“What’s Next” for the Venture Capital Industry?
The Internet has reduced the cost of starting tech businesses and accelerated the democratization of entrepreneurship worldwide. Still, entrepreneurs face the same challenges: penetrate a market or create a new one, grow solid teams, find business models that generate profits, design products that keep paying customers returning, respect the law and go global. In a knowledge economy like the one we inhabit now, successful entrepreneurship is dependent on accessing talent; otherwise, they won’t succeed.
Capital raised by startups will be spent primarily on two different types of talent; employees, and outsourced service providers like marketing agencies, law firms, accounting firms and software development agencies. But this gives rise to a problem: how can a startup founder be sure that they are using the capital they have raised in the best way possible? How do they know if they are getting the best service at the best price? How do they know if they are using the right talent in the first place? All too frequently, founders only find out that they have overpaid or sourced inferior talent when it’s too late, and that’s costly for their company and their investors. Challenges like these are precisely why it is so critical that the venture capital industry starts to create new ways to fund and grow technology startups.
The entrepreneurial nature of the venture capital industry is creating ways to deliver this change and consequently changing itself. In its 2021 US Venture Capital Outlook, PItchbook said; “In addition to macro conditions, the VC industry itself is undergoing a period of transformation and innovation. As the traditional VC model — with heavy concentration in particular demographics and geographies — has been questioned in recent years, we have seen a concerted effort to look beyond traditional VC hubs and develop new ways to capitalize startups.” Ernst & Young’s Megatrends Report says: “Crucially, fund managers will also need to find new levers of value creation, with a particular focus on three areas that are becoming increasingly important: digital strategy, purpose and transparency, and talent.”
There are a number of problems fundamental to the startup ecosystem that must be solved if we want to see the venture capital market outperform more consistently. Below, we identify some of these challenges, and firms that are looking to solve them.
The Liquidity Problem
Liquidity is a very important factor for any fund manager and their investors and the VC market is no different. The more liquid, the better for everyone as profits and returns can be realised more quickly; some of these profits will get recycled back into the industry, creating a virtuous circle of funding innovation. Liquidity varies depending on sector, geography and type of business; for direct investors, an exit might take around 8–9 years on average but for limited partners in VC funds, it can take up to between 10 and 15 years before they receive the entire return on their original allocation. Venture capital being venture capital, there are some firms that are trying to solve the liquidity problem inherent in the venture capital industry.
Funderbeam (https://www.funderbeam.com/) is a global equity funding and trading platform. It connects a diverse investor network with highly vetted growth companies across international markets and, through their marketplace, allows private investments to be traded; Balderton Capital (https://www.balderton.com/about-balderton-liquidity-i/) has raised a $145mn fund that will purchase equity directly from early shareholders including angel investors, existing or former employees and founders; Forge Global (https://forgeglobal.com/) is building an operating system for the private market innovation economy; Carta (https://carta.com/) has developed a secondary market for private shares, offering companies the opportunity to unlock the value of equity for their shareholders, whether that be founders, employees, or early investors; Draper Esprit (https://draperesprit.com/) is a publicly listed venture capital trust which invests exclusively in technology companies. Moving away from the traditional closed-end venture capital fund structure means that Draper Esprit doesn’t need to be a forced seller, a well-known issue in venture capital circles.
The Skin-In-The-Game Problem
In the startup economy, when the activities of people, mentors, experts, consultants and agencies have so much influence on the success of startups, it is legitimate to ask what level of skin-in-the-game they have to motivate them to produce the best outcome for the startups they are advising. The problem is that the majority of transactions happen using cash. Being compensated for any kind of support makes all the sense in the world on the surface, but this removes both skin-in-the-game and any interest in actually helping the client (the startups) grow over time. Indeed, there is a moral hazard here as the provider is motivated to deliver something that’s just good enough in quality that they can then upsell from — even if this is not in the best interest of the startup’s success.
