New Seed and Start-Up Funding Model?

Its pretty clear that the venture capital model that has evolved during the Internet and post-Internet era is under pressure from its two most important constituents – investors that have for the most part gotten sub-par returns in venture funds (even when risk adjusted and particularly when you get beyond the top decile of VC firms) and entrepreneurs that have found it harder to find venture funding – particularly start-up or seed funding – and more importantly have found it hard to find the right amount of funding for their given idea.

What is not clear is what will happen in light of this situation. Within the start-up ecosystem, the dynamics of what is happening with LPs (i.e., customers of VC services) is often overlooked and poorly understood beyond the VCs – but obviously has a profound impact on all those reliant on VC funding. A few months back, Bill Gurley(1) at Benchmark Capital had an excellent primer at his blog explaining the dynamics behind why he felt the venture industry is due for a contraction.Essentially, because the big LPs that fund most VCs got hammered on their overall investment strategy – not to mention their illiquid alternative investments (of which includes VC funds) – the source of funding that drove the growth of the VC industry starting in the late 1990’s is/has dried up. The result will be a contraction as lower performing VCs will find it tough sledding when raising new funds.

I agree with Bill – for the reasons he laid out – we should expect contraction in the number of VCs and total number of dollars allocated to VC funds.

As a conclusion, Gurley sees this as a good thing for VCs and VC investors:

There are many reasons to believe that a reduction in the size of the VC industry will be healthy for the industry overall and should lead to above average returns in the future. This is not simply because less supply of dollars will give VCs more pricing leverage. We have seen over and over again how excess capital can lead to crowded emerging markets with as many as 5-6 VC backed competitors. Reducing this to 2-3 players will result in less cutthroat behavior and much healthier returns for all companies and entrepreneurs in the market.

This is where Bill’s and my view diverge. The problem with the conclusion put forth by Bill is that it is a rearview mirror analysis and driven by a VC-centric worldview. Were the market for start-ups the same as it were 5 years ago, I would wholeheartedly agree with this conclusion. Today, the nature of start-up firms has changed systemically as new technologies have drastically lowered the capital required for starting a company. Maybe not building a company once achieving a “proof of concept”, but certainly up to and even in some cases through the proof of concept stage. This reality has been cited by investors such as Mike Maples and Marc Andreessen and Ben Horowitz as critical factors driving their investment philosophies.

If Maples and Andreessen, Horowitz are right (and I think the evidence is overwhelmingly in their favor) and companies don’t need $5MM start-up capital as table stakes, then merely cutting the number of VCs out there will do nothing to solve the “overfishing” of opportunities that Gurley cites – nor do little to actually improve the proper allocation of early stage capital to ideas – which is a separate but equally important issue. As capital consolidates around fewer, larger (read: more risk adverse), players this mis-allocation, which in turn drives underperformance, will probably get worse.

Part of the reason why is tied to the size of funds and not overall capital in the VC system. Cutting the number of funds will do nothing to effectively serve the needs of start-ups if the problem is investment behavior tied to the needs of, and as a by-product of, VC funds that are large when large funds have needs that are incompatible with a trend for companies in search of funding to need smaller amounts. This causes problems at a number of points in the process – everything from pre-funding selection error (only those ideas with the hopes of a $300-400MM exit are worth considering for investment), to misaligned post-funding decision making (e.g., a need to bet the farm on the big win rather than a quick early exit) to contributing to aspects of “groupthink” by artificially constricting the pool of ideas deemed “fundable” by geography, management and sector – (e.g., who needs the hassle of going to see a company out of town when your success has already been assured by management fees so large that even if you fail to ever raise a second fund you are set for life?).

The other part is tied to the fact that companies need less capital to get in business. In the old days, VCs benefited from having a basic monopoly on start-up capital and therefore a much less competitive market for the ideas that they backed. This is exactly the kind of tailwind that early LBO funds such as KKR enjoyed early on – and why returns in the early days of LBO were much higher than today. As gatekeepers for what got started or not by controlling access to capital, VCs needed to worry much less about the quality of an idea in comparison to the execution of the business plan to bring that idea to market. This has driven a bias toward managers over ideas in investment decision criteria. The whole concept of an EIR is based on that belief.

So then what happens if VCs cannot return to environment where they can exercise pricing power and manage competitive threats to investments through capital constraint because the cost of starting a company is low enough to avoid having to pray at the alter of Sand Hill Road?

The simple answer is that VCs will need to change how they work – or (more likely) new models for capital allocation and early stage investment will need to emerge. The first problem is that for the existing universe of VCs there is not only little incentive for them to change habits, but there is also increased risk associated with making such a change – one that those pulling in $20MM in management fees a year are just not going to be willing to make. If the existing players do change, I believe it will be a shift toward later, more established companies, companies that have larger capital needs and higher overall survival rates than what we have traditionally considered “venture capital.”

The second, and more vexing, problem is that the current VC model, like many other financial service models, grew up as one that is exceptionally limited by scale issues tied to a high-touch, bespoke, and time consuming investment process. A process that requires the same labor regardless of investment size. Its hard to make a business work around small investments if the effort you are putting into $500 K idea is the same as $5MM – even though you get paid 10x for the same performance for the latter. This lack of scalability, and the dissonance that it creates in incentives when combined with a universe of ideas that needs less funding is the core challenge that any future solution for seed- and start-up capital will need to address if it wants to be successful going forward.

And, (of course), my yet to be launched project, 3Strides (coming soon!) is designed to address that core challenge.

Next Time: Alternative Models for Investment – Is there an Argument for Quantity over Quality for start-ups (hint: the answer is No).

1. In the spirit of full disclosure – Benchmark was a funder of Epoch Partners – a technology-enabled investment bank at which I was the director of research in 1999-2001.

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One Response to New Seed and Start-Up Funding Model?

  1. Pingback: Secondary Markets – Do They Serve a Purpose? « A Nickel for Your Thoughts

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