The Series A Gap in VC is Real and is Widening. Here’s Why…
March 15 marks the unofficial one-year anniversary of the pandemic. In the year that’s followed, we’ve all read plenty of stories on ‘how our lives have changed’ and so forth. While true enough, there has also been no shortage of things that have clearly not changed over the past year. Moreover, there is now compelling evidence that many trends that were in evidence prior to March 2020 have only been exacerbated by the pandemic. The growing gap of Series A funding is another one of them. Here is our take:
1. A surge in new VC funds now crowd the Seed space
As chronicled in my recent post, Traditional Late Stage VC Is Being Disrupted, there has been a 20x increase in the number of Seed Stage venture funds since 2009. This influx of new Seed stage GPs and the fresh capital they are deploying is having an effect that’s now becoming clear in the data.
The surge in Seed stage valuations, especially in established tech hubs like Silicon Valley, is one clear consequence of the boomlet in Seed stage funds. As we all experienced, the pandemic fueled an exodus of tech talent (and some notable investors) from San Francisco, NYC and other established hubs. It also caused rents for apartments and office space to drop precipitously — as much as 33% in San Francisco alone. Finally, there was also evidence that labor rates for tech talent dipped somewhat in sympathy with layoffs and the attendant freeing up of talent that that caused across the technology landscape.
But the collapse that in Seed stage valuations that some market observers predicted never materialized. Indeed, Seed Stage valuations surged throughout 2020 across all established tech hubs. While there are many reasons for this, a cause that cannot be discounted has been the record amount of Seed stage capital being deployed throughout the venture ecosystem.
Innovation in VC is long overdue, but not without consequences
To be clear, we are encouraged by the emergence of new players onto the venture landscape and we welcome much of the recent innovations in the venture capital asset class — from structural and organizational innovations (i.e., “Nano funds”, rolling funds, Angelist syndicates, solo GPs, etc), to product innovations, (venture debt and revenue-based financing solutions from the likes of Pipe, ClearBanc, and others.)
Venture capital has long been an opaque industry. That opacity traditionally favored a handful of legacy venture firms while constraining access to capital and mentorship to all but the most connected and geographically advantaged entrepreneurs. The prevalence of technologies enabling distributed teams and remote workforce collaboration, however, and the innovations in venture capital mentioned above are loosening those constraints.
Clearly, more GPs toiling at the Seed stage helps a greater number of startups secure their Seed funding, bring their products and services to market, and commence their journeys to becoming market leaders. Product innovations, for their part, offer more creative (and often less dilutive) solutions for founders than traditional venture financing can typically offer.
All this innovation in the asset class and the attendant influx of new capital at the Seed stage is all well and good with the exception that it creates a bit of an ironic paradox: As more capital flows into Seed stage, more startups get funded. That’s good.
The bad news is that as more capital flows into Seed stage, more startups get funded. These startups must then compete with so many other Seed-funded startups to secure their next financing round — typically, the crucial Series A. But what’s become of traditional Series A-focused venture funds? As a percentage of funds that make up the venture capital asset class, the number of traditional Series A-focused venture funds has been declining for some time.
Indeed, most of the growth in the number of new firms (and capital) has come primarily at the Seed stage and at the later stages — Series C and thereafter. Hence the barbell problem. And a Series A crunch.
Seed funds are typically good at syndicating but few are in a position to lead a Series A round.
In the current environment, most Seed financings (in the US at least) are typically structured as Convertible Notes, which is a form of debt, or SAFE Notes. The SAFE Note (simple agreement for future equity), an innovation pioneered by Y Combinator, has had a profound impact on Seed stage financing. (There are key differences between Convertible Notes and SAFE Notes but that would go beyond the scope of this post.)
In these types of Seed financings, the notion of a “lead investor” is a bit of a misnomer since investors all invest along the same terms. One investor may take the lead on negotiating the terms in a SAFE Note — namely, valuation caps and discounts — and conduct most of the ‘heavy lifting’ in terms of diligence; otherwise, all Seed investors participate more or less equally.
Lots of Indians; not so many Chiefs.
In short order the startup which successfully raised its Seed round must prepare to raise its next financing round. Often this is the Series A, although in the current environment there can now be numerous interim rounds after the first ‘classic’ Seed round and before the Series A. Those financings go by many different names— i.e., Seed 2, Seed Extension, Seed Prime and so forth. There was a time when such an interim round bore a negative connotation as it could imply that a startup fell short of its financial targets and needed more capital and time to become “Series A ready.” That stigma has largely dissipated in the current environment where there is an abundance of capital and funds that specialize in these post-Seed/Pre-Series A financings. (Bullpen Capital comes to mind here, but there are many others.)
Regardless of when the right time is to seek raising a Series A, many startups aiming to achieve that goal often face an uphill battle. While capital is plentiful at the Seed stage (relatively speaking, of course), Series A capital is far more scarce, far more competitive, and far more selective. This is made more complicated by: (1) the relative paucity of venture funds that specialize in leading Series A rounds; and, (2) the plethora of startups funded at the Seed stage that are now competing with each other for those relatively scarce Series A dollars.
2. Series A funds are demanding more traction from startups than in the past.
It’s often been joked that Series A is the new Series B. In this environment of plentiful Seed stage capital paired with a relative paucity of Series A investors, the milestones and metrics of what would have been expected from a Series A-ready startup a few short years ago won’t be sufficient for many Series A investors in the current environment evaluating startups seeking a Series A.
Some of this exists because the amount of capital startups raise now prior to seeking a Series A is often an order of magnitude greater than what it was a few years ago. As such, Series A investors expect more in terms of traction and other metrics given the Seed capital invested to date. And one cannot really blame them. At a time when AWS and many cloud-based and “off-prem” solutions have caused startup launch costs to drop dramatically, Series A investors want to see more traction, more validation, and more robust (and more sustainable) metrics.
3. Many traditional early stage VC firms have increased AUM and moved later stage.
Another unavoidable consequence of the decade-long tech bull market has been the ‘AUM creep’ of many legacy venture funds that traditionally focused on early stage investing. While there have been a few notable exceptions of established funds that have kept their fund sizes consistent over time, (Benchmark comes to mind here,) many renown funds have increased AUM significantly over the past decade — in some cases by 4x or more.
This is tantamount to a fund that was investing out of a $200mm vehicle in 2010 doing so from a $800mm fund today. That’s a dramatic shift, but not terribly unusual. While these same firms may argue that they still consider themselves early stage and that they still invest at (the occasional) Series A, there’s little argument that the pressure of deploying 4x the amount of capital that a firm managed a decade earlier inevitably involves prioritizing larger, later stage deals to justify the GP bandwidth.
The Road Ahead
We’ve been here before. In earlier market dislocations, funds saw the opportunity, raised vehicles, and filled the Series A gap. The dynamics are different now, however. We are undergoing an ‘atomization’ of the venture capital asset class. Entrepreneurs are most educated on capital raising than ever before and are solving for selecting the right investor over the brand. While VC brand still has impact, especially at Seed and early stage when the halo effect and ‘positive signal’ that a pedigreed firm can bestow upon a company can be palpable for recruiting and for raising follow-on capital, it is becoming less important as startups mature to mezzanine and later stages. Hence, we expect to see more solo GP and rolling fund investors operating independently of larger franchises.
We also expect to see a maturation of Seed stage firms in the coming years as those that generated meaningful exits in their inaugural funds will go on to raise subsequent vehicles that will almost invariably be larger then their debut funds — sometimes 2–3x larger. Many of those firms will begin leading Series A rounds. We also expect to see more later stage funds develop a ‘full stack’ strategy and launch upstream vehicles to target Series A and even Seed. Many late stage funds have learned the hard way that if they don’t have a way to access hotly competitive early stage companies via some proprietary path — like their own Seed or early stage fund — they may never get the chance at an allocation as those companies mature.
But for the moment we have a clear dislocation in the marketplace where there is an abundance of later stage and Seed stage capital with a great deal of ground in between stages where raising funding is enormously competitive, and will likely remain so for the foreseeable future. As one entrepreneur remarked recently, “it’s never been easier to be an Seed-backed entrepreneur in the current environment, but it’s never been more difficult to be an entrepreneur of a startup seeking to raise a Series A.”
4 Expectations for Tech and VC in 2021
The year fast coming to a close was unlike any other in our lifetimes. In prior posts, we shared our observations on the state of venture and tech as the market swooned; we foretold the waning influence of Silicon Valley as smaller ecosystems benefited from the exodus of tech talent (and now VCs) from the Bay Area; and, during the market’s March bottom we made our Bull Case for why LPs should stay the course and continue investing in the VC asset class, market gyrations be damned.
Now, in these closing days of 2020, the Dow flirts with 31,000; two highly effective vaccines are being deployed around the world; and, we’ve experienced a wave of highly successful technology company IPOs and M&A transactions that rival any vintage since the heady dot-com days of the late 1990s.
