The venture capital industry has changed over the past 5 years in ways that I believe will be lasting rather than temporal change. We are in the process of our own creative destruction with new market entrants and new models of innovation at the precise moment that our industry itself is contracting.
When the dust settles, although we will have fewer firms, each type well end up more focused on traditional stage segments that cater to the core competencies of that firm. The trend of funding anything from the first $25,000 to funding $50 million at a $1 billion-plus valuation is unlikely to last as the skills and style to be effective at all stages are diverse enough to warrant focus.
I will argue that LPs who invest in VC funds will also need to adjust a bit as well.
When I built my first company starting in 1999 it cost $2.5 million in infrastructure just to get started and another $2.5 million in team costs to code, launch, manage, market & sell our software. So it’s unsurprising that typical “A rounds” of venture capital were $5-10 million. We had to buy Oracle database licenses, UNIX servers, a Sun Solaris operating system, web servers, load balancers, EMC storage, disk mirrors for redundancy and had to commit to a year-long hosting agreement at places such as Exodus.
Open-Source Software & Horizontal Computing
The first major change in our industry was imperceptible to us as an industry. It was driven by the introduction of open-source software, most notably what was called the LAMP stack. Linux (instead of UNIX), Apache (web server software), MySQL (instead of Oracle) and PHP. Of course there were variants – we preferred PostGres to MySQL and many people used other programming languages than PHP.
Open source became a movement – a mentality. Suddenly infrastructure software was nearly free. We paid 10% of the normal costs for the software and that money was for software support. A 90% disruption in cost spawns innovation – believe me.
We also benefitted economically from a move to “horizontal computing.” What this meant was that rather than buying really expensive UNIX servers (and multiple machines in order to handle redundancy) we could buy cheap, replaceable servers for compute resources.
As our needs grew we could just add more cheap boxes and as boxes failed we could just chuck them out. We had to learn how to be better at “load balancing & replication” – meaning how we managed data across all the boxes since they weren’t centralized on one box.
These two trends had a major impact on the computing industry from 2000-2005 but the effects weren’t yet felt by the VC industry.
The Emergence of “Open Cloud” Infrastructure
The biggest change in the software industry beyond open-source was “open cloud.”
When we talk about cloud computing we have to be careful to differentiate between open cloud (services the are provided solely to for the economic purpose of building a cloud business) and the “platform cloud” where certain service providers offer cloud services wrapped around their core product. These are very different.
Platform cloud players like Salesforce.com provide resources so that third parties can build applications that integrate with its core product. That’s awesome for users of Salesforce.com or companies that want to cater to them but less awesome for pure startups that want independence and are really just looking for cloud infrastructure. Facebook is a “platform cloud” provider, too. That makes both of these amazing companies great channels for startups.
True that Salesforce.com in particular has made interesting moves toward open-cloud services by purchasing Heroku and also launching Database.com. It seems if anybody wants to move more toward open-cloud services it will be Salesforce.
But for now when you want to build an independent, high-growth, VC-backed startup you need to build your overall company on a truly open cloud.
They came from a different perspective. They have the mass retailer mentality of “stack ’em high and sell ’em cheap.” They started by offering cloud storage (S3) on a super cheap, pay-as-you consume basis. Every startup I knew in 2005 (when I started my second company) was using this. Why would we commit hundreds of thousands to EMC before we knew whether we had a big business?
They then launched processing capabilities (EC2) and startups suddenly didn’t need to buy production servers. They also launched a simple database, management tools and so on. Amazon will surely keep moving up the stack. My bet is that they fold A9 (their search tool) into AWS and offer search-as-a-service, too.
It sure would put pressure on Google if they had Facebook competing on one side of them for share of users’ time and Amazon flanking them on the other side by providing search to every website out there that might threaten AdSense and even Google’s core search business. Who knows?
If you want a deeper understanding of the layers of the cloud, how it is emerging and some of the exciting new players you can read it here.
Amazon changed our industry. This is mind boggling. That little online book company. Not Google. Not Microsoft. Not IBM, HP, Accenture, Cisco, Salesforce.com or anybody else. Amazon. 100% of the credit. And 9 years after they launched AWS there are still no credible competitors.
I find this strange. And maddening.
That said, Amazon – through AWS – even without strong competition is as wonderful an experience as Amazon the eCommerce retailer feels to you as an online shopper. Jeff Bezos simply deserves to be held up with Steve Jobs as two of the most important people driving innovation in computing today.
Spawning of Micro VCs
The biggest media attention in our industry went to the so-called “super angels” during the 2009/10 timeframe and while I don’t believe there is such thing as a super angel, I do believe that much media attention was deserved.
The earliest people I spoke to who understood the changes in our industry were True Ventures & First Round Capital. They built industrial-scale funds dedicated to backing early-stage startups with $500k rather than $5 million. They knew the venture math that if only 50 companies / year are sold North of $100 million the entry price for their investments mattered. These funds were active back in 2006 when I was raising money for my second company. As were individuals like Jeff Clavier with SoftTech VC who was also way ahead of the market in spotting this trend.
