The VC industry is beneficial to innovation ecosystems… but that doesn’t mean it will survive in its current shape

The beneficial role of VC on innovations eco-systems is clearly established

Whilst it may be an underperforming asset class, the VC industry has nonetheless established itself as an indispensable element of innovation ecosystems. Evidence shows that VC-backed start-ups grow faster and bigger than bootstrapped start-ups. I identify two main reasons for this: firstly, VC-backed start-up gain greater financial stability (and are free to “aim for the stars”) and secondly VC investors add tremendous value by teaching entrepreneurs the ropes of growth hacking. 

1. VC as a reliable source of finance: just like bigger and established companies, start-ups operate in an increasingly turbulent business environment. A big part of why venture capital actually is important is because it helps start-ups stay the course and ignore cyclical fluctuations in the public market, in the late-stage investors market, and even, for that matter, in the consumer market. VC funds have a 10-year lockup on the money they receive from Limited Partners, so an industry segment can go in and out of fashion several times in 10 years and that’s something that VC-backed start-ups can disregard because they have the financial stability to stay the course
2. VC investors as growth hackers – in the B2C segment: Oliver Samwer, one of the co-founders of Rocket Internet, a successful but most controversial VC fund, has put to the test the recipe for success that he laid out in the academic thesis he wrote in 1999 (I am paraphrasing two key arguments from that thesis below)

The fast pace of change today means that B2C start-ups need a lot of funding from the start to create an aura of success, claim leadership in a hot market and sustain this claim. To achieve this, they need a comprehensive operations team (including marketing and sales) right from the start. Essentially, what many companies in the Silicon Valley do is to declare victory before they have won. In fact, they may only have a beta site and not yet shipped or even developed a working product

A very important game in the B2C segment is securing mindshare of the target consumer population – that’s a game that requires a great PR network and a serious advertising budget. In many industries customers rely on the press, analysts and other influencers for their purchasing decisions. Especially in industries that move very fast such as the fashion  industry, customers cannot keep up with all the things that are happening and they make their decisions based on what key opinion leaders say

3. VC investors as growth hackers – in the B2B segment: For B2B start-ups, securing the first 10 major corporate clients is absolutely crucial. According to Chi-Hua Chien from Kleiner Perkins if your start-up is the first to reach this milestone then the chances are you have beaten the competition already. In that context, B2B start-ups can gain a clear advantage over their competitors by choosing to partner with the appropriate VC fund since the top-tier Venture Capitalists are incredibly well-networked and can effectively be seen as gatekeepers: they have direct access and influence over key enterprise accounts (you may call this the “Harvard MBA advantage”).

However, the VC industry not only performs poorly as an asset class, it also needs to evolve in the near future due to the increased involvement of new types of participants

The ongoing economic crisis acts as a wake-up call for developed economies and a painful reminder that sustaining wealth and a large pool of high value-added jobs is heavily reliant on winning the innovation game. There is also a wide understanding that the availability of early-stage capital is an essential condition for a thriving innovation ecosystem, very much in the same way that rich nutrients carried by the warm East Australian Current are a key condition to the fertility of the Great Barrier Reef.

EAC

(picture from oceanclimatechange.org.au)

As a result, three categories of players in developed economies are upping their role in the provision of early-stage capital and challenging the traditional VC model:

  • Major corporations are setting up their own Corporate Venture Capital funds (think Intel Capital and Google Ventures) – I have already described in a previous article recent developments in the CVC industry
  • Governments are increasing their participation in VC funds / PE funds and even setting up new investment structures in order to fill the funding gap affecting some innovative industry sectors. Cleantech is a typical example: New York Governor Andrew M. Cuomo proposed in January 2013 a $1 billion “Green Bank” to draw in private sector money and spark investment in clean energy projects; likewise, Greencoat U.K. Wind Plc aims to raise £205m via its IPO on the London Stock Exchange in March 2013 with strong support from the UK government (the Department of Business, Innovation and Skills plans to take shares worth about £50m)
  • The Crowd: crowd-funding platforms such as Kickstarter, Fundable and Crowdfunder enable you and me (anyone really; no need to be a professional investor) to donate money in order to support start-ups

Out of these three categories of participants, crowd-funding is by far the most exciting development. A study from Crowdsourcing.org reported that about $1.5 billion was raised from 452 crowdfunding platforms in 2011, and this was expected to double by 2013.

And it’s not just about seed rounds; we are now seeing mammoth series A rounds going down that route too… I was fascinated by a piece of news last week that describes how an entrepreneur raised $8M in two weeks (!) via AngelList, a social network for business angels and professional investors, establishing itself as the largest crowdfunded Series A round to date.

It is truly amazing to see the speed at which crowdfunding has become an effective fund raising method for legitimate startups, despite the fact that the payback for people giving away their money has so far been limited to goodies such as T-shirts, novels, CDs, and a few new toys.

Still, this is just the beginning. The passing of the JOBS Act is about to accelerate that growth even further as it will allow private businesses and startups to sell equity (i.e. shares of their business!) via crowdfunding. Once the rules are in place later this year, anyone will be able to become an investor in a start-up and to get an actual monetary return. Fred Wilson, co-founder of the venture capital firm Union Square Ventures, predicts that once it gets up and running the equity crowdfunding market could reach $300bn, largely driven by families and individuals investing a small percentage of their assets via crowdfunding. As a point of comparison, the total amount invested by traditional VC funds across all industry sectors and all stages of maturity in the US in 2012 was $24.3bn (according to latest NVCA data)… In other words, the VC industry could very soon get crowded out…

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s