As 2021 comes into view, we turn our attention to 4 expectations of what we expect to see in tech and venture in the coming year:
1. The “decoupling” of capital and geography, accelerated by Covid-19, expands and matures.
We at Catapult, as a venture firm founded on the premise that geography was becoming less relevant as an impediment for startups to access capital, have long argued that as cloud adoption and remote workforce collaboration technologies became mainstream, more companies would eschew costly tech hubs like Silicon Valley for smaller locales offering reduced operating costs, more diverse talent pools, and lower team attrition. With little argument, the pandemic has accelerated this trend by an order of magnitude. Stories of tech talent and VCs moving from the Bay Area to places like Miami, Austin, and Seattle have gone from a theme to a meme in the space of a few months. We wholeheartedly expect this trend to continue in 2021 as more venture funds both adapt to investing via Zoom and more unicorn-caliber companies emerge from tier 2 cities around the globe, fueling a virtuous cycle of experienced VCs establishing themselves in these smaller geos to generate deal flow which, in turn, increases the amount of capital in those hubs and the likelihood that local startups can break out of their regional markets and generate big outcomes which, in turn, attracts more VCs to the area, and so forth.
2. Numerous unicorn companies will be built on the Zoom platform as remote work becomes the new normal.
Even the most optimistic prognostications of how the global economy will recover as the pandemic fades from view envision a workplace that will be a hybrid one: a patchwork of the traditional in-office work experience with a WFH/virtual office arrangement. New tools and technologies — particularly around security, data, collaboration and productivity — will address the increasing needs we will all have for the workplaces we will inherit post-Covid19. Correspondingly, we will see a stacking of services which will sit on top of these collaboration technologies— particularly that of Zoom which arguably has itself become a platform — and several unicorn companies ultimately emerge from the Zoom ecosystem.
3. The “creator economy” picks up where influencers left off, enabling talent to go direct, own their brands, and their audiences.
While the pandemic-fueled ecommerce boom has been enormously helpful for many new and established Direct-To-Consumer (DTC) brands, a less frequently discussed trend has been its impact on the creator economy. In 2020, TikTok emerged as a formidable challenger to YouTube’s apparent hegemony as the de facto platform for creators to build and monetize their online brands and following. This was something of a wake-up call. Against the backdrop of increasingly restless governments willing to take on tech platforms, myriad scandals over user privacy, and strategic missteps by Facebook and others, creators of all stripes are more insistent than ever of owning their brands and audiences. Creators are opting to bypass traditional routes to building a brand and are, instead, distributing content directly across an increasing number of new platforms tailored to their needs. While companies like Patreon and OnlyFans are not new, the pandemic — with its halting of live events — alerted many creators to the imperative of building communities of fans and of not being beholden to third parties (or their fickle algorithms) for their livelihoods. We expect to see a flurry of new services and products tailored to creators which will have the long term effect of chipping away at YouTube and Facebook’s market power.
4. Innovation and disruption in venture will continue to fuel a renaissance across the asset class.
If the pandemic has radically reshaped the technology landscape then it stands to reason that venture capital investors, as the primary funder of technology innovation, are also being forced to adapt to these changes. And these changes mean more than simply getting comfortable investing over Zoom. The changes are structural; and, for many, existential.
That realignment is well underway. Like so many things we’ve experienced in 2020, change was afoot long before the onset of the pandemic. Covid-19 was merely a potent accelerant. This is evidenced by the hundreds of new funds, many of which are focused on investing at Seed stage out of small vehicles — i.e., $25mm and below— and that have a clearly defined sector or thematic focus. While these new funds have garnered much of the media’s attention, these are just part of a broad diffusion across the venture asset class which has blurred the lines of what constitutes a venture fund nowadays. Indeed, today there exists a veritable alphabet soup of new fund approaches, strategies and structures: “Rolling” funds, investor-operator funds, sweat equity funds, solo GPs, solo operator funds, startup studios, multi-operator funds, and so forth. Against this backdrop, many of the more successful legacy VC funds — which, for our purposes, let’s call funds that were formed pre-2000 — have gone on to raise larger and larger vehicles with every fund generation. That AUM creep has pushed many (but not all) of those firms further away from seed investing and, in some cases, away from classic early stage venture investing entirely. Others have raised so many separate funds across their platforms — late stage funds, early growth or continuity funds, SPACs, hyper-thematic funds, crossover funds, etc — that they more closely resemble multi-stage asset management firms than classic VC funds of old.
The good news is that all this innovation and disruption across VC accrues to the benefit of entrepreneurs. More sources of capital means more worthy entrepreneurs will get the backing they need to coax their startup ideas into their fullest expression; and, more available talent post-pandemic and falling prices for services and infrastructure globally means those investment dollars will go farther; hence, enhancing venture returns. The hundreds of operator-investor and nano funds will fill the gap at the seed stage left vacant as established firms move upstream, while legacy funds that consistently turned in mediocre performance the last few cycles will either downsize or wind down entirely, unable to justify the management fees they require to support expensive offices and layers of human resources in a market that no longer values such things in the way it did a few short years ago.
Silicon Valley’s 70-year dominance in tech is ending…and that’s good for tech.
Earlier this month Stripe announced its $200mm acquisition of Paystack, a fintech startup from Lagos, Nigeria. For an African startup to exit at a meaningful figure at all is unusual enough, but that it had garnered a $200mm price tag would have been unfathomable by most observers a few short years ago — even by those long evangelizing Africa’s ‘emerging tech hub’ bona fides.
However, to certain observers and cross-border venture investors, such as us at Catapult, who’ve spent years shuttling between tech hubs outside Silicon Valley, stories like that of Paystack are becoming increasingly common. More to the point, they are a harbinger for things to come vis-à-vis Silicon Valley’s waning influence on the tech landscape; something that’s been underway for the better part of a decade and now accelerated by an order of magnitude by the impact of Covid-19.
The Rise of ‘Tier 2’ Tech Ecosystems Globally
While renown tech hubs such as Stockholm (Spotify, Klarna), Toronto (Shopify, Ecobee), and Tel Aviv (Waze, Mobileye) have generated significant technology companies for some time, the number of large exits originating from those geographies has skyrocketed in recent years. While this is to be somewhat expected, what is surprising is the emergence of technology leaders and meaningful exits from hubs heretofore largely dismissed by market observers. Think Dubai, and Uber’s $3.1 Billion acquisition of Dubai-based Careem; or Bogota’s Rappi and its rise to unicorn status; or Seoul’s Baemin, and its recent $4 Billion acquisition by Delivery Hero. Yes, Stockholm, Toronto and Tel Aviv are probably top of mind with most VCs by now, but I’d wager Dubai, Bogota and Seoul weren’t exactly on most investors’ bingo card.
It’s axiomatic that Silicon Valley has enjoyed an outsized reputation as the leading global tech hub since the 1960s and has cast a long shadow over the industry for decades. Silicon Valley lore is rich with heady tales of the days of Fairchild Semiconductor, XeroxPARC and the like. Technologies that emerged during that era changed the world. Talent attracted to Silicon Valley to work at those iconic companies would form a diaspora that would go on to build the next generation of technology juggernauts — Apple, Intel, Sun, Cisco, et al. The names of tech visionaries from that era and those of the investors behind them — Tom Perkins, Don Valentine, Gordon Moore, et al — are etched into the psyche of every entrepreneur and VC who came of age in the post-dotcom era.
From a geography to a State of Mind
We are a long way from the days of XeroxPARC and Fairchild Semiconductor, to be sure. Once just a patchwork of fruit orchards, Silicon Valley has become much more that its geography or its storied history.
Today, Silicon Valley is not unlike “Wall Street” or “Rodeo Drive” — iconic names that evoke in those that hear them ideas about something larger than the physical spaces they encompass. They’ve come to symbolize an idea, a culture, even a way of thinking.
Most people across the world will never visit Wall Street nor Rodeo Drive, but their mere mention evokes an instant impression. This is true of today’s Silicon Valley. For many it means bold innovation, wide-eyed optimism, and limitless possibilities. And it will continue to have that meaning for decades to come, I am convinced. But it can no longer hold claim that it has cornered the market on those attributes.
Visitors who, after having consumed Valley lore for years, finally set foot on Silicon Valley’s nondescript 48.6-square-mile patchwork of land often come away disappointed. New York City, this is not. Perhaps it’s the boulevards that stretch endlessly and are dotted with manicured office parks and unremarkable strip malls filled with every suburban cliche’s smorgasbord of nail salons and karate studios. Perhaps it’s the lack of a thumping, thriving center. Or perhaps it’s the absence of iconic landmarks. (No, the Facebook “Like” sign on 1 Hacker Way does not count.) While turning David Packard’s Palo Alto garage into a Hewlett-Packard museum was a nod in the right direction of honoring some of the Valley’s great history, there is still scant little else for a tech tourist to come and see and do.
Wall Street, for its part, does not really exist any more in any literal sense either. Most iconic Wall Street firms moved out of Wall Street — and many even out of NYC entirely — in the wake of 9/11. Judging by the number of global financial services firms operating, one could argue that the real Wall Street today is located in Hoboken, New Jersey; or in City of London; or, in Frankfurt. So much for the power of place. But it doesn’t really matter that most ‘Wall Street’ firms don’t have a footprint on Wall Street any longer. And it won’t really matter for Silicon Valley either.
