The Start-up Funding Gold Rush: a New Era for VC, or Just a Fad?
Crowdsourcing, accelerators and a rush of new funds and investors are forcing the VCs of Sand Hill Road to change the start-up money machine. But is it a change for good?
To be a successful technology start-up these days, you need a few ingredients: money, a novel idea and a catchy name. By late 2014, Beepi had achieved the trifecta. In less than a year, the Los Altos, California–based start-up had amassed $79 million in funding and a $200 million valuation. The company’s guiding idea — that the process of buying and selling a used car was needlessly difficult and in dire need of improvement — allowed investors to situate Beepi within a fashionable narrative of disruptive innovation. (Who better to disrupt than used-car salesmen?) And Beepi’s name observed the two-syllable rule made safe by Apple, Facebook, Google, PayPal, Tesla, Twitter and Uber, suggesting something compact, approachable and fun, while providing the frisson of danger that comes from a near-misspelling.
But in late December, Beepi, which connects car sellers and buyers directly online and takes a far smaller (1 to 9 percent) cut of sales than traditional dealerships, did something its co-founder and CEO admits was slightly unconventional. After raising $1.3 million in seed capital in January 2014, followed by $5 million in April and $60 million in October, the company announced that it had collected a further $12.7 million in an angel round.
The bulk of the angel round was put up by Yuri Milner, a Russian-born billionaire who believes social networks like Facebook and Twitter will eventually mutate into a global brain. But $2.8 million came from a syndicate of 99 investors on AngelList, an online service for investment in start-ups, launched in 2010. This was the largest single investment ever made through AngelList.
Raising angel capital after a series-B round, as Beepi did, is not the way start-ups usually proceed. But Alejandro Resnik, 32, who launched Beepi in 2013 after earning an MBA from Massachusetts Institute of Technology, had a broader motive. “I wanted to send a message to the whole investment community about how powerful crowdsourced funding can be,” he says. “I personally believe in it, and I think it’s going to be responsible for a lot of innovation in years to come.”
AngelList helped 243 start-ups raise $104 million online in 2014. Waves of innovation over the past decade, from widespread broadband penetration to cloud computing, from smartphones to social networking, have slashed the cost of launching a tech start-up. Ten years ago it might have taken $5 million to build a technology-intensive product and test the market’s need for it. Now, says Naval Ravikant, co-founder and CEO of AngelList, “it takes a tenth of that amount.”
A dedicated angel investor who bought early stakes in Twitter and Uber, Ravikant launched AngelList with the aim of improving transparency and access to deal flow for entrepreneurs and investors. He’s not alone. As barriers to becoming an entrepreneur fall, a deluge of new participants have entered the funding game, with a profusion of new models and approaches emerging as competition for deal flow intensifies. The same currents that have transformed entrepreneurship are fostering experimentation in equity funding. But it’s still too early to tell whether the experiments will stick or simply disappear once the market’s enthusiasm for start-ups cools, interest rates rise and investors’ scrambling for yield loses some of its present intensity.
For now, the market encourages confidence from founders and backers alike. In the U.S. there are 55 venture-backed private companies worth more than $1 billion, according to CB Insights, a New York–based data firm. Thirty-eight of those businesses joined the billion-dollar club in 2014. In 2000, by contrast, at the height of the dot-com era, there were barely ten. Venture-backed companies are growing at an unprecedented scale and speed, with many seemingly happy to delay going public — and the firms that fund them also are following closely behind.
After a decade in the double doldrums of the post-dot-com and postfinancial crises, venture capitalists saw the good times return in 2014, bringing billions in institutional cash and fresh hope to the storied firms that sit at the pinnacle of the global industry, on Sand Hill Road, in Menlo Park, California. Venture capital firms invested $49.3 billion in start-ups last year, according to Thomson Reuters — the highest level since 2000, when more than $100 billion was put into early-stage companies. In some ways the current market hasn’t yet caught up with the dot-com boom, but in others it’s already surpassed it.
