The short history of venture capital can be characterized by continuous change. The industry has had to adapt to an incredible pace in technological evolution and even a few boom and bust cycles. This post summarizes my thoughts on the current state of that change with respect to venture capital’s relationship with founders.
First, let’s take a look at the current landscape for entrepreneurs. Over the past few years, an industry that helps tech entrepreneurs launch companies in quicker and cheaper fashion has taken shape in Silicon Valley. I’m talking about Business-to-Developer (B2D), also known as API-based businesses or as I like to refer to them, “startups for startups”. (There’s an interesting parallel between these companies and the fun-fact-turned-overplayed-business-advice of selling shovels during a gold rush.) There’s content management with Box (2005), deployment and storage with Amazon Web Services (2006), messaging with Twilio (2008), data processing with Cloudera (2009), and payments with Stripe (2011) to name a few. As the developer market continues to expand, newcomers like printing with Lob (2013) and voice recognition with Wit (2014) have shown that there is still plenty of room for innovation.
Together with other factors such as the explosion of startup schools and accelerators, the barriers to entry for the startup world have been greatly reduced. The increasing interest in CS degrees at academic institutions and the availability of online coding courses have also led to more technical talent than ever before (but still far from enough). Record numbers of entrepreneurs has resulted in record numbers of IPOs. The relationship between founder and investor has evolved along with these changes.
I’ll attempt to use some Econ 101 charts to illustrate what’s going on. (I was never a great Econ student in college so feedback on incorrect logic is welcome. :)) Below is a simple supply and demand chart. Think of the x-axis as the number of deals and y-axis as the relative equity being traded (or alternatively, the cost of the deal for the founder).
Line S represents the traditional VC supply – more deals are made as the deal gets better for the VC. It’s relatively inelastic (quantity shifts slower than price) because funds generally have a set number of deals they want to make and have a specific amount of capital with which to make them. Line D represents the entrepreneur’s demand – more deals are made when less equity is given up in exchange for the same amount of capital.
So what happens when there are fewer barriers to entry for startups? Line D shifts to Line D’ – more deals are made but at a higher cost to the founders. What we haven’t explained yet is the shift in supply. Now, the supply curve has been altered dramatically (Line Sa) by the democratization of the early-stage investor market: more involved angel investors, platforms for angel investing like AngelList, and platforms for crowdfunding like Kickstarter have diversified the early-stage funding rounds for new startups. In addition, other alternative investors – private equity firms and hedge funds – have also taken an interest in the growth-tech space and have been outbidding traditional VCs for the best startups. More deals are being made at relative equity rates below that of traditional VC.
What’s the result of all this? I argue that VCs must become more service-oriented. In the graph above, blue represents the growth in deals caused by increased startup demand and increased access to funding. The purple represents the decline in funding cost for startups and the associated loss of deal quality for the traditional VCs. In many ways, venture capital has become more commoditized. These changes have forced the consolidation of traditional VCs in the last few years, with institutional investors and other LPs focusing their investments on a smaller set of all-star performers.
To make up for this, the smarter VCs are offering additional services for startups to complement their money and traditional advice-giving. Some are making a deeper connection with entrepreneurs by hosting conferences or running active blogs. Others are hosting corporate briefings to connect Big Tech with the latest startup trends. These additional value-add activities differentiate them from the pack and may be key to their continued success as the competition becomes ever more fierce to fund the best companies.
Simple conclusion: If you’re an entrepreneur, it’s a great time to build a tech company. If you’re a VC, it’s a time of smart adaptation and innovative thinking. VCaaS?
Side Note: Startup Lowdown has brought on a few new contributors and we’re very excited to get content out more frequently!