The Future of Venture Capital – A White Paper

The Future of Venture Capital – A White Paper
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I have observed the venture capital industry with scores of companies over numerous decades from many sides of the table: as an entrepreneur raising VC funding, as an advisor to VCs on which companies they should invest in, an advisor / investment banker helping startups raising funding and M&A, as an angel investor investing my own capital, and finally as a venture capitalist investing other people’s money. I also have a geographical perspective of what’s happened and needs to happen in the US, Europe on a country-by-country level and Israel. I leave you with a few of my thoughts on the future of venture capital.

My key views:

  • VCs must create and structure their investment firms to add value to the startup far beyond the cash invested. The old model of just invest and join the board is not enough anymore. Rest in Peace (RIP) old VC model.
  • The big VCs got much bigger, the mid-sized VCs died out and a large group of new VCs showed up to invest at the earliest stage followed by a just now emerging new group of funds addressing the mid sized fund market again.
  • The old VCs must demonstrate plans for succession or face a rapid decline in their brands. Look at Boston…last one out turn off the lights (for tech not biotech)! If they do not take great care the junior partners they have been grooming to become general partners for the past 10 years will jump ship and start their own funds or become CEOs.
  • Startups themselves got cheaper to start and there are a ton more of them. At the same time it is becoming more expensive to house a startup, recruit and maintain a top-notch team in SF, New York or London. We kind of went in a circle with the cash cost to fund an 18 month runway for a startup, going from expensive to cheap to more expensive, but not as bad as 10 years ago.
  • San Francisco / Silicon Valley, New York and London have and will attract the best startups…the true Hollywood of startups. BTW, I am bullish on LA / Santa Monica too as I am Scandinavia, but they do lack well developed ecosystems.
  • The gravitational center of the Silicon Valley is moving up to San Francisco. More money is now being deployed into startups in SF than on the San Francisco Peninsula, which historically has been referred to as the Silicon Valley. The Valley now officially includes SF and VCs are moving from Sand Hill Road to Soma and other parts of SF in the city to get closer to the entrepreneurs. Our SF office is in mid-Market which is kind of a dump, but the new center of startups with Twitter a few buildings down from us. In NY we are in the Meatpacking District.
  • Most of the buyers are in Silicon Valley. Nothing comes close. Nothing ever will. The list of big balance sheet tech titans is just more than I wish to list here. You will never see another region in the world ever come close. I suppose something like this may happen in China, but the Silicon Valley has 5 decades of momentum and it was 85 degrees (29 Celsius) yesterday with no pollution or humidity and tomorrow is Halloween
  • Huge opportunities exist to start companies and fund companies outside of the Valley, NY and London, but they need to be hotwired and networked into the Valley from day one and tap into the most evolved ecosystems as well as key centers of commerce globally. For a many reasons startups outside of the Valley are happening with increased chances for survival. The best ones will have hyper connected VCs from the Valley and NY. (Hint, a Silicon Valley-only VC is not enough to support a startup with global ambitions).
  • Lower valuations, cheaper salaries, more stable teams with lower attrition levels, access to other regional pools of talent such as universities and local industry corporates (like P&G) make investing and entrepreneurship in provincial locations attractive.
  • The secondary market has evolved. Investors and founders can sell some equity before the final exit. Ignoring this is foolish. Angels and VCs at all stages should increase the buying and selling activity while still privately held. Startups should migrate their shareholder base from small angels to the Fidelities of the world prior to an IPO. Liquidity has been historically lacking and it is a good thing it is here now for privately held high growth startups. If you disagree with me I say that you are in a cave.
  • Silicon Valley has gone global. Get ready for a very international situation. A good VC is an international person and is comfortable raising capital and doing business on all continents. Many markets will develop ecosystems, but the most robust ecosystems thrive in three locations.
  • Despite clashing with western politicians in recent years, Russia will always be a super power. India and China will play a larger role in the global economy. Japan quietly remains the 3rd largest economy in the world after the US and China. We are proud to have Japanese investors in Rubicon.
  • Regardless of bad news about Hamas and the IDF clashing in the Middle East Israel will remain a magic innovation hub to benefit all of humanity (and they have some world class restaurants!)
  • Despite my love affair with Scandinavia and commitment to funding their best deals, Silicon Valley, New York and London will dominate for many years to come, but the big opportunities will increasingly appear in many other markets despite the top buyers being in Silicon Valley.
  • The true rock stars of this industry are the entrepreneurs not the VCs. A good VC knows how to seduce them.

