Venture capitalists are chatting this week about a recent piece from The Information titled “The End of Venture Capital as We Know It.” As with nearly everything you read, the article in question is a bit more nuanced than its headline. Its author, Sam Lessin, makes some pretty good points. But I don’t fully agree with his conclusions, and want to talk about why.
This will be fun, and, because it’s Friday, both relaxed and cordial. (For fun, here’s a long-ass podcast I participated in with Lessin last year.)
A capital explosion
Lessin notes that venture capitalists once made risky wagers on companies that often withered away. Higher-than-average investment risk meant that returns from winning bets had to be very lucrative, or else the venture model would have failed.
Thus, venture capitalists sold their capital dearly to founders. The prices that venture capitalists have historically paid for startup equity in high-growth tech upstarts make IPO pops appear de minimis; it’s the VCs who make out like bandits when a tech company floats, not the bankers. The Wall Street crew just gets a final lap at the milk saucer.
Over time, however, things changed. Founders could lean on AWS instead of having to spend equity capital on server racks and colocation. The process of building software and taking it to market became better understood by more people.
Even more, recurring fees overtook the traditional method of selling software for a one-time price. This made the revenues of software companies less like those of video game companies, driven by episodic releases and dependent on the market’s reception of the next version of any particular product.
As SaaS took over, software revenues kept their lucrative gross margin profile but became both longer-lasting and more dependable. They got better. And easier to forecast to boot.
So, prices went up for software companies — public and private.
Another result of the revolution in both software construction and distribution — higher-level programming languages, smartphones, app stores, SaaS and, today, on-demand pricing coupled to API delivery — was that more money could pile into the companies busy writing code. Lower risk meant that other forms of capital found startup investing — super-late stage to begin with, but increasingly earlier in the startup lifecycle — not just possible, but rather attractive.
With more capital varieties taking interest in private tech companies thanks in part to reduced risk, pricing changed. Or, as Lessin puts it, thanks to better market ability to metricize startup opportunity and risk, “investors across the board [now] price [startups] more or less the same way.”
You can see where this is going: If that’s the case, then the model of selling expensive capital for huge upside becomes a bit soggy. If there is less risk, then venture capitalists can’t charge as much for their capital. Their return profile might change, with cheaper and more plentiful money chasing deals, leading to higher prices and lower returns.
The result of all of the above is Lessin’s lede: “All signs seem to indicate that by 2022, for the first time, nontraditional tech investors — including hedge funds, mutual funds and the like — will invest more in private tech companies than traditional Silicon Valley-style venture capitalists will.”
Capital crowding into the parts of finance once reserved for the high priests of venture means that the VCs of the world are finding themselves often fighting for deals with all sorts of new, and wealthier, players.
The result of this, per Lessin, is that venture “firms that grew up around software and internet investing and consider themselves venture capitalists” must “enter the bigger pond as a fairly small fish, or go find another small pond.”
The obvious critique of Lessin’s argument is one that he makes himself, namely that what he is discussing is not as relevant to seed investing. As Lessin puts it, his argument’s impact on seed investing is “far less clear.”
Agreed. Sure, it’s the end of venture capital as we know it. But it’s not the end of venture capital, because if capitalism is going to continue, there’s always going to need to be risky-ass shit for VCs to bet on at the bottom.
The factors that made later-stage SaaS investing something that even idiots can make a few dollars doing become scarce the earlier one looks in the startup world. Investing in areas other than software compounds this effect; if you try to treat biotech startups as less risky than before simply because public clouds exist, you are going to fuck up.
So the Lessin argument matters less in seed-stage and earlier investing than it does in the later stages of startup backing, and doubly less when it comes to earlier investing in non-software companies.
While it’s a little-known fact, some venture capitalists still invest in startups that are not software-focused. Sure, nearly every startup involves code, but you can make a lot of money in a lot of ways by building startups, especially tech startups. The figuring-out of SaaS investing does not mean that investing in marketplaces, for example, has enjoyed a similar decline in risk.
So, the VCs-are-dead concept is less true for seed and non-software startups.
Is Lessin correct, then, that the game really has changed for middle- and late-stage software investing? Of course it has, but I think that he takes the concept of less risky, private-market software investing in the wrong direction.
First, even if private-market investing in software has a lower risk profile than before, it’s not zero. Many software startups will fail or stall out and sell for a modest sum at best. As many in today’s market as before? Probably not, but still some.
This means that the act of picking still matters; we can vamp as long as we’d like about how venture capitalists are going to have to pay more competitive prices for deals, but VCs could retain an edge in startup selection. This can limit downside, but may also do quite a lot more.
Sharma thinks, and I agree, that venture winners are getting bigger. Recall that a billion-dollar private company was once a rare thing. Now they are built daily. And the biggest software companies aren’t worth the few hundred billion dollars that Microsoft was largely valued at between 1998 and 2019. Today they are worth several trillion dollars.
More simply, a more attractive software market in terms of risk and value creation means that outliers are even more outlier-y than before. This means that venture capitalists that pick well, and, yes, go earlier than they once did, can still generate bonkers returns. Perhaps even more so than before.
This is what I am hearing about certain funds regarding their present-day performance. If Lessin’s point held up as strongly as he states it, I reckon that we’d see declining rates of return at top VCs. We’re not, at least based on what I am hearing. (Feel free to tell me if I am wrong.)
So yes, venture capital is changing, and the larger funds really are looking more and more like entirely different sorts of capital managers than the VCs of yore. Capitalism is happening to venture capital, changing it as the world of money itself evolves. Services were one way that VCs tried to differentiate from one another, and probably from non-venture capital sources, though that was discussed less when The Services Wars were taking off.
But even the rapid-fire Tiger can’t invest in every company, and not all its bets will pay out. You might decide that you’d be better off putting capital into a slightly smaller fund with a slightly more measured cadence of dealmaking, allowing selection at the hand of fund managers that you trust to allocate your funds among other pooled capital to bet for you. So that you might earn better-than-average returns.
You know, the venture model.