Jerry Neumann wrote a piece called Heat Death: Venture Capital in the 1980s that details the VC industry’s changes from 1970 to now. As I read it, I found that there were tidbits from the 80s that related to today’s VC ecosystem that I wanted to unpack further. My thoughts (and the accompanying passages) below.
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Early 1980′s – Investors move to early-stage for better returns, demand leads to increasing valuations, increasing valuations pushes investors earlier.
More and more these days, venture capitalists are financing the birth of new companies. The typical venture-capital concerns used to provide money only after a few hundred thousand dollars or more had been put into a business by relatives and principals, and only after the company had a product well along in development. But now the values of young companies are rising so rapidly that venture capitalists who invest at the traditional stage often can’t make the five to tenfold profit they typically require. (Wall Street Journal, “To Increase Profits, Venture-Capital Firms are Investing Earlier in Fledgling Concerns”, 10/31/1983.)
There has been a massive increase of Micro VC funds raised to invest at the early-stage. There are many drivers including the shrinking costs to start a tech company that help explain the early-stage boom, but partially it has been driven by the penetration of tech among high net-worth individuals, and the broader population. Unlike in the last bubble, everyone today is on the internet, has a smartphone, and thus interacts with tech on a daily basis. With platforms like AngelList, HNW individuals (and their accompanying investment vehicles) can invest easily in what they believe is the next Facebook/Twitter/Instagram etc. and these non-VC investors are becoming LPs in smaller funds to learn the ropes and even co-invest selectively.
A tendency by newcomers to overestimate the value of new companies has contributed to the recent sharp rise in the size of some deals…some veterans are dropping potential deals because they’re wary of the competence of other venture capitalists involved in the deal. (Wall Street Journal, “Venture Firms Lack People of Experience”, 12/8/1983.)
Fred Wilson echo’d similar sentiment about the early-stage and USV moving more towards Seed. The increase in demand of early-stage deals has made valuations and round sizes consistently rise the past few years. And while some claim it is just the naming conventions of rounds (yesterday’s Series A is today’s Seed), either way, startups can raise more money, faster, than in years past.
Prices for startups rose. “The price tags on such companies are running from 20% to 100% higher than last year’s first-round financings,” said the Wall Street Journal in 19816. Some attributed the rise in prices to lack of experience. (Neumann)
Some attribute the fundraising boom to a larger overall opportunity (internet usage in 2000 vs. today, mobile penetration, etc.), but I also believe this shift in round naming conventions (and “straight to A” rounds), is because there are institutional vehicles built specifically for this demand.
No longer is it merely individuals filling out a $500k seed as a company’s first fundraise. A first formal fundraise now can creep above $1M and feature multiple institutional investors that focus their fund on this previously angel-centric round (see: Micro/Seed VCs) as well as larger funds that invest at the seed as a call option (more on this later).
These dynamics have crowded out some investors and have paved the way for “pre-seed” funds where investors can attempt to back great teams, earlier, at lower valuations, and worry less about demand that pushes round size/valuations to a point where ownership percentage does not fit within the model of their fund.
Inexperienced angels crossing over into tech also can play a small part in this dynamic. As an example, I have heard multiple instances of founders that have had “Angels” ask them how a cap worked on the convertible note, AFTER agreeing to invest.
Early 1980s – VCs overfunding a hot sector, Disk Drives. Is that e-hailing today?
The success of one company in an area such as disk drives or semiconductors immediately spawned a plethora of me-too deals in the same business20.
In 1981, 12 disk drive companies were founded and received venture capital. In 1982, 19 companies; in 1983, 22 companies. Almost $400 million was invested in the industry between 1977 and 1984, $270 million of that in 1983 and 1984 alone. By 1983 there were more than 70 companies competing in the industry. In response to the increase in competition, prices were slashed and margins fell dramatically, but fixed R&D expenses did not. The valuations of these companies collapsed. (Neumann)
I don’t know how the car-hailing market will shake out but the similarities are there. If we think that globally there will be a few successful companies like Uber, Lyft, Ola, and Kuaidi Dache, we still have well over 30 competitors that have cumulatively raised a material amount of financing from VCs and institutional investors.
We can take this a step further by looking at the entire “On-demand economy”. I believe there will be a few, sustainable $B+ companies created, but I’m not sure the rush into these spaces worldwide will allow for multiple dominant players. We’ve already seen consolidation in the most “advanced” market (car-hailing) in Kuaidi Dache/DiDi Dache, so it will be interesting to see if more consolidation happens, or if industries will remain fragmented for years to come. For more, read this post by Brian Ascher of Venrock.
Mid/Late 1980s – Returns fall, VCs force IPOs. Today’s climate is almost the opposite.
Returns from funds raised in 1980 peaked in 1983…But funds raised in 1982 and after showed abysmal early returns through the ’80s.