In 2014 the venture industry for the first time saw two deals worth $1 billion-plus each, both for San Francisco–based Uber. The taxi service, now valued at $41 billion, is the reigning behemoth of the private markets and has spawned an army of start-ups looking to replicate its success. There’s now an Uber for boats, an Uber for lawn care, an Uber for cannabis. Uber is now effectively postventure. Look at the company’s latest funding rounds, and it’s not the Sand Hill Road firms leading the charge but big mutual funds, sovereign wealth funds and banks: BlackRock, Goldman Sachs Group, the Qatar Investment Authority and Wellington Management Co. all backed Uber in the past 12 months. This isn’t the first time nontraditional money has cascaded into the venture market, but the depth of participation from the heavy hitters is unprecedented, with many corporations, cash-rich amid a buoyant stock market, forming venture arms to get in on the action.
The earliest stages of the funding cycle, however, tend to produce the most frenetic and interesting activity. Venture capitalists often like to argue that as technology allows more to be done with less, society is becoming ever more entrepreneurial. “The whole gestalt of how people think about business and what’s exciting has changed massively,” says Dan Ciporin of Canaan Partners, a Menlo Park venture capital firm. “We’ve gone from Wall Street, the movie, to The Social Network. People have shifted from a corporate, Wall Street orientation to more of an entrepreneurial orientation.” This is debatable: Recent research from the Brookings Institution reports that the number of companies less than one year old is falling as a percentage of overall U.S. corporations, suggesting that the country, which accounts for close to 70 percent of global venture capital activity, is becoming less, not more, entrepreneurial. But perception counts in investing, and the outsize success of some pioneering young tech companies is encouraging more investors to travel to the very beginnings of the funding cycle in search of the next Uber.
Small funds dedicated to early-stage investment have been a fixture of venture investing for a decade. But in the past year, funds writing even smaller checks for even younger companies have exploded in number: 124 funds with less than $100 million closed in 2014, according to CB Insights, triple 2013’s figure. Angel investing platforms such as AngelList and accelerators like the now-ten-year-old Y Combinator — a program co-founded by tech pioneer Paul Graham that gives start-ups $120,000, puts them through a three-month boot camp and provides investor introductions in exchange for 7 percent of company equity — offer further avenues for investors to get close to start-ups at their inception. Meanwhile, the 2012 Jumpstart Our Business Startups (JOBS) Act holds the promise that participation in start-ups eventually will be open to every investor, accredited or not.
These developments have produced a barbell effect: Most of the fundraising — if not in absolute dollar terms, then certainly by the number of deals done — is concentrated around the very early stages and the very late stages. Traditional venture capital “is getting compressed into an area where it can uniquely play, but it’s lost control over the entire field from beginning to end,” AngelList’s Ravikant says.
This may not be a bad thing. The great paradox of venture capital is that it’s an industry that has funded wave upon wave of innovation but has seen little meaningful internal change. That is changing, with signs that large venture capital firms are starting to rethink operations for more-demanding times. But it’s not yet clear whether the creativity unleashed in start-up funding will match the innovation from start-ups themselves or will instead turn out to be more like the creativity of the stereotypical used-car salesman — all hat and no rabbit, slick talk introducing a lemon.
oger McNamee is one of the great comedian-polemicists of venture capital. An investor with more than three decades in the industry and a haircut that seems to have evaded the attentions of a comb for just as long, McNamee, who spends his time away from capitalism fronting a blues band, carries some of the last vestiges of the hippie culture that permeated Silicon Valley in the 1970s and ’80s, before the more self-serious libertarianism of PayPal co-founders Peter Thiel and Elon Musk took over.
Ask him to summarize his take on the industry today, and the verdict is swift. “Venture capitalists — if they all disappeared tomorrow, no one would notice,” says McNamee, who was an early investor in Facebook and co-founded Menlo Park–based Elevation Partners in 2004 with U2’s Bono. For decades the industry has been dominated by the Sand Hill Road crowd, which includes Kleiner Perkins Caufield & Byers, New Enterprise Associates and Sequoia Capital. Today these firms, able to raise individual funds of as much as $2.5 billion, are, McNamee says, “Miss Havisham — they’re sitting there wearing their wedding dress around the house, all in tatters. Venture capital still exists, but the people you think of as venture capitalists aren’t the ones doing it.” The world, he says, has moved on from Sand Hill Road, with all the meaningful activity in start-up funding occurring with angel investors, on the one hand, and non-venture-capital late-stage investors on the other. (Ironically, Elevation Partners’ West Coast office is located on Sand Hill Road.)
