Changes in Software & Venture Capital – Part 2

Posted on Jun 29, 2011 | 25 comments


Yesterday I wrote Part 1 of the series on the changes to the software industry over the past decade that has led to changes in the venture capital industry itself.

If you don’t want to read that post, the summary is:

  • Open source computing drove computing costs down 90%, which spurred innovation in technology
  • Open cloud led by Amazon with their AWS services drove total operating costs down by 90%. This led to an explosion in startups.
  • Amazon in turn led to the formation of an earlier stage of venture capital now led by what I call “micro VCs” who typically invest $250-500k in companies rather than the $5-7 million that VCs used to invest.

These trends have put pressure on traditional VCs. Some have done earlier-stage deals and done well. Others have chased earlier-stage but lack the skills or relationships to do this effectively. Some have moved into later stage investments in an effort to “put logos on their websites.”

People are moving into everybody else’s space.

Everybody seems to want what everybody else has. You know the old saying from Harry Met Sally, “I’ll have what she’s having!”   This will continue while we’re in a tech bull market and I predict will wane when we’re not.

The Blurring of Investment Lines
With new micro VC entrants into to early-stage investing plus increased competition from angels, incubators and the like – traditional VCs have taken notice. So VCs spent a couple of years experimenting with earlier-stage investing, which is OK. The best of them: Spark Capital, USV, Foundry Group also understood that how they worked with these management teams was changing and I believe firms like this will continue to excel at early-stage investing. There are also others.

I would put my firm, GRP Partners in with the group working with teams in different ways. But obviously I’m biased.

I believe some VCs have entered the early-stage market as simply an option on future financing rounds. I doubt this will end well for those VCs or for the entrepreneurs they backed. I don’t think purely option-based investing in startups suits the long-term brand of the investor.

The other major trend seems to be pulling in the opposite direction.  As some of the last generation of startups have gotten bigger many VCs have also chased later-stage investments that were traditionally dominated by growth equity or mezzanine funds. It is less clear to me that this is a smart strategy but we’ll see over time. It feels more opportunistic than an “investment strategy” to me. It’s one thing to invest in a later-stage (say a C round) to help with growth, it’s another to fund companies who are already valued in the billions. Will public investments come next?

And of course hedge funds and growth-equity funds can’t resist trying to get earlier-stage exposure again. As I said, the traditional investment lines of stage-based investors has blurred.

But all of this is normal and we saw it all in the late 90′s. In a bull market many players see drift in their activities. In a correction the best people focus exclusively on their core competencies. I think Micro VCs are best at what they do, A/B round investors ought to be mostly A/B round investors and late-stage investors out to focus on companies that are already profitable and growing rapidly. Hedge funds out to be, well, hedge funds.

The LP Community Hasn’t Yet Caught Up
As I’ve started to get to know the other side of the VC industry lately (the people who invest in VC funds or “LPs”) one thing has occurred to me. As a generalization LPs seem to recognize this general trend requiring less capital to start businesses and are arguing for smaller VC funds. That’s wise. But most LPs don’t seem geared up to fund new entrants in the Micro VC category.

Many LPs want to write checks of $10 million or $25 million because they themselves have billions of dollars to manage. And the more “small checks” they write, the more VC managers they have to manage. They also often don’t want to be more than a certain percentage of a fund.

So if a VC wants to raise a $30 million Micro VC fund and if an LP doesn’t want to be more than 15% of a single fund, the math collides. Maybe Micro VCs will get larger and emulate a multiple-partner strategy like True Ventures or First Round Capital. I think some will do this.

Others will want to stay small. My best guess is that new LP funds will be set up in the future to service Micro VCs. So far I only know of one that has set up a focused LP fund to focus on this strategy. Hats off to Michael Kim of Cendana Capital – the first person I’ve spotted who focuses just on Micro VC. And no prizes for guessing that he’s getting into some of the best Micro VC funds. I think people who invest in LP funds ought to take notice of Michael’s leadership position. (disclosure: I’m an advisor to Michael’s fund. But I only agreed to do this because I know he’s really on to something others haven’t yet spotted.)

The Explosion in Early-Stage Innovation
The Amazon AWS-led revolution of startup innovation has led to a massive increase in the aggregate number of startups. This in turn has fueled incubation programs like YCombinator, TechStars, 500 Startups & many more to help early-stage teams launch businesses led by most technical founders who are getting coaching from seasoned management teams.

In addition it is much easier to get distribution than it was in the pre Facebook, pre iPhone world. It is not uncommon to see a team out of Utah, Texas or for that matter Finland with 8-10 developers build iPhone apps that get 10′s of millions of downloads and doing hundreds of millions of monthly page views.

