Whether or not there will be a “shake out” in the venture industry depends on how you define it. If it means that certain formerly prestigious VC firms will close up shop and wind down, then yes. If it means a sharp decline in the number of venture firms, then no.
I look to the hedge fund industry for an analogy of how an alternative asset class has dealt with turmoil. Back in 2006, my original thesis was that the hedge fund industry would begin to resemble a barbell (as measured by assets under management), with a bubbling cauldron of smaller start-up funds focused on alpha at small scale, while a group of large asset management titans with best-in-class compliance, control and reporting environments would reinforce their already strong positions. Firms in the middle would have a hard time, as they lack the resources to compete with the largest firms while having “alpha at scale” problems not felt by the smaller firms. While small firms have jumped to the mega-class and some larger firms have imploded, I believe my thesis has largely been borne out.
Venture, unlike hedge funds, doesn’t scale as well due to the illiquid nature of the asset class (and therefore being difficult to risk-manage using quantitative analysis) and the time required to manage a single investment. Also, the costs of compliance, reporting and control are much more easily attained by smaller firms through outsourced service providers, and once a firm achieves a certain scale (somewhere between $50-$100 million in committed capital), I’d argue that the competitive advantages of scale as it relates to running the operation has largely been neutralized. The real issue is what types of firms are best suited to the investment opportunities, and how this might impact the structure of the industry.
Unlike the barbell shape of the hedge fund industry, I’d posit that the venture industry, at scale, looks more like a normal probability distribution. If there is little operational leverage in scale, then it is the nature of the firms, their capabilities and their risk-taking that governs the shape of the industry:
- Micro VC: As with hedge funds, I expect there to be a bubbling cauldron of seed stage firms, small and nimble that are able to efficiently write smaller first money-in checks and which bring professionalism to the seed stage landscape. These firms, as they do today, will partner with angels to drive “Friends and Family” rounds of financing though may follow on as investments mature. Some Micro VCs will make the jump and morph into the next stage (Life-cycle VC), but others will keep fund size small and focus largely on seed stage investing that stops at the Series A. Most Micro VCs have funds between $10-$75 million. Examples of current Micro VCs include Founder Collective, Metamorphic, Freestyle, SoftTech VC, Floodgate and my firm, IA Ventures.
- Life-cycle VC: These are firms that will often establish an ownership position at the seed stage, but which have the capital to continue financing a start-up into the Series B and C rounds. Sometimes they will first invest in a company at the Series A, but only if is reasonably priced and where they can establish a threshold ownership position. These firms generally have funds between $150-$250 million, and will (and can) increase exposure to a winning investment as they require additional capital for growth. These firms in many way sit in the “sweet spot” of venture investing, small enough to dip down into the seed stage while having the dry powder to reserve heavily and to plow $15-$20 million into a single company if it makes sense. Examples of Life-cycle VCs include True Ventures, Flybridge, Foundry and Union Square Ventures.
- Growth VC: It strains the term to call this stage of financing “venture” investing, as much of the execution risk has been stripped out of the business and all that remains is rapid scaling. These firms are a hybrid of venture and private equity, in that the analysis of what constitutes a winning investment is markedly different than what Micro VCs and most Life-cycle VCs perform. The dollars deployed are much larger and the exit multiples much lower, but the risk profiles are sharply muted relative to the Micro and Life-cycle VC models. Investments at Series C and D stages and beyond can be upwards of $100 million per company, and require fund sizes of $750 million or more. Examples of these firms include IVP, Insight Ventures and Tiger Global.
I expect to see the greatest AUM in Life-cycle VC, with Micro VC and Growth VC being smaller but critical elements of the venture marketplace. Regardless of the poor 10-year returns, the venture capital industry is alive and well, and an essential catalyst of innovation in our country and across the world. Poor performing “zombie” firms will eventually be swept away, but it in no way casts a pall upon the industry. The quest for management fees and venture capital are anathema: those firms which became intoxicated by large AUM got burned and will die a slow death. A healthy and growing body of new, carry-focused funds will rule the day, which is why the Micro VC and Life-cycle segments of the venture landscape are so exciting and hold such promise.