As I wrote yesterday, I moderated a panel earlier this week about innovation in the venture capital world.
After the event, National Venture Capital Association chairman Jon Callaghan wrote me an email about the warp speed of innovation in the industry: “There was so much innovation being thrown around—moveable carry, geographic portfolio, unbundling and more. Many were coming up to me later saying the ideas were flying at them too fast. That’s exactly what’s happening in the market.”
Even if you don’t know what those terms mean, the important takeaway is that even the stodgiest VCs are going to have to start acting more like the entrepreneurs they serve because the market is only getting more competitive with the ways to fund becoming far more varied and “hackable.”
Just think about what’s happened in the industry over the last ten years: A strong switch to top firms being run by ex-founders, crowdfunding, syndicates, partial liquidations, seed funds, hedge funds essentially doing late stage venture capital instead of IPOs, Russian billionaires doing late stage venture capital in competition with Sand Hill Road, whole funds being formed based on arbitraging pre-IPO employee shares, highly scalable international copy-cat shops like Rocket Internet, and of course, whole new thinking on valuations which have lead to our age of mini-corns ($ 750m+), unicorns ($ 1b+), decacorns ($ 10b+) and yetis ($ 50b+).
The panel was made up of Gil Penchina, AngelList’s Naval Ravikant, Path’s Dave Morin, and angel investor Sumon Sadhu. Penchina who invests via syndicates on AngelList talked about about the freedom of not having any of the normal restrictions LPs put on funds: things like how much you can invest, what percentage of a fund you can invest in follow on rounds of existing companies, what sector you invest in, whether you can invest personally if the fund invests as a group, etc. He described a freewheeling world where he and his gang can simply invest in whatever they wanted.
Special purpose vehicles — how many of these mega growth rounds are getting done — used to be a major pain to organize. But Ravikant described the ability to spin up single purpose vehicles to fund mega-unicorn growth rounds in a matter of 48 hours. So much capital is already on AngelList just hanging out, and they’ve streamlined so many of the mechanics. It’s thrilling and scary. Thrilling for entrepreneurs who have more and more ways to get cash. Scary for those who feel anything this easy can’t be all good.
We even talked about whether sites like AngelList could change gender and diversity within Sand Hill Road because it essentially disintermediates gate keepers. The answer was yes and no. The biggest barrier? Unlike VCs who invest other people’s money, angels invest their own money. So while you don’t need an all-male partnership to give you the general partner nod, you do need to have had enough (often Valley) success to have money. Right now the frustrating reality is that means more men than women have the money to be angel investors, Ravikant admitted.
Ravikant traced all of this innovation back to one single thing that’s had an almost Moore’s Law like impact on the industry: The cost of building companies has decreased by two orders of magnitude since the late 1990s. When smaller checks can start a company (even if overall the giants are raising billions in private equity later on) everything changes.
One of the best moments of a fascinating conversation was when Ravikant talked about the recent trend of major VCs pulling away from seed investing. In the 2011-ish era seed funds, or micro-VCs, exploded. As a result Sand Hill Road firms found themselves getting locked out of the earliest rounds of funding—when historically, the industry has made the more outsized returns. It was a major existential threat.
So firm after firm announced new “seed programs”—pools of capital that they’d invest different than they did Series As, Bs, and Cs. Jedi Funds. Discovery Funds. As near as I can remember, the bulk were announced on stage at Disrupt in TechCrunch’s pre-AOL heyday. There were lone stubborn exceptions like Benchmark, which always wanted to do venture capital classic even if the market changed around them. (And the results have been pretty damn good. Some estimate Benchmark may be sitting on one of the best funds of all time.) But every other top five fund—and many more who emulate them—jumped on the seed bandwagon.
Now quietly, VCs are pulling back from these programs because of a myriad of challenges. The biggest one is the “signaling” issue. When an angel investor puts tens of thousands into a company’s seed round and doesn’t reup in the series A, it’s no big deal. Angel investors usually just let that early money ride. But when a mega VC puts tens or hundreds of thousands into a startup and doesn’t reup in the A, it’s a strong signal to other investors that the company isn’t very good. After all, the reason VCs are doing seed rounds is to see things first and scoop competitors.
But frequently there can be other reasons a VC doesn’t invest. For one, there’s the law of averages. The whole point of these seed programs was to spread money widely without encumbering the process with normal due diligence of a venture round. But a partner will only do one to two Series A deals a year. So many great companies simply won’t make the cut. There can also be conflicts in the portfolio that prevent partners from reupping. The most famous example was Andreessen Horowitz not reupping in Instagram because of…. PicPlz.
The proliferation of VCs doing seed deals also lead to a ton of “party rounds,” where entrepreneurs think they’re getting a dozen investors who will all care greatly about their future. Instead, no one really has enough skin in the game to be the one who ensures the Series A happens. There is a huge difference between Greylock investing out of its Discovery Fund and investing out of Greylock proper. (Trust me, I know. I raised $ 250k from Greylock Discovery Fund.)
Both were challenges that many entrepreneurs raising money in the dawn of “micro-VCs” figured out too late. Did they tank great companies? No, great companies always find a way to get funded. But a lot of companies don’t look so great at Series A and grind it out to become great later. And even if you run a lousy company, it sucks.
It was serious enough that some VCs tried to hack this through secret “scout” partnerships, where it didn’t look like the VC was actually investing in the startup, but the VC hoped to retain some of the benefits of doing so. But it was hardly a perfect solution.
Now VCs are looking around and seeing that many of the incubators, accelerators, and seed funds are just better at that part of the game. They’ll let them fight it out and sit back and pluck the winners – albeit at higher prices. After all what’s really in demand now are Series A deals. So they’re deemphasizing these programs, in favor of focusing efforts on the companies they want to go long on.
Makes sense. But beware, Ravikant warned the room sternly. He’ll be the first to point out the same challenges VCs learned the hard way above. But he says it’s something they just have to figure out nonetheless. If VCs give up on being the first money in, they’re doomed in the long-term, he argued. Because right now, that Series A round isn’t really a Series A round. There is so much money and influence in the seed and incubator world, companies’ cultures and DNAs are getting set way before that round. What’s called a Series A is actually more like a Series B or C. And those have never been the sweet spot of the industry, particularly when you have firms like Coatue and T.Rowe continually coming down from the other side—creeping up from IPO to Series D to Series C.
Ravikant says the current generation of partners are indeed in that sweet spot of sitting back and plucking the best Series As from an ocean of seed funded companies. But the associates coming up will graduate into a world where seed funds, syndicates, and incubators are solidly the first money in and the hedge funds and money managers are running the C rounds. They’ll be squeezed.
“You have to find a way to be the first round,” he said. “This is why Josh Kopelman was a branding genius. First Round Capital. He put it in the name. He’s always going to be the first round.”
He added this to the assembled room of the country’s VCs: “You can lie to your LPs, but don’t lie to yourselves. You are doing Series Bs and Cs right now. You are just calling them As”
At the end of the conversation, I asked what was great about VC classic; what these four hope never goes away from the Valley; and why they hope traditional firms still represent the core of the industry. The best answer came from Penchina who talked about the almost incomprehensible stress the Valley absorbs in order to scale so many companies at “uncomfortable speeds.”
“These companies run into the wall as fast as they can and hope it breaks when they hit it,” he says.
The level of stress to do that again and again is hard to fathom unless you’ve done it. As he described it, I started to think about how unhealthy that actually was as a “norm” of doing business. And then he added “That’s what I hope never changes.”
[illustration by Hallie Bateman]