The Disruption of Venture Capital

Software and the Internet are disrupting traditional industries — from real estate to transportation.

Next up: Venture Capital.

As the CEO of the venture fund + equity crowdfunding platform Crowdfunder, and a member of a leadership group that was engaged in Washington D.C. on JOBS Act legislation… I’ve had a unique vantage point into the massive changes taking place as finance and early-stage investing are moving online. (more I’ve written re: FinTech here.)

Here are the forces and trends I see disrupting early-stage venture capital.

Disruptor #1: A Broken VC Model

According to a CB Insights article from May 2015, early-stage investor-backed startups (Seed stage) have only a 1.28 percent chance of becoming a unicorn. Meanwhile, the traditional VC model entails funding 30 to 40 startups per fund, which for a top performing fund means making winning investments roughly 15 to 20 percent of the time.

Do the quick math and you see one of the challenges inherent in the traditional VC model.

After investing in over 1,000 startups, Dave McClure of 500 Startups shared some powerful figures about startup investment performance at the early stage here. The data showed that:

50–80% of startups yield no exit/return.

15–25% yield a small return of 2–5x.

5–10% might reach a valuation of $100 million with exits yielding 10–20x.

And with some luck ~1% reach $1 billion valuations returning 50X or more.

As McClure summarizes, “…most startup investments fail, a few work out ok, and a very tiny few succeed beyond our wildest dreams.”

What’s more, beyond VCs reliance on unlikely unicorns to bring investor returns, there is the Kauffman Foundation report and analysis from over twenty years investing in VC funds that the average VC firm barely manages to return investor capital after fees.

The punchline: most early-stage VCs fail to invest in enough companies, given the data. Of course, a few top performers do manage to “pick winners” at a higher rate than other VCs and beat the odds.

With this, expect new investment approaches to drive change and innovation in the VC industry over the next several years as all facets of Finance are moving online, including Venture Capital.

Disruptor #2: A Faltering IPO Market

Perhaps no indicator is as telling of the infrequency of unicorns as the frozen tech IPO market.

The US IPO market has suffered a steep decline since 2014, its biggest year since the dot-com bubble. Looking solely at the tech / startup sector, the situation is even more dire.

In Q1 of 2016, there were zero VC-backed tech IPOs. Zero.

IPOs are of material importance to VCs, as the liquidity of the public markets is a place where much of their returns are fully realized.

In part to blame for the decline in IPOs is a trend in late stage private capital financing. Unicorn companies have been shunning or delaying IPOs, instead opting to take hundreds of millions of late-stage financing from private investors at huge valuations.

But this private funding strategy is not without peril. Bill Gurley of Benchmark Capital just penned this piece about this private financing trend, “Why The Unicorn Financing Market Just Became Dangerous For All Involved.”

Given these trends, it’s clear that the VC route to liquidity represented by the IPO markets has shifted. This is now driving pressure and change in how VCs look at their investments, their path to investor returns, and their own fundraising with Limited Partners.

Disruptor #3: Traditional VC Dynamics (aka The Curious Case of AirBNB)

The CEO of Airbnb, Brian Chesky, recently told the inside story about raising $150,000 in seed stage funding for AirBnb at a $1.5 million pre-money valuation (now valued at $25 billion). One after another, otherwise intelligent VC firms rejected him and missed out on the round.

Brian wasn’t from Silicon Valley, didn’t have an incredible presentation, and wasn’t led in the door by the usual referral sources that largely generate investment outcomes in the Valley.

In short, dependency on human processes and foibles adversely selected out Airbnb, an eventual multi-billion dollar exit. One lesson: the traditional venture fund process employed for later stage deals is not well-suited for investing at the early stage.

Despite claims that “software is eating the world,” startup investing today is highly relationship-driven and location-dependent. At the early-stage, where there is often a lack of historical data and meaningful signals for investors, raising capital is often less about how good an idea is, and more about who the founders know and how well they present.

Changing this dynamic is part of our mission at Crowdfunder — to democratize early-stage Venture Capital.

Disruptor #4: Disintermediation Through The Internet

In the 1980’s a handful of upstart financial services firms set out to change the way the majority of U.S. citizens were able to invest in the public markets and the brokerage firms that enjoyed near monopoly status over access to investing.

Traditionally, as was the case in the 1980’s, investors had to call a stock broker in order to buy a public stock and perform trades. Brokers made their living on the transaction fees of this activity, often as a percentage of the amount bought or sold.

Of course, this structure created perverse incentives for brokers to continually “churn” investor accounts through unnecessary buy/sell activity.

Internet pioneers like e*Trade & Schwab.com disrupted the traditional process by putting control in the hands of the investors themselves, and creating flat transaction fees (e.g. $8 per trade), thus bypassing the broker and saving investors billions annually. The large existing wealth management and advisory firms, who had been treating themselves to those billions in excess transaction fees, began to shout from the rooftops that individuals weren’t qualified to manage their own investments and that if buying and selling were put in the hands of investors, everyone would lose their shirts.

Fast-forward to today and online brokerage is a multi-trillion dollar capital market. It’s now considered self-evident that investors can and should get access to independent information and trading/investing tools online.

Similarly, today the private equity capital markets are following suit and moving online — from early-stage venture to private equity — all powered by technology, data, and new forms of distribution online to large pools of investors.