Geography no longer really matters
This wasn’t always the case. One could argue that twenty years ago if an entrepreneur wanted to build a global technology company he/she would have been well-advised to do it in Silicon Valley. The common argument was to liken being in Silicon Valley to being in Florence during the Renaissance. At its peak, Florence possessed perhaps the world’s greatest of network effects: a flammable combination of art, innovation, commerce and mentorship that became the envy of the world. As author Daniel Coyle explains in The Talent Code, “Davinci studied under Verrocchio. Verrocchio studied under Donatello. Donatello studied under Ghilberti. Michelangelo studied under Ghirlandaio. Ghirlandaio studied under Baldovinetti. And so on. All of them frequently visiting one another’s studios in a cooperative competitive arrangement that today would be called social networking.”
Like Florence, Silicon Valley possessed all the components and constituents necessary to build a global tech company — capital, investors, talent, co-founders, sage mentors, experienced service providers, and the like. Moreover, there was serendipity in being here — the launch parties; the Demo Days; the happy hour mixers at VC firms; the summer BBQs in Napa or Atherton; and, of course, the co-working spaces teeming with talented people working on exciting ideas. Above all, there was the knowledge that at all those events — both the exclusive and the pedestrian —talented people were ubiquitous. Any one of them could be your next co-founder, angel investor, mentor, or venture capitalist. They were everywhere; passing you on the street, or bumping into you at a launch party, or in line behind you at Blue Bottle. It was frisson. The energy was palpable. Everything was possible… And then Covid.
Being Remote and Global from Day One is now table stakes
Yes, the pandemic has caused a massive reappraisal of everything — which I’ve discussed in previous posts, here, and here — from sectors benefiting from the post-Covid environment to how venture is adapting. That said, while it’s a convenient argument, it’s inaccurate to assert that Covid was the catalyst behind this clear shift away from the Valley. As in so many things, the pandemic only accelerated — ok, vastly accelerated — trends that were already in evidence for some time.
Yet, now with no events to attend, few networking opportunities, and most everything being accomplished via Zoom, the pandemic has quashed one of the Bay Area’s most resilient arguments for tolerating the exorbitant housing costs and tax rates required for the privilege of living here.
As such, the exodus of tech talent and capital that began quietly over the past few years has reached full gallop.
A post-Silicon Valley world, facilitated by tech
Ironically enough, it has been technology itself that has enabled this dramatic shift away from the Valley. Today, startup teams can avail themselves of any number of tools and platforms —Slack, Asana, GitHub, Trello, et al — which enable them to be global from day one. The competition for tech talent is so fierce and global that startup founders must pursue the best talent wherever it exists, geography be damned. That often means that a startup might have a nominal presence in the Bay Area for fundraising, but maintain a Sales & Marketing effort in NYC, a DevOps team in Kiev, and a back office or distribution center outside Scottsdale, or Nashville, or Bangalore. Indeed, the notion of having all members and all functions of a technology startup based in high rent office space in downtown San Francisco became obsolete with the Palm Treo.
This has scrambled the long-held notions of geography and labor markets. And that’s a good thing. Tech companies will become more diverse as the labor pool widens. No longer locked into a Bay Area-centric pool of applicants from which to choose — who typically must be reasonably affluent to even live here to begin with — tech companies will cast wider nets to source the best talent from across a broader socioeconomic, educational and ethnic spectrum. This will result in a more diverse, inclusive workforce which will result, over time, in technology products and services with greater reach and that can address more fundamental global challenges.
The pandemic-fueled Bay Area tech exodus is accruing to the benefit of global tech hubs
In the absence of the world which existed prior to February 2020 where Bay Area startups expected their employees to come into the office, where meet-ups were the norm, where conferences were ubiquitous and in-person, and where Bay Area evenings and weekends were humming with live music, and a bustling food and bar scene, the Bay Area has experienced an exodus of tech talent of almost biblical proportions. As just one metric, San Francisco apartment rents have now plunged 31%, year over year — the largest in the nation. Geographies benefiting from this influx of ex-Bay Area tech talent? Colorado, Texas, Nevada, Oregon, and Washington State, to name just a few.
Venture capital investors have, for their part, largely moved in lockstep with their portfolio company founders. At least in spirit. In the early days of the pandemic, many senior GPs at established funds turned their weekend homes into temporary offices. At first, most believed the lockdown would last just a few weeks. Then the weeks became a couple months, which became seven months, and which will likely be a full year before most VCs are allowed to return to their pre-Covid offices. In that time, most VCs have found that they’ve adapted extraordinarily well to investing remotely. Investment pace in 2020, particularly at early stage, has been nothing short of ferocious; and, most venture funds have continued to raise new vehicles.
The Bay Area may be going through a painful realignment but the tech industry has already largely adapted and is de-prioritizing the Bay Area as a place to source, found and build great companies going forward. Moreover, Silicon Valley VCs have been increasingly investing outside the Bay Area with some funds opening offices in Europe, Asia and elsewhere to deploy capital in those markets in a more fulsome way. And this accrues to the clear benefit of emerging tech hubs around the world which, at least for now, universally enjoy lower tax rates, lower rents and operating costs, less team attrition, and more rationale valuations for investors.
The Road Ahead
It’s folly to ever count out Silicon Valley, and this post is by no means a take-down of the world’s most recognized tech ecosystem. Far from it. A native New Yorker, I moved to the Bay Area to attend Berkeley as an undergrad. I founded three startups here as well as a VC firm that, as it happens, specializes in investing in emerging tech hubs outside Silicon Valley, while leveraging the deep networks my partners and I have built over many years of investing here so as to help those startups achieve global scale.
With the exception of two years in grad school in Philadelphia, I’ve called the Bay Area home since college. I was moved particularly by the Bay Area’s storied history of embracing the novel and the iconoclast. To borrow from a holiday film from my youth, the Bay Area was the Island of Misfit Toys. Those who thought differently, that were willing to challenge conventions, and that were perhaps a little out of the mainstream, were welcome here.
Failure and experimentation was a vital part of that history. But unlike in other parts of the world where trying a startup and failing might have meant a Scarlet Letter being stapled to your every job application for the rest of your career, failure here showed you had grit. You took a chance. You bet on yourself and your vision to build something worthwhile. You pushed the boat out, battled the currents, and put everything on the line. That was real world experience. And that experience was valued; sometimes, even saluted. If failure befell you and your venture, you’d always have a place to land. That was special, and incredibly rare.
Happily the rest of the world’s tech hubs have been studiously taking pages out of the Silicon Valley playbook for decades to help foster their own tech ecosystems. Some have succeeded better than others. Many still have work to do. But what’s clear now is that the vital elements that made Silicon Valley Silicon Valley 70 years ago — talent, capital, advisors, compliant governments, sane regulations, and a culture that embraces risk-taking rather than belittling it — are now in evidence in many ecosystems across the world. Silicon Valley seeded that.
Founding teams in those emerging tech hubs have no desire to uproot themselves to move to Silicon Valley to pursue their entrepreneurial dreams; happily, they no longer have to. They can now do it in their own hometowns of Barcelona, or Salt Lake City, or a myriad other locations. And the successes of those founders will create a new diaspora that will go on to found other great companies, or they will become angel investors, or venture investors, and become their own versions of the Tom Perkins’ and Don Valentines that had a such a profound impact on Silicon Valley. And, in the end that may end up being Silicon Valley’s greatest and most long-standing legacy of all.
4 Observations on the Current State of VC
In our last piece, 6 Emerging Tech Trends for a Post-Covid19 World, we discussed trends that we at Catapult were seeing emerge from the current crisis. The post focused on sectors and themes across the technology landscape that have been enjoying a Covid19 ‘bounce’ or, at the very least, renewed interest from tech investors who feel, as we do, that companies focusing in these areas are well positioned to benefit from the changes in consumer behavior and commerce provoked by the pandemic.
In this post, we’ll offer 4 brief insights into what we’re currently seeing in the funding environment. Hopefully, this will provide some clarity to startup teams, fellow venture investors, and limited partners (LP) who are seeking to best navigate the current market uncertainty and position themselves for the road ahead.
1. Portfolio ‘triage’ is non-trivial, but starting to abate.
As has been widely reported, many venture funds — especially those with established, mature portfolios — are having to spend much of their time going through their portfolios and systematically categorizing their companies according to immediate cash needs, runway, overall performance and other metrics. Funds are assessing their own reserves and having state-of-the-union type conversations with portfolio company teams to set expectations for the coming few quarters. This is particularly the case with funds with many mezzanine or later stage companies that have large cash burns and sizable headcounts that could require right sizing. Not surprisingly, this takes time to unwind as these conversations are complex, often uncomfortable, and can involve arriving at difficult decisions.
This presents obvious challenges to startups in a fundraising process that are seeking an audience with those venture funds that have largely turned their focus to internal matters. The good news, however, is that there are signs that this is beginning to abate. Shortly after the first market gyrations of late February, many funds got out in front of this cycle and began putting out their biggest fires first, which has allowed them to now slowly increase new deal originations and to have more ‘pipeline’ conversations with new relationships. As such, while getting on the Zoom schedule with a partner with check-writing authority at a fund that’s digging out of portfolio challenges is still difficult, it’s a lot easier than it was a month ago.
