Of evolved dinosaurs and birds - The changing face of venture capital

tl;dr — VC is stasis. Changing. Slowly. Will we see a punctuated equilibrium? 

A recent New Yorker article quoted Marc Andreessen, who asked Ben Horowitz — “What if we’re the most evolved dinosaur, and Naval [founder of AngelList] is a bird?” Can an upstart like AngelList disrupt the business of venture capital ? Software is eating the world, as A16Z’s tagline goes. And so, will it eat venture capital?

Huoy Ming Yeh, Founder of CSC Upshot Ventures and I were recently invited by “Founders & VCs” to discuss the future of venture capital. We discussed dinosaurs, VCs, angels and entrepreneurs.  Let’s start with the VC business model, and the friction and incongruities that exist in this model. This gives us a basis to make predictions. Of course, it's easy to make predictions. Some may even come true - I just dont know which ones. 

The VC business model hinges on the ability to raise a fund. If you can raise a fund, the second part — investing & generating returns — is harder. All startups look great at the first date and any fool can write a check. Some startups become blazing successes and others become epic failures — we just dont know which ones will rise. 

Raising a venture fund:

The venture fundraising process is probably the only time a VC experiences some humility. It’s a karmic circle where the LPs [Limited Partners, or institutions that invest in venture funds] indulge in the same maddening behavior that VCs themselves thrive in. Go dark, stall, give vague answers, string along etc etc..

Opacity, indecisiveness & bias: All investment activity is mired with these three elements. Be it VCs raising venture funds. Or startup entrepreneurs raising capital. Identifying investors is no easy task. Let’s take three simple questions: 

  1. Who is actively investing?
  2. What is their decision making criteria / process /timelines?
  3. What terms should you expect?

When any entrepreneur starts the journey of raising capital, often these are the first few questions that pop up. Which angel / VC should I talk to? Can I get a warm intro? To avoid being called founder's bitches, we must move away from the dark ages of “warm intros” — after all,  VC is the only business where the customer (entrepreneur) needs a ‘warm intro’ (enter — middlemen) to a service provider (VC).  The opacity on investors ability and willingness to invest can be frustrating. It creates a level of uncertainty and friction on all sides. Buyers feel like they may be overpaying — sellers want to optimize. Granted these are ‘private’ markets and a level of ambiguity will prevail. But what price do we pay when we choose to live in the dark? Longer timelines, nauseating processes and a level of angst + suspicion that plays out on all sides. Such inefficiencies need to be done away with. Prediction #1 would be: 

“A simple, searchable database - a Yelp for VCs - is much needed”  

We can search for flights (Google / Orbitz), real estate (Trulia / Zillow) and pretty much anything else. So why not VCs? After all, 20,000 investments are made each year with over $50 billion exchanging hands. A well curated, contextually relevant database could reduce a lot of friction and save time. 

Accelerators have "insider lists" of VCs - founders know which VCs are worthy of conversation and those who are gasbags. Accelerators have solved this opacity  — to some extent — by building lists of active investors. Except that VCs are not aware nor have any say in the content. Demo-days act as a forced function to “accelerate” decision making. The fear of missing out forces VCs to make “spot” decisions. The inefficiency of raising capital is minimized so entrepreneurs can do what they do best — build products and companies. All opaque processes will eventually drift to transparency.  

AngelList started off as a simple, publicly available list of angels —the first step towards eliminating opacity. No more clubs or secret handshakes! 

It shined a light on those who have capital, can move fast and empathize with an entrepreneur.  It's a marketplace that brought the buyers and sellers together in an efficient manner.  It’s not much different for VCs raising funds. The world of limited partners is far more opaque. You can subscribe to expensive databases and try a lot of cold-calling. But I have not seen a simple tool that would help a $20 million fund to identify potential anchor LPs. Or provide a screened shortlist of family offices actively investing in venture. A lot of such information flows word-of-mouth. And if you are not connected with the right sources, too bad. 

 

Average time to raise a VC fund = 16 months (Source: Pitchbook)

 

The average time spent by a VC raising a sub $20m fund is 11 - 16 months. Further, the number of smaller "Under $50m" funds is growing rapidly. Raising capital is a long painful journey for most of these funds.  The ability to raise a fund is often correlated to being a good investor, which is counter-intuitive. Fund raising requires salesmanship - its strategy combined with tenacity combined with LP connections. A lot of larger funds have full time dedicated staff for "investor relationships" - they manage the money side of the LP-GP marketplace. But smaller funds will not be able to afford such a full-time team members. The demand for LP data will continue to grow. As micro-VCs proliferate, they need an LPList, just as entrepreneurs need AngelList.

  fund raising by size of fund (source:pitchbook)

 fund raising by size of fund (source:pitchbook)

 

So my Prediction #2 is:

An online LPlist will emerge to support micro-VCs. 

