Reading The Venture Tea Leaves For 2016

Investing in the future is what limited partners (LPs) do for a living. It’s inexact, yet over the years Sapphire Ventures has developed a process to identify trends — in technology, and the venture ecosystem of course — that guide our investment decisions as an LP in early-stage venture funds. This means hours of conversations with venture funds (GPs) not only in the United States, but Europe and Israel too, as well as with our personal network of entrepreneurs, service providers and journalists to sift through the many signals and recognize patterns playing out in the venture ecosystem. Here are the trends we’ve been closely watching and what we think they imply for 2016:

Emerging managers matter. The last five years have seen an increasing number of new venture funds entering the market, most notably in the United States. In 2010, 52 of the 176 funds raised in the United States were first-time funds. By 2015, 79 first-time venture funds were raised out of 235, with the five-year high hitting in 2014 of 106 first-time funds out of a total of 271 funds.[1] Along with these new funds came new approaches to investing, and virtually overnight, a range of individuals — from entrepreneurs and journalists to athletes and celebrities — became venture capitalists for the first time or started trying new partnerships.

Venture is a dynamic industry and emerging funds, defined as the first four funds of a given GP, seem to have a high comfort level with change. Change can take multiple forms. For example, SoftTech VC evolved from an initial ‘super angel’ sub-$10 million Fund I, primarily focused on B2C, to an $85 million early-stage, institutional Fund IV with a broader investment focus that now includes B2B along with other areas. There’s also Formation 8, which recently reconfigured into multiple different funds. We believe more change is on the horizon. Venture capitalists will continue to shift in and out of funds, and venture funds themselves will reconfigure as they work through the specific type of firm and investment opportunities they wish to pursue.

However, LPs like it when they find a strong venture firm into which they can put their money for many, many years over multiple funds. And venture firms like this too. Conventional investing wisdom also says that for LPs to achieve strong returns they should invest in a handful of established venture funds (translation: funds on their fifth fundraising cycle or higher) that run concentrated portfolios targeting the top-returning companies in any given year. Yet over the last 10 years, emerging venture funds have consistently accounted for 40–70 percent of total venture gains [2]. Think Union Square Ventures, First Round Capital, Spark Capital, LowerCase Capital, True Ventures and Emergence Capital to name only a few. The obvious conclusion: emerging funds matter. Yet…

LP’s will look for the signal in the noise. We’ve also seen the well-covered rise of the unicorns — startups achieving $1 billion+ valuations. This phenomenon has created impressive, albeit on the whole unrealized, returns for many venture funds. In turn, LPs have been experiencing a lot of noise, but not as clear signal. Add to that the volume of funds entering the market over the last few years and the wavering of unicorn valuations — both publically and privately. How will LPs in 2016 assess the strength of a fund when the industry’s numbers have been up and to the right but there are fewer actual exits returning capital? LPs may very well pause to wait for (more) unicorn deflation to occur to highlight the unicorns from the ‘decacorpses’ and the corresponding impact on a venture fund’s portfolio. Even when taking seasonality into account, we could be seeing early signs of this when we look at both the absolute numbers of funds raised in the second half of 2015 as well as the year-over-year change when compared to 2014. In Q3 2015 there 53 funds raised in the United States, down from 71 funds raised in Q3 2014, and Q4 2015 came in even lower with 46 funds raised, down from 85 funds raised in Q4 2014.[1]

Funds will move towards the missing middle. In 2009 and 2010 the global markets contracted, and along with it venture fund sizes shrunk. Many larger funds ($300-$600 million+) reduced down to smaller sizes, and multi-strategy funds split into separate, more focused funds. An example of this is Morgenthaler, which transitioned from one $400 million fund that invested in both IT and life sciences to two separate funds: Canvas (IT) and Lightstone Ventures (LS). At the same time, many emerging managers raised sub-$100 million early-stage funds increasing the overall number of “smaller funds” or “micro funds” focused on seed and Series A deals. Lastly, another set of managers raised “giga funds” –$1 billion+ sized funds. These managers wrote larger checks into larger, later-stage deals. The overall dynamic created the “barbell effect” — very large funds on one side and on the other, much smaller funds with precious few in the middle.

