Why do VC firms become Platforms? (or why a16z is successful)

After having interned at Alven Capital, a VC firm in Paris, and worked for a Fintech startup in Berlin, I went back to school and spent the last year studying at MIT. While there, one of the requirements was to write a short thesis. After scratching my head for some time over which topic I was to choose, I decided to work on two recent evolutions in the VC landscape:

  1. Why do some VC firms try to become Platform?
  2. How equity crowdfunding syndicates have evolved since their inception 3 years ago? Are they becoming complements or substitutes of VC firms and how is their relationship with VC firms likely to evolve in the future?

In this first post, I sum up a few findings from part 1 about VC Platform. After quickly explaining what a Platform strategy in the VC industry is, I summarize four results from the entrepreneurial finance literature that are relevant to the topic and draw four insights from interviews I led with VC investors both in Europe and the US.

What’s a Platform in the VC World?

Josh Kopelman, GP at First Round Capital, wondering why the VC industry was so “un-innovative” in an interview with Pando in 2013

Every VC investor or industry observer I interviewed had a different definition of what a Platform in the VC industry actually is. Combining their views, I’d simply say that it’s a trend in the VC world, which is not necessarily new, that leads VC investors to offer resources to entrepreneurs in addition to money and their partner’s time and expertise. To do so, VC firms hire functional experts who don’t work on investments but focus entirely on supporting portfolio companies. They help entrepreneurs on several topics such as recruiting, marketing, design or data science. VC firms also develop privileged relationships with a network of third-parties likely to help their portfolio companies (execs in large tech companies, head hunters, or marketing agencies are a few examples). The best example is without a doubt Andreessen Horowitz (“a16z”), which has now over 150 people entirely dedicated to helping their 300+ portfolio companies.

The aim of this post is not to focus on “how” VC firms extend the value they provide to entrepreneurs but more on “why”. If “how” is of any interest to you, I highly recommend reading David Teten’s work with Columbia Business School’s students here. They detail a framework to help VC firms craft their portfolio support strategy once they have assessed their firms according to four axes: their brand, their cash resources, their in-house expertise and their network.

Why is the Trend interesting?

In the late-stage private equity world, many academic papers try to understand which part of funds’ performance stems from operational improvements. While it may be possible in the late-stage LBO world to quantify this improvement, it’s rather difficult in the early-stage VC world where performance data is scarcer and less public. The last generation of VC Platform also emerged rather recently (around 2008–2009), and data on returns are not yet available. Nonetheless, an increasing number of VC firms now embrace this strategy and some of them seem to be performing really well. Therefore, even though I was not able to deep dive in quantitative data, I gathered qualitative feedback from VC investors both in Europe and the US to understand why they embraced this strategy and what were the key performance drivers.

Four Elements from the Entrepreneurial Finance Literature

The entrepreneurial finance papers I went through were not all that old ;)

I first spent some time reading the academic literature. I will try to avoid writing too much about what the literature says, but here are a four elements relevant to the topic (if you want to know more, follow the links) :

  1. Only a very few VC firms actually perform. While some of the best VC firms provide huge returns to their LPs (for some of them over 10x their initial bet), when we go beyond the 10th percentile regarding performance, VC funds have negative returns (less than 1x). It’s the case both in Europe and in the US. (Data Source: Venture Economics, 2015).
  2. The US industry went through a severe crisis in the early 2010’s following a report published by the Kauffman foundation, which showed that most US VC firms, in which the foundation had invested, had negative returns (link). It even led many VC execs to conclude that the industry was broken (link). Other leading VC investors also showed that the VC market was probably not large enough to bear the amount of money flowing in the industry each year (link).
  3. Historically, VC returns have proved to be persistent, i.e. VC firms’ previous performances are predictive of future performances (see detailed paper here). This has dramatic consequences in the industry, as it provides evidences for LPs to invest in already established VC partnership rather than new ones. Good news for new VCs is that if LPs don’t invest in the first vintage fund, they sometimes loose the option of investing in the next funds. If the first LPs, who took the first risks, have pockets that are deep enough to fund the next vintage fund entirely, they crowd out new investors. This provides LPs with incentives to bet on new managers.
  4. And some of them made the right bet in the last decade. In fact, emerging managers, i.e. partnership currently investing one of their first four funds, found a way to break into the concentrated circle of firms actually providing returns to their investors. Their cumulated performance even accounted for 40 to 70% of the VC industry performance each year in the last decade (link). Good examples of these firms are a16z, First Round Capital, Union Square Ventures or ff Venture Capital, to name only these four (Source: Preqin 2015). In other words, these new firms gradually reshaped the industry and accounted for most of the performance. Interestingly, one can observe that it’s also the same generation of fund that embraced a Platform strategy.

