A large corporation recently requested my advice on how to set up and structure their venture fund, which they wanted to base in Silicon Valley. This corporation had initially set up a venture fund in the late ‘90s to invest in Internet startups. By 2002 they closed down the fund after determining that its portfolio companies had lost their financial value and had created little intellectual property of interest. But the startup activity of the last four years and the disruptions startups are causing in the company’s industry is leading it to re-establish its fund. This example, and many other similar ones, demonstrates a recurring theme of the past three years: corporations from a variety of industries are establishing, or re-establishing, venture funds in Silicon Valley, and other innovation clusters, and are aggressively participating in startup financing rounds. According to Global Corporate Venturing today 1100 corporations have active venture funds. The number of funds has doubled since 2009 and 475 of which have been established since 2010. VentureSource reported that corporate venture capital firms (CVCs) invested $5 billion during 1H14, a jump of about 45% from a year earlier and the highest level since the dot-com era. The emergence of corporate venture capital as a major source of startup funding has been the result of two factors, the first accidental and the second intentional. First, because institutional venture capital is being disrupted, corporate venture capital is able to fill some of the void that is created and emerge as an important startup-financing source. Second, as was previously discussed, corporations intend to access externally developed disruptive innovations by participating in the financing of startups. This blog examines what CVCs need to understand about the institutional venture capital disruption in order to best capitalize on the opportunities it will create. In the next blog I will explore how to best set up a CVC organization so that it can provide the corporation with impactful, over the horizon visibility to technologies, business models and startups that can help it achieve its innovation goals while becoming a trusted and value-added partner to entrepreneurs.
Institutional VC Disruption
I am not the first person to comment on the disruption experienced by incumbent institutional VCs (IVCs). Others (and here) have commented extensively. However, I wanted to use my 15-year experience as an institutional investor and the data I collected from my more recent interactions with large corporations and their CVCs to introduce my perspective on how corporate venture investors can capitalize on this disruption and become long-term, value-add contributors to the evolving investor ecosystem. CVCs will need to continue relying on and collaborating with IVCs in order to achieve their investment goals. They must understand what is causing the disruption, as well as the venture investment ecosystem that is emerging as a result of the disruption.
Incumbent IVCs have been disrupted for three reasons. First, disappointing returns from early stage investments made by incumbent IVCs over the last 10-12 years led institutional LPs to make smaller venture allocations to these investors causing many of them to shrink or close down their firms, or completely change their investment strategy. Second, new types of investors, as well as a new generation of IVCs, are introducing innovations that are disrupting incumbent IVCs. Third, entrepreneurs are demanding more than money from their venture investors, and are increasingly working only with investors who can address all their needs.
CVCs can also become disruptors. For the most part they don’t have to worry about investment returns. They must be able to innovate, fit in the emerging venture ecosystem, and try to meet the needs of the new generation of entrepreneurs, as the other new types of investors appear to be doing.
In 1991 I started working with VCs as an entrepreneur. In 2000 I joined a venture firm as a partner and have been a VC since then. Through these two different lenses I saw that until four or so years ago there has been little innovation in the institutional VC model. A venture partnership would raise a new fund every 3-4 years from LPs that usually included endowments, foundations, pension funds and family offices. The basic terms under which LPs invested remained unchanged from fund to fund (10 year fund life, with a 5 year investment period, 2.5% annual management fee, and 20% carry). During the period 1995-2000 (dot-com era) the model kicked into high gear; many new firms were established, including around 500 corporate VCs, and more, and bigger, institutional funds were raised (see Figure 1).
Figure 1: Number of funds raised by US technology VC firms (Prequin)
Unfortunately most of these funds produced lackluster venture returns for over a decade following the 2001 recession (see Figure 2).
Figure 2: Net IRR outperformance versus Russell 3000 Index
As a result, most LPs moved away from the venture asset class leading many incumbent IVCs to start shrinking and changing investment strategy becoming private equity or growth equity funds, close down altogether, or becoming “zombies” (and here) and be on their way of closing down. Flag Capital estimated that by 2010 only about 75 of the IVCs that existed in 2000 were able to raise new pools of capital (see Figure 3). Of the 500 CVCs that were established during the dot com era, 200 had closed down by 2004.
