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.