Fast forward to today: no one is quite sure what to call any series, as what was once a seed round is now a ‘pre-seed’ round, seed rounds are being done at what were Series A sizes and valuations, and so on up the stack. To keep pace with the increasing round sizes and their pro-rata, GPs have responded. Fund sizes have been increasing, the time between fund raises has been shrinking and multiple venture firms have raised special opportunity, growth or pro rata funds. This trend of increasing fund sizes could very well continue for most A- (and early B-) round focused venture capitalists as they pursue meaningful ownership and healthy reserves. Already funds are pushing back into the previously missing middle of the barbell. We believe this process will accelerate if more funds follow August Capital’s Fund VII lead, which, rather than raising both an early-stage and a special opportunity fund, raised one fund instead.

Geography as destiny — or not. When does a VC need to be located down the street from the entrepreneur to win the deal and when can one invest successfully remotely? This can be as granular as San Francisco versus Palo Alto or as far-flung as Europe to New Zealand. The question of geography as destiny becomes even more meaningful given the rise of entrepreneurial tech hubs around the world.

Consider this: in 2011 venture-backed companies globally raised some $49 billion with North America representing 77 percent of the money raised. Up through Q3 2015, North America now represents some 61 percent. Europe has doubled the absolute amount of money venture-backed startups have raised on the continent going from $5.1 billion in 2011 to $10 billion through Q3 2015. Asia has seen large growth going from $6.3 billion in 2011 to $28.4 billion in Q3 2015.[3] Returns are also internationalizing. According to Cambridge Associates [2], of the top 100 value-creating deals in a given year, international investments have accounted for an increasing share, going from 5 percent from 1995 to 1999 to a recent high of 50 percent in 2010.

What does all this mean? Generally speaking, proximity matters at the earliest stages. Most VCs won’t travel (far) to be the first money in, and the credibility bar for entrepreneurs seems to go up in direct proportion to the miles a VC has to travel.

One can break this rule. At the early stage, two great examples are Point Nine and Union Square Ventures. Point Nine is a Berlin-based seed fund that invests in SaaS companies at very early stages around the world. Their system for doing so is beautifully explained in their #RemoteVC blog. Union Square is a leading New York City-based early-stage VC that has been investing in Europe since 2008 with 22 percent of its current portfolio in Europe.

Once a startup’s metrics are showing signs of achieving escape velocity, international relevancy with product/market fit locked in, all bets are off. At this stage of company growth, money has been coming in from venture funds located near and far.

Where the GPs go, LPs will follow. Back in 2004 there were a mere handful of VC bloggers; notable early bloggers include Brad Feld, David Hornik and Fred Wilson. Now there are hundreds. From there over the last decade plus venture firms have further evolved to be even more transparent, founder-friendly and focused on adding value beyond capital. We believe LPs will follow suit.

Case in point: today, there are a handful of LPs blogging, tweeting and writing. Sapphire Ventures has been sharing our LP perspective since last May joining the company of LPs like Chris Douvos at VIA, Michael Kim at Cendana, Horsley Bridge, Top Tier Capital and Weathergage Capital. While newer to the institutional LP side of house, we expect to hear more from Foundry Group Next. And this is just the beginning. We believe LPs too will be well-served to be transparent, agile and able to deliver value in addition to capital just as the venture ecosystem and leading venture funds have evolved to do.

Author’s note: Special thanks to Annis Steiner, Winter Mead, Eugene Chou, Marta Bulaich and Colette Ballou for their help with this article.