This is a signature rhetorical trope for McNamee, who unleashes his many opinions on venture capital with the verve of an indignant meerkat. But it’s also a signature trope for the industry. Complaining about the demise of venture capital, it turns out, is an exercise almost as old as venture capital itself. In 2000, at the height of dot-com hysteria, Arthur Rock, one of the pioneers who gave the industry its institutional footing in the 1960s, lamented that “the people entering the business in the late 1990s were promoters. They’re becoming a different kind of business, in my opinion. They are making bigger investments in non-start-ups.”
This attitude says more about how venture investment got started than it does about the state of the industry today. Venture capital, whose basic scenario involves an investor allocating money to a high-risk enterprise in exchange for equity, has been around “since the days of Christopher Columbus,” says Charles (Chuck) Newhall, who helped found New Enterprise Associates in the late 1970s. The roots of today’s industry are most often traced back to American Research and Development Corp., which Harvard Business School professor Georges Doriot started in 1946. Doriot’s key contention, dutifully repeated by nearly every venture capitalist since, was that venture capital is not investment in the conventional use of the term. ARDC, Doriot wrote in the firm’s 1951 annual report, “does not invest in the ordinary sense. It creates. It risks. Results take more time and the expenses of its operation must be higher, but the potential for ultimate profits is much greater.”
The early decades involved something of a struggle for venture capital’s soul between its two geographical centers, Route 128 in Boston and Silicon Valley’s Sand Hill Road. East Coast venture capitalists, as Udayan Gupta explains in his 2000 history of the industry, Done Deals: Venture Capitalists Tell Their Stories, used financial engineering as the basis of their approach to start-up investing; West Coast venture capitalists, by contrast, had a higher appetite for risk, favoring a style based more on intuition.
The Silicon Valley approach has come to dominate the world’s view of venture capital. Rock, an early investor in Intel Corp. and Apple, approached investing with missionary zeal, getting involved with companies at inception and stressing venture capital’s social purpose. “If you’re interested in building a business to make money, forget it,” he said in 1997. “You won’t. If you’re interested in building a business to make a contribution to society, then let’s talk.”
High tolerance for risk; an exceptionally long investment horizon; close, early and continuous contact with funded start-ups; and a belief in venture investment as an almost artistic endeavor informed more by social vocation and a sense for entrepreneurs’ characters than a concern for potential returns: These were the founding traits of the organized venture capital industry. Financing structures in the early days allowed relaxed attitudes toward performance. Rock and others like him raised much of their capital from immediate networks — mostly, from middle-aged businessmen who had made their fortunes and were looking to invest as a later-career second act. This reduced the pressure to generate returns felt by investors in more-mainstream asset classes.
But the growth of venture investing, coupled with legislative changes that allowed pension funds to make riskier allocations, led to an influx of institutional capital into the industry through the 1980s and ’90s. The proselytizing, daredevil nature of early venture capital gave way to something more professionalized, with relatively predictable economics (most funds followed the 2-and-20 model, receiving a 2 percent management fee and 20 percent of profits), a settled general partner–limited partner fund structure and a better balance between serving company founders and institutional investors. To meet the requirements of the latter, which needed to invest at scale for venture to constitute a meaningful allocation, established firms ended up constructing larger funds composed of bigger rounds for companies deeper in the financing cycle. In the process, they mostly surrendered the early-stage, company-building focus.