Clearly, this is also a fund-by-fund issue. Some firms with more troubled companies will be more preoccupied than others with firefighting distractions this year. Fortunately, this is not quite the case for newer funds without a legacy overhang of prior investments requiring attention. With valuations coming down, along with lower operating costs and more talent available, this is an exceptional time for newer funds unburdened by troubled companies to triage to be deploying capital on new investments.
2. Cadence of fundings at Seed/Early stage increasing whereas Mezz/Late stage companies still face challenges.
Of the investments that are closing, there is a clear bias toward Seed and early stage rounds. On one level, this is predictable: Seed/Early stage round check sizes are smaller; there is less of a company or product to diligence; and, funds are typically more comfortable approving and funding a $500k investment in a company they’ve never met in person than one they would for, say, $10mm.
On another level, this uptick has a lot to do with the market environment facing a Seed/early stage company versus a more mature one, and the kinds of expectations attached to a Seed investment. Investors understand that, typically, the first two years after funding a Seed stage company will be dedicated to building the product or service, not profitability or concerns about near-term macroeconomic conditions. In many ways, this makes a bearish market like the one we are experiencing now and will likely continue to inhabit for the rest of this year ideal for funding and growing a Seed stage company — a point we covered in detail in a prior post, The Bull Case for Venture Capital in a coming Bear Market.
In contrast, later stage companies are viewed through an alternate lens by investors and held to a different standard. The expectations are also different. Near-term market conditions carry much more weight; and, unless the company is in a sector that will likely be a clear beneficiary of Covid-19, those near-term market conditions are not terribly favorable.
Additionally, the pandemic has altered the late stage funding landscape which has, in turn, ratcheted up financing risk for many late stage companies that continue to burn cash. Six months ago when there seemed no shortage of Fund-of-Funds, Corporate Venture Funds(CVCs), and family offices eager to invest in promising later stage companies, financing risk was considerably mitigated. This is not the case today. While there is still a good amount of late stage capital available from non-traditional investors, it seems to be accessible now only by the strongest and most sought-after companies.
3. Overall mood improving as notions of the “new normal” come into view
While it’s still early days, in recent weeks the overall mood seems to have improved among broad constituencies in the asset class. The panicky nervousness of investors that seemed ubiquitous in the weeks following the market’s tumbles in late February and during the early weeks of shelter-in-place seems now to have been replaced with a more muted tone. Investors remain concerned, to be sure, but there now seem to be boundaries around those concerns and around what we can expect in the months ahead. Many investment mandates that were entirely put on hold in early March have now been re-activated. The performance the Dow, now that it’s recovered more than 60% of its losses since the market bottom in early March, has certainly helped; so, too, has the strong performance of the tech-heavy NASDAQ. This all serves as a harbinger that tech, writ large, is poised to perform well in a post-Covid world.
On the GP side, fundraising remains robust. There has been a record number of $1Bn+ venture funds raised in just the past quarter. While many of these fundraising conversations were already well advanced before Covid19 hit, there were still a number of funds that began marketing and had closes while the markets were just coming to grips with the pandemic. While some LPs have backed away from participating in these funds, there has been no shortage of other LPs willing to seize an opportunity to access a manager it long wanted to access and, thus, stepping in to take those available allocations.
4. Companies now need to prove they’re a Covid benificiary or are Covid-resilient
Finally, another evolution we are seeing is the kind of companies that are successfully raising capital now. While hotly competitive companies and those with high-profiles but perceived to only be temporarily impacted by Covid have closed financings in this environment, most companies securing new rounds are either clear beneficiaries of the post-Covid environment or possess a Covid-resilient business model. As such, founders are well advised to embrace the current market realities in their investor collateral and make a cogent case for how their businesses will prosper in this post-Covid world. Clinging to a marketing plan or investor deck from six months ago will appear to investors oddly tone-deaf. A better approach is to address the “elephant in the room” early in investor conversations, demonstrate how the current environment is ideal for the company’s product/service (or at least does not meaningfully impact it) and lay out a clear 18–24 month roadmap for how the company plans to navigate it successfully and emerge as an ostensible leader in its category.
6 Emerging Tech Trends in a Post-Covid-19 World
On January 30, the WHO declared COVID-19 (C19) a global health emergency. In the 9 weeks since, the lives of most everyone in the developed world has been radically altered.
Beyond the destabilizing personal and social impact of C19, the pace and breadth of these changes across the business world have been profound. As ones who’ve lived and invested through the dot-com bust and the Great Recession, as both company operators and as venture investors, we’ve collected our thoughts on some of the trends we see emerging from this current moment and how these shifts will inform future investment opportunities for venture firms and Limited Partners alike.
1. The Remote Workforce Collaboration Revolution shifts into hyper drive.
One of the clear early winners of the WFH boom has been the videoconference and team collaboration platform providers and those companies providing related tools and services. As one oft-cited example of this, video conference company Zoom recently achieved a market cap of $45 Billion, making the 9-year old company worth more than General Motors. Granted, Remote Workforce Collaboration has been an active trend for some time — and a core investment theme for us at Catapult — as companies have increasingly sought to decouple their human assets (employees) from their physical assets (expensive offices.) This desire by enterprises, traditionally focused on cost containment, is not a new one. What’s changed has been how these same companies are recognizing more of the strategic advantages, not simply the cost advantages, in spinning up remote teams — i.e., speed to market, employee flexibility, the ability to access global talent pools, etc. While C19 clearly did not launch the remote workforce revolution, it has accelerated it dramatically. As we exit this crisis, we expect the imperative to be ‘global from day one’ for many companies will become part of the standard operating playbook.
This will accrue to the benefit of not only those tools and technologies that facilitate these transitions, but to emerging tech ecosystems across the globe that can offer emerging growth companies many of the same advantages of a dominant tech hub, but with greater flexibility and at a fraction of the cost.
2. Digitally Native Brands extend well beyond CPG and Fintech.
Digitally native brands — those born on the web untethered from brick and mortar origins — is not a new phenomenon. Yet, it was only in the past decade that brands like Dollar Shave Club and Casper became household names and established in the business world firmament the direct-to-consumer (DTC) category. My partners and I were early investors in both Casper and Dollar Shave Club. Dollar Shave Club cleverly bypassed the Byzantine channel conflicts inherent in the razor blade industry and is credited with pioneering the now-ubiquitous subscription ecommerce model. Casper jettisoned the painfully inefficient and expensive showroom sales model and offered no-questions-asked returns policies to gain early adopters. Predictably, in the wake of the huge successes of both DSC and Casper, there has been an expansion of the DTC playbook well beyond CPG. Neobanks or challenger banks are one example from the Fintech world but there are many others. We expect to see a continued and rapid expansion of digitally native brands that will sweep across dozens of categories and sectors where, heretofore, such brands were not considered viable.
As discussed above, the C19 age is rapidly decoupling physical assets–be they office space, showrooms, bank branches, or retail stores–from the sale of goods and services. For some time now, consumers and businesses have been increasingly comfortable transacting in a virtual world that offered little to no human interaction. However, what we now see are more consumers and businesses preferring to transact that way. For many, the less human interaction in a transaction, the better. As such, today’s virtual experience is no longer considered a poor replacement for an in-person transaction; it’s often considered an improvement over it.
3. VR/AR & Immersive Experiences come of age.
Roughly a decade ago, a new wave of Virual reality/Augmented reality (VR/AR) technologies emerged, generated a great deal of interest and fanfare in the tech community, and went on the raise sizable amounts of venture capital. One notable company, Oculus, went on to be acquired by Facebook for roughly $3Bn. Shortly thereafter, however, investment activity in the sector cooled significantly. Candidly, many of the early technologies were still quite crude: serviceable enough to play certain games but not of a professional grade sufficient for most business applications. Unable to shake the market impression that they were niche-y toys, most of these technologies were not deemed serious or reliable enough to become mainstream. However, C19 is now fueling a renaissance in the VR/AR space, which now includes other fields in the broad “immersive experience” genre. This renewed interest in VR/AR technologies is spurring new investment and innovations designed to shed the “gamer” associations which bedeviled prior VR/AR technology generations. We expect to see a new crop of companies (and new investments) focused squarely on developing hardware and software solutions aimed at vastly improving the current state of VR/AR and, in so doing, extending into new categories and applications within enterprise/business services and ecommerce heretofore not considered practical or viable for prior VR/AR solutions.
4. GovTech accelerates
One bright story which has been lost in the drumbeat of dour C19 news has been one of how a tiny country on the Baltic Sea not only managed to effectively weather the C19 crisis, but how it is leading the way for other nations on how best to protect itself from the next one. That nation is Estonia. At the onset of the crisis, Estonia did what most other European countries did. It closed its borders, shuttered its schools, and prohibited the operation of businesses where people gathered. While Estonia still experienced C19 casualties, it did not experience civil unrest. Perhaps it is because Estonia’s economy is almost entirely digital and, as it happens, one of the nations best prepared for the consequences of a pandemic. Most of Estonia’s government services are entirely digital. Voting is done online, and a single piece of I.D. stores a citizen’s person information, which includes health, tax and police records. Except for marriage, divorce, and the transfer of property, every other transaction can be (or must be) done electronically. As such, when the government ordered its citizens to work and study at home, it cause barely a ripple. As we exit this crisis, we expect to see renewed interest and investments in the broad GovTech space; technologies and that facilitate the migration of municipalities — and, indeed, entire governments — to predominantly (or exclusively) online services and solutions.