[1] NVCA Press Release Jan 12, 2016: Venture Capitalists Raise $5 billion in Foruth Quarter, $28 Billion for Year

[2] Cambridge Associates Research Note Nov 2015: Venture Capital Disrupts Itself: Breaking through the Concentration Curse

[3] CBInsights & KPMG Global Venture Capital Report — Q3 2015

 Information provided reflects Sapphire Ventures’ views as of a particular time. Such views are subject to change at any point and Sapphire Ventures shall not be obligated to provide notice of any change. While Sapphire Ventures has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability or completeness of third-party information presented herein. Any forward-looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. The information set forth herein is not intended to constitute investment advice and under no circumstances should any information provided herein be considered as an offer to sell or a solicitation of an offer to buy an interest in any investment fund.
 The funds and managers identified and discussed above do not necessarily represent any or all of the investments made or recommended by Sapphire Ventures. It should not be assumed that any recommendations or investments made in the future will be profitable or will equal the performance of the investments identified above. Past performance is not indicative of future results. No representation is being made that any investment or transaction will or is likely to achieve profits or losses similar to those achieved in the past, or that significant losses will be avoided. No investment decision should be made based on any information provided herein.

Next Story — My Chat With The Twenty Minute VC On LPs And The World Of VC
Currently Reading - My Chat With The Twenty Minute VC On LPs And The World Of VC

My Chat With The Twenty Minute VC On LPs And The World Of VC

Today, I had the pleasure of going on The Twenty Minute VC to share some thoughts on the world of limited partners (LPs) in venture. My good friend Harry Stebbings is a masterful interviewer and got me talking about how LPs source and invest in funds, LP/GP “market fit”, what makes a great VC and much more.

It’s the first time an LP has ever gone on the show, and I’m excited to share the episode here:

You can also learn more about what we covered in Harry’s TechCrunch post, “What investors want from venture capital firms”.

And if you’d still like more, check out OpenLP, where you can hear from a diverse group of LPs — what they think, what they do and why they matter to entrepreneurs and GPs alike. You can also follow the conversation on Twitter at #OpenLP.

As always, any feedback on how LPs like me can create more knowledge-sharing and understanding for the VC community is most welcome!

Next Story — New York Venture State Of Mind
Currently Reading - New York Venture State Of Mind

New York Venture State Of Mind

At Sapphire Ventures, although our portfolio has traditionally skewed towards the Bay Area, we constantly track a number of other vibrant tech ecosystems, including New York. Yesterday in a blog post, Fred Wilson referred to New York as “vital and growing rapidly.”

From what we have observed, we agree that there has been a significant growth of active venture capital firms in New York in the past two decades. Some of the most known players in New York, such as First Round, Greycroft, Insight, RRE, Tiger Global and USV were started prior to the recession in the late 2000’s. There has also been a plethora of rising new players in the last decade such as Bowery, Brooklyn Bridge, Collaborative, FirstMark, Metamorphic, NextView, Notation and Thrive. Moreover, many other firms that were started outside of New York are now setting up permanent offices in New York, such as Bain, Spark and Venrock. And some have even transitioned a significant portion of their human capital (and sometimes headquarters) to New York.

It’s clearly an exciting time in New York, so we dug into market level data to better understand this ecosystem. Some of our take-aways are below.

1. While California is still larger, New York has a higher growth rate both in terms of number of deals (10% CAGR in NY vs 5% in CA) and dollars invested (16% CAGR in NY vs 13% in CA).

Source: Thomson Reuters

2. Looking at the chart below, 2000 is clearly an outlier with over $15 billion committed to what Thomson Reuters defines as New York venture capital firms. In 2015, almost $7 billion was committed to NY-based VCs, and two larger firms comprise approximately $4.1 billion of this amount.

Source: Thomson Reuters

3. Most of the NY-based VC firms in existence today were started after the mid-1990’s. There is a clear proliferation of seed funds in recent years.