There is some irony to this. It would be difficult to think of an asset class less suited to conservative, returns-focused institutional investors than the high-risk, long-term, company-focused activity venture capital was at its inception. This is the venture capitalist’s dilemma: Funding and practicing often run in contrary directions. To attract institutional capital, funds need to be big, which means writing bigger checks for companies at a more mature stage of development, where risks are lower and the probability of decent, if not windfall, returns is more certain. But venture capital at its heart is the “art of exceptionalism,” says Mike Maples Jr., founder and managing partner of Palo Alto–based Floodgate Fund, which manages more than $250 million in five seed funds. Unearthing one-in-a-million bonanzas — the task early venture capitalists set out to accomplish — requires investors to get to know companies before anyone else has heard of them. “When you’re managing a billion-dollar fund, that’s virtually impossible,” notes Maples.
In rising markets this tension was not a problem. But since the turn of the 21st century, consistent underperformance of venture capital has tarnished its image for many institutional investors. Accurate, complete, fund-level performance data remains fiendishly difficult to obtain. Fund lengths, which typically range from ten to 15 years, compound venture’s general lack of transparency: Returns for funds of younger vintage, even when they are advertised, include unrealized gains from follow-on rounds for companies that have yet to achieve meaningful exits.
In 2012 the Kansas City, Missouri–based Ewing Marion Kauffman Foundation released a report asserting that venture capital had delivered consistently poor returns since the turn of the century, with the majority of brand-name funds underperforming public markets. The report stirred agitation in the industry, but few had any hard evidence to reject its central claim that “there is no argument for investing in a large fund based on the data,” as lead author Diane Mulcahy, who manages Kauffman’s private market investments, says. Her solution is to invest in smaller funds, which “have a much better record of outperformance than larger firms.”
But for more-enterprising minds, venture capital’s underperformance, especially as it strayed from its roots in very early-stage investing, provided an opening. “The industry has been crying out for innovation for over a decade,” contends Aaron Harris, a young partner at Y Combinator. That innovation may now have arrived.
Capital scarcity caused by the dot-com downturn and deepened by the financial crisis forced many venture capitalists to reevaluate their business model. Barely $20 billion was raised in each of the slowest recent years on record, 2003 and 2009. After years of plentiful inflows, venture capital suddenly had to work to attract interest, from both entrepreneurs and institutional investors. For limited partners “venture capital is kind of the man behind the curtain,” explains David York, CEO of Top Tier Capital Partners, a San Francisco–based venture capital fund of funds with $3 billion in assets. “There’s lots of levers being pulled, and you don’t know how it all works.” Institutional investors, he says, “wanted that transparency.”
Firms began to market themselves. The first venture capital social media emerged: Fred Wilson of New York’s Union Square Ventures debuted his blog in 2003. It remains influential, as do blogs and social media feeds of other prominent venture capitalists, many of whom — like Marc Andreessen and Chris Dixon of Andreessen Horowitz, a Menlo Park firm that manages nearly $4.5 billion — maintain hyperactive Twitter presences.
The return to a very early-stage focus altered industry dynamics. “When we started, everyone said, ‘The world doesn’t need a new venture firm,’” says Jon Callaghan, who co-founded San Francisco’s True Ventures in 2003. “But there were few people out there taking early-stage risk.” Today, True Ventures manages $1 billion in institutional capital and has a portfolio of companies employing 4,500 people. Performance is difficult to measure in a meaningful way; distributions from the firm’s four still-young funds remain scant. But venture capital obeys a power law: A tiny portion of venture-backed companies generate most of the returns. In that sense, headline moves matter. Callaghan was the first professional investor in Fitbit, a San Francisco–based maker of wearable health-tracking devices, and was early in drones and the MakerBot 3-D printer.
True Ventures; Union Square Ventures; Boulder, Colorado–based Foundry Group; and San Francisco’s First Round Capital moved into seed and series-A rounds vacated by Sand Hill Road incumbents. “Discipline is critically important to success,” Callaghan says, but he concedes that “in venture, once you get successful, it’s hard to stay small.” This group of decade-old venture pioneers feels that difficulty keenly: Fund sizes now stretch to $250 million. As venture firms have traveled down the funding stream, new entrants have come in behind them. All the innovation of the past half decade has to be seen through the lens of investors trying to get access to companies “before the rest of the industry finds out,” says Floodgate’s Maples. Seed funds, generally smaller than $100 million, have exploded in number, but it’s in nontraditional, nonfund vehicles that capital is being deployed in the most interesting ways.
