Why VC May Be Poorly Positioned for the Coming Decade, a Technology-First Analysis

Over the last few decades, Venture Capital has grown explosively, funding many of the era’s most successful companies. The oft-repeated saga of a couple of upstarts founding and growing a massive businesses has captured the attention of ambitious technologists and savvy investors alike. But how durable is this model at its current scale? Is the success of VC indicative of a new normal, or did the model fulfill a particular, temporarily massive, niche? If so, will this niche continue to exist it in the coming decade?

Personal Computing and the Generalist Engineer Founder

Beginning in the early 1980s, a new category of technology entered the scene: Personal Computing. It began with the aptly named Personal Computer (PC), and continued with the development of laptops, the web, and mobile. Collectively, these technologies allowed software to solve consumer-scale problems.

Consumer-scale problems with software solutions are the perfect breeding ground for Venture Capital. Low marginal costs and large markets mean that portfolio companies can grow hundreds or thousands of times over, allowing VC funds to invest in dozens of failures for every one success.

The dynamics of Personal Computing also shaped the necessary characteristics of a founding team. Many of the best opportunities involved solving everyday problems, so domain expertise wasn’t necessary. Facebook’s founders weren’t experts in social interaction, Airbnb’s founders weren’t experts in hospitality, and Uber’s founders were simply clients of the black cab industry.

Furthermore, many of the actual solutions to these consumer-scale problems are technically straightforward. They are best solved by an archetype I’d like to call the Generalist Engineer. Generalist Engineers are not deep specialists, instead they are capable of analyzing a wide variety of existing inefficient processes, and improving them with software and hardware.

All a founder needed was a basic understanding of the new technology, the the ability to think outside the box, the risk tolerance to start a new company, and the time and energy to capture an opportunity first.

The Maturation Trap

It has been 13 years since the iPhone was first released and the mobile computing wave began. “App Fatigue,” the lack of consumer desire for more mobile apps, is a well-documented phenomena, and the number of new companies in the space have slowed.

This isn’t surprising. Every technology wave sees an explosion of new uses, followed by a gradual decline. Company formation doesn’t stop after the peak, but instead shifts. Once the low hanging fruit has been exhausted, the remaining problems are more technically challenging, or exist in niche, undeveloped domains.

This trend works against the VC model in a couple ways. First, problems that require advanced technology often require lots of R&D to create that technology, and R&D succeeds in fits and bursts. VCs that back these kinds of startups gamble on the chance of a breakthrough before the money runs out. If the breakthrough does not occur, the startup will go bust or be sold cheaply for its patents.

Consider Magic Leap, an AR/VR startup that was able to raise $2.6 billion. Despite making significant strides in AR/VR technology, they have simply been unable to bring a successful product to market. Due to this unpredictability, these kind of problems tend to be solved by larger companies with the cashflow necessary to invest in R&D for the long haul.

Second, problems in specialized niches have their own complications. Niche markets tend to be smaller, which is an issue for VC funds that need their winners to be huge. Plus, niche markets also require founding teams with both sufficient domain experience and sufficient technological experience.

Such teams become rarer and rarer as the domain gets further from the technology industry itself. Techies and domain experts will tend to cross paths less and less, and domain experts will often be later in their career and more established, less likely to embark on an all-or-nothing founders journey. Venture Capital’s model relies on new companies being founded, so if the supply of potential founders dwindles, so does the supply of good VC-friendly deals.

This shrinking of VC-friendly opportunities is what I’d like to call the Maturation Trap.

The Next Generation of Technologies and Companies

Previously, Venture Capital was saved from the Maturation Trap by the regular introduction of new Personal Computing technology. Just as the PC or Web 1.0 was losing steam, a new innovation like Mobile would appear and reenergize the space, creating new opportunities.

But is another such innovation on the horizon? Personal Computing has strove for decades to be more powerful, more portable, more accessible, and more feature-rich. But now most of the developed world has access to powerful, constantly connected computers; computers with GPS receivers, cameras, accelerometers, touch screens and more. Is there a logical next step in Personal Computing, or have diminishing returns begun to set in? I may be wrong, but I believe that we are facing a significantly longer gap between Personal Computing technologies than we have become accustomed to.

