Venture capitalists this week discuss a recent article in The Information titled “The End of Venture Capital As We Know It”. As with almost everything you read, the article in question is a bit more nuanced than its title. His author, Sam lessin, makes very good points. But I don’t entirely agree with his conclusions and want to explain why.
It will be fun and, because it’s Friday, both relaxed and cordial. (For fun, here’s a lengthy podcast I participated in with Lessin last year.)
A capital explosion
Lessin notes that venture capitalists in the past made risky bets on companies that have often withered away. Above-average investment risk meant that the returns on winning bets had to be very lucrative, otherwise the risk model would have failed.
Thus, venture capitalists have sold their capital to the founders dearly. The prices that venture capitalists have historically paid for start-up capital in high growth technology companies make IPOs appear de minimis; It’s the VCs who get gangbanged when a tech company floats, not the bankers. The Wall Street team has just taken one last turn on the milk saucer.
Over time, however, things have changed. Founders could rely on AWS instead of having to spend equity capital on server racks and colocation. The process of creating software and bringing it to market has become better understood by more people.
In addition, recurring fees have overtaken the traditional method of selling software at one price. This has made the revenues of software companies less similar to that of video game companies, driven by episodic releases and dependent on the market receiving the next version of a particular product.
As SaaS has taken over, software revenues have maintained their lucrative gross margin profile, but have become both more sustainable and more reliable. They got better. And easier to predict to start.
Thus, prices have increased for software companies – public and private.
Another result of the revolution in building and distributing software – high-level programming languages, smartphones, app stores, SaaS, and, today, on-demand pricing coupled with API delivery – was that more money could accumulate in companies busy writing code. Lower risk meant that other forms of capital found the seed investment – a very advanced stage to begin with, but earlier and earlier in the start-up life cycle – not only possible, but rather attractive.
With more varieties of capital turning to private tech companies thanks in part to risk reduction, prices have changed. Or, as Lessin puts it, thanks to the market’s better ability to measure start-up opportunities and risks, “investors at all levels [now] the price [startups] more or less the same way.
You can see where this is going: if it is, then the model of selling expensive capital for a huge raise gets a little soggy. If there is less risk, then venture capitalists cannot ask as much for their capital. Their return profile could change, with cheaper and more abundant money offers resulting in higher prices and lower returns.
The result of all of the above is Lessin’s lede: “All signs seem to indicate that by 2022, for the first time, non-traditional technology investors – including hedge funds, mutual funds and others – invest more in private technology companies than traditional Silicon companies. Valley-type venture capitalists will.
The influx of capital into areas of finance once reserved for corporate high priests means that VCs around the world often find themselves fighting over deals with all kinds of new, richer players.
The result of this, according to Lessin, is that companies “companies that have grown around software and internet investing and see themselves as venture capitalists” have to “step into the bigger pond like a small enough fish,” or go find another small pond ”.
The obvious criticism of Lessin’s argument is a criticism he makes himself that what he is discussing is not as relevant to the seed investment. As Lessin puts it, the impact of his argument on seed investment is “much less clear.”
OK. Of course, this is the end of venture capital as we know it. But that’s not the end of venture capital, because if capitalism is to continue, there’s always going to have to be some risky shit for VCs to bet on substance.
The factors that made SaaS at a later stage invested something that even idiots can earn a few dollars are becoming scarce early on in the startup world. Investing in areas other than software compounds this effect; if you try to treat biotech startups as less risky than before just because public clouds exist, you’re going to screw it up.
Thus, Lessin’s argument matters less at the seed stage and earlier investment than in the later stages of start-up support, and doubly less when it comes to investing earlier in non-companies. software.
While it’s a little known fact, some venture capitalists still invest in startups that aren’t software-focused. Of course, almost all startups involve code, but there are many ways you can make a lot of money by building startups, especially tech startups. The discovery of SaaS investing does not mean that investing in markets, for example, has benefited from a similar drop in risk.
Thus, the concept of VCs-are-dead is less true for startup and non-software startups.
Is Lessin then correct that the game has really changed for middle and late stage software investing? Of course it does, but I think it takes the concept of less risky private market software investing in the wrong direction.
First, even though private market investment in software has a lower risk profile than before, it is not zero. Many software startups will fail or fail and sell best for a small fee. As much on the market today as before? Probably not, but some still.
This means that the act of picking always counts; we can vamp for as long as we like on how venture capitalists are going to have to pay more competitive prices for deals, but VCs could retain an advantage in selecting startups. It can limit the inconvenience, but it can also do a lot more.
Anshu Sharma from Skyflow – and formerly from Salesforce and Storm Ventures, where I first met him – made a point on this particular point earlier this week that I’m sympathetic to.
Sharma believes, and I agree, that winning businesses grow. Recall that a billion dollar private company was once a rare thing. Now they are built daily. And the biggest software companies are not worth the few hundred billion dollars Microsoft was widely valued between 1998 and 2019. Today, they are worth several trillions of dollars.
Put simply, a more attractive software market in terms of risk and value creation means that outliers are even more outliers than before. This means that venture capitalists who choose well and, yes, go earlier than before, can still generate insane returns. Maybe even more than before.
This is what I hear about certain funds regarding their current performance. If Lessin’s point held as firmly as he says it does, I think we would see declining rates of return in the top VCs. We are not, at least from what I hear. (Please let me know if I’m wrong.)
So yes, venture capital is changing, and the bigger funds look more and more like types of money managers entirely different from the VCs of yesteryear. Capitalism is coming to venture capital, changing it as the world of money evolves. Services was one way VCs tried to differentiate themselves from each other, and likely sources other than venture capital, although this was less discussed when The Services Wars took off.
But even the Rapid Fire Tiger can’t invest in every business, and not all of his bets will pay off. You might decide that you are better off putting capital in a slightly smaller fund with a slightly more measured pace of trading, allowing the selection of fund managers you trust to allocate your funds among other mutual capital to bet on. for you. So you can get above average returns.
You know, the business model.