5. TeleCommuting/Virtual work elevates its image
On a personal level, we have all learned, at rapid speed, how much can be moved online with minimal friction. The C19 crisis has forced so much into the virtual sphere that it has unquestionably caused a reappraisal of what being “virtual” means and its value to both consumers and enterprises. For decades, “telecommuting” was often viewed skeptically by many traditional corporations. Employees that telecommuted — either for necessity or lifestyle reasons — were often viewed suspiciously by management and even fellow employees. Were they really working the hours they insisted they were working? How effective were they outside the office? How could they possible be ‘in the loop’ when not physically in the office and privy to the water cooler conversations that often sets a company’s culture? Would their ‘virtual’ status hurt them when promotions were on the line?
C19 is not going to settle all those issues, but it is lending a legitimacy (and, now, urgency) to telecommuting and is elevating the practice. More seriousness is be given to virtual work and virtual teams. Millions across the globe are, at this very moment, upgrading their WFH set-ups and creating virtual Zoom backgrounds. Millions more are finding that they have been surprisingly productive in a WFH context and are rethinking the traditional ‘5 days a week in the office’ routine which defined much of their professional lives. Across the country, companies are evaluating how when the crisis lifts whether it makes sense to reconstitute their teams entirely back in their offices as they existed pre-quarantine or, perhaps, shift to flex time.
Companies around the world are having these conversations. By their very nature, tech companies have more experience working with distributed teams. As such, their transition to even further virtualization and distributed workforces will be easier. More traditional companies that have been reliant upon the classic centralized workforce playbook and have struggled to adapt to the recent WFH mandates will continue to experience challenges, but the evolution is decidedly taking place.
6. The Virtualization of (almost) everything
Finally, as discussed above, the rapid migration of so much of what we do and how we interact to a virtual context is stretching our notions of what can exist virtually and what cannot It will also lead to new categories of experiences that will exist only in a virtual context. As VR/AR/Immersive Experience technologies improve, they will no longer be utilized to replicate a poor facsimile of an experience better had in person and in real time. Peloton is one company that’s pushing the boundaries in the fitness space by creating a user experience that’s more than just a grainy virtual reproduction of what attending an in-person spin class would be. Peloton — not a Catapult portfolio company; we’re just fans — has integrated novel technologies and features that create a rich user experience that even the most highly advanced state-of-the-art fitness facility would find difficult to match. Nowadays, fitness centers are scrambling to add technology features to their facilities to compete with Peloton.
Given the rabid devotion of many of Peloton’s fans, the Company is clearly doing something right. Beyond just virtual representations of a brick a mortar experience, we expect to see a wave of new experiences — in entertainment, sports, education, healthcare, etc — designed entirely to be consumed virtually, with no brick and mortar counterpart. These experiences will leverage the idiosyncratic advantages of being virtual to make them unique which, by their very nature, will create competitive moats.
In conclusion, as saddened as we are by the human and economic toll of C19, we at Catapult remain sanguine about the future of tech innovation and the investment opportunities that will emerge from this crisis. The themes discussed here are just a handful of the trends and behavioral shifts that we are already witnessing and serve as a harbinger for what’s to come in the months and years ahead. We believe these themes will present enormous market opportunities for those investors and company leaders that stay the course.
As a famed investor commented during the last market reset, fortunes are made and lost during times of transition. The ‘fortunes made and lost’ part is a bit premature to assess, but we are certainly undergoing a time of profound transition. If history is any guide, the tech sector will withstand current market headwinds better than most and those investors and companies that remain disciplined and engaged will weather this storm and emerge stronger for having done so.
The Bull Case for Venture Capital in a coming Bear market
A Black Swan Health Crisis; Not a Tech-lash
As sad and horrific as the human toll of COVID-19 is, from a market perspective what we are experiencing is not akin to the wholesale collapse of tech valuations following the dot-com bust of 2000–01. COVID-19 was (and is) a black swan health crisis, not a tech-specific market selloff.
While some recent tech IPOs have not fared well, the reasons for the public market’s lukewarm response to those debuts have more to do with the underlying fundamentals of those businesses. It should be noted that the market has not soured on tech companies per se; it has soured on wildly unprofitable tech companies with wobbly unit economics, unsound management practices, and still-unproven business models.
While a bear market will encourage investors to be even more skeptical of such businesses — and, in some cases, to conduct actual due diligence, not simply the illusion of due diligence — it will not unduly prejudice the technology sector.
Traditional Late Stage VC is Being Disrupted. Here’s How:
Venture capital is experiencing a sea change. Consider just a few of the things we’ve witnessed in recent years:
- A 20x increase in the number of seed funds deploying capital in and around Silicon Valley since 2009. (I credit Ahoy Capital’s Chris Douvos for this stat.)
- Most legacy firms raising larger and larger funds with every fund cycle, with a few notable exceptions. This upward migration has caused many of these same Ivy League venture names to largely move away from Seed stage investing and, in some cases, even move away from what was traditionally considered “early stage venture investing.”
- The rise of fast-emerging ‘Tier 2’ tech ecosystems outside Silicon Valley that are catching up quickly with Silicon Valley and now challenging the Valley’s once-indisputable hegemony as the dominant ecosystem for tech innovation; and, finally,
- The flood of late stage investment capital and an influx of new investors, many of whom are recent arrivals to the asset class.
While each of the first 3 bullet points would individually merit an entire post to its examination (which I may explore in a forthcoming piece), it is this last point on which I want to focus. I believe mature and maturing tech companies will be funded in coming years in fundamentally different ways and from fundamentally different types of investors and investment products from what we’ve traditionally seen. With those changes, I believe we are seeing some structural and lasting changes in the late stage venture landscape and a possible winnowing of pure play late stage-only venture firms unable to adapt to new market realities. Allow me to lay out some of the elements to this argument…
1. The ‘arrival’ of debt
While private debt, in some form or fashion, has been around the venture ecosystem for decades we are undoubtedly seeing a renaissance in the perception of debt and its utility as a means to fund emerging growth companies. With this renaissance comes a long overdue re-appraisal of some of the less-than-favorable connotations about debt — some fair, many antiquated — that have traditionally soured venture investors and founders on debt as an funding option. There is also a newfound recognition that as technology companies mature and as their revenues achieve a level of predictability the notion that equity is the only “tool for the job” for accelerating growth is being challenged. A number of recent blog posts on the subject — Alex Danco’s ‘Debt Is Coming’ stands out here; Ali Hamed’s ‘Is Debt Coming to Tech?’ picks up where Alex left off and adds nuance — have elevated the conversation further within venture circles. Both are worthwhile reading.
I agree with many of the arguments posited therein; namely, that debt will become a more common tool for financing later stage, mature technology companies that enjoy predictable revenue streams, high customer retention, and long-term customer contracts.
As more technology companies mature and develop revenue models that possess these characteristics, the argument for raising large amounts of dilutive equity for these companies becomes more difficult to make. I expect to see a marked increase in the number of institutional investors offering low cost, highly flexible, minimally dilutive, innovative debt structures to mature technology companies. In many ways, these firms and their offerings have already arrived.
2. The influx of ‘non-traditional’ late stage investors
Late stage venture investing has long held a broad appeal to a wide swath of investor types: from pure-play late stage VC firms, to corporates and strategics, to non-traditional types such as Sovereign Wealth Funds (SWFs), family offices and financial investors typically known for focusing on other asset classes, such as hedge funds and real estate. What’s different today is the dramatic increase in the number and the activity of these more ‘non-traditional’ groups on the venture stage.
In addition to active LP groups that are banding together to invest later stage in co-invest deals (see #3 below), corporate/strategic investors, financial investors such as hedge funds, and corporate venture capital arms (CVCs) have also grown in prominence in recent years. By some estimates, strategics/corporates and CVCs are more active now than at any time since the peak of the dot-com era. While some detractors may argue that these groups have been known to abruptly shutter their VC investment arms or curtail their activities at the first hint of a market downturn, this current trend feels different. Many of these groups seem more thematic and committed to the asset class this cycle. The strategic imperative of corporates building a pipeline to access emerging technologies and innovations is more acute than ever and, some might argue, somewhat inelastic to market gyrations in the fiercely competitive environment that corporates find themselves in. As such, when the inevitable downturn comes, I don’t believe we’ll see the exodus of CVCs and strategics as some cynics might predict. Many appear to be here to stay.
3. The boom in late stage co-invests and in ‘going direct.’
In the current climate, most every LP active in the venture asset class will profess that they are interested in seeing and investing in late stage co-invest opportunities. At my firm, Catapult, we see the same dynamic. My partners and I have been venture investors for 15+ years and have invested more than $660mm in 275 companies in the aggregate, so we are fortunate that many of our prior portfolio companies return offering us allocations in their follow-on rounds. Often the allocations are too large for our Main Fund but perfect to share with LPs interested in co-invest opportunities in highly vetted, de-risked later stage companies. Like many VC firms, we offer late stage co-invest opportunities to LPs as a kind of “membership has its benefits” perk to them for being investors in our fund.