future-crystal-ball

The main point about the future of venture capital is that VCs must add value. To raise capital VCs need a highly differentiated strategy. They can either be a dynasty raising fund eleven or fund fifteen like a Sequoia or NEA or they must have highly differentiated value added strategies and roles in the market. Absent a solid differentiated strategy, VC manager teams will struggle to raise a VC fund. Absent a differentiated strategy a VC will miss out on the best deals and fail to become one of the greats. Even if some VC team manages to raise capital in order to get into the best deals, they will need to climb to the top of a crowded heap of VCs trying to get their fund money into the very best deals at sensible valuations. Almost anyone can overpay. Make no mistake – CEOs of the top startups have a choice of which investors to take money from.

Any decent VC firm must have at least one true and experienced entrepreneur as an active general partner running the fund. The days of the European investment banker turned VC by simply removing his tie and putting on grandpa blue jeans are numbered. How can they succeed at getting into the very best deals? Simple – add value to each deal. Demonstrate that value when trying to invest into the deal everyone wants to get into.

Dollars, euros and rubles are commodities. Trends will come and go, but this point from now and into the forever future will remain a constant. For the really hot deals, it’s not about the cash; it’s about the specific value added the VC can point to prior to wiring money to the startup.

Tim Draper was correct when he said in the beginning of my book that funders will always fund good deals. In 2000 and again in 2008 as Draper pointed out, the venture backed technology startup economy collapsed. The credit crunch arrived in August of 2007 and by September 2008 Sequoia sent out their infamous Good Times Rest in Peace (RIP) slides confirming we too along with real-estate had fallen into the dumps for a second time in less than 10 years. Rather than the big VCs returning LP dollars as some had done in the 2000 economic downturn, the large pools of money seemed to think venture capital was a safer bet than real estate or public market hedge funds and the average size of surviving VC funds got bigger. We actually watched $250m sized VC funds close $550m funds and the $350m funds closed $700m+ and $1.2bn funds. At the same time Europe struggled except for a few outlying winners. The smaller mid-sized $50m to $250m funds failed to raise any new capital at all and began to die off. We call these zombie funds, because they don’t raise a new fund, but need to keep someone running it for the full 10 to 12 years. These larger funds added some partners, but for reasons of splitting management fees these larger funds did not add more partners commensurate with the increase in assets under management and needed to shift their focus to funding companies with bigger capital requirements and not the smaller sized financing rounds.

The result of these mega-sized VC funds is that they need to invest in startups that can take on that much more capital prior to an exit. Fund physics requires that these mega-funds invest in companies that can return the entire fund and get into “unicorn” billion dollar exits. Considering that the mega fund will only own 5-33% of the share capital at the time of exit they need billion dollar exits to make their model work. Most startups that are successful enough to be acquired are sold for an average of $50m to $100m. Plenty sell for much more, but sub-$100m is very common. If a mega-VC fund owns 33% of the share capital of a startup sold for $50m, $16.5m does not do much to move the needle on a $750m fund. If the partners at a mega-fund are limited by the number of board seats they can take, these small exits will not return the fund and provide LP investors or the fund managers with a meaningful return. This forces the mega VC board member to go as far as fire a founding CEO and replace him with another CEO willing to accept a big $30 or $50m financing rather than accept an offer to sell the company for $50m. CEOs know this and are beginning to seek out smaller VCs to partner with and avoid the obvious conflicts of interest. (Disclaimer, I am friends with many of the guys at these mega-funds and Rubicon Venture Capital happily co-exists with them and I’m sure they’d never fire a CEO. I am just trying to illustrate a point about what I call fund physics.)

