A Super Fast Overview and History of Tech VC: Part V
Thanks to Michael Ramos-Lynch for co-writing this series with me.
This is the final of five posts in a series on the history and future of venture capital. While prior installments were retrospective and provide helpful context for this post, they aren’t necessary reading to understand this one, which looks to the future. The four previous posts covered: (1) early formalization of venture capital from the 1950s through the dotcom bubble, (2) cleantech and the Internet in the post-dotcom era, (3) the rise of mobile technology and Web 2.0, and most recently, (4) the influx of capital in all stages of venture.
Looking ahead, we see three trends of note. First are new sources and increased levels of capital being invested at all stages. Second is innovation as funds are forced to compete in a more crowded ecosystem. Third are new sources of liquidity that reduce the pressure for companies to exit. After exploring each of these, we will make some predictions about what this corner of the world will look like in a few years.
New Money, Old Money, and Funny Money
In Part IV, we covered new sources of capital, the pump from low interest rates, and how the number of new investors has recently increased dramatically. We see this expansion continuing, with new investment from corporates, foreign wealth, public market investors, and even governments. Institutional sources of capital that typically focus on fund investing continue to make more direct investments into companies at the later stages and will do so as long as they see return and the time to liquidity stays high.
Unaccredited and/or inexperienced investors continue to join the early stage market, directly as angels, but also through platforms like AngelList, SeedInvest, and DealBox. The first 12 months of JOBS Act’s crowdfunding rules being in effect (2016–2017) saw over 300 companies raise $40 million+ in capital. The next 12 months, from 2017–2018, saw those numbers triple. Early-stage financing structures (SAFEs and Series Seed templates replacing convertible notes and burdensome priced rounds) have decreased the cost and time to close early-stage financing, further reducing the friction.
More investors and more capital may or may not be leading to more rounds or deals. Data suggest deal counts are decreasing across all stages, but we think the data is flawed. Rounds may just be harder to track as companies and investors seek more privacy by skipping regulatory filings and press.
The vast amounts of wealth created through crypto, with fiat inflows of $10+ billion being responsible for creating hundreds of billions of market cap, also continue to drive investment. In 2017, we saw $7 billion in ICOs (initial coin offerings). That pace quadrupled with $14 billion of ICOs occurring in the first half of 2018 alone. The past several months has seen these numbers fall off a cliff, but 2019 promises to be the year of STOs (security token offerings).
Crypto has opened startup investing to a global capital market bringing unprecedented liquidity, drawing from a now inflated set of currencies. The increased demand and liquidity premium has resulted in companies that can’t raise a $2M round from VCs raising $20M from crypto investors, with returns expected from speculation vs. revenue or profit. Losses have mounted as Bitcoin trades at a ~80% discount to its all-time highs, but the appeal of liquidity in an otherwise illiquid asset (startup equity) and investing from an inflated asset will remain strong.
As the hype and easy money fade, future investment will depend more on the performance of existing investments. In 2013, there were 39 unicorns (tech startups valued at $1B or more), with 4 more created annually. Five years later there are 146 unicorns and we’re adding about 15 more annually. That said, unicorns are arguably overvalued by almost 50% on average. It’s hard to envision all of these companies growing into or exiting at these values.
Conventional wisdom and historic data suggest we’re due for a reversion. From Fred Wilson in 2016:
“…going back to the 1970s, every year there are roughly 20–30 investments that, if you made, you made a fortune. Every year. There’s never a year where that’s not true. And, there’s also never a year where that number is 200.”
Relatedly, Samir Kaji at First Republic Bank had this to say:
“If you believe we’re at the early stages of a technological revolution, and then you look at the size of the venture market, it is a pimple vs. other asset categories. PE is 12x the size of funds raised and deployed. There’s not room for everyone to succeed, but you’ll still have 10% to 25% of managers that drive returns.”
The truth is probably somewhere in the middle, with an elevation in value creation, but also in overvalued companies that will deflate soon enough. Where the balance falls will dictate whether more or less capital enters the market.
Old Dogs Learn New Tricks
With new investors and more capital, there’s increased pressure to innovate and stay competitive. Why would a founder spend months pitching VCs for a seed investment if she could simply do an ICO/STO, raising more money in less time giving up less control and getting earlier liquidity? Why would management of a pre-IPO company raise a growth round from an established late-stage VC if they can raise more money at a higher valuation from a sovereign wealth fund or SoftBank’s $100 billion Vision Fund?