Everyday investors are, for the first time, getting access to investing alongside VCs on platforms like Crowdfunder, and doing so for as little as a few thousand dollars per deal.

Disruptor #5: New Regulations and Equity Crowdfunding

What happens as investing into early-stage VC-backed companies moves online, and becomes more open and inclusive through online investing platforms?

A recent Goldman Sachs report, The Future of Finance, highlights my company Crowdfunder and a few others, and defined the total overall crowdfunding market opportunity at over $1 Trillion.

A new wave of innovation and growth for capital formation is being ushered in through crowdfunding. The crowdfunding industry is doubling each year and is estimated to surpass venture capital in 2016 (VCs invest $30 billion per year and crowdfunding as a whole is is on target for $34 billion in 2016). See more data in my prior post — Trends Show Crowdfunding To Surpass VC in 2016.

The new capital market of equity crowdfunding has been doubling each year and is set to explode as an entirely new class of everyday investors, and billions in new capital, come into the market under new laws myself and others helped shape in Washington D.C. (JOBS Act Title II, Title III, Title IV).

With new ways to raise capital competing for the attention of startup founders, a growing number of startups are bypassing VC firms at the earlier stages — where the investor returns can be greatest — in favor of online distribution tools and equity crowdfunding platforms.

Many savvy startups today are using a combined approach of traditional offline angel/VC financing alongside online equity crowdfunding to save them time and increase their reach and access to big and small investors alike.

Disruptor #6: Scale & Diversification In Venture Capital

Given the importance of diversification and Modern Portfolio Theory in other areas of investing… why hasn’t a highly diversified approach been taken to Venture Capital?

Some leading minds in the world of private equity and institutional investment have been asking this question for years. Scott Kalb, Executive Director of the Sovereign Investor Institute and former CIO of the Korean Investment Corporation, have seen and quantified the opportunity for a more scalable and diversified approach to private equity and venture. See Scott’s report and presentation from 2013: The Tipping Point: How Sovereign Wealth Funds are Taking Risk in New Ways and Changing the Game.

One of the reasons this more diversified approach hasn’t been taken yet is that there have been structural and regulatory roadblocks in the way of doing so. At least until now…

A massive new market window has recently opened — brought on through a combination of new securities laws, the exponential growth of online finance, and the global spread of software and automation. And with this new market window open, we’re seeing the Debt/Lending and the Equity capital markets move online.

The debt & lending markets have been about 5 years ahead of the equity capital markets in moving online. In the debt/lending market a flood of new capital has come into the market via “marketplace lending.” Many of the leaders in the space moved beyond the peer-to-peer lending model and found scale another way — by creating diversified investment products that allowed larger institutional investors to come in with millions and spread their risk across a large number of loans.

And we’re just now starting to see early stage Venture Capital follow suit. VCs and their own investors (LPs) are now poised, perhaps for the first time, to adopt diversification as a strategy to capture returns. Instead of being confined to a narrow portfolio of companies in a single fund (usually with 10-year lockup periods), new diverse models are being developed.

Recent regulatory disruption in the form of the JOBS Act are enabling seed-stage investors and VC firms to invest with the same type of diversification they could achieve in something like an S&P 500 index fund, but for angel or early venture stage.

Some examples of these innovate and quantitative VC models are already here. Funds with broad diversification of 10X of traditional VC funds, or more, include Crowdfunder’s VC Index Fund (see in TechCrunch, WSJ). Another less diverse yet highly data-driven venture fund model is SignalFire.

Meanwhile, the new JOBS Act laws and equity crowdfunding create the potential to achieve diversification in the private markets by opening a whole new universe of access to vetted, early-stage investment opportunities for individual and institutional investors alike.

As the Equity capital markets move online, it’s likely that the winners in this new generation of online investing will be the ones who don’t simply scale their platforms and users, but who access the deal flow of some of the leading private investors and VCs — effectively leveraging their expert sourcing, diligence, and selection efforts.

That’s what we’ve done at Crowdfunder with our VC Index Fund. Using several data sets, we developed a quantitative model that has selected a list (index) of leading VC firms at the Seed Stage. Our VC Index Fund automatically invests in Seed and Series A deals alongside these leading VCs, accessing the deals either by referral, via our scalable platform, or by gaining direct access to the deal in the market as any venture fund would on its own accord.

And using this scalable investment model, the VC Index Fund is positioned to invest in a highly diversified portfolio of hundreds of deals sourced, vetted, negotiated, and backed by many of the leading VCs.

In just our first three months investing out of the VC Index Fund we’ve invested in the same rounds / terms as over half of the 50 VCs selected by our model: 500 Startups, Andreessen Horowitz, Arena Ventures, Better VC, Blumberg Capital, Correlation Ventures, Crosscut Ventures, CrunchFund, Great Oaks, Greylock, Kapor Capital, KPCB, Lowercase Capital, NEA, Obvious Ventures, Right Side Capital, SK Ventures, Social+Capital, Structure Capital, SV Angel, Techstars Ventures.

I predict that the future of the early stage investing landscape will look quite a bit different in three to five years. The top tier VC firms will still be around… but alongside them, competing for large institutional investor dollars, will also be more diverse models that leverage software, data, and the web.

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