The past, the Challenge and the Future of the Venture Capital Industry

The single most critical change that leads the tech industry’s transformation is the cost of starting a company and the time it takes to validate an idea (for those who are not familiar with the lean startup concept read here):

Cost of 5 years ago Today
Infrastructure Need to buy dedicated servers, software and potentially a firewall and lease a high speed link – a couple of hundreds of towards Cloud development – $0-$100 a month
Development cycle Usually 6-12 months. Product must be fully functional. New versions are launched on a quarterly basis. I’m familiar with companies developing a product in as little as 3-4 weeks. Lean version released. A new version can be launched as quickly as every few minutes (Zynga launching a new version every 20 minutes).
Company size Startups would usually include ten and more team members before a product is actually launched. Usually need office space. Startups can launch a product with a single to 2-3 co-founders, working from a coffee shop.
Validation timeframe 6-12 months of development + a couple of months to validate the idea. As little as one month for development + days or weeks to validate the idea and assess traction.
Salaries More team members + Longer cycles = high salary expenses 1-3 co-founders + number of weeks to validate = No to low salary
Go-to-market  channels Massive campaigns, commercials over expensive channels etc. App stores, Facebook, SEO/SEM.

In summary a company today can launch a product and get an initial validation with less than a $100,000 in cash. A fair number of companies will scale and turn profitable with a ~$5M round. Historically, companies raised ~$5M to develop and launch their product and a significantly higher round to scale.

A new Era in Fundraising

There has been an emergence of a shadow venture system over the past several years as angels have institutionalized, yesterday’s successful multi-millionaire entrepreneurs have become a legitimate capital market, and incubators have re-entered the funding formation process. In the later stages, a few traditional VCs are turning into mutual funds. Add secondary markets, and the world of investing has profoundly changed.

What does this mean for VC firms

Deal flow is the single most important element for a VC firm. The math is simple: More deal flow => higher quality investments => higher chances for high returns.

A couple of elements in today’s environment challenge the access to quality deal flow:

-          Early stage competition – Given that less funding is needed in the seed stage, angels (high net worth individuals), incubators & super angels are emerging as alternative sources of capital.

-          Early stage acquisitions – Many startups will never raise a VC round/Round A. Zappedy acquired by Groupon last month after a small seed round a couple of months ago. Groupon also acquired Grooper nine months after they raised a small friends & family round.

-          Late stage investments are competitive – The rounds for high quality deal flow (e.g companies that receive impressive traction early on) are becoming very competitive and VCs are required to be quick in their decision making.

To address the challenges, a number of VCs have reinvented themselves and changed their strategy.

-          Micro VCs – VC firms like First Round Capital, Union Square Ventures & Felicis Ventures have identified the transformation and raised smaller funds, focused on early stage investing. This is not a trivial change: Managing hundreds of investments in a given time or quickly making investment decisions (First Round Capital made 5 investments this month, according to CrunchBase) instead of waiting for the monthly partners meetings, requires a different operation model.

-          Internal deal flow generation – some VC firms have hired serial entrepreneurs as Entrepreneurs In Residence (EIR) and give them a small fund to explore different ideas. Greylock, for example, have 7 EIRs including Josh Silverman, Skype’s ex-CEO.

Finally,  many VC firms will not raise another fund and will discontinue their operations. The number of VC firms has been in decline since 2001 and I expect that to continue in the upcoming years. The transformation discussed has affected many VC firms, whose initial fund strategy did not match the current era.

Total VC since the late 90s

Total VC since the late 90s

A final thought about the industry moving forward: This is little differentiation between VC firms today. Most of them focus on online consumer & mobile (some cleantech or cloud/SaaS). I expect VC firms to try and develop a differentiator that will help them emerge as leaders in their niche (by sector, expertise or geographies). Vinod Khosla’s venture is a good example of that.

When will that happen ? We’ll have to wait & see.

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About shanishoham

After 14 years of General Management and incubating/scaling new businesses & organizations for enterprises (established a $55M mobile business and a $100M/400 employees global division), I became an investor Today I’m a board member/mentor with 5 incubators & micro-VCs and involved with many other private & public incubators around the world. I also founded a VC firm named 2020 and I'm a member with a number of angel groups so i get to see & work with many startups, innovation centers and other parties across the ecosystem. I’m an alumnus of the Stanford Graduate School of business - Sloan Master in Management program, a 10 months intensive program for 57 carefully selected experienced Executives and leaders from all around the world.

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