Many venture firms have been raising more and larger funds to stay competitive in this new landscape. Many are also trying new strategies. Conventional wisdom and history suggest that the combination of larger funds, more competition, and new strategies means lower returns for most, but outperformance for a select few.
Scout investing as a strategy seems to be at an all-time high. In general, scouts are individual investors deploying small amounts of capital on behalf of funds without the fund’s involvement. Sequoia’s scout program was first “revealed” in 2012 by Sarah Lacy, and many followed. Reportedly Accel Partners, CRV, Founders Fund, Index Ventures, Lightspeed, Social+Capital, Spark Capital, Flybridge Capital, and First Round Capital all have scout programs. AngelList even launched a $35M “scout” fund called Spearhead, arming founders with up to $1M to invest.
These programs increase a fund’s breadth and access in addition to building relationships with both the scout and investees. They’re better than a managed seed fund or practice in that they don’t require much more operational overhead and prevent or reduce signaling risk (more on that below). But now that everyone has a scout program, Sequoia seems to be on to the next (or back to the old) having launched a separate seed fund, combining its early-stage practice and scout program.
Funds usually focus on one or two apposed stages, as each stage requires different expertise, structure, and resources. But multi-stage investing is a common strategy to increase AUM and competitiveness if a firm can pull it off. This strategy can also increase the chance of reaching carry if funds are separately managed entities. Managing multiple funds under a single brand creates the potential for synergies.
Later stage investors in these models have unique access to their early-stage investor colleagues and earlier stage companies. Existing investors usually have a better understanding of a company’s performance and potential than new investors, and when under a single umbrella they can more easily share otherwise confidential information. The strategy also increases the ability of later stage investors to build a relationship with early-stage entrepreneurs before the question of investment arises.
Multi-stage strategies isn’t without its downsides. A larger team is needed to cover the requisite skills, markets, and networks. Additionally, they create signaling risk. If a fund can invest at all stages but isn’t following on into a particular investment, outside investors will be concerned as to why. Existing investors are expected to have better information and access. There are multiple good reasons for not following on, but the situation will always be met with skepticism and the question will always need to be answered.
As a result of these challenges, late-stage investors may prefer to just invest in or monitor earlier stage funds while early-stage investors will raise SPVs or opportunity funds to re-invest in their own portfolio. But those that can pull it off may have a winning strategy to maximize returns. The best and rising brands will likely try to innovate in this way as their predecessors have.
Social+Capital attempted a higher degree of innovation than many others, with a multi-stage strategy going from seed all the way up to a public market hedge fund. It also created a SPAC to reduce the burden of going public and an “automated” investing platform called capital-as-a-service, or CAAS to rapidly identify opportunities anywhere in the world. CAAS invites companies to submit information and metrics, with certain thresholds driving responsive interest from the fund in a more automated fashion. While it seems intuitive, most venture funds don’t have a system to manage cold contacts / inbound investment interest and in fact encourage founders to find a warm intro or have associates and analysts conducting outreach. Most founders also bristle at the idea of providing detailed information to investors without context and in advance of a meeting. Still, the initial inbound for CAAS was reportedly massive. The current state of affairs at the firm is uncertain amidst departures as founder/CEO Chamath Palihapitiya advocates a return to fundamentals. It remains one to watch.
Firms also keep trying to make “moneyball” happen in VC, i.e. using data to identify and assess companies and founders. Reportedly at least 50 different firms have some data system like this, and GV (formerly Google Ventures) reportedly relies on it very heavily. There’s enough on this for a full blog post, but in short, these systems seem great for identifying, assessing, and benchmarking companies, but still largely incapable of reliably predicting the future better than the best humans or collections of humans.
Another phenomenon we’ve seen is the establishment of “pre-seed” as a stage, including funds like Afore Capital in SF, Wonder Ventures in LA, and Notation Capital in New York. Pre-product investment was formerly the realm of angels and incubators/accelerators, but new funds are being built to take this risk and mitigate it. The early results show promise, as these funds regularly find and invest larger amounts at lower valuations than anyone except incubators/accelerators. We expect multiple to persist and outperform.
In addition to stage specialization, we’re seeing increased verticalization. Funds focused on an industry or geography have existed for decades, funds focused on business models or technologies are newer. Industry-specific funds continue to proliferate outside of the life sciences into financial services, education, and healthcare. SaaStr and Acceleprise focus on the B2B SaaS business model. Eclipse, Bolt, and Lemnos all focus on hardware. Everyone and their 22-year old cousin has a crypto-focused fund. Building expertise and portfolio services around a vertical like this allows for specialization that should improve competitiveness. We expect this trend to continue in the earlier stages.
