Revolution or Evolution: What Next for VC

The below is a talk I gave at the excellent 2017 BVCA Summit. The theme for the day was Revolution!

Introduction

At MMC we invest in fast growth technology companies. And as a result I spend a lot of my time with entrepreneurs who are building businesses with the intention of disrupting large markets or industries. These entrepreneurs talk of sleepy incumbent players who have failed to innovate their business model or adopt new technology and, as a result they are ripe for disruption. The entrepreneurs are planning on replacing these players as new leaders, and ultimately taking them out of the market. These conversations are highly energising, it is what venture investing is all about, about working with people who are trying to change the status quo.

But occasionally I pause and think, am I one of those sleepy incumbents? Are we innovating, are we adopting new technology in our business? Who is trying to take us out of the market? And how might they do it.

That is what I wanted to talk about today. How might the venture capital industry itself be changed by the technologies that we are busy investing in. Will the industry be subject to evolution or revolution?

An effective way of looking at the potential for disruption in a market is to look at its supply chain. As VCs we love to pretend that we are different but we are financial services businesses and we operate in the financial services supply chain. Above us sit the ultimate owners of the capital and the aggregators, the administrators and asset allocators. Below us sits the innovators, the companies that need our capital to grow.

Looking at that, there are two ways that venture capital could get disrupted:

1. a significant increase in the percentage of capital that flows through the supply chain without passing through a venture capital firm: disintermediation
2. a significant reduction in the supply or demand for capital in this supply chain

I am going to explore how the emerging technologies of today may impact these two dynamics.

Disintermediation

Lets start with disintermediation. It would be possible if the incumbents were failing to innovate or adopt new technology and as a result taking more value out than they are putting in. They would have left an opportunity for new players to generate the same return at a lower cost, or better returns at the same cost, or even better returns at a lower cost.

The attempts to do this in the market to date have largely been driven by the crowd funding play. We have seen companies like Angellist, Crowdcube and Seedrs launch platforms aimed at connecting investors directly with high growth companies. If you asked these platforms 5 years ago I think they would have told you they were trying to disrupt venture capital. The theory being that the crowd would make better decisions and the companies could take more control of their destiny. Fast forward 5 years and I think this view would have changed, these companies are building successful platforms but more in collaboration with, rather than competition against VCs. It doesn’t feel like they haven’t taken significant capital away from the venture industry.

The biggest shift in the venture industry over the last 10 years has been driven by people and their attitude, rather than technology. The venture scene is now far more dynamic, and there are a lot more players.

The balance of power has shifted, VCs now sell to entrepreneurs more than entrepreneurs sell to VCs. To get access to the best entrepreneurs we need to show that we will help rather than get in their way. If you find yourself in a deal where that balance is the other way round, then there are probably better deals in the market.

The very early stage of the market has completely transformed. The platform of capital and advice for entrepreneurs now is far more dynamic and structured than it was. The number of well structured accelerators and seed funds has grown significantly.

The amount of capital flowing into venture has increased. Round sizes have tripled and valuations have doubled.

With the need to demonstrate value has come the rise of the platform VC. VCs are hiring dedicated functions in the firm to help entrepreneurs access talent, customers and capital, meaning they have a better chance of getting to the best deals and improving the outcomes. Andreeson Horrowitz is the case study for this. Take a look at the team page on their website if you want to get a sense for what I mean!

We have also seen some innovation in the structure of funds, there are more PLCs and they are very active in the market. There is a lot more corporate venturing and public fund managers have been a lot more active at the growth stage.

All of those change the way capital enters the system, but the core venture model has not really changed. In the main, venture is still a team of people making data light, highly personal and relationship driven decisions based on experience.

Now compare this to what technology has done to other markets over the last 10 years

1. The iPhone arrived and the blackberry died.
2. Mobile stopped being a business category and became central to every business
3. Cloud stopped being a business category and became central to every business
4. Facebook has transformed the advertising industry
5. Cyber crime became a big problem, then a really big problem and then managed to influence the most important democratic process in the world
6. Amazon went from being an e-commerce to the fastest growing B2B company of all time
7. The way we consume video has changed beyond recognition
8. Digital market places like Uber and AirB&B are part of the everyday persons everyday life

As a result of all this, tech companies make up 5 of the 6 most valuable companies in the world.

So while the innovation and technology that we invest in has completely changed the shape of other industries it hasn’t yet made a major dent on ours.

And I don’t think that is very surprising.

VC and AI

The core value within a venture capital firm is knowledge and network. Knowledge allows us to make better decisions and give advice to companies. Network allows us to access deals and make helpful introductions to companies with talent, capital and more.

Given that knowledge is a core part of what we do there should be an opportunity for Data Analytics, and more recently, Artificial intelligence to significantly improve our decision making process but venture capital decision making is not low hanging fruit for AI because:

1. Data sets for small private companies are small, patchy and you need a personal relationship to get most of it
2. Even if you identify a company you don’t know what price you can buy or whether you can invest
3. To find that out you need a personal relationship with the company
4. Factors affecting the success of the companies at such an early stage are very hard to define
5. The feedback loop is very very long, which means that the ROI of your AI driven system would take a very long time to prove

So if you were building an AI business, selecting which early stage growth companies might make the best equity returns in ten years time would be low on the list of priorities. In fact of the 400 AI companies we have mapped in the UK we have only found one that is trying to apply AI to venture decision making.