A burgeoning accelerator network, which includes Y Combinator, 500 Startups and Techstars, has introduced a novel, mentorship-driven approach to backing new companies: Airbnb, Dropbox and Reddit all started in accelerators. The program backers, typically angel investors, provide small sums of their own capital and a start-up boot camp in exchange for minority stakes. Many are committed to finding talent outside Silicon Valley and the Northeast. Techstars’ David Cohen says he and his co-founders launched in 2006 because “we wanted to improve our start-up community here in Boulder,” but the firm has since expanded to ten more locations, including two in Europe. Some 500 companies have gone through the program, raising $1.1 billion in follow-on rounds. The accelerator boom has “opened the industry up in an unprecedented way,” says Y Combinator’s Harris. “It gives people access to funding without having to go through the traditional gatekeeper of venture capitalists.”
AngelList, launched in 2010, offers a potentially more democratic avenue to funding. The service is open to any accredited angel investor and any start-up, offering them a single online site to connect with one another. Howard Lindzon, co-founder and chairman of StockTwits, a New York–based social media network for sharing investment ideas, began angel investing in 2008. “We were writing checks and there was no competition,” he notes. “But you didn’t have price transparency. It was very frustrating.” AngelList, in Lindzon’s view, has delivered transparency while enhancing the quality of and depth of access to deal flow; he personally invested in the platform in 2010. Removing some of the Oz-like mystery associated with traditional venture capital, AngelList captures and makes visible investors’ track records.
A syndicate model, introduced in late 2013, allows investors to finance leads of their choice. Unlike traditional venture capital, which involves a one-time, all-in commitment to a whole fund, investors on AngelList can pick or drop individual deals or syndicate managers with a single click. The economics of the syndicate model are flexible in a way most traditional venture investing, with its rigid 2-and-20 formula, is not. Investors pay no management fee to back a syndicate, lead angels have to contribute their own money to the investment — in contrast to most venture capital funds, in which general-partner contributions are drawn largely from management fees — and leads set their own carried interest, averaging about 15 percent, to date. “That combination of sophisticated investors, new technology, transparency, flexibility and sound economics is very powerful,” notes Harvard Business School professor Josh Lerner.
Deal activity is growing. Prominent lead investors such as Tim Ferriss, author of The 4-Hour Workweek, and Gil Penchina, a former eBay executive, each invested more than $5 million on behalf of their syndicates last year. AngelList’s Ravikant is understandably bullish on his company’s potential: “There’s going to be more and more small companies, so you’re going to need a lot more small investors. And if you’re not at the seed stage, you’re going to miss out on the lion’s share of the value creation.” Many investors on the platform, he says, are active after the angel and seed stages, allowing them to maintain their pro rata equity shares and “double or triple down” once the companies meet early success.
Why is all this happening now? AngelList’s syndicate model was made possible by the 2012 passage of the JOBS Act, which relaxed rules around private company funding for accredited investors — broadly, anyone with an annual income exceeding $200,000 or net worth greater than $1 million. Other services have emerged since then to take advantage of the legislation. The Internet had already made it far easier for money and ideas to find each other than in the early days of venture capital, but in recent years the process has been hastened by the falling cost of technology, which has allowed entrepreneurs to test a broader range of product ideas more efficiently. “We live in a world where you can now create an online service and deliver it to billions of people overnight,” says Techstars’ Cohen. This has also been good for investors, as it takes less money to detect an idea that is not worth pursuing.
Top Tier Capital conducted an analysis of its four most recent funds and found that the loss ratio — broadly speaking, the number of deals returning less than their investment — of the two youngest funds is roughly half that of their older peers. Entrepreneurs “now have this ability to course-correct the way a company’s going, as well as have less capital exposed if you decide to shut it down,” CEO York says. This “makes venture capital as an investment area less risky.”