This increased appetite from LPs for late stage co-invest opportunities has added a fairly new dynamic to the late stage venture ecosystem. It has also extended the reach of VC firms that would typically not be very active after, say, Series B. Today, with LPs willing to provide capital to enable VC firms to continue to support their breakout companies, these firms can now lead and follow on in these rounds in ways that would not have been possible a short time ago.
Moreover, some fund-of-funds (FoFs) and institutional investors have developed discrete programs to productize late stage co-invests, essentially providing seed and early stage VC firms with a turnkey solution to offer allocation opportunities in later stage companies to LPs.
Finally, in addition to going the co-invest route, more LPs are simply ‘going direct’ in venture opportunities. By building robust deal sourcing mechanisms and instituting some process and post-deal support, these LPs are bypassing the VCs altogether. Yes, there are myriad pros and cons to taking this approach, which has been covered in other blog posts of late so I won’t rehash them here, but it’s axiomatic that this is occurring more frequently now and altering the landscape.
4. The ‘platforming’ of VC firms and the advent of the Opportunity fund.
These days, it seems that if you throw a rock down any street in downtown San Francisco or Palo Alto you will hit five seed stage VC firms that recently launched a ‘Continuity’ or ‘Opportunity’ fund to sit alongside their seed stage-focused Main Fund. The logic behind these vehicles is obvious: more capital to continue to support a VC firm’s breakout companies as they scale and require more capital. These Opportunity funds also enable the VCs themselves to maintain or even augment their ownership in the underlying companies rather than incur the equity dilution from not following along in subsequent rounds in a fulsome way. Where these vehicles differ from the late stage co-invests discussed earlier is that these Opportunity funds are discrete, committed vehicles established and managed by the GPs, whereas late stage co-invest opportunities are simply allocations offered to a firm’s LPs without any obligation on the part of the LPs to invest in those companies.
As discussed earlier, the increased presence of these Opportunity and Continuity funds is enabling more seed and early stage VCs to continue investing larger amounts and at later stages of maturity than before, which is impacting the value proposition of a new, late stage financial investor — who might only be contributing capital and ostensibly some growth stage operating expertise and capital markets expertise — coming into the round.
5. More investor syndicates keeping their best companies “in the family”
Finally, and perhaps most controversially, there’s been a trend in recent years of syndicates of seed and early stage investors choosing to continue funding their breakout companies themselves rather than, as they once did, taking their best companies to late stage institutional firms when growth stage capital is required. Some investors have taken to calling this practice “keeping it in the family.”
Part of this rationale is returns driven. The most famous (or infamous, depending on your perspective) example of this was Sequoia being the sole institutional investor in WhatsApp. By providing essentially all the venture money WhatsApp required, Sequoia went on to reap a massive windfall from the company’s $19Bn sale to Facebook. Other firms have taken notice.
Another part of this trend is the benefit of avoiding the ‘upsetting the apple cart’ dynamic that often occurs when a new investor appears, especially if it’s a traditional late stage VC firm. That new investor routinely demands a Board seat, which in turn often necessitates a previous investor either reducing its Board involvement or stepping off the Board entirely. This is not always ideal or welcome. A well-functioning Board of Directors is a highly prized, somewhat rare, and delicate organism. Well functioning Boards often like to stay intact. As such, by contributing most of a startup’s capital requirements internally (or through affiliated groups that won’t require a Board seat) and not bringing in new investors there is a higher likelihood that the current Board composition remains unaltered.
Finally, ego and the tension that sometimes exists between early stage and late stage firms has a role to play here as well. Sharp elbows exist in all areas of finance; venture is no different. Some early stage investors admit openly that they avoid taking their best companies to traditional late stage firms where follow-on capital is required.
While this perspective may be an extreme one, in some ways this overall trend should not be surprising or discounted. As discussed earlier, more early stage firms are raising larger sums of capital themselves, either in a Main Fund or through a platform strategy/Opportunity fund, or through partnerships with their LPs or other groups. With more capital around the table, the imperative to go outside to raise late stage capital from new financial investors is mitigated significantly, notwithstanding some of the signalling issues inherent in inside rounds with no new investors joining. With capital abundant for great companies, late stage investors have to compete fiercely to put capital to work in the most sought-after companies. As such, Boards of directors can be very picky in choosing which late stage investor should be given the opportunity to invest. In most of these cases, the late stage investor who is ultimately selected is bringing more than capital to the table. This gives a significant advantage to a strategic investor or a CVC who can deliver highly desirable channel partnerships, domain expertise, cross-border capabilities, a name association “halo” effect, and a plethora of other advantages far greater than simply capital.
As is often said about the venture capital asset class, investing in venture capital is playing the long game. VC funds are typically closed-end, 10-year vehicles (with 1–3 year extensions) and it can take years for trends to appear, the dust to settle, and for industry standards to emerge. Portfolios take a long time to mature. Venture investors often won’t know for many years whether they are any good at venture investing. As such, I am not predicting the end of the traditional late stage VC firm. Indeed, some traditional late stage firms have been superb partners to many of my portfolio companies, have added real value, and have been great to work with. That said, there is no denying that the landscape of late stage venture capital has changed in fundamental ways. With more ‘platform’ VC firms building a latticework of multiple funds under management, with innovations in debt structures and new funds deploying such solutions, with more non-traditional investors active in the space willing to right sizable checks at generous terms, and with more early stage investors reluctant to go outside their syndicates for follow-on capital unless that capital comes with very specific value-adds, I believe how late stage technology companies will be funded going forward has being altered dramatically and both the value proposition and the future of all but the very best late stage venture firms is in question.
Joy Raises $10M Series A
End-to-end wedding management and services platform Joy recently announced the close of its $10mm Series A round, led by Avalon Ventures with the participation of Sound Ventures and the support of existing investors. The company has been accelerating nicely and establishing a solid position in what is inarguably a crowded space for wedding apps, platforms and service providers. Building a business that demonstrates solid network effect in the wedding space has long been the holy grail of the sector. Due to the seasonal and cyclical nature of the wedding business, the question becomes how does a wedding-focused business build a strong brand and virality and repeatability when its customers are typically single use. As such, it is critical to provide real value to the broader ecosystem of wedding guests, venues and service providers; and we think Joy has done a masterful job of provider a simple, elegant solution that drives value across that ecosystem.
The fresh capital will enable the company to continue building out its suite of solutions and to expand its team. More information on Joy can be found here.
20 Questions with Jonathan Tower
The following is the transcript to an interview with Catapult Managing Partner Jonathan Tower that appeared on Taiwanese Television Network, CTV. The interview was conducted in Taipei City, Taiwan on January 25, 2019.
Q: Welcome back to Taipei City. You were here only a couple months ago. What brings a venture fund from Silicon Valley all the way to Taipei?
While Catapult is headquartered in Silicon Valley, the firm has a global investment orientation. It’s a guiding principle of the firm. We’re focused on working with the best entrepreneurs wherever they compete that are developing meaningful, transformational innovations, and we’re committed to helping those companies achieve global scale. That’s our core value proposition. Geography is not a gating issue for us. And we have a specific focus on investing in underserved markets outside Silicon Valley, which would include a place like Taipei.
Q: But you still invest in Silicon Valley, yes?
Of course. Silicon Valley has been a dominant innovation hub for decades. Historically, we’ve been very successful investing in Silicon Valley companies, and we will continue doing so. But the tech innovation story is no longer just a Silicon Valley story. Great entrepreneurs and transformational innovations are coming from every corner of the globe, not simply from Silicon Valley. And those startups are typically utilizing the prevailing technologies of the day which are making the world a lot flatter and, hence, mitigating the traditional barriers of geography and time zone differences.
Q: How so?
Well, whether you’re a startup based in Mountain View or Madrid you’re likely using something like Amazon AWS and any number of technologies like Slack, Github, Trello, or Asana which are all making working across disparate teams in multiple time zones both more effective and efficient. Moreover, your customers are likely global customers and—unless your product or service has a particularly high-touch local context like prepared food delivery from local restaurants, for example–your customers likely don’t care where you’re headquartered.
Q: True, but what about the concerns about finding talent?
Great teams and great talent are bubbling up from everywhere. When you look at the smaller tech hubs what you often find are many of the same characteristics that made Silicon Valley into the Silicon Valley we know today: world-class universities and research institutions; a great quality of life; an affluent, tech savvy, well-educated population; a deep pool of technical and creative talent; and so forth. What’s not in evidence in most of those smaller innovation hubs is a robust venture capital ecosystem and sufficient mentorship and know-how to help those startups scale beyond their local ecosystems which, by their very nature, are too small.
Q: What about the argument about talent in Silicon Valley being better than that elsewhere? Or that entrepreneurs in other geographies are not as ambitious?
I think these are stereotypes. I spend much of my life on airplanes crisscrossing the globe and I’ve met with all manner of entrepreneurs. I’ve concluded that any notion that only Silicon Valley entrepreneurs have grit or hustle, or a strong work ethic is nonsense. Of course, there are cultural differences here and there. But that does not mean those differences are inferiorities. In many ways, entrepreneurs in smaller geographies, or “geos,” have more of a chip on their shoulder precisely because they know their home markets are small; so, they must think global from day one.
