sovereign wealth funds, public and private pensions, endowments, foundations, and corporations
- Wealthy individuals & family offices
To provide some context on the investors:
- Harvard Endowment Fund is worth USD$39.2 B
- UC Regents manages about USD$120 B
- Norway’s Pension Fund has the highest market value at USD$1 trillion
When it comes to private wealthy individuals, some very public examples are Jeff Bezos or Bill Gates who are each worth more than USD$100 B.
Each institutional investor has a distinct investment policy. Investment policies favor liquidity and growing returns. Therefore, investment models allocate resources accordingly. A typical example is to invest 50% in public equities, 30% in fixed income and <20% in high-risk asset classes. The latter category includes hedge funds, real estate, private equity, buyouts, and venture capital. High-risk asset classes are less liquid and are considerably more volatile than public equities and fixed income asset classes.
In the last 10 years, venture capital as an asset class has been increasingly attractive. Why?
- The public equity asset class is yielding fewer returns and is more volatile. This has shifted the perception of high-risk investments like venture capital, making them seem less of a risk.
- The success of isolated companies, referred to as unicorns, has many institutional investors chasing rainbows.
- Technology has altered the pace of disruption. Large corporations see the venture capital ecosystem as a source for innovation to keep up with the pace of technology. This has pushed the boundaries of the venture capital fund model and aided the proliferation of models like venture studios and venture networks as an extension of corporate innovation units.
Corporate investors are an interesting class of institutional investors for the latter and have contributed to the transformation of entrepreneurship. Including how ideas are sourced and how capital and talent flow into startups. Examples of such include Google Ventures, BCG Digital Ventures, and IDEO CoLab, which illustrate how large corporations are leveraging their core capabilities, reputation, and strategic partnerships to capture and create value in the venture capital value chain.
Venture networks like Silicon Foundry, which sells an annual membership to corporations that want to access their elite Silicon Valley network, are proof of the corporations’ eagerness to gain access to the venture capital ecosystem one way or another.
For the investment cycle, the increased interest in venture capital as an asset class has resulted in the creation of extra rounds of funding: pre-seed and post-seed, bridges, series C, D, E, F, and so on. Also, corporate innovation overlap with venture capital has led to earlier exits from mergers and acquisitions. In 2016, most startups exited before reaching series B through merger and acquisition deals.
All of this partially explains why the investment roadmap of every startup looks different.
The Investment Cycle: A Hypothetical Startup Journey
Meet Laura, a Mexico City entrepreneur. She has the vision to create a street food delivery platform that connects vendors and foodies all over Latin America. Laura is 30 years old, is a bachelor of science in communications, and has recently graduated from an MBA in an American university. Laura has been pitching her idea to friends and family. The feedback is great and some of them want to fund her vision. Their investment will help Laura build the website prototype and get the first customers to test if there is indeed a market-fit for her idea.
Friends and family investors are referred to as Angel investors. These early investors have very little information to deliberate if they will see a return on investment. It is very likely that they will lose their investment. Yet, they feel confident and are willing to take the risk because they trust Laura.
Trust in the team and the market opportunity are the only two factors available at this point.
Laura raises funds from angel investors in the form of short-term debt. Convertible notes are a loan with a guarantee of future equity. The loan will convert to equity when the company is valued, at the rate established in the note.
Assuming Laura’s startup is one out of ten to survive this early-stage, the company is ready to start its journey towards scale. With no assets to set as collateral, no bank will issue debt for Laura. So she decides to raise money from a venture capital fund, taking her fundraising efforts institutional.
Laura is well-positioned to pitch a seed venture capital fund. She has validated her idea’s market fit with a prototype of the product. With a full-scale platform, she forecasts rapid market growth. She needs talent and capital to do so and is willing to give up partial ownership to the right partners.
A venture capital fund in Mexico City is satisfied with the results from the initial due diligence:
- Evaluation of the market opportunity
- Analysis of available company data
- Personal and professional references
The venture capital fund in Mexico City proposes to Laura leading the seed round. Also known as pricing the round, and refers to setting the value of the company. While it is unusual for venture capital funds to set a valuation for a seed-stage company, the fund feels there is a strong market and the team is solid. By leading the round, the fund secures the largest piece of the pie among all the investors. Securing a big enough piece is important because ownership will dilute in future investment rounds. The startup will build its “pedigree” from attracting well-regarded investors, which lend credibility.
Once Laura raises this seed round, she has started the venture capital investment cycle: seed, series A, series B, an exit, or additional rounds until an exit is secured or the company fails.
Laura was successful in raising USD $1M in seed funding after proving to investors three of the five desired factors:
1. Talented team
2. Market opportunity
3. Product prototype
With the seed funds, Laura builds an iteration of the product. The full market launch is a hit. Customers LOVE the platform and are making a lot of noise on social media. This is great news for Laura and her company. Customer testimonies and revenue are the fourth and fifth factors. Laura needs to raise the next round, series A.
