What’s Next in VC? Transformation & Innovation: VC Outlook 4.0 and Future Trends
In order to have a competitive advantage, old and new VC players have to innovate and differentiate their offerings for founders. This is leading to exciting evolutions that will change the way companies are funded for years to come.
Short Overview
- The latest trend in early-stage funding has seen VCs transition to provide a variety of financial instruments (equity, debt, revenue share, SEALs, etc.), digitize various aspects of VC work, and integrate incubators, accelerators or venture studios into end-to-end funds.
- More and more VCs are developing ML and AI models to automate processes in identified deals, screening deals and investor outreach. This process is somewhat slow but undeniable.
- Women in Venture Capital are still underrepresented both at the founder and at the investor level, and, despite some progress in recent years, funding for female entrepreneurs and female VCs has fallen.
- Emerging market early-stage funding has grown more than 2x over the last few years but is still vastly undersupplied.
Instructions for Readers
- If you have yet to read ‘Part 1’ of the Evolution of Venture Capital, you can find it by clicking this link.
- Feel free to also review the supporting presentation to get a visual overview.
VC 4.0 — The Latest Innovations
Since the end of the 2000s, Financial instrument evolution in VC has produced several models: Equity Financing, Venture Debt, Revenue-Share, SEAL etc. We have simultaneously seen the evolution of non-standardized VC models, like Platform VCs with a greater focus on novel investment strategies, using NLP to influence decision making, and combining capital with services across classes.
In the last few years, that evolution has accelerated. VC 4.0 — defined as the further evolution of VCs, has fundamentally led to a new ‘branch’ of the evolution: consolidation in VC size and significantly differentiated financing tools.
This evolution in part came about by the need to remain more relevant than incubators and accelerators in a way VC firms knew best — the provision of finance. For the first 50–60 years of the VC industry, funding came predominantly in the form of equity financing. However, as VCs became more like investment advisers (i.e. Andreesen Horowitz), the growth of venture debt financing, revenue share-based financing and shared earnings financing, has started to accelerate. VC funds like Lightspeed and Clearbanc offer billions in non-dilutive funding, bridging the gap between venture finance and growth equity. While this type of funding is still in its infancy, rapid adoption is likely to follow.
To compete, some of the most innovative VCs, like indie.vc, diversified their investment process as others like General Catalyst sought to create VC ecosystems, providing a set of loan and financing options. This prompted many VCs to provide an assortment of financing instruments, giving founders the options of multiple sources of financing from one investment firm. Other VCs, meanwhile, focused on accelerating the process of securing funding via innovative instruments like platform venture capital models and SPACs. This evolution in the financial model has been further compacted by the likes of Social Capital, which has continued to seek synergies with the accelerator model, following the capital-as-a-service idea, and providing further hands-on support to improve their attractiveness to prospective startup partners.
Distinctive Examples of VC Evolution
An excellent example of continued VC evolution is Flashpoint VC — a multi-asset financing firm, which evolved from a 3rd generation ‘Active VC’(providing hands-on support, consultancy and equity financing to early-stage startups), to a more comprehensive model 4th generation VC, (providing a combination of equity financing, debt financing and secondary support) to ensure startups have full in-house support. Akin to many other VCs 4.0’s, Flashpoint also demonstrates the broader trend of adopting models to segment deal flow and better understand their customers.
Other notable innovative 4.0 VCs include firms like Entrepreneur First — a cross between a Studio and a VC Firm and Village Capital (& Village Capital Investments) — hybrids combining acceleration, incubation and investment, and Open Water VC — which seeks to combine their remote accelerator with a rolling fund-structured VC (a topic that deserves an article of its own).
Personal Experience
My journey within this process started at the deeper end, having first explored the VC industry as an intern with Christian A. Schröder at his hybrid VC — 10x Value Partners — a top venture studio x venture fund in Europe, offering hands-on venture building support and early-stage investment.
Since then, I have experienced the breadth and depth of this evolutionary process, working with firms across the VC landscape.