Figure 3: Number of active US institutional venture firms (Flag Capital analysis)
Not all of the incumbent IVCs were impacted by the shrinking LP venture allocations. In fact, the firms included in the bar chart of Figure 3 are actually split into two groups: the top tier group and the second tier group. The top tier group saw little change in the allocations they were receiving from their LPs. This group includes approximately 20 IVCs, such as Sequoia, NEA, Benchmark, and Greylock, and has remained largely unchanged, with only few exceptions such as the addition of Andreesen-Horowitz. The members of this group continue to capture the majority of the capital allocated by institutional LPs to the venture asset class. They can raise new pools of capital almost at will and under the same terms as in the past because they consistently provide superior returns and consequently are in strong demand by LPs. Their LPs allow them to use the capital they raise to employ different strategies and create specialized investment vehicles, such as Andreesen’s Google Glass fund, Accel’s Big Data fund, and Greylock’s Growth fund, as they see fit.
The second tier group has been the one impacted the most. The returns of the firms belonging to this group, particularly those attributed to early stage investments, have been inconsistent and weak. LPs are funding fewer of these firms, giving them smaller allocations when they fund them, and for these allocations demanding economic terms that provide better alignment between LP and GP. For example, LPs ask for smaller fees, higher investment rate in the existing fund before raising a new fund, higher contribution to the fund from the GPs, close scrutiny of the board seat capacity of each investing partner, requirement for side by side investing, clearer definition on when the GP can take carry, and a few others. All these factors made the second tier incumbent IVCs vulnerable to disruption.
New venture investors
These days an entrepreneur can start an information technology-based company (software, internet, hardware) for significantly less capital than was required 5 or so years ago. This capital efficiency combined with the abundant capital available globally and looking for a place to get above market returns, and the interest by LPs in new investment ideas and structures has led to the arrival of new types of investors that today compete with incumbent IVCs in general and the second tier group in particular. Six types of competitors have emerged:
- Crowd-funding platforms such as Kickstarter and Indigogo.
- Superangels (and here) that also use platforms like AngelList through its Syndicates feature to support their efforts.
- Micro-VC funds (see examples in Figure 4) that raise smaller pools of capital than IVCs, typically less than $50M, and invest in seed stage companies. These firms bridge the gap between angel and Series A investments, and oftentimes have a single GP. CB Insights estimates that today there are already 135 micro-VC firms.
Figure 4: Sample set of micro-VC firms (Samir Kaji and CB Insights survey)
- Emerging venture managers, e.g., firms such as Emergence Capital, Shasta Ventures, Union Square Ventures, Greycroft Partners, that raise $100-200M per fund primarily from institutional LPs and typically build their firms around deep sector expertise, e.g., SaaS, digital media, consumer internet.
- LPs, both institutional and family offices, such as Top Tier Capital Partners and Aeris Capital, that have set up direct investment groups or are expecting to invest side by side with the GPs they support.
The first five of these investor types, let’s call them new-style VCs, not only create competition to incumbent IVCs but they have also introduced disruptive innovations that are having a big impact on the venture ecosystem. These innovations include:
- Different ways to generate deal flow. These investors create deal flow by reaching out to entrepreneurs, often using big data methods and other technology-enabled approaches their portfolio companies use to sell their solutions.
- Providing value-added services to each portfolio company, developing community and maximizing collaboration among the portfolio companies to allow entrepreneurs and management teams to learn from their successes and failures.
- Different ways of managing portfolio companies. Create larger portfolios of smaller investments, but always be ready to quickly terminate support to underperforming portfolio companies and increase support to the ones that perform well.
- New types of GPs. New-style GPs tend to be ex entrepreneurs with technology and/or product background and knowledge on how to start and build companies in today’s business environment. They want to share the risk and the upside of making each startup a success.
- Concepts such as lean startup, minimum viable product, business model canvas, agile development and design thinking that are revolutionizing startup creation are being broadly embraced by new-style VCs and their portfolio companies.