New money managers have a unique problem, though. They need to show they can make their LPs money before they go to raise a new fund. They need exits. Some observers claimed that new VCs were “grandstanding”: demonstrating their ability to exit by exiting too soon, especially through IPOs11. By forcing their companies to go public before they were ready, they ended up with sub-optimal IPOs. This not only hurt the VCs involved, but it poisoned the well for other companies hoping to go public. (Neumann)
This seems to be the antithesis of what is happening today. Almost no VCs are rushing their companies to public markets. With the increase of late-stage non-VC investors, there is plenty of capital to continue to fund growth and win industry land-grabs without dealing with public market scrutiny. In most cases, this allows for steadily increasing valuations as the new late-stage investors aren’t looking for the same exit multiples as VCs, and make the VC fund’s on-paper IRR that much better.
To serve this new dynamic, some VCs have used this later-stage explosion to go back to LPs to raise larger funds, as well as to raise “Opportunity” funds to ride their winners, and/or maintain pro-rata in later rounds.
Mid/Late 1980s – A late stage boom in 1986 and 2015.
VCs figured that, absent blockbuster companies, IRRs could be improved either by shortening holding periods or having a higher company survival rate. Despite learning in the 1970s that early-stage investing is where the returns are, firms in the 1980s started to invest at much later stages and in already-established markets.
America’s venture capital industry has been restructuring itself in a way that is eroding its historic role as a source of seed money…venture capitalists have been putting a greater share of their money in later-round financings and LBOs29.
From none in 1980, LBOs grew to 23% of VC dollars by 1986. Seed and early-stage financing, once a quarter of VC investment, fell to 12.5% by 1988. (Neumann)
Enough has been said about the late-stage boom. There are multi-billion dollar VC funds including the largest of all-time closing this past month, hedge funds creating VC arms, and the previously-mentioned opportunity funds. And don’t forget special purpose vehicles that allow investors to ride their winners even more, in some ways potentially getting around allocation caps (maximum % of a fund allocated to a single position) that they might have in their LP agreements. While a lot of this activity isn’t happening in already-established markets as it was in the ‘80s, the trend is similar.
Mid/Late 1980s – VCs funded rollups. Rocket Internet has built multiple $1B+ businesses doing this.
Instead of backing entrepreneurs to develop new companies, many deal makers are emphasizing investments in companies that plan to grow through acquisitions…the growth of the venture capital industry is making it harder to find worthy new companies to support. So they have to find other places to put their money. (Wall Street Journal, “Venture Capital Turns to Mergers For Faster Growth and Lower Risk”, 1/7/1986.)
We’ve seen this at a smaller scale in the previously-mentioned Kuaidi Dache merger as well heard rumors about this in regards to a “global alliance of regional players” being formed to battle Uber. Softbank could be behind the latter, however the player doing this the most is Rocket Internet.
The investor/holding company/clone factory took its unparalleled ability to scale quickly, execute in new markets, and raise money, to incubate Foodpanda, take a ~40% stake in Delivery Hero, and subsequently build out an empire of international online food ordering platforms via a rollup that is now called Global Online Takeaway Group. They have since done the same thing in online fashion with Global Fashion Group, and recently raised $35M at a $3B valuation to increase efficiency across all of its brands.
Late 1980s – Megafunds are born, VCs split to late-stage and early-stage. Today’s “megafunds” cross stages and are skewing early-stage dynamics.
The VC investing landscape had, essentially, bifurcated. One group of VCs made small, earlier investments and tried to manage their risk by investing in established markets or by building products, not companies; another group made much larger, later investments and tried to manage their risk by investing in companies that were not “startups” at all. (Neumann)
The initial successes of the venture industry in the first half of the decade have led to an excess of “megafunds”–venture pools with hundreds of millions of dollars to invest. The sheer size of these funds has, in many instances, transformed seed capital from a primary activity to a marginal one. (Wall Street Journal, “Venture Capital’s New Look”, 5/20/1988.)
This further speaks to the types of larger VC funds we’re seeing raised now, and how often those funds look to invest across all stages. As I said before, these investors are treating the earliest stages as mere call options for future investments. They care less about the valuation at the seed stage, and in a way this has marginalized seed valuations to larger players, while smaller VC funds are forced to go earlier in the life cycle of companies as we discussed in regards to the development of pre-seed as an investment stage.
If you’ve somehow made it through this post, the first takeaway should be to read Jerry Neumann’s post. Second is to think about what this “history repeating itself” narrative may suggest.
Is it merely that regardless of where we are in a cycle, the media will continue to opine about the ever-changing state of venture capital? Is it that history will always repeat itself, and thus we are headed for another downturn as we’ve previously seen? I’ve done enough opining for now so I’ll end with a quote from Jerry Neumann which I believe perfectly describes how to think about the future of VC.
The only thing VCs can control that will improve their outcomes is having enough guts to bet on markets that don’t yet exist. Everything else is noise.