Lots of discussion these days about the changes in the VC industry. Here’s my take:
1. The VC industry grew dramatically as a result of the Internet bubble - Before the Internet bubble the people who invested in VC funds (called LPs or Limited Partners) put about $50 billion into the industry and by 2001 this had grown precipitously to around $250 billion.
2. But VC is an “illiquid asset” so funds didn’t disappear quickly - In 2000/01 the stock market quickly adjusted punishing investors in the NASDAQ and in individual public technology stocks. Consumers pulled their money out of these risky investments, but when LPs make commitments to VC funds they make 10-year, legally binding commitments. So as of 2008 total LP commitments were still at nearly $250 billion.
3. The VC industry in shrinking – Paul Kedrosky was early on the scene with this prescient prediction that the industry would shrink. What accelerated this was the collapse of the public stock markets. LP’s who invest in funds are typically university endowments, public & private pension funds, insurance companies, large corporations and very high net worth individuals called “family offices.” To give you an indication of how bad, for example, university endowments are suffering check out this chart. You’ll notice that Harvard lost 30% of the entire value of its portfolio. If you’re interested to read a more detailed piece on how they think about this check out.
So the people who invest in VC funds have two problems. One is the “denominator problem” which says that if an LP invests X% (the numerator) into “alternative investments” such as venture capital and if their total amount available to invest (the denominator) goes down by 30% then the amount they allocate to VC will by definition need to go down by 30% to stay the same percentage.
The second problem is more troubling. The VC industry has performed terribly over the past 10 years. Many firms didn’t even return LPs their original money let alone a profit. So even within the “alternative class” our LPs are looking at other asset investment choices such as distressed buyout funds, private equity or hedge funds.
VC will shrink. Oh yes it will.
4. This means that some funds will disappear – Returns are not even. The top quartile funds have performed well. [side note: our last fund at GRP Partners is currently ranked as the 5th best performing fund of the year 2000. Our current fund was raised in 2008/09.] Many funds have not performed and will start to disappear. This is finally happening because the boom of 1998-01 means that many funds are reaching the maturity of their 10-year funds [strangely, 10-year funds usually last about 13 years!].
The best and most consistent funds in Silicon Valley (e.g. Sequoia, Kleiner Perkins, Accel) can and will easily raise money. But even great funds that are not in this historic and long-established funds will not find fund raising easy. This is best told in this amazing and brutally honest piece by Alan Patricof where he talks about the recent difficult fund raising experience at Greycroft [they just raised a $130 million fund].
I was at dinner with a large LP and mentioned that I had heard the industry would shrink by 50%. She laughed and said, “Our predictions are for a much larger drop.” Gulp.
5. Funds that raise money will be smaller - There is not only less money going into the VC industry, those that raise funds are often raising significantly smaller funds. Some funds like Battery Ventures have bucked the trend by raising $750 million. Others will, too. But my conversations in the private corridors on Sand Hill Road in Silicon Valley is that many fund sizes will be smaller going forward.
6. This is producing a game of musical chairs – You know: the music is playing while 8 partners walk around a circle of chairs. The fund size shrinks by half so half the chairs disappear. The music stops. Partners leave the industry. Some partners don’t have to walk – they just sit down while the music is still playing and therefore other partners need to go.
But equally some partners joined firms in 2000 and have still never seen any upside in cash since their funds haven’t yet returned the initial capital [note: VC funds usually return all of the capital that they raised first and then share 20% of the profits above this hurdle].
I suspect both were at play in Rustic Canyon Partners that went from a $500 million fund to around a $200 million fund. PE Hub reported that there were defections and the implication was that the fund was “fighting for its life.” I don’t think this is accurate. There are some very talented partners remaining at Rustic Canyon and I’m told some committed LPs. But I also know that some of the partners who left were also very talented. PEHub followed up their analysis with this. Think about the math. It was clearly a game of musical chairs in some cases and in others a case of talented people believing they could make more money in a different job. After all, most people don’t understand that “venture capital is a get rich slowly” scheme.
7. It takes less to start a business these days – We all know that it takes less to start a technology company these days. You don’t need to buy hardware – there’s Amazon AWS. You don’t need to buy expensive software – there are free open source solutions for nearly everything. You don’t have to hire as many sales people because much can be sold online. So companies are running for the first 1-2 years on significantly less capital than they did 10 years ago.
8. So super angel and seed funds are proliferating – As a result there has been an explosion in the number of amazing early-stage investors such as Softtech VC, Floodgate, Felicis Ventures, K9 Ventures, OATV, Lowercase Capital, Founder Collective, and many, many more. There are also super angels that are so numerous I’d rather just link to the best list out there, which is VentureHacks’ AngelList.
9. And VC’s are doing earlier stage deals – And we all know that VCs are doing earlier stage deals. The most notable is First Round Capital who built their entire fund and model around this type of investment and the notion that exit values in the future will be lower than they were 10 years ago. They are also the most innovative new fund to enter the market in the past 10 years in my opinion. There is also True Ventures that does early stage, seed investments. And of course Foundry Group, Union Square and a whole host of other firms including my own. I have written more in depth on this topic in the past.