“…any notion that only Silicon Valley entrepreneurs have grit or hustle, or a strong work ethic is nonsense…”
They know that most venture investors will insist that their startups have the potential to expand to the major geos – north America, greater Europe, Asia, and so forth. Dominating a small geo that’s not growing much is like saying you’re the prettiest ballerina in Amarillo. In other words, no one cares. The pond you’re swimming in is simply too small, and the startups you are competing with in that market are not strong enough.
Q: We’ve read recently that there are now more people moving away from Silicon Valley and the Bay Area than moving there. Is that true?
That’s accurate. There has been an exodus of startups away from the Valley and toward other markets—some nearby and some farther away. There is a talent shortage and operating costs have soared. Other areas are picking up the slack. Oakland is booming, for example. Los Angeles is experiencing a nice growth spurt with new VC funds focusing on the region. We like Nashville and Miami also. It’s happening all over. This is not necessarily at the expense of Silicon Valley, mind you. Like I said, the Valley is not going anywhere. It’s a tremendous ecosystem and has had a remarkable track record. But, as I mentioned, we are in a global tech innovation boom. And I’d say we are in the 2nd or 3rd inning of this boom, so we have a long way to run. And, ironically, it is technology itself which is enabling these startups to exist anywhere and to become successful.
Q: Is this apparent exodus of people and startups from Silicon Valley a cost issue?
Partially, yes, but there are many factors. The Bay Area has long been one of the most expensive places in the world to live and/or operate a business. That said, it’s an amazing place and will always attract people and companies that want to be here.
The challenges of living here and/or running a company here are non-trivial, however: hiring, real estate, legal, healthcare, overhead, the constant fear that your best talent will be poached, etc. Many companies are finding it difficult to remain competitive in Silicon Valley so you are seeing some companies move elsewhere and/or have their workers be remote. A top engineering candidate in Silicon Valley might be 2-3x as expensive as a comparable hire in a Tier 2 market. This has real impact for both companies and investors.
Q: How so?
Well, for one thing, your capital does not go as far in an expensive market. As an investor, I want Catapult’s portfolio companies to have enough capital to achieve their objectives, but I also need to be efficient with my firm’s capital, which comes from our limited partners. In a perfect world, an early stage venture investor wants to take as little financial exposure as possible while its startups are navigating the high-risk stage of getting to product-market fit. It’s not clear there is a real business there yet. Seed stage investing has a high morbidity rate because startups are iterating on lots of new ideas. Perhaps there’s a crude product. Maybe there are a few pilots underway. Perhaps there are beta customers. That’s often about it. There is still much that must be de-risked. As such, you don’t want a lot of your precious capital going to landlords and the like when it needs to be allocated very deliberately to investing in whether there is a real opportunity.
Secondly, by its very nature, a less expensive market will give you a longer runway. A modest seed round in a Tier 2 market might provide a company 18 to 24 months of runway. In a more expensive market, perhaps it provides 8-12 months of runway. That’s a huge difference in terms of how far along a startup can develop its product and business before having to return to the capital markets to raise more money. As an early stage investor, I would much prefer that my portfolio company teams be working heads-down on product for 18 months or two years and building something amazing than them having to return to the capital markets in 8 months because they’re running low on cash due to high operating costs. This is a huge advantage of operating in less expensive markets.
And, third, there is the management distraction and the all-consuming nature of fundraising. Every VC wants their companies back at work and every entrepreneur I know wants to get off the fundraising trail and back to focusing again on the business. If you can extend the length of those fundraising cycles, all the better.
Q: Do you see this trend of “remote work” as a fad or a long-term trend?
I prefer to characterize this as “decentralizing the enterprise,” and it’s a theme we have been thinking about a lot. And I do consider it a long-term trend. We are seeing more companies embrace the notion of hiring the best people and teams wherever they exist, geography be damned. And it’s a big departure from the BPO (business process outsourcing) trend of the early 2000’s. It’s no longer about outsourcing call centers. I issued a term sheet for a company a while back where the CEO was based in Seattle, the company’s sales and marketing team was in New York, all technical development was in the Ukraine, and they were a Delaware C Corporation. So you have to ask: where do you exist as a company?
This distributed nature of enterprises creates all kinds of opportunities. It also means great talent does not need to uproot itself to work in its chosen field. It’s becoming more feasible than ever to stay put, live where you wish to live, raise your family where you to wish to, and have a fulfilling career in your chosen field. I think this is very liberating and very exciting—for companies, for their employees, for communities, etc.
Q: We’ve read that talent retention tends to go up outside Silicon Valley and other dominant tech hubs. Do you find that to be the case also?
I think that’s true. The battle for talent is very real and it’s probably most fierce in places like Silicon Valley where the sheer number of startups means talented hires have lots of options of where to work. Moreover, bear in mind that that talent is being fought over not simply by other startups, but by the tech juggernauts as well—Google, Facebook, etc—and they have almost unlimited resources with which to woo the best. And that level of competition drives up compensation and people churn more as a result.
Q: You mentioned that underserved markets had many of the same characteristics of Silicon Valley but on a smaller scale, but that they lacked mentorship and other requirements. What did you mean?
One of the primary challenges we find in many underserved markets is that their venture capital ecosystems, processes and infrastructure tend to be relatively immature. Obviously, this is a generalization and there is wide variation in the issues being faced in a more mature tech hub like, say, Toronto and those in emerging hubs like Nashville. But, for many emerging tech ecosystems one of the primary challenges for startups is finding sufficient venture funding options and sufficient mentorship. In many emerging hubs you might have some active angels and a few regional VC firms of some consequence locally. But oftentimes, those angels and VCs are little known outside that local ecosystem and have little to no footprint in Silicon Valley or other dominant VC hubs. The established VC firms simply don’t know them well.
The challenge this presents is that a startup in a small geo can often times be successful in securing capital locally from angels or seed VC funds, but fairly quickly they exhaust the local VC ecosystem long before they’ve gotten to a scale where they can attract a branded VC firm from Silicon Valley or elsewhere that can help that company achieve global scale. And this presents a problem because many established Silicon Valley firms have gone on to raise increasingly larger funds in recent years. With more capital under management, it becomes difficult for larger funds to justify making small investments in markets that are thousands of miles away. As such, many established funds prefer to wait to invest into a startup that is far away in a market they don’t know well until that startup has gotten to some level of scale, but the Catch-22 is that often these startups never get to scale because their local ecosystem of VCs are not able to continue to fund the company for it to reach the level of scale that it would need to attract an established Silicon Valley VC.
Q: Hence, the Catch-22?
Precisely. At the end of the day, venture capital is a relationship business. VCs typically like to work with other VCs that they know and like and have collaborated with in the past. They have built up scar tissue with these other VCs over good investments and ones that fared poorly. There is a trust that is created over time. These networks are built by having co-invested together. Unfortunately, when a startup is not funded by well-known investors, and is not demonstrating very compelling traction, and is in a small geo far away from established VC hubs, it presents a real challenge.
“…a startup in a small geo can often secure capital locally from angels or seed VC funds, but fairly quickly they exhaust the local VC ecosystem long before they’ve gotten to a scale where they can attract a branded VC firm…”
Fortunately for us, my partners and I have been investing in Silicon Valley for 10+ years over dozens of companies, so our networks here are well-developed. Having done this a long time and having established a strong track record with tier one VCs, I think I can say with some immodesty that we are now a respected “feeder fund” to established VC brands. Our reputation precedes us now such that when we fund a company and make an intro to an established VC firm we’ve worked with in the past, that firm—assuming the startup is a fit for their stage and sector focus—will take the company into consideration because of the degree of social proof that our involvement provides. This, of course, does not guarantee that one of our portfolio companies will be offered a term sheet from one of these VC partner funds but it certainly helps connect our portfolio companies to global pools of capital, which is one of the most important things a seed or early stage investor can do for its portfolio companies.
Q: Do most established Silicon Valley VC firms avoid underserved markets?
Not all the big firms avoid small markets, but many do when the startups are very early. There are reasons for this. Like I’ve mentioned, VCs like to refer deals to one another and like to work with other investors they have some reputational currency with. That’s why you rarely hear a VC admit that he or she financed a startup that came in from a cold email over the transom. VCs like opportunities to be referred by trusted sources. In smaller geos, that’s harder. The local investors are typically not as well known among the established VC community. There hasn’t been an established track record of companies emanating from that ecosystem. It’s harder for the established VCs to diligence that opportunity given they likely do not know many people in that ecosystem—other investors, founders, partners, etc—with whom they can run reference checks on the founders, help with recruiting, and so forth.
Then, there are the partner dynamics at that firm and the post-investment issues. What partner will want to fight the good fight at the Monday meeting trying to convince the other partners why he or she is spending time chasing a seed stage company with a Cap Table of investors that the firm does not know, that’s perhaps thousands of miles away, where there are no ways to clearly diligence the opportunity, and where it is not clear who would be supporting the company or taking a board seat post-investment. For these and many other reasons, established VC firms prefer to focus on companies closer to home and that come through established networks they already have and only consider startups far away when they are much further along in their evolution.
Q: So how do startups coming from these smaller hubs resolve this challenge?