The risk is therefore asymmetric and most founders buy services from professionals that aren’t going to suffer from providing the right services at the wrong time. Nassim Nicholas Taleb’s thesis is that skin in the game — i.e., having a measurable risk when taking a major decision — is necessary for fairness, commercial efficiency, and risk management, as well as being necessary to understand the world. To that end, it is fascinating to see some players in the VC marketplace use some of the principles of ‘skin-in-the-game’ to win deals.
Sweat Equity Ventures (https://www.sweatequity.vc/) is LinkedIn founder Reid Hoffman’s $30M bet: it sends partners, not cash, to startups. The firm is a ‘Value Accelerator’, a new kind of investor that invests expertise and time, not cash, in exchange for equity. Kindred Capital (https://kindredcapital.vc/) offers some carry to their founders; this allows them to win deals as founders are financially incentivized to take the money from Kindred vs another fund as the latter route would not provide something in addition to the committed capital. The Founder Institute (https://fi.co/) has developed an ‘Equity Collective’ where everyone shares equity in the companies formed from each program cohort.
The Portfolio Size Problem
It’s extremely difficult to predict which startups will actually break out and become viable, sustainable businesses; that’s why venture capital fund managers tend to have many investments in their portfolio because the likelihood of that ‘home run’ is increased the more startups are added to their stable. But even a portfolio of 20–30 startups is likely to be too risky so some investors are refocusing on the numbers game as opposed to trying to be too detailed about the initial investments.
Loyal Venture Fund Group (https://loyal.vc/) has redesigned the VC process to work at scale. Their core Startup Index Fund holds more than 130 companies, and is growing. Loyal allocates only small amounts to begin with, and optimizes follow-on investing, using a multi-stage Darwinian process where winners continually emerge over time. Loyal has also revamped the fund structure. LPs want to be able to access their money quicker but entrepreneurs want long term capital; consequently, Loyal’s core Startup Index Fund has no end date, yet it prices and transacts quarterly. In effect, the fund acts as its own secondary market, so investors have better liquidity. Loyal’s founding partners don’t like the concept of annual management fees as the main compensation mechanism either, so the Startup Index Fund fees are tied to investors receiving real gains and liquidity. AngelList’s Access Fund (https://angel.co/v/access-fund) invests in 200+ startups annually alongside top-tier VC firms.
These two models are reserved for “sophisticated” and “accredited investors”, meaning that access is still very exclusive and regulations dictate who can invest, which is largely institutional investors and wealthy individuals. But the principle — that casting a wider net with smaller initial investments provides a better chance of making better overall returns — remains.
The Ecosystem Problem
Historically, startups operated in a very siloed way; they raised capital but then went off to do everything on their own. However, capital has become more abundant in recent years, so venture capital funds have begun to offer more to their investee companies as competition has increased.
Human Ventures (https://human.vc/) is a ‘business creation’ platform; they have an incubator program as well as a fund, so the latter can invest in the successful businesses that emerge from the former. Lerer Hippeau (https://www.lererhippeau.com/platform) provides post-investment support and services to early-stage founders and FirstMark Capital (https://firstmarkcap.com/platform/) has the ‘FirstMark Platform’ network that connects founders with seasoned entrepreneurs who’ve been there before.
Other incubators and accelerators outside of traditional venture capital fund managers have sprung up like mushrooms in the past few years; they offer a combination of services including direct funding, training, mentorship and access to workspace so the founders and early employees can collaborate more effectively. The key difference between the two models, as we see it, is that accelerators typically provide these services in a limited time period through a cohort-based programme (usually three to twelve months), whereas incubators typically operate under more flexible terms, taking on new startups on an as-and-when basis with no time limit (the average stay is around two years). Examples are numerous.
