Ep. 1- Evolution of Venture Capital Pt. 1

Venture Capital has changed quite a bit over the last 20 years years, to the point where Bill Ericson, Founding Partner at Wildcat, believes that it’s time to step back and stop calling anything that invests in a technology company that is nonpublic “Venture capital”.  For he and the Wildcat team, the very term venture capital has been mutated, without precision.

It was a cottage industry where funds were small – $100-$200 million even, with brands like Sequoia and Kleiner Perkins – and those funds created very high returns. The landscape has now morphed into an environment where there are significantly more funds available with many of the dollars being raised by very large funds. In fact, two thirds of all venture capital money goes into funds that are over 500 million, which is almost twice the share seen 10 years ago.

Venture also began as a business of high capital efficiency which was a core metric for the likelihood of a company succeeding. As a result, the round size was not large. In fact, in the nineties, a Series A of $4 million was a hot commodity. 

Fast forward to today, startup investment has changed dramatically as round sizes have increased exponentially. In the last couple of years, rounds over a hundred million accounted for almost half of the venture capital dollars as venture capital is defined. Much of this change is centered around the ever-increasing size of funds – as funds get larger and larger, these bigger funds have to put more capital to work. 

The Impact and Drivers of this Sea Change  

With funds increasing, so too have check sizes and as such, investors have started waiting to invest until later. Investment dollars are going into companies that already have products, are in market and have customers – these are now established companies. 

As a VC you’re not as focused on doing market analysis and that entrepreneurial assessment, but rather it’s shifted to spreadsheet analysis. You’re in a different game because a Series A isn’t truly early stage anymore.

Bill’s view on what has been driving venture investment over the past several years is non-venture players (e.g. family offices, sovereign wealth players, large asset managers who are not capital venture professionals) playing in venture, particularly in the later stages.

They are looking at big assets and are willing to put a lot of money into companies that are still fairly immature as a business. So, with more capital needing to be deployed as fund sizes have gotten larger, what Bill and the Wildcat team have seen consistently in venture is a decline in returns. 

It’s now created this dynamic where many VCs have traded off higher returns in exchange for more certain returns. Further, with this shift to later stage and growth stage, liquidity events are also happening sooner – but that’s not the return and investment time horizon that venture capital has typically delivered. 

In fact, venture as an asset class is now being compared from a risk and reward perspective among non-traditional investors to private equity and hedge funds which is misleading. It’s also making these investors question whether typical VC fund fees are worth it because of the return compression. 

The Reality – Why Bigger (Funds) isn’t Better

With the basic dynamics of the industry having changed, investors are not necessarily understanding that these big funds are going to generate much tighter returns.

It’s going to be much harder to see a 5x or even 10x return on a fund when you’re trying to invest a billion dollars- it’s a simple math problem. The real question for investors is whether they are looking for outsized returns or are satisfied with investments that have a good, but not great, IRR.

Bill and Wildcat’s view is that smaller funds are better from a multiples standpoint. It’s about getting back to the business of venture capital which is true early stage. 

It’s a high risk, high reward business because venture investing is all about taking risks. To drive those returns, it gets back to the power law of venture portfolios – this law of large numbers where you have really big hits but also big losses. Yet the small subset of winners more than compensate for those losses. Whereas in late stage portfolios, they tend to follow a normal distribution vs. that power law distribution. 

To generate those 3-5x returns that investors expect from venture, fund size does matter, and bigger isn’t better in this case. In fact, funds over 250 million in size have generally generated lower returns. Further, Kauffman report data suggests that fewer than 15% of funds over 400 million outperformed the public markets.

And contrary to what most may think, early stage is not necessarily more risky than later stage. In fact, a well-managed venture portfolio, focused on big winners and breakout opportunities at the earliest stage of those companies, should be low risk but high reward. The whole beauty of a really well-constructed venture portfolio is that it’s low risk as a portfolio, but has the ability to generate high returns. And a key dynamic of that is the size of a fund.

So from Bill and Wildcat’s perspective, early stage and small fund size is key to driving investment traction.

Tune in to our next podcast episode where Bill will discuss what’s critical to unlocking the trapped value that exists from the market, people and ideas, as well as generating the best returns sustainably. 

Traction and Trapped Value is produced by Flywheel Associates