Statistically this is not probable to reach billion dollar sized exits and therefore a risky strategy regardless of past performance. I don’t want to criticize the mega-fund strategy. I am just pointing out what they must do so that they can be profitable and reach an actual return.

Rubicon Venture Capital is organizing an event in San Francisco with a VC panel focusing on this topic.

San Francisco November 18th: Blurred Lines in VC: Seed vs Series A, Micro vs Mega-Funds. VC Panel + Drinks. Register here.

After 2000 and much more after 2008 angel investors began to fill in the role of funding early innovation. More angels sprung up in 2005 and 2006 than ever before. The stock option wealth created by Google alone spawned a burgeoning population of angels in the Valley. We have many of them in our VC fund at Rubicon. As the market for exits began to heat up in 2006 and more so in 2011 the number of active angels began to proliferate at never before seen proportions. Every exit gave birth to new ecosystems of risk taking angel investors of all ages. Vesting stock options for early execs at big titan tech companies in the Valley put more angel money to work in the Bay Area. By comparison a CEO with a successful exit in Germany needs to keep all of his exit money to fund his next startup, because Germany lacks the angel community. In the US a successful entrepreneur can invest some of her exit money into another startup knowing that other angels will invest in her next startup.

Around 2009 I began to formalize my angel network around The Founders Club and I formed my own angel group with one of my life-long best friends Joshua Siegel who happened to be one of the most active angel investors in New York City. We then raised capital from our angle group and institutional investors and formed Rubicon Venture Capital. We placed a bet that New York City would become the tractor beam for entrepreneurs and VC ecosystem on the US East Coast and we were right. We also placed a bet that the best companies in the Valley, New York, across the US and around the world would want to work with a VC fund with offices and hyper-connected in SF and NY. Angel List also became a significant factor and countless crowdfunding platforms began to form despite the SEC failing to implement the JOBS Act in a meaningful manner.

We also saw the emergence of the micro-VC class of investors. In the Valley SV Angel led this movement with institutional funds, investing other people’s money like a super angel or super angel fund. Others followed such as SoftTech VC, FLOODGATE, CrunchFund, First Round Capital, 500Startups, Lerer Ventures, Metamorphic Ventures, Baseline Ventures, Founders Collective, NextView and my own Georgetown Angels, which evolved into Rubicon Venture Capital – a hybrid of VC fund and angel and institutional investor club of investors. We have seen some like FLOODGATE, First Round Capital, Blumberg Capital and True Ventures begin to take a position where they might play in the micro-VC seed stage with many small bets, but they tend to allocate more of their fund to later stage seed and series A filling in a gap created by the VCs that moved downstream driven by fund physics of their larger funds. New players like Bullpen started to fill in a missing gap of funding after the angels and before the big VC series A providing founders with the option to scale but still take an early offer that might not satisfy the mega-fund needing to move the needle on very large amounts of capital in their oversized funds.

Now we are seeing more smaller to mid-sized VC funds start to fill in what some are calling the new smaller or earlier series A going back to what a series A looked like before the mega funds. As I write we are seeing many VC funds close new capital to match a major imbalance of too many deals and not enough capital to match the volume and different stages of good deals seeking capital.