To appreciate why I consider these as innovations you need to understand that the majority of the old-style VCs develop their deal flow either with inbound requests for money or by networking with other venture investors they know well, bankers and other intermediaries. To entrepreneurs they emphasize their investment experience and legacy, financial expertise, willingness to support their portfolio no matter what, hands-on governance style, and thought leadership in the VC ecosystem. These investors tend to interact with their management teams primarily in board meetings. Finally, they often continue investing in portfolio companies even when these are underperforming over the long term, because of a belief that abandoning such companies will negatively impact their reputation. In fairness, there have been situations where long term support of a venture-backed company that was underperforming for some period was handsomely rewarded by the market, but these cases are exceptions.
In several private conversations with LPs and venture investors I also heard first-hand what appears to be developing as a trend over the past three years: while the institutional LP appetite for the venture asset class is starting to increase, there is a definite preference to support smaller funds ($80-200M), see Figure 5, that invest in new ideas, e.g., consumerization of the enterprise, big data infrastructure, and consumer internet. These funds allow for better LP/GP alignment and demonstrate good returns more consistently. For this reason, I expect that we will continue to see the creation of new micro-VC firms and emerging venture manager firms.
Figure 5: VC Funds closed 11/13-4/14 (CB Insights)
What entrepreneurs want
In the last 5-7 years, entrepreneurship has changed dramatically. Even in countries where employment in a large corporation or government agency was considered a young person’s career goal, entrepreneurship is now promoted, celebrated and starting to flourish. Today’s hyper connectivity allows entrepreneurs from around the world to rapidly share ideas, information and best practices, make fewer mistakes and get to market faster. Though only a small percent of these entrepreneurs are backed by institutional venture capital, the information disseminated among entrepreneurs points to significant differences between what entrepreneurs want to receive today from their investors and what they have actually been receiving in the past.
Younger entrepreneurs gravitate towards the new-style VCs. To better understand the difference in perspectives between old-style VCs and the new generation of entrepreneurs and old-style VCs it is instructive to see the results of two surveys that were conducted 2013. The first survey (and here) is about the characteristics which entrepreneurs value in a VC compared to the characteristics VCs emphasized about themselves (Figure 6).
Figure 6: Characteristics valued by entrepreneurs and VCs (DeSantis Breindel)
The second survey (Figure 7) is about the VC characteristics entrepreneurs consider important when they are choosing a venture investor. In this survey operational and industry experience emerge as very important characteristics in a VC along with strategic insight, scaling guidance, recruiting support, business development and customer and partner introductions.
Figure 6: VC characteristics valued by entrepreneurs (Upfront Ventures)
The CVC opportunity
CVCs can take advantage of the IVC disruption and become major and long-term factors in the venture investment ecosystem. To do so they must:
- Demonstrate consistency with their investment approach and continue supporting startups even during averse economic times.
- Become good investment partners to IVC syndicates by showcasing the value they can provide.
- Establish well-thought out investment themes and theses that reflect the corporation’s innovation needs.
- Demonstrate their value to entrepreneurs.
CVCs are well suited for adopting the characteristics of new-style VCs. Moreover, they have the opportunity to provide additional unique value to entrepreneurs making them even more attractive early stage investors. In particular, CVCs could provide:
- Access to company personnel and through them business and process knowledge to help the startup build a better application.
- Access to company executives who can offer operational support and mentorship to the startup.
- Investments with fewer conditions than a typical institutional VC because they don’t have financial objectives as IVCs do.
However, to succeed, in addition to these characteristics, they will need to make a concerted effort to adopt an investment culture, approach and infrastructure which to date we haven’t seen from most CVCs. Their investment culture will need to be coupled with a corporate culture that would favor moving fast and in general working differently in an effort to quickly assimilate the most promising of the innovations being funded by the CVC. The adoption of the right culture is the hardest issue and a topic I will address in my next blog.
Second tier incumbent IVCs have been disrupted by a new set of competitors that includes new-style VCs. The disruption was driven by their poor performance for over a decade, the innovations of the new-style VCs, the changing LP expectations for better LP/GP alignment and the evolving needs of entrepreneurs. Corporate VCs have the opportunity to capitalize on this disruption and become important members of the venture ecosystem providing great value to the new generation of entrepreneurs.