Institutional capital is now becoming interested in early-stage investment. Angel networks, accelerators and a growing number of funds of funds are thinking carefully about investment aggregation in a way that makes it possible for limited partners, which typically have minimum investment thresholds of $10 million to $15 million, to put money to work in early-stage start-ups at scale, circumventing a traditional barrier to institutional participation. In April 2014, AngelList launched a $25 million fund for LPs to get exposure to top syndicate leads; in January, Techstars closed a $150 million fund to invest in its own accelerator graduates and other early-stage companies.
University of Texas Investment Management Co. contributed $65 million to the Techstars fund, says Lindel Eakman, who heads the $40 billion endowment’s $4 billion private investment program. UTIMCO, one of the most active large institutional investors in early-stage venture, also has a $100 million managed account with Cendana Capital, a San Francisco–based fund of seed funds. “We know we can make the most money in early-stage,” Eakman says. “The fact that companies need less money makes it tough to do at scale, but that’s changing.”
The result of this experimentation is that competition for deal flow is more intense than ever. “Before, it used to be that entrepreneurs would seek out VCs,” says Kleiner Perkins partner Ted Schlein. “Now finance has to work hard to find the entrepreneurs.”
Do innovations in early-stage investing, coupled with the increase in late-stage deal making from mutual and hedge funds, threaten traditional venture capital? Much will depend on the durability of the new arrivals. Late-stage non-venture-capital funding for big private companies is nothing new; in the late 1990s private equity shops such as Kohlberg Kravis Roberts & Co. and now-defunct Hicks, Muse, Tate & Furst and Forstmann, Little & Co. were enthusiastic, if not always successful, participants. “This is all a matter of the study of tides,” says Newhall, who retired from New Enterprise Associates in 2012. “We’ve seen this in hot markets before. Eventually, the tide will go out and the tourists will go home.”
But today’s markets offer a fresh explanation for tidal shifts. It’s often said that mutual and hedge funds are playing in late-stage venture capital to get a foothold in companies likely to go public. IPO allocations are more competitive today, the argument goes, and these big beasts are no longer able to build the kind of positions they once did.
The most fascinating aspect of this argument is how ferociously mutual fund managers reject it. “Getting an IPO allocation doesn’t move the needle for me,” says Henry Ellenbogen, who manages the $15 billion New Horizons Fund at Baltimore-based T. Rowe Price. His motivation is to invest in companies for the long term, “not to do a private-public arbitrage.” Besides, non-venture-capital participants in late-stage equity financing, especially those with a public markets focus, such as T. Rowe Price, have a freedom venture capitalists lack. They can choose not to do any equity financing at all. They can exit whenever they want, and when interest rates rise, as the Federal Reserve suggests they will start to do later this year, much of the impetus to seek yield in risky alternative assets will likely evaporate.
But at the early stage, the picture is different. Participants there have no other focus. In dollar terms, early-stage deal activity — through seed funds, angel networks and accelerators — represents a fraction of what’s happening in the funding cycle. “There are more and more people playing this market, and that will only increase,” StockTwits’ Lindzon says. “Eventually, wealthy individuals will deploy small parts of their wealth into start-ups the same way they invest into ETFs. VCs will not be able to compete with that.”
Much has been made of the potential of the JOBS Act’s Titles III and IV, which allow ordinary, nonaccredited investors to put their money to work as part of an equity crowdfunding effort. That potential may be overstated: The Securities and Exchange Commission, which should finalize rules under these parts of the act later this year, has to balance the task of protecting investors with the need to spur growth through capital formation. Many early-stage venture investors fear that the final rules will make auditing and reporting requirements, not to say personal liability for company directors and officers, so burdensome that no company will want to raise capital from nonaccredited investors.
