Things change slowly in the world of venture capital, with its seven- and ten-year funds, but change is most assuredly afoot. The venture industry exists to service the capital requirements of start-ups and as those capital requirements change so must the structure of the industry that provides for them.
The prototypical venture fund over the years has been, say, $300-500m with a nine- or ten-year lifespan. That size and duration came about in the 1980s and 1990s – formative years for the venture capital industry in the US – and they evolved to fit the requirements of the software and semiconductor businesses that dominated the market back then. These businesses typically needed $30-50m of venture investment and took 5-7 years to get to exit. Companies like Cisco, Sun Microsystems and Citrix are among the great venture backed companies that fit this model.
Over the last ten years, things have changed. Open source software, cloud computing, and internet distribution have combined to reduce the early costs for many start-ups by an order of magnitude and, in parallel, the exit markets have undergone a radical shift. Firstly, corporates are making more acquisitions at sub-$50m valuations and, secondly, IPOs are both harder to come by and less attractive post Sarbanes-Oxley.
These changes have created two sets of new opportunities in the venture capital industry. Firstly, there is now a requirement for funds that can work with highly capital efficient start-ups who, while doubtless hoping for more, would be happy with a $50m exit. That means more, smaller investments, quicker decisions and generally smaller funds – accelerators like Y Combinator and funds like First Round Capital are a good examples of investment companies designed around the needs of today’s start-ups. Secondly, there is a requirement for funds that step into the gap that used to be filled by IPOs – deploying large chunks of capital from very large funds into well established companies at IPO-type valuations. DST is the poster child for this type of fund.
This trend towards smaller and larger investments and fund sizes is often referred to as a hollowing-out of the venture industry – there is less in the middle and more at the edges. Many traditional venture funds have responded by making fewer standard A- and B-round investments and more seed- and late-stage investments. Many have launched ‘seed programmes’ and those that can have raised larger funds or dedicated growth funds to enable them to play better at the larger end as well. Accel, Greylock, Kleiner Perkins, and Sequoia are good examples of funds with a long history that have responded to the hollowing-out by investing more at both the earliest and the latest stages.
It is early days for these new types of investor. Pioneers like Y Combinator, First Round, and DST already look like they are going to be successful, but we have yet to see enough results from those that have copied their models to know whether they have invented new categories or if they are one-offs. It is also too early to see whether the move by traditional VCs to a barbell approach of investing both very early and very late will work.
If I were to stick my neck out and make a prediction, I would say that focus will win out, and that, in the future, we will see more specialist early-stage funds like First Round and more specialist late-stage funds like DST. The accelerators also have a focused model and many of them will continue to be successful, but the number of programmes has exploded in the last couple of years, and I suspect some of the newer ones will shut down. I also think that most of the traditional funds that have adopted the barbell model will eventually decide to focus at one end of the spectrum or the other, but not both. I say that because, as 3i and Apax both found in the last decade, investing at the early stage and the late stage within the same partnership is very challenging from an execution point of view.