Coauthors: Elaine Truong, Neil Serebryany
Over the past few months, there are a few trends in venture capital that we have noticed. As we got our toes wet, we were surprised to find out how qualitative the industry approach is when it comes to evaluating investments.
However, the VC industry has gone through a number of fundamental shifts in the last couple of years and the ways that startups are funded in the future are changing.
One of these major shifts is that more and more startups are being created every year. With so many startups to sort through, the tech VC industry has adapted with its own titanic shifts in investment methodologies and evaluations. VC is largely a people-centric industry where investors go to their network for everything from referrals, market research, and guidance in evaluating startups. However, there appears to be a trend towards with this people-centric approach is now being complemented by quantification. Since the VC industry has such few winners (only 20% of firms make money) there’s an increasing need to test new strategies. The key disadvantage of a referrals-based process is that investors are only limited to who they know and end up missing out on potentially game-changing deals because they don’t have the analytical resources to evaluate each deal adequately. The following is a list of trends I’ve been noticing within the tech Venture Capital Industry and why they matter.
For a long time, tech VC was like private equity where partners have traditional backgrounds in investment banking or consulting. Recently, we are seeing more partners with hyper-specialized skills and specific domain knowledge.
As startups become increasingly competitive and more difficult to launch, the value each investor brings is significant. Tech VC firms are bringing on board specialized people who have experience with technology and startups. Notably, A16Z (Andreessen Horowitz) only has partners to have prior startup experience, resulting in a team that understands the evolution of a startup and the core technologies that power a successful venture rather than a team who understands how to do a double irish (a complex tax strategy). Tech VC used to be rooted in finance and drew it’s people from private equity private equity but it’s moving further from its finance roots since fundamentally the skills needed because tech companies develop differently at the early stage and you aren’t doing value investing - your job isn’t to make things more efficient, it’s to create new things. Startup experience is crucial for partners to offer value to early-stage portfolio companies because former entrepreneurs will understand key metrics, great product, customers, and failure.
Changing Expertise & Talent in VC Funds
In the 1990s, a lot of VC firms had more people who could complete an M&A transaction for a large company or advise a corporate CEO on his company’s tax strategy than people who understood product and how technology works.
The core skills of VC employees, however, are changing. From engineers and designers to subject matter specialists, more and more VC employees have worked within the field of technology before going down the VC or consulting route due to the fact that it’s hard to intimately understand an industry and what a company should look and viscerally feel like without being present in the past at a startup. For example, KPCB’s team distribution clearly shows that individual backgrounds are more diverse, more tech-focused, and less oriented towards the world of management consulting or corporate finance.
On the partner side, it's become almost a requirement that you start a successful company or work in a senior role at a high-growth startup to become a partner at any well-respected firm. From anecdotal experience I’ve found the distribution to be successful entrepreneurs can start their own firms our become partners at existing firms while startup employees or individuals with failed startups beneath their belt become associates.
VCs that regret missing out on giants like Google and Facebook are now increasingly concerned with seeking the next hot startup. VCs know that the worst thing than being the highest bidder is being the only bidder so they tend to compete for the most-hyped-about startup. This fear of missing out on potential ‘unicorn’ companies have led to some shifts in approach. To stand out among the many VCs trying to get a piece of the hottest startup, a VC has to offer much more than funds. The investor must possess expertise, domain knowledge, connections, and must resonate with the startup’s vision in order for the startup to admit the VC in their funding round. In addition, VC partners have to demonstrate to the community that they care passionately about the startup ecosystem by speaking at conferences, writing blog posts, and maintaining their personal brand.
A case example is discussed in this Fortune article - Renaud Laplanche, CEO of online credit site Lending Club was about to close a 9-figure funding round from private equity investors before Google Capital swooped in, with Laplanche reflecting that it was “the most value-added investment we ever had.” Similarly, Google Capital created 10 working teams from their 40,000 pool of Googlers to help portfolio company ZenPayroll with “things like choosing a new office location (Denver) and developing a plan to beef up its customer-service team.”
This huge shift means that VC partners & employees can empathize with founders, bring more realistic expectations to the table, and, most importantly, they can help troubleshoot or provide support and guidance to their portfolio companies. Given their in-depth knowledge of tech, they can also evaluate technologies and markets better.
Subject Matter Expertise
After A16Z came onto the scene and fundamentally challenged VC firms by introducing full- service VC’s (the CCA model), many VC firms took a similar route by offering legal and financial expertise or media opportunities (i.e. services that previously required startups to invest their own money).
Firms are also building a lot of internal technologies to share with entrepreneurs, because they’ve realized that it doesn’t make sense to do the work over and over again in terms of building tools to scale up growth.
Angels and AngelList are revolutionizing the Valley.
Angels are becoming increasingly powerful and active because of a few reasons:
1) the type of investor has shifted to one with successful startup experience and
2) angels who can act quickly and make fast decisions are increasingly valued.
3) Angellist is becoming an incredibly powerful force in the valley that has delivered companies like Shyp, Honeybook and Soothe.
4) Angellist has been able to raise a $500 million dollar round.
As more and more deals arise, a phenomenon is occurring in which there are too many deals for established VC firms to screen. Thus, new types of funds and people are investing through crowdfunding and online syndicates. Additionally, the SEC is moving forward with Title III of the JOBS Act in 2016 to allow non-accredited investors to participate in equity-based crowdfunding.