In any case, venture capital appears unperturbed. Apart from a few breakout successes — the Ubers of the world — that can jump straight from early-stage finance to very late megarounds, most companies still grow incrementally and need the medium quantities of capital and guidance that traditional venture relationships offer. Venture capitalists see developments in the early stages as another step toward the nirvana of perfectly efficient capital allocation: Accelerators and angel platforms serve as vetting mechanisms that allow venture capitalists to pick winners without taking on early-stage risk or conducting time-consuming due diligence. “The front of the funnel is bigger than ever,” says True Ventures’ Callaghan. “It’s not encroachment; it’s expanding the pie.”
For now, the relationship between early-stage investors and traditional venture capital remains happily cooperative, especially because many angels coinvest alongside traditional venture capitalists in follow-on rounds. And some larger venture capital firms have begun to innovate. Partners at Andreessen Horowitz, which was founded in 2009 and has become what Harvard professor Tom Nicholas calls “the Elvis of VC firms,” use its 2 percent management fee to fund a platform of services — recruiting, marketing, technology, product development support — for portfolio companies. This is not a new idea; Kleiner Perkins and others experimented with the platform model in the 1990s. “It’s early days whether they are adding value through these services,” Nicholas says, especially because the funds are not sufficiently mature to give investors a good sense of performance. But experiments like these are a sign that traditional firms are taking seriously the need to do more to maintain and grow deal flow.
Whether this is evidence of proactive innovation is difficult to say. There’s some defensiveness in the way venture capitalists speak of the evolution of the industry, and no small measure of anxiety when it comes to assessing the potential of the new entrants. Angel platforms, they say, are an undisciplined, unfocused exercise in playing “sprinkle and sprout,” all “spray and pray,” and angel investors, no matter how organized they become, will never have the muscle or the time — because many have full-time jobs — to be deep sources of strategic guidance. “We have institutional experience,” says Canaan’s Ciporin. “We have institutional memory and domain knowledge. We have pattern recognition that is inherently stronger than just an individual in an angel fund.”
Pattern recognition is not necessarily a winning sales pitch when it comes to a discipline as dependent on unearthing the nonobvious as venture investing is. But for now institutional investors appear uninterested in the debate. Size, history and reputation still matter. The Sand Hill Road elite, most observers agree, will survive, even though second- and third-tier funds may find it tougher. “There’s little risk for institutional portfolio managers if they hand their employer’s money to an established brand,” notes Kauffman’s Mulcahy.
But nothing locks the incumbents into dominance indefinitely. “If you’re good, you’ll be around,” Kleiner Perkins partner Schlein says. “If you’re not, you won’t be.”
This sudden abundance of capital has opened the possibility of entrepreneurship to a broader class of people. The rise of Silicon Valley venture capital was in part an outgrowth of efforts to foster entrepreneurialism at Stanford University. In an industry that depends on connections and relationships, an elite pedigree still counts. But “there are lots of smart people out there with a lot of tenacity who didn’t go to Stanford, MIT or Harvard,” says Beepi’s Resnik. The new creative capital gives these people fresh avenues “to prove they are made for this,” he adds.
Whether that will happen remains to be seen. For now, entrepreneurs find themselves invested with more power to pick and choose their investors than historically has been the case. “There’s now a much better alignment of capital growth and company growth,” says Resnik, adding that Beepi received a term sheet from nine of ten venture capital funds it presented to for its recently closed, $60 million series-B round.
The expansion of the funnel is not without risks, however. It’s worth questioning how sustainable valuations for many of the big late-stage start-ups really are. Given that today there are barely ten public software companies in the U.S. with market capitalizations greater than $20 billion, it seems fair to assume that a number of the start-up billion-dollar club will fail to turn early success into a durable second act. Abundant capital can foster founder indiscipline. “If equity capital is really inexpensive, then a lot of companies that otherwise would have been successful can sometimes learn really sloppy lessons,” says T. Rowe Price’s Ellenbogen. When the market suffers a correction, investors can be left attending to “problem children at the point of the economic cycle where everything else is cheap and the opportunities are most plentiful,” he says.
Today’s buoyant funding market and enhanced liquidity management tools allow successful start-ups to stay private longer. The 55 venture-backed U.S. companies worth more than $1 billion apiece have an aggregate value of $182 billion — a sliver of the $21 trillion market cap of all U.S. public equity, but the trend is intensifying.