AngelList is already pioneering the online set-up and tear down of a fund — a streamlined process that costs less than $10,000. This is a 10X improvement in fund legal costs, timelines and closing processes. Software is eating the lawyers! And the next logical step is to gather / make LP data available. I foresee a nice subscription model here, where micro VCs and scouts have access to pools of capital. This phenomena has already started but need not be hidden or secretive, really! ( WSJ report on Scouts - Secretive, Sprawling Network of ‘Scouts’ Spreads Money Through Silicon Valley)

Skill versus luck: Decision making:

LP decision making criteria for fund investments is primarily based on track-record. Track record is the proverbial rear-view mirror. It’s the past and cannot be replicated easily. Nor it’s a guarantee of future success. Sectors are cyclical, regulatory forces impact markets and black swans spoil the day. Partners quit venture firms and individual performance attribution is often overstated. So LP’s add another layer to past performance — consistency of returns over multiple funds. Call me when you are past Fund V becomes the baseline threshold. Fund managers who have just started, often find themselves locked out. The bigger debate — is it skill or luck that generates consistent VC returns — remains unanswered. If we look at IRR data over 2001-2010, the top quartile returns go from 37.6% (2001) to a low of 9.5% (2006) and then back up to 19.8% (2010). The delta between the top quartile and bottom quartile is large. The challenge for LPs is to find a top quartile manager. And once a LP finds such a manager, it's always hard to predict if their skills can be persistent. Can they repeat their performance? 

top quartile irr varies as much as 4x over a decade (source: pitchbook)

Author and Investor Michael Mauboussin writes in his book The Success Equation- Untangling Skill and Luck in Business, Sports, and Investing that greater skill often leads to greater reliance on luck. This is baffling. The more skillful we become, the more we rely on luck! Go figure! In “The Theory of Gambling and Statistical Logic” Richard Epstein writes, “It is gratifying to rationalize that we would rather lose intelligently than win ignorantly.”

But are we losing intelligently in venture? According to Aileen Lee of Cowboy Ventures, 1 in 1,538 companies become a billion dollar company. That’s a pretty lousy ratio. Are we one big glorified slot machine? We owe a better answer to our LPs that to pretend that we are losing intelligently. 

Improving our odds: 

LPs have not pushed VCs for innovation on improving our odds.  In their book, Made to Stick, Chip and Dan Heath describe how British Petroleum (BP) decided to reduce their ‘dry-holes’ — the costs of unsuccessful drilling. It costs as much as $40 million to drill a large oil well. BP found that their estimates of hitting 1 in 10 were way off — they were actually hitting 1 in 100! This is actually worse than venture capital investments but read on. To avoid wasted expenditures, BP launched an ambitious ‘No dry holes’ strategy. There was much push back internally. Explorers like to explore — it is education, they say! And they were irate. But the senior management stuck to their guns and voila, in ten years, BP’s hit rate moved from 1 in 100 to 2 out of every 3 wells! Put another way, from 1% to 66% ! When I brought up this example to a Sand Hill Road VC, he scoffed, “Tch tch..so many reasons why these companies fail. Where should I start?”  Let’s file this away under intellectual laziness for now. BP reflected on their situation, probably felt some financial pain and decided to improve the odds. When we dont reflect on our pain / losses, we dont make progress. In the meantime, our LPs pay the price. So I look forward to the day when prediction #3 will become a reality:

VC’s improve the performance odds, just like BP did!

I rarely find VCs reflecting upon the losses. It’s a common practise in the medical community to hold a Morbidity and Mortality (M & M) conference. Practitioners learn from complications and errors, to modify their own behavior and judgment based on previous experiences. The focus is improved patient care. In VC, we bury our dead quietly, fire the investment partner and move on. If we can “pattern match” in some parts of the business, it’s disingenuous to say we cannot learn from our failures. Brad Feld shared that at Foundry Group, they assess each portfolio company every year and ask if they still love it. If not, why not? Such exercises can be a great start. Just like the M & M conference, we could ask (a) under what conditions we made the investment decision (b) what assumptions went wrong and (c) how can we reduce the probability of making the same mistakes again. 

Pain + Reflection = Progress

A small asset class — can venture grow:

In any year, VC funds raise ~ $30 billion from LPs. But in comparison, private equity pulls in $200 billion every year. That’s more than 6X VC allocation. And hedge funds are averaging $1.5 trillion each year.

Investments in VC Funds (Source: NVCA)

When asked, most LPs told me that VC is 

  1. Illiquid — LP money is locked up for 10 years.
  2. High risk — we can lose all our money.

AngelList has solved the sourcing side of the VC business - one half of the problem . You could be sitting in London or Dubai and invest in a YC startup — this could not have happened 5 years ago! Granted AngelList has to continue to list good opportunities, but this is the dawn of the marketplace. The other half of the problem  — liquidity or selling shares  could well be on the horizon, regulatory challenges not withstanding.  

