September 7, 2010
I was on a panel last year titled “The Future of Venture Capital” with four other panelists who had way more experience in venture capital. In fact, I’m not sure what my credentials were to be on the panel, given my six months’ experience in the industry. My credibility with the audience fell further based on what I think most people perceived as my naive and wacky comments. All of my co-panelists agreed that venture capital was broken and that we’d likely see half the number of funds in five years. All agreed that this would be a bad thing for entrepreneurs.
When it was my turn to speak on the subject, I predicted that we’d see double the number of funds in five years. No doubt this further diminished my credibility, but I tried to explain my view that the venture industry was rationalizing and that it made no sense to have hundreds of funds managing hundreds of millions of dollars each. Instead, we think what we were doing at Founder Collective and what our peers are doing at First Round, Floodgate, Harrison Metal, Baseline, IA Ventures, Betaworks etc. fills a big gap in the venture industry and that there is room for many sub $100MM funds. I view this as a very good thing for entrepreneurs, but I also see this as a very good thing for larger venture funds. In the last year, with the advent of what some are questionably calling the super-angel bubble, I believe the industry has shifted as I hoped with a much more active super-angel community and a more than tripling of the number of micro-cap funds raised. In my view, this is a big win for everyone in the ecosystem.
There have been many blog posts lately commenting on the criticism of mainstream venture capitalists and the tension with angel/micro-VCs. This has hit the ultimate peak with Sarah Lacy’s Super Angel/VC Smackdown with David Hornik and Dave McClure screaming at each other. Some of this tension is only natural as we all get comfortable working together and competitive juices start to flow. Brad Feld wrote a thought-provoking post on the topic last week. My personal view is that this tension needs to die quickly. Let’s all agree that most VCs don’t “suck” and nearly all seeded startups will need VC funding to become important companies. It’s hard for me to think of a single company in our portfolio at Founder Collective that doesn’t intend to raise money at some point from a larger VC. The tension needs to die quickly because we all are creating value for each other and are largely non-competitive. I’m going to try to articulate the role seed investors play in the VC industry, but first I’d like put seed investment in the context of the last decade of venture capital.
Looking back, as venture funds got bigger during the dotcom bubble, they became and marketed themselves as “life cycle investment partners.” VCs were sized to invest in every round of a startup, though not always lead, and maintain 20% or greater ownership in every portfolio company. In theory VCs told their Limited Partners that they would “lean into their winners,” but in practice they knew it was very hard to stop investing in the underperforming companies for a variety of reasons – Rob Go wrote a great blog post on this. The biggest challenge is that VC backed startups are rarely good or bad companies for future investment. The world isn’t so black and white. Lots of companies have merit at inflection points, but hold tremendous risk. Given the intention of being a life cycle funder, a VC walking away from a follow-on round of a portfolio company is typically catastrophic to that company. If the initial investor wasn’t willing to write a check and that investor had the best information, why should anyone else be willing to do so? In other words, any deal that a VC didn’t want to continue supporting would find no other venture capital support and die. VCs didn’t really want to be in the business of killing companies and turn out to be much better at company creation and support than company termination.
The implication of large funds doing life cycle investing is an implicit huge commitment to any portfolio company regardless of the size of the initial investment. There are recent exceptions to this rule as some larger funds are making lower commitment seed investments to many startups, which can be highly problematic for founders, but historically any investment was a long term commitment unless it was performing very badly. This was generally a good thing for entrepreneurs, because through good and bad times VCs kept writing checks (not always at desirable terms), but it created a huge burden to clear the hurdle of getting an initial check. VCs had to be very careful in their diligence and their conviction needed to be extremely deep, as even a Series A $2MM check could be an implicit $10-$20MM commitment to a company. Unfortunately, deep diligence and high conviction is not fully correlated to investment success, as it only analyzes a snapshot, not a movie, about the merit of a startup. These companies need time to show their worth and truly justify the large commitment. Historically angels have provided some capital for this purpose, but the angel community was greatly damaged in the dotcom bust and further injured by the great recession.
This life cycle investment approach also lent itself to investing in repeat entrepreneurs and avoiding first time entrepreneurs, as VCs really had to decide out of the gate if an investment was worthy of “taking a slot” among a handful of deals in a fund and an implicit commitment to a big chunk of capital long term. In essence, this market structure led to very few at bats, but lots of swinging for the fences right out of the gate. If considered as a funnel, the structure of venture, post the dotcom bubble, looked like a thin and minor taper round after round. Few entrepreneurs were getting at bats, but the ones who got to the plate had the benefit of an over commitment from funds that needed to put lots of capital to work in a limited number of deals and were really bad at killing the companies that did not deserve so much capital. To be fair, this had some pretty big pitfalls for the entrepreneurs too, but that’s not the focus of this post.
The common refrain of VC funds is that too much capital is chasing too few deals. For me, this hits a major philosophical question as to whether great companies are born or are made. If you believe they are born, i.e. they can be identified from day one and it isn’t the execution that matters, probably the increased birth rate has little benefit for creating more great companies. If, like me, you believe great companies are made, i.e., by getting more at bats, more entrepreneurs will get a chance to prove they can build great businesses and more great businesses will be created, then the increased birth rate is a really good answer to the issue of too much money chasing too few deals.
My belief is that the shape of the investment funnel is changing for the better. Angels and micro-vcs should be focused on the seed round, creating opportunities for entrepreneurs to build validation that justifies larger commitments from larger funds. Seed investors must also avoid signaling by keeping funds small and showing restraint when it comes to follow on financings. That way many more founders will get at bats and less capital will be overcommitted to experiments that don’t merit the investment.
The failure rate will be much higher, but I’m not sure that’s a bad thing. Fred Wilson wrote a great post on “The Expanding Birthrate of Web Startups” in which he fears that angels and small funds won’t be positioned to support the growing population of funded companies. Fred asks “who is going to house, feed, school and send all these kids to college?” I agree with Fred that this is an issue, but I also think this is the creative destruction of a major improvement in the startup industry. The market should be in a position to decide the merit of a startup without the challenges of sunk costs of a large venture fund or the signaling of a single fund determining the future of a company. This is particularly true if the implication is that many more founders get a chance to create something of value. Most founders would rather be funded to try and fail, than never to try at all. After all, an implicit commitment of $10MM being allocated to a very early stage startup going sideways can be used to fund 10 similarly staged startups at $1MM and perhaps create a few companies that become rocket ships. Nearly all of them will require more capital from larger funds at some point to be successful. Larger funds get the benefit of seeing more validation early of a greater number of startups without the obligation to over invest round after round, which should yield higher investment returns for everyone.
Not only will this broader funnel create more companies with capital to prove value, but it will also attract more people to entrepreneurship, as founders won’t be deterred by the notion that getting funding is impossible unless they’ve run a company before. I believe we’re already seeing this benefit. This is a positive spiral that will further create more interesting opportunities for the venture capital industry.
On a macro industry level, venture capital might have the same amount or even less capital infused into startups in the coming years, but I believe that capital will be more productive as it is redirected from overfunding underperforming companies to funding the creation of more companies that have a shot of proving their worth. I believe this is a big improvement for founders, seed investors and large funds.