The accelerator model has also changed the landscape. Y Combinator, TechStars, 500Startups, Dreamit and many others now invest a specified amount of capital into each startup accepted into their program providing the startup with $35k to $150k on the day the startup joins the accelerator. Some like 500Startups invest $100k into every company admitted into their accelerator and then require the startup pay them $25k in office rent and payment for other services. That’s a brilliant model for Dave McClure. He’s actually got management fees and carry on his own revenue. The guy’s an innovative alchemist! This is an example of the future of venture capital departing from the past. Expect to see more totally new models like Dave McClure’s 500Startups. Expect leading VCs to organize all kinds of events at many different levels from specific educational topics to super exclusive events ranging from the “bro-preneur” heavy drinking parties to UX design events. Each promoting their own VC brand in their own way. Rubicon organizes a full calendar of different events. Check our web site for details. http://georgetown-angels.com/

The accelerator model does not normally provide for any follow on investing. Dave McClure at 500Startups is a great example of someone breaking through the missed opportunity and he doubles down with more investment into his best companies and he’ll even invest in companies that do not choose to go into his accelerator – very smart. Dave’s latest fund is a $100m vehicle to invest in follow ons from his wide portfolio of seed investments – also very smart. So this is an example of the pure accelerator model just unraveling in a good way seeking the best returns for the investor and supporting startups with capital and value add. Ron Conway recently led a $200m investment into Pinterest by creating a Special Purpose Vehicle (SPV) for his investor contacts to put money into one fund to make one later stage investment into Pinterest. We have been doing exactly that at Rubicon for years, but limited to offering our SPVs to investors in our VC fund. This gives us the flexibility of a small early stage venture fund coupled with the power of a top tier angel network and the deep resources of large corporate and institutional investors. The startups get our chest beating support towards a small $75m flip exit or we can commit to these same startups charting a course to go for the unicorn exit and buy Alibaba. Investors in our fund share in the carry (profit) from our sidecar / SPV opportunity funds making it a win-win-win for the startups, the investors in our sidecar funds and the passive investors in our main fund that do not participate in the sidecars (Get paid on other people’s money being put at risk into the sidecar funds. That’s a no brainer.)

With so many accelerators popping up everywhere globally we truly have a lot of capital funding total experiments and raw startups. The growing masses of accelerators and flawed government startups programs around the world are manufacturing new populations of entrepreneurs in places where they did not previously exist. I often see young startups teams in their mid 20’s telling me they are on their 3rd startup. This is happening in places like Lille, France! Those early failures are good training grounds to eventually create a successful startup that will make money for founders and investors. Ten years ago you did not see this anywhere but Silicon Valley. Now it’s literally everywhere.

In sum, the lower cost to start a startup and get customers, the explosion of accelerators, the proliferation of angel investing, the increase in real crowdfunding and adoption of Angel List have created a combined effect of funding larger volumes of startups than ever before taking on early risk creating more startups that a VC fund can chose from, which will increase the performance of the VC asset class.

Another change in the VC landscape is VCs actually investing in their own businesses. That may sound like a novel idea, but we only saw a bit of it in the late 90’s when Highland Capital hired an in-house headhunter to focus on staffing their own portfolio companies. When the 2000 economic downturn hit, they trimmed down these services. Then Marc Andreessen and Ben Horowitz created Andreessen Horowitz – a16z – I guess there are 16 letters between the A and Z in their names. These guys raised so much money so fast for their oversized funds that they decided to invest a sizable percentage of their management fee into infrastructure to help their portfolio companies. They hired HR directors like other VCs before them, but they went further putting in place another core 4 business areas of resources to help their startups including technical development, pubic relations (PR), business development and investment banking. Another VC to create a candy store for entrepreneurs is Google Ventures. When I look at the resources that startups get from a16z and Google Ventures I think twice about investing in startups that compete directly with their portfolio companies. These guys are the true professional athletes of the game. This is an advantage of the mega fund. Their management fees support their investment into things that bring value to their portfolio companies. When I began my career as a fundraising CEO in the 90’s I was just trying to find VCs that would not destroy value after providing the capital I needed. Now it’s all about real value creation from your investors.

At Rubicon we work with a growing number of big corporates in the fortune 500 to treat them like clients and invest their money into innovative startups via our fund and provide them with access to innovation and real technology. Our startups benefit from the value of getting early pilots and strategic partnerships and distribution channels. It’s a win-win-win. If the corporate wants to create its own corporate VC (CVC) we are happy to help them with advice and how to build up their team, even staff up and avoid mistakes made by other CVCs. These make perfect LP investors and syndication co-investment partners for Rubicon.