Can we link their performance to their innovative strategy? What were the reasons driving their new strategy choice? Here are a few findings.

Four Findings about Platform Strategies in VC

  1. As Jay Acunzo, VP Platform at NextView Ventures, puts it: every VC firm “runs a bakery on a street full of bakeries that all sell one thing: plain bagels”. Beyond their partners’ expertise and reputations, VC firms use their Platform strategy as an additional differentiator in a market that has become over-competitive. It’s like the new sauce that makes the customer knock at the bagel shop. The ever-increasing influx of capital available to entrepreneurs forces VC firms—in particular new partnerships— to differentiate. Nonetheless, the efficiency of such strategies relies on its alignment with the needs of the firm’s target companies. Scott Maxwell at OpenView Ventures explains why alignment between the VC firm’s portfolio support strategy and its stage and sector of investment is critical in this post.
  2. VC markets are reputation-driven markets, i.e. most reputable VCs are those which perform the best (link). Nonetheless, reputation takes time to establish — sometimes over a decade. Emerging managers, which could not benefit from a proven track-record of investments, used their added-value beyond financing as a go-to-market strategy. Marketing their specificity and their additional services, these VC firms found a way to increase their visibility and, subsequently, the size of their deal flow. It has also given VC investors additional arguments to convince the best entrepreneurs to sign their term sheet rather than the one of another firm.
  3. An overwhelming majority of the VC investors I talked to considered that having the best deal flow was the single most critical performance driver in the VC industry. During their first years, a16z monitored every deal made by their US competitors and made sure it had been through their deal flow previously. When they realized that they were seeing 60% of the deals made by first-tier US VCs, they considered that they were on track. Marc Andreessen says it clearly: “To succeed in venture capital you must be one of the top five firms. And to get there, you must have amazing deal flow.” This makes another compelling argument for VCs to raise awareness around a renewed and differentiated value proposition and, thereby, try to attract the best entrepreneurs.
  4. Now, the interesting point here is that the main value driver for VC firms that embrace a Platform strategy revolves around deal flow quality and size. In other words, while we could have expected these VCs to aim first to improve the operational efficiency of their portfolio companies subsequent to the investment, their rationale is rather to improve companies’ performances prior to the investment (and to be chosen by the best entrepreneurs). This quote from Chris Dixon, GP at a16z, provides further explanation: “The popular view of venture investing is that it is about picking good companies, because that’s what’s important with public equities. But you can’t apply the logic of public equity markets, where by definition anyone can invest in any stock. Success in VC is probably 10% about picking, and 90% about sourcing the right deals and having entrepreneurs choose your firm as a partner”.

A quick Graph to highlight the Benefits of this Strategy

To sum it up, a Platform strategy is first and foremost an effort undertaken by VC firms to market themselves differently in order to attract the best entrepreneurs.

Again, that’s why a key element for a successful Platform strategy is to align it with the needs of the firm’s investment targets. It guarantees a higher deal flow quality, but also a higher efficiency of resources allocated to portfolio support. A good illustration is ff Venture Capital in New York, which invests at the seed stage. Realizing that their portfolio companies required extensive help on financial aspects, they hired a team of eleven people who focus only on helping their portfolio companies dealing with accounting, building financial projections, or raising funds with follow-on financiers. Point Nine Capital in Berlin is a VC firm dedicated to SaaS and marketplace startups. They have recently hired a SaaS marketing expert who focuses almost entirely on developing a wide range of useful resources for SaaS startups.