Source: Thomson Reuters; Sapphire Ventures

4. With the rise in active firms, the number of deals and amount of capital invested in 2015 is increasing to levels not seen since the dot-com era.

Source: Thomson Reuters; Sapphire Ventures

5. Despite the recent rise of more new firms, the vast majority of funding from LPs to NY VCs still goes to follow-on funds (vs first-time funds).

Source: Thomson Reuters

6. Pitchbook data shows that in the last few years, more capital is being funneled into New York by outside venture capitalists than by local VCs, and later stage investments have been on the rise.

Source: Pitchbook; Sapphire Ventures

7. Since 2009, the number of exits by NY-based companies has steadily increased per year. In particular, New York is becoming known for billion dollar plus exits, including Etsy, OnDeck and Tumblr, among many other companies that have sold for significant value.

Source: Thomson Reuters; Sapphire Ventures

8. Enterprise-only funds are still few and far between at the early stage in New York, despite a significant percentage of investments going to enterprise companies since 1995. According to our research, many funds targeting New York for enterprise investments have generalist investment strategies.

Source: Pitchbook; Sapphire Ventures
Source: Pitchbook; Sapphire Ventures

Many thanks to Eugene Chou for his help and feedback!

Next Story — Breaking Our Rules
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Breaking Our Rules

Yesterday, Nicholas Chirls and Alex Lines at Notation Capital launched the first episode of Origins, a new podcast about limited partners (LPs). As a sponsor of the series, I’m very excited for them. Their podcast aims to highlight the all-too-often missing perspective of LPs in venture — something that we at Sapphire are equally passionate about and is precisely why we launched OpenLP earlier this year.

But I’m also excited on a broader level because this podcast series gives me an opportunity to discuss why Sapphire is an LP in Notation, which, by our own definition, is out of the ordinary when it comes to our fund investing strategy.

The rules we (generally) play by

To explain why we pursued an “out of scope” investment, let me first explain our sweet spot as an LP. Like GPs, LPs have specific types of venture funds they target and check sizes they like to invest. These vary from LP to LP depending on their particular portfolio.

At Sapphire, our proverbial “sweet spot” for investment is in early-stage funds ranging in size from $125 million to $400 million (aka “disciplined” in size) with thoughtful portfolio construction and a clear point of differentiation. Loosely speaking we like to be 10 percent of a fund up to about a $20 million check.

We typically write checks in the $10–20 million range as we believe that amount makes us a friendly, meaningfully-sized investor for our GPs, but not overbearing, and can produce a meaningful return impact to our portfolio. If we write checks that are much smaller than that amount, those checks will have to work too hard to return our capital. And if we write checks that are too large and things don’t go well we could be in danger of underperforming our own return expectations.

But rules are made to be broken

Now that I’ve outlined our rules, to hell with them. We can, and do, invest opportunistically above and below these fund sizes.

And Notation is one time we did. Notation is a sub-S10 million fund, and our check into it is accordingly small. The parallel would be if a large venture fund wrote a small seed check. For the money to make an impact on the fund, it would have to do 10x or better. Pretty high bar.

So why’d we do it?

Notation is based in New York, specifically Brooklyn. This matters because prior to investing in Notation I had been looking to invest in New York City for a number of years, mapping the ecosystem while figuring out what to do from an investment standpoint. NYC has been near and dear to me for a long while. I lived there back in 2000, when I first entered the fascinating world of venture capital, working at one of NYC’s early VCs/incubators.

Ever since, I’ve kept a close eye on the ecosystem and watched closely as it’s evolved, trying to understand the types of companies that have thrived there and the stage and types of investments being done by locally-based funds (seed and A predominately) versus non-NYC based funds (typically later series). So I’ve invested meaningful time meeting with NYC-based managers and entrepreneurs. And over time, I observed a number of lighthouse New York companies create a wave of second- and even third-generation entrepreneurs. These are the signs of an ecosystem growing up and maturing.