There are other factors that have also protected us from disintermediation.

1. Our customers, our LPs, believe strongly that the team, ie people, are extremely important for the success of a venture firm
2. Investee companies would prefer to have fewer investors to manage
3. And Venture returns have trended up in a period of low yields. This may be cyclical but it does add a layer of protection.

Having said all this, we need to evolve the venture model. Access to data is improving and there is increasingly technology available that will improve our decision making and reduce our cost base. We also need to continue to show that we can improve the chances of success of the companies we invest in. But I do not believe the revolution will come from disintermediation in the traditional sense.

Shifting Supply or Demand

Going back to the start of this talk I said that there were two dynamics that would materially change the venture world. The first, disintermediation, we have talked about. The second was a significant change in either the supply of, or demand for capital. i.e.

1. Do investors continue to allocate capital to high risk innovation companies (supply)
2. Do the underlying companies continue to need equity investment to grow (demand)

We should explore how the technologies we are seeing developing might effect the outcomes of these questions.

Hyper-Centralisation

We are at the early stages of a cycle of innovation that is getting branded the 4th Industrial Revolution. I want to focus on two, core enabling technologies of this revolution: AI and Blockchain. Starting with AI.

With each wave of technology innovation, new companies have been created, and those companies replace others as the most valuable companies. This is what venture capital investing exists to fund. But the way AI plays into this cycle of innovation that may change this dynamic.

As always the large incumbent technology companies have significant scale advantages over new players. Scale gives them:

1. cheaper supply
2. traditional network effects from their large customer bases
3. strong brands and trust
4. enormous R&D and acquisition budgets.

As you would expect they are expanding vertically and horizontally to find growth.

But there is a new factor that needs some thought. Their expansion is being driven by Artificial Intelligence — think Amazon Echo in the home, or Google’s driverless cars. And in AI there is a second network effect that hasn’t been as powerful in the past and it comes from data.

If you are building an intelligent system, access to data significantly improves that’s systems ability to learn, and hence improves its performance. Better performance means you win more customers, more customers means you get more data, and more data means your system performs better, which means you win more customers and so on.

And these large technology companies have a huge data advantage over the companies that will try to disrupt them.

If AI is driving the next cycle of innovation then the companies that have the most intelligent systems are likely to win. And on today’s evidence the existing players have a significant advantage.

If they do win, then in this cycle of innovation less value will be passed from old companies to new companies.

This would make venture investing a lot harder. And it would mean capital can access innovation through the public markets. Both of which might reduce the supply of capital

I would call this scenario hyper centralisation. The shift to Intelligent systems consolidates power in the companies that own the systems, and a few super competitors dominate.

Decentralisation

But, as you might expect, there is an argument developing against hyper-centralisation, it is the argument for decentralisation and that is where blockchain comes in.

You will no doubt have seen the hype surrounding, ICOs or initial coin offerings. There are some huge fundraising’s at an incredibly early stage with questionable value, not to mention the fraud. But I don’t want to debate the pros and cons of the current ICO market. I think that may be a distraction from the fundamentals.

There are a number of different dynamics driving the interest in what blockchain can enable, but you can probably summarise them into trust and incentives.

I am going to horribly over simplifying Blockchain. But it is a transparent, distributed and robust system of record that removes the need for a centralised rule making entity. Participants can input freely, the network effects can lie in the infrastructure layer, not the application layer and data is far more accessible.

Blockchain also has an inbuilt incentive structure (tokens) that allows those same participants (users, developers, investors and service providers) to be incentivised in the future performance of the network. These networks can incentivise early adopters and developers in a way centralised platforms cannot. This allows the network to tap into the huge global developer community and also to bridge the customer network effect gap with customer incentives.

Which gives them a chance against the hype centralised incumbents I described above!

“show me the incentive and I will show you the outcome” Charlie Munger

Great, we say, venture capital is saved by blockchain. But wait a minute.

This innovation completely changes the existing corporate structure. These new entities don’t need to sell equity to raise capital. And venture capital is set up to invest in equity!

So this totally changes the way a venture capital firm sets up and invests. We would need to re-think how we raise capital, how we access investments, how we assess them and how we value the asset we are buying.

All driven by a significant change to the demand for capital!

The VC Revolution?

So in summary the technologies driving innovation the 4th Industrial revolution may have dynamics that turn the cycle of innovation on its head. In last digital revolution new companies disrupted old companies. In the 4th industrial revolution the dynamics of the technology involved may mean that:

1. a lot less value is transferred from old companies to new companies OR
2. old companies are disrupted by entities that aren’t companies in the normal sense of the word.

And as a result the dynamics of a venture capital investor would need to revolutionise!

Now I want to pour a little cold water on all this. We are at the very very early stages of this whole thing and I have been talking in extremes to help the point. We have no real idea of how it is going to play out and the current situation feels very inflated. But there are some underlying fundamentals that we need to understand and be ready to embrace.

As always change will create plenty of opportunity.

The only thing we can be certain of is we don’t know what will happen! So a talk like this should not end with conclusions but questions. I believe those questions are:

1. how do we continue to innovate our model and adopt technology to make better decisions and add more value?
2. how does venture sustain its value in a world where a few large companies have dominant technology platforms?
3. how does venture remain relevant in a decentralised world?