The noise reaches a venture capital fund in Los Angeles through Laura’s alumni network. With proof of amazing customer testimonials and revenue, the fund helps Laura raise USD$10M. The series A helps Laura expands the business into three new markets, well en route to make some investors happy. A potential exit lays on the horizon. Along with the venture capital fund in Los Angeles, a large tech industry player looking to expand into food delivery services has invested in the company and negotiated a seat on the board of advisors.
At this point, Laura has a few options.
- Start negotiating an exit deal
- Start cashing out by selling some equity at a premium and continue the cycle until an exit occurs
- Get a bridge (more capital) from some or all the current investors or get venture debt to reach a relevant milestone and improve the exit offer
*A note on venture debt. This refers to a loan from venture banks, like Softbank or Silicon Valley Bank. It is only granted to startups that can provide important assets as collateral and have the investors with the right reputation on their team.
A Design Approach in Venture Capital
Laura’s story is quite optimistic. In real life, Laura’s journey would have many more obstacles. From the brief intro about Laura provided earlier, we can assume she lacks product development experience. She is also a first-time entrepreneur and has no experience in fundraising. Laura needs much more than capital.
Even after successfully entering the institutional investment cycle, 92% of startups fail within the first 3 years. A study by Autopsy that surveyed 300 failed tech startups echoed the five top patterns of failed startups I observed in live panel discussions, articles, books, and one-on-one conversations with industry experts sharing their experience.
The top patterns of failed tech startups:
- The wrong team (20%)
- A flawed business model (18.7%)
- Poor product (14%)
- A product searching for a problem (11%)
- Lack of a sustainable competitive advantage (9.3%)
As a design strategist, I believe there is a strong business case to bring the design approach into the venture process. There are three major assets from design that can lay the foundation startups need to address common failure patterns and contribute to optimizing venture capital investments.
Design puts the user first
The key to building strong teams and culture is giving everyone a common cause to fight for. With design at the center of culture, every decision is aligned with the user needs. When this is true individual egos disappear. There are no bad ideas, just ideas that either do or do not align with user needs. The latter can make or break the team, especially in the early stages and through periods of fast growth. Building a user-centric system creates accountability and provides clarity amid startup ambiguity. The result is a functional team, a system that captures value from talent, and top customer experience. According to the Design in Tech Report, 89% of companies in 2018 said the customer experience is their competitive advantage.
The design thinking mindset is agile
The design thinking mindset is all about embracing iteration and fast-failure. The faster you fail, the faster you will succeed. It takes some practice to feel comfortable “killing your darlings”, but in the end, practice instills a mindset that makes teams agile, flexible, and highly collaborative. Venture capital has very long feedback loops. The standard 10 year investment period is long and can create a sense of futility for investors and founders. A design approach creates ongoing feedback loops that aid strategy for product development and operational prioritization. Some 87% surveyed companies for the Design in Tech Report believe design leads to higher sales and faster product cycles.
Design frameworks make things real, cheap
There is a big difference between thinking something and putting it down on paper. Once something is in a tangible format, it is sharable and can prompt all sorts of feedback and opportunities for improvement. This is the essence of design tools. Design methodologies can be the best ally to entrepreneurs that want to move fast and bring others along. Tools as simple as a business model canvas, a three horizons product road map, or a storyboard, can put cross-functional teams on the same page, uncover priceless customers insights, and even bring the board of advisors on board with a pivot plan. These tools are in fact, the antidote to taking a flawed product, service, or business model too far. Many startups today, operate driven by quantitative data. Qualitative data should be a part of the essential data analysis to inform business and product development. The answer to “how many?” will rarely yield a competitive advantage, but the answer to “why?” will. Some investors have realized this, and that is why in 2016, 36% of the top 25 funded startups were co-founded by designers, up from 20% in 2015.
Some venture capital funds are aligning their investment strategy with design, advocating it is a critical contribution to the venture process. One example is Designer Fund, co-founded by Ben Blumenfeld and Enrique Allen. During a presentation for the MBA in Design Strategy, Blumenfeld explained the creation of Designer Fund came as a result of realizing design is hard to access for those outside the design community. Designer Fund positions itself as a strategic partner to its portfolio companies by providing education to adopt a design mindset and incorporate design capabilities to improve processes and product development. The co-founders believe design is a foundational element that has to be part of the company’s DNA from the beginning and this is why their investments are focused on early-stage companies.
Sequoia Design Lab is another example. James Buckhouse, the founder of Sequoia Design Lab and Head of Design at Sequoia, explains in an article that the purpose behind the lab is “to prove the case for investing in design and to raise the status of designers everywhere through exceptional work and active participation in design’s global community.” Designers can be part of the lab through its fellowship program or as a visiting designer, taking a role in one of the portfolio companies while receiving training and mentorship from Sequoia. The focus of design, unlike Designer Fund, is not on early-stages but rather on pivotal moments. In other words, Sequoia uses design to keep its teams going. It is used as a communication tool that helps founders and their teams get on the same page when the vision is unclear.
These two examples illustrate design adds value to the venture process throughout different stages when it is integrated into the company’s culture.
This is by no means an exhaustive list, just a starting point if you want to continue exploring the venture capital world.
Thank you to Jessica Straus, who sat down with me and gave me a download of her experience of venture capital and provided some of the resources above.