The venture capital industry exists as a means to innovation. Does the industry itself, however, generate the types of innovations that one would expect? In this article we argue that the traditional industry operating model is becoming less and less competitive and discuss potential improvements that can be made to be more inclusive, innovative, and ultimately long lasting.
The central thesis of this is that the industry needs to move past an operating model that focuses on the limited activities as it relates to writing checks, raising funds, and managing portfolio companies and one that creates or integrates an entire ecosystem around the practice of venture investing.
When we say ecosystem, we mean a community that includes all stakeholders and expands horizontally as much as it does vertically. This is the most effective way to add value to the industry vis a vis the rising tide that lifts all boats. A key goal is redefining how the industry measures success. We start by looking at the weaknesses and the opportunities within the industry’s traditional means of operating.
In addition to macro conditions, the VC industry itself is undergoing a period of transformation and innovation. As the traditional VC model—with heavy concentration in particular demographics and geographies—has been questioned in recent years, we have seen a concerted effort to look beyond traditional VC hubs and develop new ways to capitalize startups. – Pitchbook’s 2021 Venture Outlook
With the rapid ascent of companies such as Facebook, Netflix, Uber, AirBnB, and still private companies like Clubhouse and Cameo – it’s clear that companies who seek to generate network effects and create value through interactions among their users are growing faster and faster.
The key innovation among these companies is that while they do act as a middleman between users, much as VCs do between capital and companies, their products and platforms create value far beyond what a traditional “connector” does.
What does this have to do with the Venture Capital industry itself? The traditional role of the Venture Capitalist is limited to these lesser value activities when VCs only see themselves as providers of capital and judge success by return multiples on said capital.
Add to this the pressure that smaller and newer funds face given the growing power of incumbents. According to Crunchbase, 12% of VCs in the US accounted for 66% of the total raised in 2018. This puts the Venture Capital industry itself in a near oligopoly, and these megafunds are well protected by a competitive moat given their wide network and access, strong brand, and ability to attract top talent.
To survive, this means the vast majority VCs need to differentiate beyond writing checks and managing the portfolio operations. There’s simply too much risk (i.e. uncertainty) to rely on being able to pick winners at a better rate than anyone else as a true differentiator and core operating model. And due to this reality, a lot of small-time fund managers opt to do a lot of following, investing into companies backed by the larger incumbents, in an attempt to capture some of their (somewhat) historically reliable returns. But this isn’t exactly innovative, nor does it serve to break the industry out of its comfortable echo-chamber.
The first step in breaking the mold is to begin moving beyond the traditional operating model to developing an ecosystem. Below, we demonstrate how VCs can do this:
This operating model, or how the company delivers value, focuses on raising capital from investors, generating deal flow and making investments, managing the portfolio, and distributing capital returns before repeating.
How might a VC think about expanding to incorporate the entire industry stakeholders into what we call the ‘Ecosystem-Driven’ operating model? Here’s an example of what the new Venture Industry Company looks like:
Let’s break each of these down and explain them further to help create actionable takeaways:
The Venture Capital industry has a reputation for being a boys club, which leaves far too many talented people on the outside looking in – which is a detriment to the entire industry. Venture firms that develop a talent pipeline from universities and other, nontraditional sources have the potential to discover value and perhaps develop a competitive advantage relative to their peers.
This attempts to solve the chicken-or-the-egg problem within many industries. For Venture Capital, it helps resolve the problem of needing to understand the Venture industry before getting a job in the industry (and of course, needing that job in order to understand the industry).
Given the industry relies on information as fuel, moving towards more transparency, idea sharing, and collaboration across the industry when it comes to thought leadership serves two purposes: First, it creates ‘idea liquidity’ meaning that there’s more conversations and therefore more discoverability of startups or solutions. The VC industry tends to do this well and should continue to do so.
The second is that thought leadership can build credibility where performance, which is rarely publicly available, cannot. Contributing to the ecosystem works in both directions.
Continuing on the two above themes, how can funds partner with academics, public entities, tech platforms, and the like to give and receive benefits and value? Examples of this include incubators such as Y Combinator and tech hubs like 1871 that actively work to connect founders and funders by hosting events and demo days, classes, and literally putting them together in a physical space.
Here we finally introduce the traditional focus for VC funds – the operations of raising, managing, and returning invested capital. What does this look like in an ecosystem-based model? Publicly available.
Investors and founders stand to benefit from transparency when it comes to reporting returns and portfolio holdings. Tools like AngelSpan assist with standardizing the reporting process for startup financials and VC fund performance. Investors become more informed about how well their capital is being invested, how talented the GPs are, and the industry as a whole benefits from the adoption of a more professionalized process.
While fund operations is likely the most well developed part of any part of the Venture Capital industry, it may also have the most to gain from change. In an industry where investors who are not in the top quartile of funds or invested at the opportune time have limited success relative to other asset classes (see also: Kauffman 2009), how have we not yet figured out how to better attribute risk and returns?
One of the key takeaways for those who intend to seek this type of business is how goals are redefined. For example, a poor goal for someone who wants to lose weight is to set an end-weight goal. The better approach is often to set a goal of exercising daily with the outcome of achieving these goals: weight loss. The point? The goals focus on the process, not the outcomes.
For VCs, this means setting goals to create better hiring, communicating, and relationship building, with the outcome of meeting those goals the improved returns for investors. The next question then becomes, “What tools do I need to make this happen?”
In the future, many of the above will come from the growth of syndicates and rolling funds and the rise of super Angels (likely at the expense of micro VCs). We’re already seeing the continuation of what SAFE notes have done to simplify early stage funding agreements with the launch of SPACs that deliver much of the same value for IPO-intended exits.
Adding to this the adoption of more tools that make communication easier and a focus on expanding the table to bring in more folks through not only VCs themselves but also investor-favorable regulations around crowdfunding and Reg-CF and you begin to shift the benefits towards founders and non-traditional investors. This becomes all about access and adoption of the tools and processes to realize it.
Below we sketch out some examples of how this might look:
For VCs who are operating traditional models, this all speaks to the potential competition and erosion of any sort of illiquidity, information, or “opaque” premiums and moats as the barriers to entry weaken. We saw this in the Real Estate industry with the launch of online portals such as Zillow – any intermediary-type business faces immediate threats with initiatives like this, and it’s critical that those with the foresight to adapt do so.
At GoingVC, at the core of our mission is to create a more transparent and diverse industry. That’s why we launched our Venture Capital Flagship Program, with diversity and inclusion focused goals, and recently launched GoingVC Angels, a professional community for accredited investors to learn about Angel Investing, get access to high quality deal flow, and generate additional resources for founders.
We support a network of incredibly talented people across the globe that share this mission and continue to see the exciting changing trends and shape of the industry.
In fact, if you’re a Venture Fund looking to diversify your talent pipeline or train your incoming analysts, we’d love to hear from you!
Our new VC Partner Program is designed to solve the biggest challenges facing funds, like hiring and training, sourcing, and due diligence.With an expansive network of VCs, qualified VC and portco candidates, and top MBA scouts, we’re uniquely positioned to deliver fund services that will save you time and money and drive your fund forward. For more information, you can reach out directly to Steve Nehlig at Steve@GoingVC.com.