VC firms also have an incentive to diversify and spread risk across their portfolio, and increase the number of investments. With pre-seed and seed rounds becoming the new “Series A,” people are making high-risk micro-investments. The AngelList investing model, which allows angels and institutions to invest online, offers more transparency in funding rounds. Entrepreneurs can increase their company’s visibility and investors can syndicate investments.
The high number of deals and the large amount of money entering the VC market is placing more pressure on LPs to invest in ‘hit’ deals. Associate positions are increasingly competitive as LPs look for young recruits with wide networks to source investments - the best example of that is the growing number of micro VC funds (according to Samir Kaji, there were 250).
Democratization of startup funding
More and more hot startups are now being funded by regular investors rather than top 10 firms thanks to the Jobs Act, a bill to jumpstart the economy that allowed equity crowdfunding from accredited investors. Title III of the JOBS Act will level the playing field even further in 2016 by allowing non accredited individuals to participate in funding rounds.
AngelList is the main vehicle for this type of financing and it is exploding - $100 million was raised on AngelList last year. Investors are using it as a channel to source startups and entrepreneurs are encouraged by success stories to reach out to mentors through its platform.
Associate to fund
Associates/junior partners oftentimes have an easier time forming relationships with founders since they are more likely to have startup experience. More firms are looking for successful entrepreneurial experience rather than corporate or banking experience in their junior recruits due to the fundamental shift towards full-service firms. For firms that make seed investments, it’s difficult to find investable startups that fit their criteria since the challenge is that such early-stage startups are under the radar and relatively unknown. Thus, partners often send associates to related networking events to build their social capital.
Lately, there has been a trend of LP’s funding the creation of small funds by these younger VC’s (see KPCB’s Edge Fund) because they oftentimes have access to a lot of deal flow and are better positioned to see trends in the marketplace due to their background and younger age.
More deals are occurring and many more companies are being funded by VCs that are encouraging a data-based reality. VC’s are catching up to automated investing trends (Google admits to using algorithms to evaluate deals) and are trying out new tools in ‘blackbox investing.’ The VC industry is becoming much more competitive and since it’s such a hits-driven industry, start discovery tools have an outsize influence. What this means is that the VC industry needs new tools to discover startups first because the traditional people-centric model isn’t working and tools like CB insights and Mattermark are trying to fix that hole. They are also looking into more efficient ways to evaluate startups because only 25% of firms make money and actually achieve superior returns.
Quantitative discovery of companies
For a long time, venture capitals rely on second-degree referrals for investment consideration. The problem with a referrals-based networked system is that every venture capitalist is looking for the next Palmer Luckey, or the next Docker. However, so many groundbreaking innovations and teams may not have any direct links to venture capitalists.
Venture capital is moving towards a more outbound future analyzing which factors (especially for technical companies) directly correlate with success and outreach.
The problem lies in diminishing returns - as more people start using this type of methodology - the inefficiencies in the market that allow such a technology to work are fixed.
Quantitative Assessment of Companies
Since VCs who invest in early-stage companies often evaluate investments by the quality of founding teams, they seek a level of trust and personal connection with the entrepreneurs. Vice versa, entrepreneurs seek partners, not just investors. VC deals are assessed by looking the founders in the eye and making a subjective judgement of whether the VC can trust the founder. There are a number of problems with this approach, the biggest problem being that the type of founders being backed are of similar backgrounds and are working on ideas that target the same people. Thus, this neglects huge, untapped opportunities to make money in other unfamiliar industries.
Currently, it takes many years of experience doing deals and witnessing financial cycles to accumulate the knowledge needed of a reputable VC. This is both time-consuming and expensive as investors will have to endure several failures before seeing a success.
The VC industry is undergoing a shift - only 25% of firms make money because the primary differentiator between the best firms and the worst has been access to deal flow. VCs are now realizing that there are other ways to differentiate themselves such as getting in earlier and crunching the data in new ways.
Smaller VC funds are often having an easier time achieving a 4x return due the to the fact that if you have a fund that’s $100 million or above needing to find unicorns (companies valued at a billion dollars or above) due to the math of it. If we take a 100 million dollar fund that’s later stage - each partner makes ~3 investments a year over about 3 years (the typical investment time that I’ve seen) and the fund would probably have 4 partners. They would try to go for about 20% of a company under this model and what that means is that their companies have to create a combined $2 billion dollars of value in order to be a top fund. The mat gets even more difficult the bigger the fund is (IE: I $1 billion dollar fund would have to deliver $20 billion in value to return the fund).
Ideas for future directions include:
Project based evaluation of entrepreneurs. The best way to evaluate a good entrepreneur is to work on a project with them. Possible ways to do this in a scalable way include having an online platform for entrepreneurs to propose a case study for his team to work on.
Analytics tools and the methods that VCs use to eliminate subjectivity and human bias.
Use affective computing tools like the facial action coding system to see how truthful entrepreneurs about a project are and if they are passionate about them.
Another trend that can occur are better stores of information on typical patterns in an industry because it's hard to evaluate a founder's market assumptions without having an industry expert.
Growing internationalization of startups - the goal of a startup rather than any other type of startup is to fix a problem and rapidly grow to dominate a market and the pool of venture backed startups for a long time has mostly been limited to the United States. but that makes no sense - the United States only has about 5% of the world's residents.
Overall what these trends tell us is that the VC industry is in a period of bifurcation with the top firms taking almost all of the profits and small firms existing just like a seed stage startup on the premise that in the future they’ll be able to generate large profits. VC’s are looking for new tools to nurture and discover startups and hopefully generate better returns by moving towards diversification and data-centric investment analysis.