This is both good and bad. On the one hand, ordinary investors can’t invest directly in private companies. On the other, private companies will arguably be more mature once they undergo an IPO, potentially reducing misvaluations that arise when unsophisticated investors pile into hot offerings. Much of the motivation for staying private is a desire to avoid the reporting and regulatory burdens that come with being public. But the policy repercussions here are similarly double-edged. A lack of transparency may foster malpractice; however, staying private can encourage innovation. A paper published last year by Shai Bernstein, a finance professor at Stanford Graduate School of Business, showed that companies experience a decline in the quality of internal innovation after an IPO but that they are more likely to recruit talent and acquire external innovations. If markets exist to fuel the broad objectives of capitalism — drive growth, employment and innovation; boost capital efficiency and productivity — it’s not clear how optimal the shifting balance between public and private markets really is.
Assuming more companies stay private while achieving scale, founders will increasingly face a tricky exercise in managing the expectations and agendas of diverse and expanding shareholders groups. By the time a company reaches a billion-dollar valuation, early-stage investors may want very different things than their late-stage peers, especially when it comes to negotiating exits and managing the balance between profitability and growth. “It’s totally problematic to have this misalignment of interests,” says Cendana Capital founder Michael Kim. “I don’t think the market has really thought through how that clash will be managed.”
It remains a matter of debate whether the new venture creativity will fundamentally alter the quality of start-up investment. In the world of what’s aridly referred to as content — journalism, TV, music and film — the innovation in and multiplication of delivery channels made possible in the Internet era has arguably led to a golden age in the quality of what’s being delivered. Will services like AngelList and crowdfunding platforms create a revolution in how we think about and practice equity investment in start-ups? The traditional approach of most venture investors has been to base their assessments of start-ups around people, markets and technology. Is there a good team in place? Does the venture involve a sizable market opportunity? Is there something genuinely new about the technology? Those questions will remain relevant, but the answers may be different.
Venture veterans agree there’s a similarity heuristic at work in investing today. This is the flip side of venture capital’s self-declared strengths in pattern recognition: Established firms tend to favor ideas that look like past successes. “One of the problems the venture business has is that in the short term it’s easier to raise money if you follow the consensus,” Floodgate’s Maples says. “A lot of people can do consensus investing for a long time and stay in business.” But the real returns, he notes, come when investors buck consensus. “Wildly disruptive start-ups will be misunderstood for a long time,” he says.
Bucking consensus may be easier for people not exposed to the biases that come from a long history of investing. Venture capitalists love to talk about what makes a good investor. Many of the top practitioners today, such as Andreessen and Reid Hoffman of Waltham, Massachusetts–based Greylock Partners, have had success running businesses themselves: Andreessen wrote the Mosaic web browser and helped launch Netscape in the 1990s; Hoffman co-founded LinkedIn. But some people with little to no entrepreneurialism in their backgrounds have had storied venture capital careers. Bill Gurley, who led the investment of Menlo Park’s Benchmark Capital in companies such as GrubHub and Uber, was a design engineer in his pre-venture-capital life; Michael Moritz was a journalist before joining Sequoia Capital in 1986.
There is “no formula” for success, says Elevation Partners’ McNamee: “This is what I love about being a tech investor. One day you’re a total fuckup, and the next you’re a genius.” McNamee is of the camp that says entrepreneurs will always make the best investors, though he concedes that new participants will bring fresh perspectives. The unpredictability invites those perspectives, suggesting there may be new ways of unearthing value — finding, as Maples puts it, the “long-shot start-up that can turn into a moon shot” — that a small and clubby industry has not considered.
At its most basic, transactional level, “venture is just an institutional evolution of someone loaning someone else money to start a business and asking for a piece of the action,” says Y Combinator’s Harris. “Fundamentally, that concept won’t change.” But as experimentation in both the deployment of venture capital and the ends to which it is put increases, the ways of doing that well, and the number of people looking to do it, almost certainly will. •