All of this innovation is awesome and there have even been new online tools such as AngelList to help entrepreneurs raise money more easily from angels or early-stage funds. Much credit for the mindset of keeping companies lean, having them launch & experiment on products and trying to “find product / market fit” goes to Steve Blank (author of the much respected Four Steps to Epiphany) and Eric Ries, spiritual leader of the “Lean Startup” movement.

The explosion of startups coupled with lower costs to build in the early days and the freely available capital at the sub $1 million funding level has led to a lot of talk about whether the old Venture Capital model is still relevant. It’s my judgment that VC is as relevant to helping today’s startups become large businesses as it was 20 years ago but perhaps the skills of VCs themselves have to adapt.

I believe that most companies can exist in the experimentation mode for 3-4 years. They should start “lean.” If they hit a product / market fit (meaning you suddenly see a massive uptick in usage and/or revenue) then these companies need to go “fat.” If they don’t the industry titans around them will eat their lunch.

Enter VC. You can’t scale a large business quickly on your $500,000 alone. The Venture Capitalists can help these young founding teams scale their engineering departments, develop business development relationships, deal with onslaught of PR, handle executive management challenges, etc.

Not to mention providing the capital for growth. People who believe that you can easily build a huge company quickly for just $500,000 are mistaken.

The other argument against venture capital is that all of these new startups can exist on their own without ever raising venture capital and they can build meaningful, but small businesses. I acknowledge that is true for some segment of the market and there’s no shame in having a $15 million / year, 15% growth business churning out 20% annual profits. In fact, that’s pretty awesome. But that will be the minority of these startups.

For those that do survive without VC because they figure out how to make enough revenue, many of them will be “ramen profitable.”

Ramen profitable is good while you’re in search of a more scalable business model but is not sustainable for most companies in the long term. Most ramen profitable businesses achieve profitability because the founding team is paying themselves very little and hiring almost no staff. This can be sustainable for a young team for 3-4 years but beyond that the teams start to fracture. Some people get married, have kids, want to buy a house or simply get lured away by the next hot idea.

In either case, venture capital will remain an attractive option for teams who want to pursue their business ideas and scale.

  • http://usemighty.com Aaron Crayford

    Nice cliffnotes Suster!

  • http://www.smallbusinessbible.org Small Business

    Hats Off! For your great article.

  • http://www.kineplay.com Ben Milstead

    Great post and series — looking forward to the third piece. I agree with much of your analysis, well thought-out as usual. One digressive comment: Having been in mobile since the early 2000′s and iOS almost four years: Suggesting that tens of millions of iOS downloads is commonplace is a bit generous – it has happened to several devs but compared to the number of teams pounding Obj-C (not to mention the shear volume of apps), I still see the user successes (and certainly revenue successess) as fairly exceptional. The endcaps at AppleMart :-) have been in need of some overhaul for a while now and until that happens, the number of apps and crapps crowding the decks can make it challenging to get great numbers on one title. OTOH the growth in mobile is astounding — a lot of the infrastructure we were dreaming about even five years ago is happening now (particularly location and to a lesser extent AR). So lots of room for good app implementations for some time to come, and that will drive healthy consolidation and better digital merchandising, etc…. there endeth the digression. Thanks so much for such a fabulous blog! I’ve been a reader for a while now and I can’t tell you how much I appreciate the time and effort you’ve put into making your blog so useful and informative.

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  • http://www.commun.it SharelOmer

    Gr8 post and once again, very relevant to us as an earls tage startup :)

    This quote is amazing, we believe in it a lot “I believe that most companies can exist in the experimentation mode for 3-4 years. They should start “lean.” If they hit a product / market fit (meaning you suddenly see a massive uptick in usage and/or revenue) then these companies need to go “fat.” If they don’t the industry titans around them will eat their lunch.”

    Gr8 stuff and important focus on keeping it lean until you need to grow…

    Mantra: Find & implement a scalable buisnes model.. then scale :)

  • http://bothsidesofthetable.com msuster

    Ben, first thank you for your comments and kind words.

    Yes, perhaps it us overstated. I didn’t mean to imply many companies do it. I was trying to say that teams in Texas (NewToy), Utah (BackFlip I think is in Utah??) or Finland (Rovio) have done it without the support of Silicon Valley money. Or any VC money for that matter. You couldn’t have done this in the pre Internet / mobile platform world. Today it’s possible. But not EASY!

    Thanks for keeping that comment in check.

  • http://bothsidesofthetable.com msuster

    “Find & implement a scalable buisnes model.. then scale” not that other way around. Bingo. Thanks for calling that out.

  • http://www.commun.it SharelOmer

    :) Thank you for the personal attention :) we learn and grow a lot thanks to you. 

