All signs seem to indicate that by 2022, for the first time, nontraditional tech investors—including hedge funds, mutual funds and the like—will invest more in private tech companies than traditional Silicon Valley–style venture capitalists will.
Many people are quick to write this off as a momentary blip where extremely cheap money and the global search for returns are awkwardly pushing all investors toward the private innovation markets; however, that read misses the main point.
What is really happening is that capitalism is functioning as intended—and as it has worked throughout history. The era of West Coast–style venture capital that has been shaped by the growth of the software industry is coming to an end.
In any new market, venture capitalists come in and provide very expensive capital for high-risk, high-reward propositions at the frontier.
Over time, these investments in new industries become better understood and instrumented. Their risks and opportunities can be more easily measured, and investors across the board price them more or less the same way. As these shifts occur, massive flows of capital follow and investors compete with each other to offer industry builders cheaper and cheaper money.
This happened in the New England whaling industry in the 19th century (in what was arguably the first VC cycle), and it is happening today in software. What we are currently calling venture capital is rapidly becoming just run-of-the-mill globalized, highly competitive and reasonably low-margin finance.
Now, firms that grew up around software and internet investing and consider themselves venture capitalists face a choice.
They can become just “capitalists” (drop the venture) and engage in direct and cutthroat competition with larger East Coast and global institutions to offer cheaper and cheaper capital. Or they can stick to their roots and move on from the increasingly tame world of software and internet investing to wild new horizons. (Think biotech, new parts of artificial intelligence and much more.)
The choice, in a nutshell: Prepare to enter the bigger pond as a fairly small fish, or go find another small pond.
Historical Analogy: Whaling and the Energy Industry
History usually rhymes, and the first modern VC cycle in New England is worth understanding.
In the 19th century, demand for energy was growing, and a bunch of entrepreneurs figured out a high-risk, high-reward energy opportunity—whaling off the coast of New England. There were fewer than 1,000 of these whaling operations at the peak, and a handful of these entrepreneurs grew fabulously rich. New Bedford, Mass., became the richest city per capita in the world.
But, of course, the boom didn’t last.
The riches in energy propelled technology and innovation that ultimately led to oil drilling. Drilling was far more efficient and predictable than sending boats offshore to kill enormous mammals, and the whaling industry collapsed.
As the energy industry became more predictable, the capital market for energy went from a risky venture proposition to just plain finance, with predictable businesses and returns. Investors primarily competed for margins by figuring out ways to assemble massive pools of capital cheaply and then deploy those pools marginally more efficiently. Lots of people still make a lot of money in the industry, but no one would really categorize it as venture capital.
The Taming of the Wild West of Software and Internet Investing
A few centuries later, the same pattern is basically playing out in software and internet investing.
For the last twenty years we have been living through the whaling years of the market, where starting software and internet companies was a high-risk and high-reward endeavor.
People really didn’t know how to start software companies; the strategies for growth were unclear. There wasn’t much infrastructure in place to support business building. Investors weren’t sure what metrics mattered, how to instrument companies and how to pick winners.
Fast-forward to today and the West has largely been tamed.
The broad-based knowledge among entrepreneurs of how to start successful companies has been widely distributed. A ton of infrastructure is now in place–from Amazon Web Services on down—to support business building. The dark art of growth and engagement has been demystified and people know the playbooks. And, of course, the finance community’s knowledge about how to evaluate startups and price risk has gone mainstream.
The net takeaway is that in the last several years, as software investing has gone from fringe to mainstream, enormous flows of global capital have been unlocked to finance software and the internet at increasingly competitive rates.
Implications for Traditional Investors
What this means for investors who focus on Series A investment rounds and beyond is that the market should become more and more efficient while investing becomes less and less profitable.
Greater predictability of and investor confidence in these early-stage investments will mean skyrocketing valuations as demand from investors grows. Every investor will see all the same deals and will have the same tools to evaluate their potential.
The way to win deals in this market is to give startups the cheapest possible capital (that is, agree to the highest valuation or most favorable terms for them). And you need to be as big as possible so that your cash-on-cash returns are very high even if your margins compress.
What does this mean in practice?
It means you need lots and lots of cheap money to compete against everyone else globally. Access to cheap money—through relationships with the world’s largest limited partners and sovereign wealth funds—is going to be the biggest determinant of success.
It also means investors won’t be very collaborative, because as margins go down they need to invest as much money as they possibly can in every deal. They need to make up for lower margins with higher volume.