More recently, great funds like IA Ventures, Floodgate, Rincon Ventures, Founder Collective, Freestyle Capital and others have raised money to focus on early-stage investing as a strategy. And many more individuals that I respect are switching from investing as individuals to fund structures to invest in this category like Aydin Senkut (Felicis Ventures), John Frankel (ff Venture Capital), Manu Kumar (K9 Ventures), Chris Sacca (lowercase capital), Dave McClure (500 Startups) and many more.
I have called the creation of Micro VC as the most important change in our industry and I believe it. These people understand that the nature of startups have changed. They have increased the number of investments, they understand that outdated board meeting formats are too slow & unresponsive, they have designed founder-friendly term sheets that can be executed cheaply and they are allowing for a massive increase in the rate of new startup innovation.
The larger ones also do more to hold CEO summits, create recruiting databases, set up email distribution lists, create pools of stock options that can be shared across companies, etc.
I still think it was Amazon that created this category not the other way around. Where open-source computing gave us a 90% reduction in our software, Amazon gave us a 90% reduction in our total operating costs. Amazon allowed 22-year-old tech developers to launch companies without even raising capital. Amazon sped up the pace of innovation because in addition to not having to raise capital to start I also didn’t need to wait for hosting to be set up, servers to arrive, software to be provisioned.
I know I’m going on-and-on. I’m not a shareholder. I’m just in awe of what they’ve enabled and baffled that the media doesn’t give this more focus.
The Blurring of Investment Lines
With new micro VC entrants coming into to early-stage investing plus increased competition from angels, incubators and the like, traditional VCs are taking notice. So VCs spent a couple of years experimenting with earlier-stage investing. The best of them: Spark Capital, USV, Foundry Group also understood that how they worked with these management teams was changing. I believe firms like this will continue to excel at early-stage investing. 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 90s. 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 turn 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 eight to 10 developers build iPhone apps that get tens 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 three to four 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.
Downsizing Venture Capital
The venture capital business itself is going through an even more fundamental change than just the entry of a new category at the earliest stage. The industry is shrinking back to a mid-90’s level in terms of both dollars and numbers of firms.
The doubling of the industry size was caused by the euphoria of the dot-com bubble and since funds take 10 years or more to dissolve the bursting of the funding bubble has taken its time. We all know the result of the over-funding of the asset class – poor returns in aggregate for the industry. The best firms have still delivered results, though.
So what’s happening now is the elimination of funds that probably should never existed as well as the questioned relevance of some older firms that failed to find good succession strategies or remain relevant.
That’s certainly good for our industry in terms of future returns for investors but I would argue also for entrepreneurs. In the last 90’s it was impossible to charge fair prices for products & services in a market where you had 5 competitors giving away free products to acquire “eyeballs” and fueled by an excess of venture capital.
A normalization of the venture capital market will bring more rational valuations over time but should produce more stable companies and better returns for VCs and LPs. It doesn’t feel like that now because we’ve entered a mini bubble in pre IPO valuations for a segment of the tech market but this, too, shall pass.
The Coming Brick Wall
What I’ve started to observe is that we’re certainly headed for a bit of a brick wall for early-stage companies. The explosion in number of startups coupled with the decrease in numbers & dollars of VCs portends this.
As an industry this is probably OK. Creative destruction is what drives capitalism and innovation. Some startups won’t make the cut but those founders will have developed invaluable skills and will join the ranks of the survivors. I’m proud to see this creative destruction happening more prevalently in the US right now because it gives me comfort that we haven’t lost our footing in terms of global innovation.
I would argue that the explosion in startups and the coming brick wall will continue to create compelling opportunities for venture capitalists. As an industry we have more startups feeding into the top end of our funnels from which to evaluate and choose the most prudent investments. The coming brick wall will ensure that valuations reach their natural limitations and return to normalcy. The coming brick wall will produce more second-time entrepreneurs whom we can fund that will bring real experience to the table in their next businesses.
I know that a brick wall is a rather nasty metaphor, but it’s not all bad. Like any market that overheats we will have the negative collateral damage but also the blossoming of the next wave of innovation and returns.
Borders, Normalization & The Continued Relevance of Venture Capital
My prediction for what comes beyond the brick wall?
- Continued high pace of startup innovation. The lower costs & lower barriers to entry support this. Also break-out companies like Rovio and NewToy that grew big without much capital will continue to encourage young entrepreneurs.
- Increased reluctance of angel investors to fund any new hot team based solely on the “social proof” of who else invested. Brick wall = lost money for early-stage capital primarily concentrated on angels. I’ve been on-record here for a while.
- Return to focused strategy for investors where micro VCs have a more established position in their market and traditional early-stage VCs become more comfortable waiting for products to be completed as FOMO (fear of missing out) subsides
- Hedge funds and growth equity firms returning to their traditional segments of the market
Basically, I believe that each market participant brings strengths relevant to their stage and I don’t believe in huge stage drift. The software industry is changed for good and the next decade will truly be dominated by the open cloud and open platform companies that embrace this. And the IT segment of the Venture Capital industry will continue to evolve to meet the market needs, not vice-versa.