As we enter the 2020s, some of the most promising new technologies are Internet of Things (IOT), AR/VR, Blockchain, and Cloud Computing. IOT, AR/VR and Blockchain have not yet had their “iPhone moment”, their moment when they begin to achieve mainstream appeal, and as such are not yet ripe for successful VC investment at its current scale.

So which technology is beginning to achieve mainstream appeal? Cloud Computing. Cloud Computing has been growing enormously year over year, and the industry size reached over $200 billion in 2019. Cloud Computing clearly is a new wave in technology, but is it as VC-investable as previous Personal Computing innovations?

Instead of enabling solutions to entirely new consumer-scale problems, Cloud Computing enables existing enterprises to modernize. Cloud Computing also enables a slew of Platform as a Service (PaaS) and Software as a Service (SaaS) offerings that offload technical expertise from these existing enterprises.

Subsequently, the economic value created by Cloud Computing will accrue in three places. Cloud Providers (AWS, Azure, Alibaba Cloud), SaaS/PaaS companies, and existing enterprises that can utilize the new technology to improve their current business lines.

How Investing Will Be Affected

Cloud Providers and existing enterprises are either publicly traded, or privately held but long past the stage of requiring VC-style investment. This leaves only SaaS/PaaS companies as a potential fit for the VC model.

In SaaS/PaaS companies, initial investment can be used to build out the product, and then the product can be scaled to serve lots of enterprise users. That being said, SaaS/PaaS companies tend to require more salespeople and more integration work in order to sell their software, and therefore have lower margins than most consumer software companies. This leads to lower valuations than consumer software companies. VCs must therefore be more cautious with their investments, as they can’t rely on a couple massive successes returning the whole fund. (It should be noted these lower returns also make startups less appealing to solid engineers, who are increasingly incentivized to just work for big tech companies.)

Am I claiming that VC is doomed in the coming decade? No, absolutely not. There will always be technological innovations, new circumstances, and new domain expert founders who make VC-investable companies possible. I do claim, however, that the number of good VC-investable companies is going to be a lot smaller than the industry has gotten used to in the past couple decades. The number of good investments will shrink, and competition for these investments will rise. According to the data, this is already happening.

Top VC firms with strong brands will continue to do well, as they will be able to capture the good deals in the marketplace. But most VC firms have mediocre performance, and will likely be unable to raise new funds as their current ones begin to underperform. I believe the VC industry will therefore contract and consolidate throughout the 2020s.

(It should be noted that this conclusion is contingent upon not having a large new wave in Personal Computing tech. If I am wrong and another such wave occurs, VC will once again be able to fill its niche.)

Another Path Forward for Technology Investors

Others in the space have been observing and predicting the underperformance of VC for a couple years now. Since VC is poised to be a poor investment, technology investors who aren’t in top funds need to find a new way to generate returns or leave the field entirely. What can this technology-first analysis tell us about where to find returns?

The most obvious approach is to invest in the Cloud Providers and other big tech companies. But, investing in public companies doesn’t give technologists any leverage, and the public equity space is already dominated by hedge funds.

Luckily, our analysis points to another entity that will benefit from Cloud Computing: existing enterprises that are technologically outdated that manage to modernize. If tech investors can invest in the process of modernizing these enterprises, they can capture some of the value generated by the rise of Cloud Computing.

I believe that technology investors can borrow techniques from Private Equity, allowing them to invest in, and profit from, larger enterprises. Many existing enterprises don’t need deep technical expertise to modernize. They need Generalist Engineers! The same kind of Generalist Engineers that were once a perfect fit for VC-backed startups, but now find themselves more and more incentivized to stay in big tech.

This an arbitrage opportunity, moving engineers and funding from where they are in abundance to where they are in short supply. I believe the potential economic impact of bringing Generalist Engineers into other industries is enormous. I also believe VC firms are best situated to raise a new Tech-PE fund and profit from this shift in dominant technology. The 2020s may not be kind to Venture Capital as an asset class, but they can still offer great opportunity to technologists willing to change the way they invest and build.