I was, therefore, a soft and informed target when I met a brand new team on the brink of launching Notation. In fact, I met Nick and Alex while they were still in the ideation phase for their fund. They knew they were too small for a Sapphire check, so when they approached me it was about getting advice instead of money. We met occasionally to discuss their ideas and investment thesis, and as they started fundraising, I couldn’t kick the feeling that if Sapphire wasn’t part of their fund, we’d be missing something.

The case for Notation Capital

Notation Capital is a first-time fund, started by two second-generation investors/entrepreneurs with deep networks. Nick brought seed-stage investing experience from Betaworks, and Alex was the chief architect at Betaworks, ie. the “technical founder type”.

Through months of diligence, we found Nick and Alex to be incredibly well networked and well liked, and we really enjoyed getting to know them personally. What I especially liked about Notation at the outset is that I believe the fund has both a differentiated theme (to filter incoming deal flow) and a differentiated pre-seed offering (to attract entrepreneurs). There was also an arguable under capitalization in the NYC pre-seed area in which they were looking to invest.

Nick and Alex would be the first to say that Notation Capital is an experiment. It’s a fresh way of working with early-stage founders in NYC. It’s also an experiment that we believe offers Sapphire potential upside and small downside, given the relatively small check as a measure of the capital we manage.

We back emerging VC managers with the hope that we can partner with them for years, and possibly decades, as they build their firms. But it’s possible that Nick and Alex could run Notation Fund I and move on to something else. Not every VC manager, even if s/he is really talented, will want to be a VC for the rest of his or her life, and we understand that.

But Nick and Alex are off to a great start, and we believe Notation Capital has the opportunity to build a fantastic firm and brand in NYC. Of course, if their experiment works, they may well choose to raise a larger fund next time around, and that might enable us to put more money to work. The returns are appreciated along the way too.

So that’s that. We broke our own rules, and there are multiple factors that came into play to facilitate this.

I knew the geography and investing landscape well prior to meeting Nick and Alex and was predisposed to making an investment there. While small funds are by no means a guarantee of large returns, they have been known to “hit above their weight class” because one good hit can produce impressive returns. Case in point, Lowercase Capital’s sub-$10 million fund, which might be the best-returning venture fund ever.

Notation is targeting an arguably still under-capitalized section of the NYC market with a lot of head room above them. NYC might lack in local growth funds, but it does not lack for seed funds and has local Series A funds as well. Last but not least, Notation has a differentiated strategy — their deal flow is predicated on the next generation of NYC entrepreneurs looking to work with a technically-strong fund.

I’m personally very excited to see where Notation will go in the coming years. I, as well as everyone at Sapphire, am delighted to be along for the ride. It’s hard for me to call myself a true rebel, but breaking the rules does feel pretty good. After all, history was never made by those who follow all the rules.


Sapphire Ventures is a limited partner in Notation Capital.

Nothing presented herein is intended to constitute investment advice and under no circumstances should any information provided herein be used or considered as an offer to sell or a solicitation of an offer to buy an interest in any investment fund managed by Sapphire Ventures. Sapphire Ventures does not solicit or make its services available to the public and none of the funds are currently open to new investors. The investments identified above do not necessarily represent all of the investments made or recommended by Sapphire Ventures, and were not selected based on the return on Sapphire Ventures’ investment in them. It should not be assumed that any current or future investments were or will be profitable. Past performance is not indicative of future performance.

Information provided reflects Sapphire Ventures’ views as of a particular time. Such views are subject to change without notice. Any forward looking statements or forecasts are based on assumptions and actual results may vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. While Sapphire Ventures has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability or completeness of third party information presented herein.