To summarize, one can outline two positive effects (and self re-enforcing up until a certain point) of this Platform strategy detailed in the following graph — thanks MIT System Dynamics class:

The positive feedback loops of VC’s portfolio acceleration strategies
  • A “selection effect”: the more a VC firm invests in portfolio support, the more it can communicate about its differentiators, and increase awareness around the firm’s specific value proposition. In return, the firm benefits from a larger deal flow, which increases the likelihood of VC investors selecting more promising companies. More promising companies are then more likely to provide the fund with better returns. In the end, better returns help investors raise larger funds, which allow them to increase their expenses in portfolio support.
  • A “VC value-adding effect”: Because they benefit from their investors’ additional resources, entrepreneurs are more likely to hit higher operating performances, to grow faster, and can potentially become more successful exits for the VC firms.

How to scale a Platform in the VC world?

Now, what this graph does not show is that a Platform strategy is not a one-size-fits-all approach. There are clear limits to this strategy. While it can help new VCs build a reputation, it’s only as a complement of what underpins VC firm’s reputation over the long run: their investment track record and their partners’ expertise and time. An underlying risk is also that it forces general partners to become managers of larger teams. It finally jeopardizes VC firms’ economics because it requires a larger chunk of VC firm’s management fees to be allocated outside of the investment team. Brad Feld, GP at Foundry Group, gives here a compelling argument against such strategies, that he experimented while working for Mobius Venture Capital in the 90's. In any case, the amount of management fees available to the VC firm clearly sets a limit to the amount of resources available for portfolio support. Hence, the strategy can’t be scaled unless…

…Unless one could find a way for VC firms to incentivize a larger network of people to help portfolio companies without having to pay for their salaries. Asking him to re-invent another model of VC firm after a16z, Peter Levine, GP at a16z, gave me a few hints last January:

“Probably, if I created a Venture Fund, I would create a firm with virtual services, not too different from the a16z model, but without employing people. So I would get CPOs, Engineering Talent, Marketing people who wanted to be involved with the venture fund and provide services. The reach in that case may be greater than the reach we currently have. You would create a network of people who could help companies without necessarily hiring them. They would get shares, have the privilege of investing with the venture firm, maybe get a little carry. I think there are ways you can actually create a virtual network of people; much greater than the internal network we have at a16z. Like a social network of Venture Capital operating people. Thousands of people as opposed to a few. It might be possible. I think we do a very good job [at a16z], but I am just thinking we could do more if you create this virtual group. You have to raise multi billion-dollar fund in order to hire 150 people. What if you keep the fund relatively small and have thousands of people helping you out through this virtual network? You could replicate the functionality of what a16z does, without having to pay everybody…that would be cool!”

Interestingly, combining their traditional investment arm with a syndicate or a SPV for accredited investors on AngelList on the side (check SPVs on AngelList here), one could imagine that VCs could scale this value-added by aggregating very easily a large number of value-added investors as their syndicate backers. Those would form together a large network of people, with different expertise, located in different geographies. They would pool their investment, and share incentives to help VC firm’s portfolio companies…

To be continued in the next post on the evolving relationship between VC firms and AngelList syndicates

A huge thanks to Raffi Kamber and Jeremy Uzan who introduced me to the VC world while I interned at Alven Capital in Paris. Thanks also to Christian Catalini, who supervised my thesis at MIT, to Peter Levine at a16z, David Teten at ff Venture Capital, Jay Acunzo at NextView Ventures, Jeff Fagnan, TJ Mahony & Sarah A. Downey at Accomplice, Alex Mittal at Fundersclub and François Veron at Newfund for their time during the interviews I held for the purpose of the paper I wrote at MIT, and from which this shorter post stems.
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