MORTAL KOMBAT IN THE VENTURE CAPITAL ARENA
One of the most important, and least discussed, factors that influence venture capital activity is the competition between VCs. Even though you will rarely see VCs speak poorly about other firms in public, behind the scenes competition between firms has a significant impact on VC activity and returns, and subsequently on the potential success of their portfolio companies.
I bring this up because recently the NVCA released their 2016 yearbook, recapping US VC activity in 2015. What is noticeable is that there were 93 first time funds opened in 2015, as compared to 32 in 2014 (almost 3X as much!). Clearly this means more competition, with more firms and more money flowing to the same pool of startups.
As has been well discussed online, VCs in general look for the home runs, and assume that the overwhelming bulk of their investments will fall flat. Therefore, as more and more funds become available, firms must jostle for position to get in to the hot deals.
Prof. Yael Hochberg, who has written at length about the VC ecosystem, points out in her paper called “Specializing and Competition in the Venture Capital Industry” that increased competition between VCs directly contributes to less profitability (on average). Specialization in sectors or industries can help mitigate this effect, but only by so much.
More specifically, new firms must compete against incumbent firms that have a track record, reputation, potentially more cash to deploy, and an extensive network. This last factor, the VC network, is the most critical in assessing whether a new firm can thrive in a crowded VC marketplace.
In one of the more cited pieces of academic literature on VC performance, Hochberg states unequivocally that
VC funds whose parent firms enjoy more influential network positions have significantly better performance, as measured by the proportion of portfolio investments that are successfully exited…
and
Startup companies funded by well-networked VCs have higher probabilities of both interim survival and eventual successful exit that do not derive solely from network enhancement of the ability to select investments.
The power of the VC network, for better or worse, was aptly defined by Michael A. Eisenberg from Aleph. In his post, Michael describes the difficultly of “outsider” VCs. By outsider VCs, we mean anybody without an office on Sand Hill Road in Palo Alto and a few select players in London. These firms face a continuous uphill battle for gaining access to the hottest startups, not to mention securing LP funding.
So what are these 93 first timers supposed to do, especially those that aren’t spun off from larger dominant firms or aren’t backed by massive corporate sponsors like Samsung Next.
First, as Michael points out:
Venture capital is an access business that services entrepreneurs. Venture Capitalists build brand and reputation to get access to the best entrepreneurs and convince them to take their capital. Limited Partners that invest in the best venture capital funds are also in the “access business” that services the best venture capitalists.
In other words, hustle, hustle, hustle. Hustle to get on people’s radar. Hustle to create brand recognition. And hustle to build trust and credibility.
Other upstarts are challenging the entire VC model. Companies like GrowthX are meshing early stage investing with the in-house services of a top accelerator. Right Side Capital has a transparent “spray and pray” approach, and has made over 100 micro-investments per year since 2012 (!!!). Venture Science incorporates tried-and-true financial best practices of risk management and analysis. (Matt Oguz — we should definitely talk, there is too much synergy between us not to join forces.)
And many others will look to partner with bigger firms, taking lead positions on diamonds in the rough and effectively working as local sourcing agents for bigger firms.
Unless newer firms are somehow able to hitch their wagons to the network externalities of incumbents, they will be left behind. The number of fantastic startups with legitimate sustainability is fairly fixed year of year, and will instinctively turn to the top tier VCs first for fund. The top tier VCs will immediately snatch them up, and exploit their deep network to help their portfolio companies gain traction, customers, users, etc.
The startup ecosystem has become “sexy” in the since 2008, and the influx of new firms and new funds makes capital easier to acquire, which not only drives the creation of more startups (if every barista in LA has a screenplay, every barista in Tel Aviv has a startup), but also drives up valuations as VCs compete amongst themselves, even for the less attractive startups.
Ultimately, if the status quo remains, we will see increasing “inequality” in the VC world. Name-brand firms with deep networks will continue to win and garner better returns and LP support, while newer firms will struggle to stay relevant.