    Another company mantra JFDI :)

  • http://www.betadvisor.com Jerome Camblain

    Mark,

    I guess you’ve just started a new industry: the fund of Micro VC funds, in order to provide size and diversification to the large LPs, following the industry changes you’ve just described.
    Too bad European funds have so low returns that I cannot start a FoF based on local managers!

  • Dave W Baldwin

    This is a good series.

    The lean is so important, though easy to say yet hard for the masses to follow.

    All Angels- truly do the Due Diligence regarding Production Costs.  If you give too much to a team, they will end up doing too little.  IOW, they will be on the beach sipping cocktail vs. getting the job done. 

    Besides, the more you save on the production side offers more to use toward achieving Traction/Scalability.

  • http://twitter.com/peters_paul Paul Peters

    Mark- I really liked your post, and I would love for you to expand on the issue of LPs when you have a chance. You say that LPs need to adapt to smaller fund sizes, but for larger institutional investors I am not sure that this is a viable option given the amount of money that they need to put to work. I wonder whether the shift towards micro VCs will also cause a shift in the kind of LPs that invest in these funds, since it seems like wealthy individuals may be in a better position to fund these micro VCs than the traditional institutional investors. Have you started to see this sort of shift happening, or do institutional investors still dominate the LP community?

  • http://twitter.com/rodrigofuentes7 Rodrigo Fuentes

    Loved bit where you said “If you don’t want to read that post, the summary is:”  Now that’s what I call KNOWING YOUR AUDIENCE.  ;)

  • http://bothsidesofthetable.com msuster

    Funny you say that because I have actually been out talking to people and suggesting microVC Fof. Reason: if the size is too small for LPs – why not have them carve out $50m for a FoF manager who can then carve it up for 5 managers? Makes sense to me!

  • http://bothsidesofthetable.com msuster

    So what I wrote doesn’t translate exactly to what I mean. I don’t think LPs need to change per se. But the LP community has got to find a way to play in the MicroVC category. One way would be for large LPs to carve out money for fund-of-funds to invest in emerging micro VC managers. Example: if $5 million is too small an investment for me, why not give $50m to a fund of funds managers on 1/10 structure to then invest that in 10 individual microVC managers. That gives the institutional investors exposure to that asset class.

  • http://bothsidesofthetable.com msuster

    ha. If I had more time I’d just write shorter posts!

  • http://twitter.com/peters_paul Paul Peters

    Thanks Mark. I guess that makes sense, although adding an additional layer of intermediation somehow feels like the wrong solution to me. I guess my question really comes down to whether a $50 million fund will need to raise money from institutional investors at all going forward, or whether they should just raise capital from angels and other wealthy individuals. As you have said, the drop in funding requirements for early stage companies has given many startups the ability raise money directly from angels (essentially disintermediating VCs) and I wonder if a similar drop in fund sizes will enable micro VCs to raise money directly from investors (essentially disintermediating LPs). 

  • http://byJess.net Jess Bachman

    geez, what search terms led you to the most disturbing frame from WHMS? (When Harry Met Sally)

    In other news, I think I have too much Suster in my media diet, as many of the recent meals feel like a blend of the Suster talking point staples.  Surely it’s fine dining for those unfamiliar already, just an observation, still tasty.

  • http://www.victusspiritus.com/ Mark Essel

    :D

  • http://500startups.com/ Dave McClure

    great post mark.

    might be worth identifying what skills / attributes make for good investors at the various stages you identify.

    IMHO, incubators & micro-VC investors should have skills & experience in primarily 1) product development & design, 2) marketing & sales, 3) connection to downstream investors.

    thoughts?

    -Dave McClure

  • http://bothsidesofthetable.com msuster

    I don’t know your background or whether you’ve been involved with this type of fund raising but here is my experience:

    - the MicroVCs ARE raising money from the people you suggest
    - this is a slow & difficult process
    - these people are even less sophisticated about investing in managers who know this asset class
    - so the problem is that MicroVCs struggle to gather enough capital to do fund formation rapidly enough

    My 2 cents

  • http://www.vidappy.com Jody Presti

    As an entrepreneur I’m hopeful that a capital partner can do all three.  More specifically, do #3 well.  Staying lean means managing a lot of balls in the air and ‘in for a penny, in for a pound’ takes the helium out of one of them. 

  • Anonymous

    You certainly know a lot more about this than me, I was just speculating. A related question that I would love to get your thoughts on is whether these micro VCs can survive on only a 2% management fee to cover all of the costs involved in making lots of seed stage investments, particularly if they need to put a lot of time into the startups they invest in. 2% of a $50 million fund is only $1 million, which doesn’t seem like enough to cover their costs.

  • http://www.victusspiritus.com/ Mark Essel

    Looking forward to what Michael Kim is cooking up. I’d like to see what happens when alignment between LPs, Micro VCs, and entrepreneurs is restructured.

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