History of the NASDAQ is a precursor indeed. At first, it was merely a quotation system. NASDAQ merely presented the bid-ask prices of various shares. It did not provide a way to perform electronic trades. It brought transparency to an opaque market. This helped lower the spread (the difference between the bid price and the ask price of the stock) - as buyers and sellers were empowered and became savvy, NASDAQ became unpopular among brokerages which made much of their money on the spread.

Any open trading system that hurts the middlemen margins is always unpopular - with the middlemen. This often drives the middlemen away - in search of opacity in other areas. How do open platforms like AngelList impact the "VC" middlemen remains to be seen - for now, most of the talk is about partnerships. VCs often conduct outreach & source opportunities that are featured on AngeLlist. 

Prediction #4: AngelList becomes a marketplace for selling shares.

If we can solve the liquidity risk and improve the odds / performance, can we expect the VC inflows to increase to $50 bn? $100 bn? After all, mutual funds like T Rowe Price and Fidelity have already jumped in the later stage market. 

Who drives innovation in VC? And of what kind?

Innovation is much needed in the VC model. But when innovation occurs from within, it’s often self-serving. As Josh Koppelman quipped at a PandoMonthly event, “If you look at the venture business, for an industry that funds innovation — it really doesn’t have that much - there are many firms where I’d say their single greatest innovation over the last 20 years was raising carried interest from 20 percent to 30 percent.” And the origins of 20% carried interest go back to biblical times

Sourcing and diligence of opportunities used to be based on a blend of analytical + subjectivity. In the movie, Moneyball, three baseball talent scouts describe a potential baseball player, which offers a classical insight in how management diligence is conducted. The scouts, while picking baseball players speak of intangibles such as eye candy test, attitude, swing, ugly girlfriends and lack of confidence. Then there is one scout who describes his pick as a “the kinda guy who walks in the room and his dick has already been there for two minutes..”  Subjectivity in conducting diligence can often be crippling. Yet it is often the case in baseball as well as in venture capital. The attributes of strong management teams, or the proverbial jockey, are difficult to assess and often, practitioners have a short window of time to say "yes" to a hot deal. But technology and data can help minimize our biases. Some interesting "big data meets social media" techniques of sourcing opportunities have started to emerge: 

  • YL Ventures has hired a firm to track over a million entrepreneurs in Israel. Their gambit is to catch these opportunities even before they are formed. They look for social signals and generate over 100 alerts a month. See WSJ story here.
  • SignalFire, a $53 million "quant" seed fund took six years to build a platform, Beacon, which tracks talent and capital. They look at more than half a trillion data points  from two million data sources, from patents to academics publications to open source contributions to financial filings. More in the WSJ story here.

While such innovations in sourcing, services, brand & marketing has occurred, the results are always uncertain. I believe much exponential innovation in VC has come from outsiders like Naval, PG and CSC.  All of them follow the mantra for seed stage investments which is: 

"The information required to make decisive investments  in disruptive technology simply does not exist…It needs to be created through fast, inexpensive and flexible forays into the market” – Clayton Christensen, The Innovator’s Dilemma

Paul Graham ("PG") is not a VC  but has done fast, inexpensive and flexible forays into the startup land. We can debate if YC is a fund or an accelerator, but does it matter? They invest in cool companies and generate returns - in 2015, they will invest in 1000th portfolio company. 10 years later,  700 YC companies are active. That's better odds than VC. And they just raised a $700m fund.

70% of YC portfolio is active (Source: WSJ)

Naval, the bird, was an entrepreneur - he launched AngeLlist to reduce opacity for other entrepreneurs. China’s CSC Group has pledged $400 million to launch CSC Upshot Fund - the largest seed fund for startups on this platform. USA has some of the largest, most sophisticated LPs managing trillions of dollars. Yet no one saw the light that AngelList can be the platform for VCs.

The accelerator boom ignited the path, angel.co created the platform and CSC committed $400m. As the story goes, it could have been more than $400m, but Naval wanted to start slow. But can AngelList become like Blackrock ? That's my moonshot prediction #5, as it has the potential.  At Blackrock,  1000+ investment teams deploy capital in public markets. Fundraising teams are separated from investment teams. And risk is managed in a centralized manner. In a period of 25 years, it has become the world's largest asset manager, managing $4.5 Trillion in assets.  

With the ability to improve transparency / data, trades / liquidity, the VC model is being disrupted. I dont know what it will look like in 20 years. But when Model T arrives, people seldom care for a better horse-buggy.