Next Story — Dear VCs, There’s Something You Need To Know About Raising Funds This Year
Currently Reading - Dear VCs, There’s Something You Need To Know About Raising Funds This Year

Dear VCs, There’s Something You Need To Know About Raising Funds This Year

Originally posted on April 27, 2016 in TechCrunch

Times are changing. Startups and VCs are facing tougher times, layoffs, down rounds and eroding valuations. However, already a record amount of money has gone into U.S. venture funds this year. As an LP (a limited partner, which is an investor in venture funds), am I seeing something others aren’t? Or am I just nuts?

I don’t think I’m nuts, but admittedly I may be a little biased. What I think we see shaping up is a year of “the haves and the have-nots.” I believe the first quarter of 2016 was a classic example of what happens when there is uncertainty in the overall market.

Experienced venture fund managers with existing LPs all fundraise at the same time, and LPs prioritize established managers and wait to work with newer, smaller funds later in the year.

Experience is invaluable

For example, of the 57 funds that closed last quarter, the gross majority of the money ended up in the hands of experienced managers like Accel, Battery, Founders Fund,General Catalyst, Index and Union Square Ventures. Moreover, the percentage of sub-$100 million funds dropped from 65 percent to 54 percent, which is the lowest it’s been since 2007. Also, funds greater than $500 million are disproportionately represented at 16 percent of all funds raised in Q1 2016, versus an annual Q1 average since Q1 2015 of closer to 10 percent.

Both VCs and LPs understand the value of having capital to invest at lower valuations. Further, the funds that have raised to date have strong market positions, track records and, in many cases, realized returns and experience weathering downturns. Obviously these are all factors LPs value, especially in an uncertain market like the one we face today.

The ugly denominator effect

With the bleak outlook, why are all the funds in the market? Well, some are raising based on their firms’ typical fundraising cycle, and others have accelerated their fundraising timeline to get ahead of any potential “denominator effect” — basically where a continued decline in the market affects LPs’ ability to invest.

LPs that invest in both public and private sectors often determine how much to allocate toward venture capital as a percentage of total assets; and the amount that gets invested in venture decreases if the value of their public assets decreases. As a result, venture funds that try to raise later might face the hard truth that money has dried up.

With the boom times calming down, knowing how your fund and your portfolio companies plan to navigate through this change is critical.

Based on the market activity in January and February, the ugly denominator effect appeared to be an impending inevitability. Although the market has rebounded, and the denominator fears dissipated, the net result of the stampede to fundraise early in the year could leave those funds yet to raise wondering if there’s any money left.

Beat the odds

The good news for you is that LPs with a dedicated venture program understand that smart investing requires investing in up and down markets alike — and allocate capital accordingly. As Alex Mittal of FundersClub noted in his recent blog post, great companies get founded in downturns as well as bull markets.

The same is true of venture funds. Andreessen Horowitz’ first fund was raised in 2009, and Lowercase Capital’s famous first fund in 2010 — both years when venture fundraising was under extreme pressure. Money from LPs dedicated to venture will still be there and notably, strong emerging managers can be “haves” alongside established managers. This is true even in uncertain markets.

Here are a few things I recommend to attract LPs and improve your odds of raising:

  • Give advance notice: For any of you who plan on fundraising this year and haven’t told your LPs, do so now. We need the heads-up to plan for the upcoming year.
  • Prep for diligence: Expect LPs to want to understand what is driving the underlying performance of your individual portfolio companies. We’ll ask you what your unrealized valuations are based on. Where do the revenues of your portfolio companies come from? Is it based on other startups that might get caught sideways trying to fundraise, or from companies that will still be able to pay their bills if the market dips? We want to know how you’re thinking about the next few years. With the boom times calming down, knowing how your fund and your portfolio companies plan to navigate through this change is critical.
  • Leverage your LPs: If you have existing LPs, ask them for intros and to give you market feedback. Ask them what they are hearing from other LPs and who is actively allocating to new managers.
  • Be patient: Can you slow your roll and fundraise in 2017? For funds still establishing track records, consider using 2016 to develop your portfolio companies, help them to raise their next rounds, and wait to fundraise yourself until early next year.

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