September 3, 2014

Understanding the Changing Face of the Venture Industry – Part 2

The key for investors is to be prepared to shape their portfolios for the next shift in the opportunity set and not get too fixated on what worked in the past @TimBliamptis @WeathergageTeam

Further de-mystifying the changing landscape in the venture industry.

In my last post, I discussed how the migration of opportunities up the technology stack disrupted even the elite ranks of the venture industry. This post addresses a second consequence of that migration that has impacted the very structure of the venture industry: the resurgence of small funds focused on the earliest stages.

Why have venture fund sizes become barbelled?

Software development costs have collapsed. This phenomenon is at this point widely reported. Thanks to the easy availability of libraries of code and services, software developers no longer have to recreate the wheel when writing a new application and can instead focus their energies on their specific application. Tricky and expensive to craft capabilities like login and security, transaction processing, etc. are now effectively infrastructure, available for rent at very modest cost. As a result, an application that in 1999 might have taken a building full of engineers two years to write can now be cranked out by a couple of college kids in a Red Bull fueled weekend. I exaggerate, but not by much.

The costs of finding product/market fit have collapsed. It also costs much less to test an application for market fit. Consumer applications don’t spend a lot of time in alpha or beta. Entrepreneurs put them out on the web and see what happens. That weekend in the dorm can easily be followed by a trial run on Monday with feedback on Tuesday. In the case of Facebook, the first test ended when overwhelming demand for the nascent application crashed the Harvard University server only a few hours after the software was put up.

Now to the “small fund” end of the barbell. How much did it cost to start a software company in 1999? Well two years work for a building full of engineers might have cost on the order of $10MM. That was Series A. Testing and market fit pre-internet could take another $10MM in a Series B. That’s $20MM of investment before revenue. Add another $20MM in a Series C for the rollout and that’s a $40MM ticket. Split it two ways and each investor is on the hook for $20MM. $500MM early stage venture funds make perfect sense in such a world.

But back to the dorm room. How much does a case of Red Bull cost? Seriously, thanks to the greatly reduced costs to develop software applications the initial development costs are on the order of a few hundred thousand dollars. Similarly, the cost to find product market fit is a few hundred thousand more. The time frame is also shorter. So a $500,000 investment and maybe three months can accomplish what took $20MM and three or four years in 1999. $500,000 investments don’t make sense for $500MM funds. But they do for $50MM funds. Micro VC and small VC funds are pursuing this opportunity aggressively, and the most successful of them rapidly become closed to new investors.

Importantly, the fact that the software development phase has become inexpensive does not necessarily mean that the opportunities are small. In fact, the opportunities for software-based companies are colossal. Software based companies are reinventing existing industries that generate tens and hundreds of billions of revenues. It’s not too big a leap of faith to see that a company that successfully reinvents a $30B industry will ultimately have a market value in the multiple billions of dollars.

However, the fact that the software development phase has become inexpensive does not necessarily mean that growing and expanding such companies is similarly inexpensive. Building a billion dollar company still takes growth capital, and lots of it.

Enter the billion-dollar venture capital fund. The venture firms that have proven their success in the current cycle have the ability to raise large amounts of capital, and many have. Where can they deploy it prudently? Supporting the growth of the new crop of application companies. The largest funds compete for these investments on the strength of their ability to help these companies grow “to the next level”, where the next level might be $100MM of revenue from $20MM. Or a $1B of revenue from $200MM. Brand matters tremendously in this competition. Entrepreneurs look to these players for:

1. the critical mass that a large bolus of capital provides,

2. the opportunity to work with high profile general partners with track records of success in helping other companies achieve ambitious growth targets and exits, and

3. access to other resources such as recruiting, research, and business development assistance.

It’s hard for the typical $200-300MM VC fund to compete for such investments—it’s too big to effectively engage at the seed stage and it’s too small to run with the big dogs. Thus the barbell effect is the industry’s logical response to the shape of the current opportunity set.

Conventional wisdom to the contrary, the venture capital world is dynamic. The key for investors is to be prepared to shape their portfolios for the next shift in the opportunity set and not get too fixated on what worked in the past. That means building access to the venture capitalists who have great brands with the entrepreneurs who matter today.

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A nautical term that indicates a favorable position relative to the wind. A ship that "has the weathergage" has the initiative and hence a significant advantage over its rivals.