Finally, some funds are questioning the entire model of venture itself. The power law states that one or two investments drive most of the return of any given fund. Even some of the best funds/vintages of recent history (USV 2004, Lowercase I in 2010, Benchmark VII in 2011) exhibit this skew, albeit with higher hit rates. Funds like Indie.vc and General Catalyst’s rumored debt fund are innovating with models that anticipate a higher hit rate but lower potential return per investment. We expect success for the aforementioned due to their experience and sophistication, but no significant expansion as higher hit rates are so difficult and rare historically.
New Sources of Liquidity
An influx of capital and investment models across all stages of venture means more companies have more chances to succeed. As a result, more companies should succeed. Early data as compiled by Eric Feng seems to suggest just that: returns haven’t yet gone down despite a tripling of investment. But as we mentioned above, unless public markets and acquirers are similarly bullish, the combination of regulatory overhead and readily available capital at the late stages will keep companies private longer. As a result, they will feel pressure to provide liquidity to early investors and employees.
Coins and tokens provide inherent liquidity. The first wave of ICOs saw unrestricted tradability nearly immediately. Now with security token offerings, many have a 12-month lockup, still much shorter than 7-10 years typically seen in tech VC. Regulatory uncertainty on these models persist, but crypto is not the only liquidity solution. New innovative approaches are seeking to solve the same problem for established companies with traditional capitalization structures.
EquityZen provides any accredited investor with access to shares in late-stage companies that may IPO in the near future, companies like Spotify, Lyft, Slack, Instacart, and Palantir. The shares usually come from early employees, creating an opportunity for them to have liquidity. Equidate provides a similar service and recently raised $50 million to grow their offering in addition to launching an index fund of pre-IPO companies. Funds and companies are also getting more involved in creating liquidity for early investors and employees. SoftBank’s investment in Uber is the most well-known secondary in recent history. Palantir reportedly has had a very large, regular buyback program for early employees, and early investors have the company’s blessing for secondary sales.
A Silicon Valley investment bank estimates that these transactions tripled from $11 billion in 2012 to $35 billion in 2017. Our rough estimates for 2018 have them well beyond that number. By providing this liquidity, these services create a positive feedback loop, increasing the size of their own market by allowing companies to stay private even longer and continue authorizing secondary transactions.
According to Beezer Clarkson at Sapphire Ventures, more late-stage money also exacerbates this, with non-traditional players investing:
“One of the striking differences about today is that availability of capital into private companies from other sources that are not part of the numbers raised by traditional venture funds. There was no dialogue about the ‘private IPO’ in the 2000s. Companies aimed to go public if they wanted to raise hundreds of millions of dollars of growth capital. Now they don’t have to.”
The impact of private companies staying private longer is uncertain. There are pros and cons to being private vs. public, and they also shift based on what side of the table you’re on. Less mature companies will have more time to incubate before public investors get access, potentially reducing risk to retail investors in the public markets. However, if these liquidity solutions enable private investors to capture value that would or should have gone to public market investors, the losers are those who couldn’t or didn’t access the private market directly or indirectly.
The Future is a Full, Liquid Stack of Niches
And now some predictions. The trends of more investors, more capital, new strategies, and more liquidity lead us to these conclusions:
1. Venture will be more liquid and democratized.
A constant increase in information symmetry and connectedness will also allow investors and companies to be more organized and aware of the ecosystems they are operating within. More competition will finally erase mythical seasonality and increase startup formation. Crypto has brought 24/7 tradability of assets, and with other platforms, unprecedented liquidity. Other less radical solutions will continue to grow until companies and investors adopt security tokens en masse. Indexes of security tokens will also be created, allowing you to invest in US-based healthcare startups as an index without investing in a venture fund.
Fed up with the lack of representation in the general partner ranks and funded by limited partners who agree, funds founded and led by women and minorities are increasingly funding entrepreneurs with diverse backgrounds. For example, women-only teams historically raise about ~2% of all venture capital while all-male teams raise about 80% of it. Relatedly, only 8% of partners at top firms were women. That number ticks up higher when looking at new funds, with women founding over 20% of all new micro funds (funds under $100M). Similarly, immigrant founders are often restricted from starting their own companies due to visa issues despite having all the other resources in place.