10. This is producing a “boomlet” or a bubble in early-stage investing. That’s OK. – This massive increase in seed & angel funding caused Paul Kedrosky to predict that there is a coming seed fund crash. I don’t know whether there is a “crash” coming per se but I do believe that too much money is going into angel and seed companies too quickly. I’m OK with this – it feels fairly benign. But one problem it is causing is that early-stage deal prices are creeping up again higher than historic norms. This smells like classic froth to me. So IMHO it’s probably more of a mini “bubble” than an impending crash.
11. But it takes the same amount of money to scale a big business and this is where outsized returns are earned – If you want to build a big business you still need big bucks. Fred Wilson wrote a great piece on this. He acknowledged the importance of the growing seed fund movement in creating a new wave of cost-effective innovation. He then profiled his portfolio company FourSquare who started with a very small investment. But now that it’s time for them to scale they need a lot more capital and therefore just raised $20 million from Andreessen Horowitz. Think about it – while FourSquare has established itself as the clear market leader it is unquestionable that Facebook, Yelp, CityGrid and many more well capitalized companies will be gunning for them. Staying “lean” is not an option. If FourSquare wants to dominate it’s market it’s time to GO FAT.
12. Many angels and some seed funds will get burned – In good times it’s great to be an angel or seed investor. You invest low amounts of capital and the company gets to IPO (96-99) or trade sale (05-08) without raising too much capital and certainly not on punishing terms. But in bad economies many angels get burned. More money is needed, VCs are harder to come by and when they invest it can be on penalizing terms. Often if you have deep pockets (or a proper fund) you can protect yourself by getting out your checkbook again. But this only works if you have deep pockets. And ironically the one time angels hate to get out their checkbooks is in a difficult market (in part because they’re also feeling it in their real estate investments, stock market portfolio, etc.). So angel and seed stage investors’ returns will be dependent on good times continuing or on the ability of their portfolio companies to get financed.
13. So forming tight relationships with larger investors in the value chain is a critical skill for investors – The smart angels and seed fund investors know that one of the most important success criteria for an early stage investor is the ability to get the next round of the company financed. Nobody understands this better than First Round Capital. I have never seen a fund that spends so much time building relationships with every other VC (in addition to many entrepreneurs.) Some seed angles and seed funds clearly get it. Others spend less time on this activity.
I also think that seed funds with a very clear sense of purpose will do well. One of my favorites is K9 Ventures. Listening to Manu Kumar speak is like listening to a focused entrepreneur speak (and I can’t say this about all funds). He has a set of clearly defined criteria in order to invest. Price MUST be in a certain range. Team must be purely technical. Revenue must come from a primary source (as opposed to advertising or other third party sources). Teams MUST be in the Bay Area. And so on. When you listen to his rules you get the sense that he really has a strong thesis for his investments and a belief in how he’ll make good returns.
14. This is especially true if we have a double dip economy – If the economy is in recovery then angels and seed funds are heros. If we hit a double dip economy then the next phase of their investment cycle begins. They’ll need to focus on getting portfolio companies funded. Those that invested narrowly enough and/or have great relationships with VCs will do well. Those that spread there bets widely or haven’t fostered VC relationships will have some triage work cut out for themselves. ”Financing risk” is one of the biggest risks for seed stage investors. This only becomes noticeable in down markets.
15. The reality is that right sizing the industry isn’t enough. You need to right size each segment of the industry. – While many people publicly predict that the future of investing is about seed investing I think this is wrong. There is a certain size market for seed funding that should exist. Excess capital will drive up prices in that segment and drive down returns. I think this segment has expanded due to structural changes discussed earlier but it still has a natural limit. Then there is a certain size market for A round VCs, B round VCs and growth equity investors willing to put $50 million to work.
What you’ll see is a natural segmentation of the industry (which already exists) where each segment is right-sized and we’re all inter-related and our successes mutually dependent. The earlier the stage, the cheaper the price, the smaller the check, the higher the risk and therefore the higher expected return. So Chris Dixon is right that super angels and seed funds should perform better than VCs – they’re taking higher risks due to an early stage. But many others won’t navigate these risks well and will underperform. You don’t get the increased reward without the commensurate increase in risk.
I did a short explanation of this whole phenomenon in this video. Start at minute 50.30 and run for just a few minutes.
16. Importantly, what does this all mean for startups? As I argue in the same video above – startups are better off by the “right sizing” of the VC industry. When there is too much money in VC then too many companies get funded and raise too much money. Try selling your product at a fair price when you have 4 competitors who’ve each raised $10 million in VC and who expect it will be easy to raise the next $10 million. Over funding drives poor market behavior and makes it difficult for strong players to earn proper returns. I’m not anti competition – to the contrary. I just don’t like too much competition armed with large balance sheets funded on speculation and hoping purely for user numbers.
So in the future less of you will likely raise VC money. You’ll have to find alternate ways of financing your dreams and that’s OK. But those of you who do get funded will build stronger businesses, make better returns, hire better & more committed employees. And of course you will produce our next wave of innovation.