Another key change in the landscape is the lower cost of starting a startup. Today $1m funding (I used to say $500k, but now it’s more expensive) achieves what required $5m of funding 10 to 15 years ago, but remember most VC funds raised larger not smaller funds post 2000 and 2008 economic crashes. Let’s look at what really changed.

  • 3bn people online, proliferation of mobile web via smartphones
  • Women are online and make up 70%+ time on Facebook and other social networks and casual gaming (Proctor & Gamble has announced they will stop advertising during soap operas because the new moms are reading about their friends on Facebook on their smart phones while their kids play on the jungle gym – no more day time TV for today’s full time moms)
  • Amazon AWS hosting – no need to buy servers & Oracle licenses. Rackspace, IBM and Microsoft making scaling issues a commodity (my own investments into NodePrime and NephoScale are further driving this)
  • OpenSource code & lower cost offshore development, developers everywhere
  • The technical founder. Now that founders do the coding themselves that took a big bite out of the cost to get to a minimal viable product or prototype
  • Lean Startup dynamics (cheaper, faster, 3-90 day product development cycles, measure, learn, iterate, pivot)
  • Platforms to acquire users cheaply & quickly (Facebook, Twitter, Google, Apple, Android, YouTube, Pinterest, Instagram, Tumblr, etc)
  • Proliferation of 1,000’s of accelerators like Y Combinator & TechStars seeding startup experiments, active angels, seed funds & Angel List invest first $500k
  • Many micro-VC or super angel funds have appeared investing in seed rounds. Rubicon cherry picks investing in the best ones often showing product-market-fit and ready to scale
  • Crowdfunding platforms are funding some unfundable or toping up other startups with higher valuations. Crowdfunding often validates market demand when investors may not have been so clairvoyant (If the SEC ever changes this may actually deliver on the initial promise of what was signed in the Rose Garden of the White House April 8, 2012)
  • It has never been easier or cheaper to launch a startup
  • Accelerators now moving later along the continuum from seed to later stage
  • Now it’s not all cheaper, cheaper, cheaper. Some of this startup business is getting increasingly and painfully expensive. Here’s what’s changing on that side of the scale.

Office space in San Francisco, New York and London is expensive. Today startups need to pay 12 to 18 months office rent upfront in cash and sign 5-year leases. Some of my startups located in Palo Alto are struggling to hire technical talent and relocated to Soma (South of Market area of San Francisco) just to hire folks. The technical people that are willing or want to work on the Peninsula (the area south of SF typically known as Silicon Valley) often end up working for the big tech titans like Google and Facebook.

Good developers are getting expensive and it’s a challenge to keep a technical team stable and not jumping ship for the next-door neighbor startup that just got more funding. Offshore development might sound appealing, but investors like to see a technical cofounder and ultimately want to see most engineering in-house.

In sum, it might be cheaper to create a startup than before, but seed financing rounds are changing from $500k and $750k to $1.5k or $2.5m followed by another $1.5m angel round before VCs invest. We just invested in the very first outside financing for a startup and the round closed at $6.5m and was oversubscribed (Navdy). They had literally only raised $20k from an accelerator before we invested in their first ever financing alongside other VCs and angels. That company is now on fire with explosive revenue growth and over 800 retailers have asked to stock and sell their product. Check out www.navdy.com.