If you believe that underrepresented founders are equally likely to be successful and you acknowledge the data suggesting under-investment, this is an obvious and massive opportunity to be (as many investors love to say) “contrarian and right.” Cue Arlan Hamilton of Backstage Capital, who has already made 50+ investments backing diverse founders with her debut $36M fund. Female Founders Fund is on its second fund, supporting women entrepreneurs with $27 million to invest. Unshackled Ventures has developed a system for immigrants with visa restrictions to start their own companies and is on its second fund. The benefits exceed moral or financial returns for those involved. Miriam Rivera, the founder of Ulu Ventures, put it best in saying, “If we could do a green card with every diploma, that would be a huge economic improvement.” The same is true for greater representation in the population of funded entrepreneurs.
2. Venture will grow increasingly unpredictable and localized, functioning like niche public markets.
A more robust and liquid market that is still based on localized information and largely driven by localized “hands-on” investors will be even more prone to hype cycles. In observing the industry and speaking with investors, we foresee smaller and more rapid microcosms of the phenomena so expertly described by Jerry Neumann in his blog post entitled Heat Death, where investors quickly pile into a segment (or geography), driving valuations up, only to be mostly disappointed, quickly leaving behind what may actually be a promising segment for more patient longer-term focused investors and entrepreneurs.
We’ve seen this recently in crypto, space, computational biology, esports, and robotics. According to Josh Nussbaum, Partner @ Compound, we’ve already seen the first and second cycles of crypto. A third cycle may be varied based on regions and industries. Artificial intelligence is in some ways on its second cycle, but also arguably on a much higher iteration. Either way, it’s still “hot.” As Nan Li, partner Obvious Ventures quipped:
“Now, everyone is talking about AI, computer vision, deep learning. NIPS went from sleepy technical conference for practitioners to being like SxSW. T. Pain performed at NIPS this year!” Such excitement and fun are usually correlated with less discriminating capital.
While technology and sector cycles have existed for decades, geographic localization has not yet occurred to a meaningful degree. It may never occur as we move to a more globalized market, but we still predict a measurable geographic concentration of bubbles and depressions, especially at the earliest stages, due to the inherently face-to-face nature of venture investing. As a city claims to be the next Silicon Valley or has an outsized outcome, outside investors may drive more investment into that region, pushing investable dollars and valuations up. We’ve seen this behavior already. In most cases, this hype will revert to a mean or even regress, giving us geographical volatility. Eventually, some newer regions will reach sustained presences, but we don’t expect any US city to be a “new” Silicon Valley.
3. Incumbents will create more volatility than in past cycles.
As we study our own economy more thoroughly and such information becomes more intertwined with the building and maintenance of businesses, core concepts found in the “Innovator’s Dilemma” and “value investing” begin to favor incumbents. This is actually a source of market stability on a macro level, but increases volatility for entrepreneurs and investors seeking to challenge incumbents.
This phenomenon will usually look like large, public companies coming late to a market category and still wildly surpassing the leaders. From Zavain Dar, partner at Lux Capital: “The more cycles we have, the easier it is for firms to protect themselves from disruption. Facebook learned from MySpace’s failure in not acquiring Facebook, but then Facebook acquired WhatsApp, and now they look like geniuses.” Similarly, Facebook copying Snapchat thru Instagram late in the game resulted in a major loss to the upstart and a huge win for the incumbent.
The largest tech companies have already won in cloud computing, which none of them had as a core product. Incumbents are also poised to beat startups in voice-based products, self-driving, and virtual and augmented reality, despite massive VC investment there. Does the innovator really have any dilemma or challenges once it “wins” and becomes self-aware? Or does it actually have monopolistic power through R&D and M&A? While VCs are rapidly investing in more and more companies at all stages, incumbents can simply look for ways to enter and capture the opportunities already having a significant market response. While most will agree it’s never been easier to start a company, we maintain it’s likely never been harder to win a market. Another reason to expect bigger losses at the later stages than ever before.
There’s so much more we wanted to cover here, e.g. what’s happening in VC markets in other countries such as China (China surpassed the US in venture investment this year, tipped by a $14 billion “venture” financing), the impact of immigration laws on venture, VC outside of tech, more about the actual companies and technologies currently of interest, etc. If there’s something you really want us to write about, leave a comment and we’ll try to get to it. Thanks for reading!
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Neil Devani is an early stage investor based in San Francisco, California working with companies that create positive externalities, with a focus on the healthcare, financial services, and education sectors as well as certain frontier technologies. He is also a licensed attorney in the state of California.
Michael Ramos-Lynch previously worked for a venture firm in Palo Alto, California and is currently an entrepreneur and practicing attorney in Austin, Texas.
None of the above post is intended as investment or legal advice.