Firms must look for every possible advantage to help them lower the cost of their capital for entrepreneurs. This can come from brand appeal (some great firms will help startups raise cheaper capital downstream because their stamp of approval carries weight with other investors). It also can in theory come from staffing up big service arms and claiming that the capital brings with it lots of valuable freebies.
Still, I am skeptical that today’s Silicon Valley firms will end up winning over the long term.
Even the biggest Silicon Valley venture capitalists are very, very small by global finance standards. And as the parochial world of Silicon Valley finance is exposed directly to the broader East Coast and global financial system, VC firms that once thought of themselves as big will discover they are small fish. Some will obviously survive, but the competition will be brutal. Any VC firm of today that survives will look more and more like every other global financial shop. That means they will play in every part of the capital stack with lots of products, including public equity funds, debt funds and more.
The Impact on the Seed Market
One question I care about deeply is what will happen to seed investing. This outcome is far less clear because a few countervailing forces are at play.
On one hand, as more formal VC rounds shift, seed rounds could shift along with them in lockstep. When Series A rounds get more expensive, people are willing to price up seed deals to match. (That brief window of the last few years when Series A prices were rising faster than prices for seed deals, creating a wonderful temporary window for seed investors, has closed.)
When Series A and beyond gets bigger, it is easier and easier for any large fund to throw nearly free seed dollars at entrepreneurs simply as marketing for their main fund, swamping the market.
On the other hand, seed investing is somewhat insulated from the shifts occurring in the venture market because, almost by definition, brand-new startups lack the instrumentation and metrics needed for efficient scale. As a seed investor, you are still mostly betting on people and ideas—not metrics.
Seed investing is also insulated because seed companies just can’t consume that much capital before they either die or graduate to financeability in the mainstream system. Seed investing also rapidly becomes uneconomic for any large fund; even enormous wins from a seed fund simply cannot earn the sheer dollars needed to make a larger fund successful. It isn’t worth many investors’ time.
All that given, the seed market is unlikely to be totally immune to the onslaught of global capital. With more funds bringing in more dollars, the prices of deals will rise as long as they fit on the conveyor belt that yields the metrics for Series A investments and beyond.
Over time, even seed deals—the riskiest of the startup class—are likely to become run-of-the-mill investments, priced reasonably efficiently after you adjust for risk.
The Choice for Today’s Venture Capitalists
If you are a young person working in and around the VC ecosystem, you have a big choice to make right now about how you want to spend your career.
If you want to be in private equity (and let’s be clear, those folks get paid really well), then staying at a mainline VC firm makes a ton of sense. There is every reason to believe that firms like Andreessen Horowitz will indeed turn into the next Blackstone, Fortress or KKR, if not the next Goldman Sachs or Morgan Stanley—and will certainly be in direct and brutal competition with the whole field. A reasonably early partner, pre–initial public offering, at these firms can anticipate a very lucrative career.
However, if you want to be a venture capitalist leading the next era, you should look for opportunities no one else is funding because they are too weird, too crazy or too small—at least today.
With the speed at which information spreads now, the cycles of real VC opportunities will come faster and last for shorter periods. Even areas like crypto, which were fringe a few years ago, have already been subsumed by mainstream finance, at least for certain types of opportunities.
You will know you are doing real venture capital when you aren’t competing with other investors to finance a deal but are instead offering to invest in people, industries and ideas that don’t yet have access to capital. That is where money can be most useful, and also where returns can be the highest.
In 2015 Marc Andreessen tweeted that he believed venture capital was restructuring into a few large franchises and a large number of small boutique specialists. The firms in between, he said, would die.
In the years since he made that statement, many of the large VC brands have followed that trajectory. But I think Andreessen missed the truth that venture capital isn’t an industry at all. It is just a style of investing that exists for a while in a new market before the big money guns show up.
It isn’t that venture capital is restructuring, as an industry does. But it will vanish from certain types of investments, like software, where bigger financial institutions will swallow up the opportunities.
Specialists will exist, but they won’t be investing in the things that have defined the VC playbook of the recent past, like software and marketplace and e-commerce businesses. They will have moved on to new opportunities at the current frontier.
There is a truism that as startups mature, they eventually look pretty much exactly like the companies they set out to disrupt. Today’s prominent VC firms will follow the same trajectory. And the boutique investors will move on.