Well, the throwaway response is to build an amazing business such that no one can ignore you. But the more practical approach is to work with investors who can help you bridge the gap between your local VC ecosystem and the more established VC and strategic partner ecosystems in Silicon Valley and elsewhere. Work with investors that are willing to invest in your company when it’s still early but can really add value when you are ready to tap into global pools of capital. Ideally, have an least one investor around the table that can bridge that divide. Having many local angels might be sufficient to get a first product out, but they probably don’t have more capital to deploy beyond their initial check nor the credibility to bring in tier one VCs from Silicon Valley or elsewhere when the startup is ready for its next round. Those investors also might not be as conversant in knowing what established VCs want to see in terms of metrics and traction to support a next round.
“…work with investors who can help bridge the gap between the local VC ecosystem and the more established VC and strategic partner ecosystems in Silicon Valley and elsewhere…”
One of the advantages of being in Silicon Valley every day as we are is having that granular sense of what’s happening here on the ground among the investors and helping our portfolio companies navigate that opaque environment. What are the themes that VCs here are thinking about? Which sectors are in vogue; which are overfunded or out of favor? What firms are ascending. Which partnerships are imploding? Which partners are on the way up; which partners are transitioning out? Which firms just raised a new fund and are actively looking to deploy capital, and which firms are at the end of their fund life? This may seem like a lot of ‘inside baseball’ but it’s critical when contemplating a fundraising process. When a startup’s investors are far away or are not actively networked in Silicon Valley, that level of detailed market knowledge is missing from the equation. The net effect can often be a lot of wasted time pursuing and pitching the wrong investors, or not being aware of the right investors who might resonate with the company and the offering because the company’s existing investors don’t know who they are and/or how to approach them.
Q: Are you implying that most startups still need to raise capital from Silicon Valley to scale their businesses and/or to be taken seriously?
I’m not suggesting that all top VCs are based in Silicon Valley, or that they need to be. Fortunately, there has been a boom in new VC firms forming across the globe. This is great for founders. And, to be sure, there are many highly respected VC firms in smaller geos. My point is that in order to build dominant global companies it is often necessary to have investors that are global as well. And even with the boom in new VC brands, many of these new firms are sub-$50mm funds and focused on seed. Having firms that can straddle those stages and geos is vital.
Additionally, most of the venture capital being deployed on the planet is still being deployed in the US; and within the US, Silicon Valley is far and away the dominant VC ecosystem. Silicon Valley still holds tremendous sway in the VC/tech economy and is a powerful brand in its own right. There remains a powerful halo effect that is conveyed to a startup when an established, highly respected and recognized Silicon Valley VC leads a large round. This is particularly true when the startup had its origins elsewhere. It creates positive signal.
Q: What other differences are you finding in your travels to these emerging tech hubs? Are you investing any differently by looking outside Silicon Valley?
It’s axiomatic that every ecosystem is idiosyncratic and has its pros and cons. When Catapult was founded a lot of time was spent in the formation stage studying how other firms had successfully and not so successfully navigated the challenges of investing cross-border. Obviously, Catapult would not be the first firm to look for startup opportunities in markets far away. We quickly determined that “drive by” investing, however, does not work.
Q: What do you mean by that?
What I am referring to is the practice of flying into a market once a quarter, holding a couple days’ worth of meetings with founders and other investors, and then flying back. That approach doesn’t work. To invest successfully, a firm needs to make a commitment to the ecosystem and develop a ‘boots on the ground’ approach to deal sourcing and post-investment support. This does not necessarily mean spinning up an office in that locale and taking on the OPEX burden of doing so, but it does mean having resources there 24/7. For us, we have adopted a seed scout or venture partner strategy. Our Seed Scouts are often angel investors we already know and have co-invested with in the past, former and current founders the firm has worked with in the past. and people like that who have strong deal flow from the area but are not institutionalized in any sense. They might be writing small checks on their own but that’s it. We bring them onto our platform, provide more capital for them to deploy on our behalf, and share economics with them on investment on which we collaborate. It’s a win-win. These relationships provide us local and cultural expertise in a new ecosystem, and a point person to lead investments and provide mentorship. It also provides the firm an asset who can liaison with the constituencies in that ecosystem daily – coffees with founders and angels, meetups, launch parties, demo days, and the like – and build our brand and our access to great founders and opportunities, writ large. The net effect is to provide Catapult first look at many, if not most, of the exciting startups emanating from that emerging ecosystem in ways that other VCs simply won’t have.
Q: Have you identified areas of strength or differentiation in these ecosystems?
Like I said, there are innumerable differences in these emerging tech hubs. We have a thesis around identifying ‘centers of excellence’ and investing in those areas. When you consider many of the emergent areas of what’s often referred to as ‘frontier tech’ that’s garnered a lot of attention these days—artificial intelligence, machine learning, autonomous vehicles, and so forth—you find that many of the strongest technology teams working today and focused on these areas are coming from smaller tech hubs than Silicon Valley. Take AI, for example. I’d wager that it’s hard to argue that a fund is a serious investor in AI if they are not spending a lot of time in Toronto, or Pittsburgh, or Tel Aviv and speaking with the incredible teams working in those geos. The same can be said for Fintech and places like London, Atlanta and Frankfurt. And there are many others. Therefore, it stands to reason that if a fund has a strong investment thesis in any of these areas they need to be investing in the best teams in these sectors, and these teams are often coming from smaller geos.
Q: How many markets do you focus on now?
We have identified a dozen cities in North America and Europe where we have now or will have shortly a local investor working with us as a Venture Partner or seed scout.
Q: How do you think about Asia?
Obviously, I am a fan of Asia and am closely watching the different ecosystems here. I am in Taiwan today, I leave for Beijing tomorrow. I was in Tokyo in September. Later this quarter I will be in Southeast Asia. I am meeting with all manner of founders, strategic partners, limited partners and co-investors that could work with us here over the long haul. But, for the moment, we are focused on the markets we have already identified. We are still on Fund I and not entirely done with fundraising, so we are being cautious and calibrated in how we scale the firm. But, for sure, there are enormously exciting things happening in Asia and I am confident Catapult will be here in due time.
Thanks for your time. We are excited with what you are doing. Please let us know when you are back in town and we will catch up again on your progress.
Will do. Thank you for having me.
Our Investment in Preemadonna
We are excited to announce our investment in Preemadonna, an emerging consumer lifestyle brand and the company behind the Nailbot, a robotic manicurist which uses a smartphone camera to print full color art on nails in seconds. The Nailbot uses Bluetooth to decorate each nail with only a swipe. Artwork from a smartphone—think photos, emojis, logos, or a custom design—can be rendered into nail art through Nailbot’s inkjet-based technology, which combines the phone’s camera, machine vision and other technologies.
We’re pleased to be participating in this current round alongside Halogen Ventures, SOSV, Draper Fisher Jurvetson co-founder Tim Draper and prominent angel investors. Our journey with the company began in the fall of 2014 when we first met Co-founder, CEO and “lead Preemadonna” Pree Walia. For the next few years we tracked the Company’s progress, including its successful turn at TechCrunch Disrupt SF in 2015, its inclusion as one of only five companies admitted to an accelerator program created via a joint venture between Founders Factory and beauty juggernaut L’Oreal, and at a myriad of other events where the Nailbot was an instant favorite despite a heady field of competitive consumer hardware offerings. At every turn, we have consistently been impressed by the team’s grit, tenacity and vision in taking Preemadonna from raw concept to a company that is now poised to become a leading lifestyle consumer brand with a specific focus on young women.
At Catapult, we found Preemadonna an attractive investment on a variety of dimensions. The Catapult team has a long history of success investing in disruptive ecommerce companies and consumer brands competing in the lifestyle and beauty category, most notably Dollar Shave Club (acquired by Unilever for $1Bn), Jet.com (acquired by Walmart for $3.5Bn) and Madison Reed, a leading subscription ecommerce company focused on women’s hair color and haircare, using chemical-free, fragrance-free and sustainably sourced products. While these companies differ in many ways, the commonality across them was their focus on enormous markets that had seen little innovation in decades; that were rife with channel conflicts and inhabited by complacent incumbents; and, where there existed few technology-enabled solutions. Our thesis behind the investment in Preemadonna was a direct distillation of our experience as investors in DSC, Jet and Madison Reed and our recognition that the nailcare category was another enormous market that was both ripe for a disruptive technology-enabled solution and where a new brand entrant that could build community and fierce loyalty among young women could spur real innovation in the category and delight users. Finally, Preemadonna aligned well with the Catapult brand, culture, how we think about supporting female founding teams (Pree’s co-founder is hardware engineer Casey Schultz), our proclivity for startups tackling relatively overlooked but large markets, our desire to invest in robotics companies focused on the consumer space, and our desire to support mission-driven startup teams that adhere to common goals of diversity and inclusion and are focused on building companies that can achieve global scale.
Yes, Preemadonna is tackling an enormous market opportunity in the nailcare segment. That’s axiomatic. Yet, it doesn’t stop there. The founders have a broader vision of empowering young women and girls by creating technology that nurtures self-expression and originality while simultaneously spear-heading a technology movement in the beauty and lifestyle category. We’re excited to join Pree and the Preemadonna team on this journey. We think there is a great deal of white space ahead and we feel Pree and Casey are the right startup team to coax Preemadonna into its fullest expression.