The Equity Dilution Problem
Start-ups tend to raise many rounds of financing, and every time at least one equity owner — usually the founders — gets diluted. Indeed, many early-stage venture capital funds might get diluted as well. But many start-ups do produce revenue early on in their evolution; for these firms, other financing options are emerging which are non-dilutive to equity, thus increasing the profits for investors when they exit.
Clearbanc (https://clearbanc.com/en-uk/) provides working capital for companies with recurring revenues. They use a data-driven approach to select which companies will receive offers of funding but this capital does not dilute shareholder equity and importantly does not credit-check, something that benefits very young companies. They have also recently launched an angel investing platform which again does not take equity. Lighter Capital ( https://www.lightercapital.com/) also does not take equity; their allocation criteria includes a certain amount of monthly revenue, a certain number of customers and a path to profitability. Pipe (https://www.pipe.com/) enables revenue-producing startups to trade in future revenue for a discounted up-front payment now.
The Awareness Problem
More companies are launching now than ever before; although many of these are forced launches due to layoffs caused by the effects of the Covid-19 pandemic, people are realising that they can work effectively from home, something critical in the early stages of a tech start-up.
With increased competition comes increased difficulty in getting the word out. UK-based Channel 4 Ventures — its portfolio includes location system What3Words, mattress company Eve and crowdfunding platform Crowdcube — offers high potential brands the opportunity to accelerate their growth through TV advertising, in exchange for an equity stake in the business. Spain and Italy-focused Ad4Ventures is the venture arm of Italy’s largest broadcaster, Mediaset Group, and has worked with home furnishings company Westwing, sports store Deporvillage and fintech Satispay, again using the media for equity model.
The Data Problem
Venture capital investing has historically been conducted using a significant degree of ‘feel’: Do I like this founder or founders? Does my gut tell me that they will never quit until they succeed? Do I think they are coachable and open to receiving feedback that might be critical or challenging? Increasingly, the venture capital industry is making use of AI and a more quantitative approach to sourcing investee companies. One of our favourite articles on this subject is by Francesco Corea at Balderton Capital. You can read it here https://francesco-ai.medium.com/data-driven-vcs-839f2454d22.
The Future of Venture Capital
It’s clear that the venture capital industry is reinventing itself already but much of what we have covered above uses conventional means to solve the industry’s current set of challenges. That said, there are other firms which are leveraging the extraordinary opportunities afforded by digital technology — i.e. blockchain — to further the prosperity of the venture capital industry.
SPiCE (https://spicevc.com/) is a venture capital firm focusing on the tokenization ecosystem. They provide their investors with wide exposure to the massive growth of the Blockchain / tokenization ecosystem by investing in firms which develop tokenization technology. They walk their talk, too; they have tokenized the LP interests in their own fund. Ultrastack (https://ultrastack.substack.com/p/ultrastack-whitepaper) is proposing a new system to replace salaries with publicly tradable shares, and to help workers diversify their ownership and income across multiple companies. Stacker Ventures (https://stacker.vc/) is a community-run protocol for initiating and managing pooled capital on the Ethereum blockchain. Structured as a DAO (decentralised autonomous organization), Stacker Ventures initiates decentralized funds, accelerates portfolio investments through a community, and provides checks and balances to fund management. The DAO’s first fund is an expedited crypto-native fund that invests in up-and-coming projects.
Here at Consilience Ventures, we have created our own ecosystem where all of our members — startups, investors and experts — exchange fiat currency, equity and time for our proprietary digital currency, CVDS, and each member shares in the growth of CVDS as the startups in our ecosystem grow. We are providing skin in the game to outside experts as our model motivates them to support our startups in the long term; we provide both capital and expertise to our entrepreneurs and we provide pre-diligenced startups to investors who are incentivised to play both investor and expert roles.
The venture capital industry has always been one that is synonymous with the remarkable, relentless advancement of other industries. Now, finally, the venture capital industry is reinventing itself so that it can continue to support innovation and entrepreneurship in a way that adds value for all stakeholders.
