For the past few years, I have read over what seems like hundreds of blogs and thousands of tweets that either directly claim or indirectly hint at a disruption of traditional venture capital. For some, the factors relate to the economy, that limited partners and institutional investors were reviewing their investment approaches. For others, it seemed as if there was too much money in the asset class, that there was too much money chasing too few real opportunities. There seemed to be a long laundry list of why venture capital was undergoing this shift, but never any thread that could lay out all the factors and synthesize just how each factor contributed to shift, until now…
(Note: 1. Since “venture capital” is applied to many different industries with vastly different economic structures, this post will focus on software startups. 2. I am not going to list examples below because there are too many and I don’t want to exclude any particular companies.)
First, we have Amazon: It’s cheap to build, host, test, and optimize software. Amazon Web Services, for instance, reduce operational costs for young companies, directly impacting a startups’ burn rate. Whereas in the past a not insignificant part of an investment may be allocated to hosting, Amazon’s innovation has helped entrepreneurs better manage costs and dampened the need for venture capital investors to help out early with operational expenses.
Secondly, Angel Investors: Once a products gets to some proof of concept, an entrepreneur can raise seed funding from an incredibly wide range of sources. Those that are either connected or lucky can solicit checks from family, friends, former bosses and colleagues, or they join incubators (more on this below), or reach out to relatively obscure or more well-known angel investors, all the way up to small institutional funds, what some people refer to as “Super Angels” or “MicroVCs,” or websites dedicated to pairing investors with investment opportunities (more on this below). The flood of early-stage capital has triggered some venture capital firms to also invest in the seed stage, where they have to compete directly with smaller funds or vehicles, though a small handful of firms have resisted and focused on Series A-style investments.
Third, we have AngelList: Simply one of the most disruptive forces to the venture industry, the folks behind AngelList have created extremely useful social software that pairs investors with investment opportunities. For angel investors, AngelList provides an asynchronous way to scout, monitor, track, and communicate with potential investment; for startups, the system provides an opportunity for them to network, build reputation and good signals, and connects them to a wider range of potential funders. The disruption AngelList provides to venture capital is that the system could theoretically be used for larger Series A and B fundings, and in some cases, probably has. It remains to be seen if it can scale across to this level, but given how much it has accomplished in a few years, it’s not out of the question.
Fourth, we have Kickstarter and crowdfunding: For some particular startups that aren’t able to secure seed funds, either from angels, super angels, angel-focused software, or venture capitalists that make seed investments, they can leverage crowdfunding platforms like Kickstarter to tap into an even wider pool of available funds. And now with the JOBS Act, which will allow for crowdfunding of certain startups in certain situations, new companies can now raise small amounts of money from many different people, just as a political candidate may use small online donations from a large base to raise funds.
Fifth, there’s Y Combinator: While there seems to be an incubator popping up weekly nowadays, the system, network, and brand built by the partners at Y Combinator has, in a relatively short period of time, captured significant power in the early-stage ecosystem by attracting, vetting, and training technical entrepreneurs on the ins and outs of how to start technology companies. Each class in Y Combinator prepares for their Demo Day, and each company has the option to accept $150,000 in convertible debt — and not just from anyone (more on this below). Having this cash on hand affords these companies a bit more time and runway should they need it, and gives them some negotiating leverage when talking to larger investors who are keen to invest, sometimes resulting in higher valuations that venture capitalists have to compete against.
Sixth, is “New” Venture Capital: The money given to these YC companies isn’t just normal money — it’s in part from a new style of venture capital pioneered by firms like Andreessen Horowitz (A16Z) and DST. While DST has made big bets and partnered with YC, A16Z has also raised large funds with a relatively small partnership, choosing instead to challenge the traditional venture capital personnel structure by operationalizing services across functional areas such as business development, recruiting, public relations, and sales. For a founder, the services offered in this model are attractive, and this has motivated some other venture capital firms to change their own structures in an effort to provide more services to their companies. Additionally, the A16Z investment thesis, which seems to be designed around a belief that this is a particularly unique period of opportunity for transformation both on the web and in mobile and that a small share of winners in these categories will produce outsized returns. As a result, they seem to be willing to pay higher prices, which either forces traditional venture to compete or wait for the next thing.
And, finally, seventh are secondary markets: Now that early-stage shareholders (investors, founders, employees) of certain companies can sell their shares on these secondary markets, such as SecondMarket or SharesPost, they are able to access liquidity much earlier in the past. On the flip side, larger venture capital funds that may have missed out on the next big thing because the new company was incubated, or crowdfunded, or funded via a social network or small or large angel investors may have a chance to own a piece of the entity through these markets. In some cases, venture capital firms have been quite opportunistic to buy and sell shares of larger web companies in a short period of time, making a quick flip and marketing to the world that they, too, have invested in a particular company. While these markets provide venture capital with access, they also have to compete with a larger number of firms for these deals, a factor that could drive up prices and thereby affect returns.
All of these forces combined, and each individually in their own way, have altered the landscape for traditional venture capital in software. It is on average significantly more difficult to for traditional firms to find early-stage opportunities because there is more competition for those investments, and once a company does breakout and require more institutional funding, the prices for those rounds may not look like they have in the past. Some of this is reflective of the competitive forces that set market prices for private companies, or, depending on where you sit, is simply the new price to pay in order to own a piece of these coveted assets.
And while we’re able to analyze what has happened so far, I have no clue what the next few years will hold. Will the next big breakout originate from an incubator, will it be funded by software platforms, or will it be discovered by a small set of angels and venture capitalists, as it has for so many years to date? In the great race to find incredible talent before others, and the great race to own shares in private companies, there are more questions here than answers, but there’s no denying that it will be fascinating to see unfold.
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