Over the course of my experiences in the sector, from my first role(s) to that of Co-Founder at MZZ Ventures Europe, I have seen the significant differences between the variety of VC firms and the various innovations that continue to cause ripples along the fabric of venture capital.
Whether it is the growth of supporting sectors like Incubators, Accelerators and Venture Studios, who encourage VCs to become more hands-on, or the internal evolution within the industry spearheaded by changes in mega-funds’ offerings, and increasing diversification amount smaller VCs, clearly change at the VC 2.0, VC 3.0 and VC 4.0 level is real in spite of an ever-more-consolidated passive VC landscape at VC 1.0.
Founders and investors alike should recognize that ‘venture capital’ and ‘early-stage equity financing’ are no longer two interchangeable concepts. VC has evolved into a complex set of different sub-sectors and has, in the process, changed significantly.
Trends to Watch in 2021
While VC models of finance and structure have been constantly evolving, it is probable that outside influences like token sales will further disrupt VC. At the same time, considering the range of innovation in the early-stage investment space already taking place, further change will likely come from both outside and from within the industry. With the ever-increasing demand for capital from new startups, larger rounds across sectors and an increasing set of financing options available to founders, VCs absolutely must continue to evolve in order to remain a competitive partner for a fundraising startup founder.
In terms of where said innovation will be most notable — this remains unclear. Based on my experience, these are the three core areas to watch:
1) Accelerating the Disintermediation of VC Processes
“More and more VCs are trying to minimize gatekeepers in the industry…right now, AI is the way to harness the intelligence from dozens of experts to better screen deal flow and maximize efficiency” — Yifu Wu (Technical Program Manager, John Deere, DigitalDx Fellow)
Due diligence, screening, term sheet issuance and other aspects of the VC industry are still very heavily human dependent and the industry incumbents are often very slow in adapting to new ideas. New VCs have been quick to capitalize on this trend, and there is now a greater adoption of ML & AI models among 3rd Generation VCs, as they evolve to a more data-driven and intelligent screening process. This, in turn, is likely to prompt more firms to create more niche sector focuses — because it will be easier to develop more accurate AI predictions, based on the standardization of input data.
“AI usage for screening is going to definitely get more widespread in these coming years. While the VC industry is quite slow in adopting new technologies, especially at the earlier stage due to limited funds, I definitely foresee more VC’s using niche ML algorithms in line with their thesis going forward as a clear trend” — Ankit Sharma (CEO, Angelfund.Ai)
This greater adoption of AI will likely lead to a greater demand for AI and data science specialists in VCFs, as these specialists can help a VC make truly informed decisions. This is likely to present an opportunity for those in the overlapping fields of Database Management, Data Science, AI & ML to break into the VC industry, now far more receptive to a data-centric approach to deal flow.
For those interested in this topic, I would recommend checking out Mountside Venture’s comprehensive analysis of the latest trends in ML & AI in VC and Bartosz Trocha’s 2019 piece on Data-Driven VCs. A brief quote from Bartosz’s article:
For an industry which is supposed to be at the forefront of innovation, it’s shocking how outdated, or rather broken, venture capital really is — Bartosz Trocha (Prominent Polish Angel Investor)
2) Funding for Female Founders — a bright spot in the push for gender equity.
“Women are tremendously underrepresented in Venture Capital. At DigitalDx Ventures, we are committed to changing this ecosystem. We seek to make room at the table for diversity of thought from both female founders and funders. This mission is incredibly rewarding” — Michele Colucci (Founding Partner, DigitalDx Ventures)
The funding gap, estimated at $189bn + between all-male and all female-founded teams out there — remains pervasive and the disparity between funding for male-only founders’ funding and that of female-only or mixed teams remains a significant barrier even today. This is especially prevalent in emerging markets like Africa and South East Asia where high rates of entrepreneurship among female-led teams are not substantially reflected by an increased proportion of gender-lens investing. Surprisingly, in the US, this is not very different: in every year since it’s been measured, less than 3% of venture capital is invested in women-founded companies.