Although accelerators that have followed the Y Combinator (YC) model have only been in existence for a few years they have evolved and changed quickly. What I think has happened is that experienced and new entrepreneurs alike realized that if they get into a top accelerator they will close funding before and at demo day and the dilution from the accelerator is worth it on a blended basis with a higher valuation for their seed round and higher degree of certainty that they will close a seed financing following or leading up to demo day. The result is that more companies have applied to join these accelerators. Now that YC gets more applicants per seat than Harvard’s MBA program and they are going to take 5 to 7% of any admitted company, they may as well take equity in companies that are further along, are generating material revenue and 100% certain to attract funding at YC’s famed demo day. The result is that when I attended YC’s last demo day and watched 79 pitches for funding, 90% of them showed a hockey stick illustrating how their revenues started on the first day of the 3-month accelerator program and doubled or grew by 35% every week or every month. I concluded that YC was only admitting companies that had product or services offerings fully built and were ready to begin with customer traction on day one and possibly even line up customers and game the system so they could show the obligatory YC demo day slide with revenues or usage metrics flying off the chart up and to the right. Originally these accelerators spent the first month of a 3-month program brainstorming and challenging the idea of the startup – not blowing up revenues on day one.

Why a Fully Developed Ecosystem Matters

Wolfgang Seibold, an old friend of mine who recently left Earlybird Venture Capital in Germany to start his own venture capital firm, showed me some data recently that illustrated that there is an abundance of seed and VC funding in Germany for startups, but almost no later stage growth capital. He had charts showing significant capital going into seed stage and series A and B financings, but then only a tiny fraction of capital funding them in growth stages.

It occurred to me that German VCs backing innovation, need to fund or be prepared to fund their portfolio companies all the way to profitability without any outside syndicated investors to join them in backing these startups. This is a big problem. In Silicon Valley, New York and London we can take risks in backing startups with the knowledge that if we do a good job reaching key milestones we can introduce these startups to other growth stage investors downstream that will invest more capital at higher valuations than our initial investments. Our entire portfolio has more than doubled in valuation in the last six months as I write this. All we need to do is move the ball forward up the field and then we can pass the big funding burden to growth stage funds. The Rubicon model actually enables us to open sidecar funds for the later stage rounds, but we syndicate these with the other growth stage funds.

This is not the case in Germany and in my view the entire model can fall apart for this reason alone. Forget the early stage investor taking some liquidity on a huge uptick in valuation, but most importantly the VC in Germany cannot deploy capital in the way she can in a well-developed ecosystem. Keeping your startup in Berlin is like keeping your startup in New Orleans. After you run through the accelerator and local government backed funds there is no ecosystem to support you. So move to one of the well-developed ecosystems.

In SF/Silicon Valley, New York and London we have witnessed the death of the mid sized VC funds. We watched the rise of professionalized angels and many micro-VCs funding seed stage deals. We watched the dynastic funds become mega sized private equity funds being managed by career VCs. And now in 2014 and 2015 we are seeing the creation and closing of new mid-sized VC funds. We are not yet full circle. What we have now…the future of venture capital, is the most well developed ecosystem in the history of the world. I invite everyone in the entire world to start companies in whatever location you are in. You do not need to move to the Valley where I live. However, I urge you to visit and develop your network here. Consider opening an office here. Connect to the network. Plug in and do not remain isolated or complain about the Valley. Just work with us from a distance and visit frequently.

The key to the holy gateway, in my opinion, is to do someone a favor. Helping fellow entrepreneurs and investors is the magic dust that creates relationships that make things happen. Try to speed up the time it takes to make things happen. Ideas are everywhere. Ideas without people executing the idea and strategy are worthless. As IBM’s boss Lou Gerstner once said, “It’s all about the people.” The world is an expensive place to reside in. People cost money. And so startups need capital. Ideas + people + value added capital = success.

TWITTER: @RomansVentures | LINKEDIN: www.LinkedIn.com/in/romans | BLOG: http://georgetown-angels.com/blog | BOOK: THE ENTREPRENEURIAL BIBLE TO VENTURE CAPITAL: Inside Secrets from the Leaders in the Startup Game (MacGraw Hill. Being published in a few weeks in Chinese and Russian. Japanese translation with new stories from Japanese VCs and entrepreneurs being translated and written now for publication in 2015)

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