“For systematic change to happen in the startup and VC world, the number and type of investors must diversify — both horizontally within the VC industry and vertically in the chain of LPs to Fund Managers to Founders to Boards to the C-Suite if we are to achieve solutions for a diverse population. Bottom line: the number of women in all categories must increase” — Michele Colucci (Founding Partner, DigitalDx Ventures)
Historically, it has been a combination of factors (see Shreya D’s article), but, according to industry experts, the biggest obstacle to this systemic change is the VC network itself.
This is slowly evolving, with female founders having to overcome greater challenges to break into the industry. Despite strong industry performance, a lot of change is still needed. Nevertheless, the increasing support from entrepreneurial networks like Women in VC and She Loves Tech suggests that a decrease in gender disparity and greater funding for female and underrepresented founders will come.
Gains to be made in Gender Equity
With the latest rise in diversity initiatives and a resurgence in women overcoming barriers and breaking into tech and VC, I foresee a significant change in the industry. As generations pass, more Venture Capitalists are now taking the responsibility to put gender biases aside. If this trend continues, then it follows that more funding for female and underrepresented founders will materialize from the VC sector going forward (See Alexandra Davis’ suggestions)
This will in turn reflect back on the VC industry itself. As shown by a recent All Raise report, female investors are 2–3x more likely to invest in startups with female founders or a female CEO. This suggests that an increase in women in VC will have an impact on female founders downstream. As suggested by the HBR, VC firms that increase the number of female partners by 10% experienced a 1.5% increase in fund returns and exits were 9.7% more profitable. This data on returns is largely mirrored by Goldman’s Sachs report on female fund managers and is even more prominently seen in the hard sciences (See Joanna Zhu’s article)
Some of the more active voices empowering female founders and female investors include the aforementioned: Women in VC and She Loves Tech. These organizations have worked to increase the number of women on both the investment and founder side, and their growth is reflective of a step in the right direction.
3) Funding for Emerging Markets
The proportion of global VC funding going towards emerging markets like Sub-Saharan Africa has grown but is still far from appropriate, despite the high returns in these markets and the incredible potential for innovation. While the VC sector is growing in areas like Sub-Saharan Africa, many challenges remain like a lack of follow-on capital, angel networks and appropriate support networks.
Following COVID’s wake, a lot of early-stage startups will suffer from the cash crunch resulting from limited venture activity. However, the growth of emerging market startup activity is undeniable, whether in Africa, Latin America (see also) or South East Asia. This growth could continue exponentially, as markets recover from COVID-19 and an increase in entrepreneurial activity resurfaces. This trend has been documented and there has been an increase in micro-VCs focused on emerging markets. That being said, more investment is needed to level the playing field as chronic underfunding remains a problem — especially in Africa.
In Conclusion
Venture Capital, as we initially defined, is, “a form of financing provided by venture capital firms to startups at an early stage, or to emerging companies that are predicted to have high growth potential.”
This definition applies to early-stage equity financing, but only covers a small aspect of the wider VC world as described above. When considering accelerators, incubators, studios, and Venture Firms, it seems clear that Venture Capital as a concept has changed significantly over time, and represents an overarching concept symbolizing early-stage resource support for startups. It will be interesting to see how this definition changes moving forward.
Most of the changes I describe above, whether in the evolution of the financing instruments or in the evolution of the service offering of VCs, have occurred in the last 20 years. This is an indication of how fast-moving the industry really is. Many peers and experienced investors narrow-mindedly dismiss VC as a static industry populated by old white men. Anecdotal experiences of the 8 VCs I have worked with, research on diversity in VC and the growing number of new VCs, suggest this is not the case.
To all those that complain about issues in the industry right now, I would say:
“Never stop hustling, run through walls and don’t believe anyone who tries to convince you that change is impossible and you will succeed” — Mark Kleyner
Special Credits to:
- Michele Colucci from DigitalDx Ventures for her extensive insight on the issues that remain to be solved for women in VC, and for her support, feedback and guidance
- Marton Medveczky from the Flashpoint Team for his insight, contributions and support
- Ankit Sharma from Angelfund.Ai and Inventive Byte teams for his thoughts and opinions on the Digitization Processes in VC
