VC Evolution: Physician, Scale Thyself.

TL:DR: This post aims to recap significant changes in the venture capital industry over the past ten years, and then make some [biased] predictions as to major forces at play in the next five years. In particular, I hope to highlight some less obvious [r]evolutionary shifts that people outside the industry may overlook. This is a long piece, so if you’re not a fan of inside baseball, skip it.

Vitruvian Man, Leonardo Da Vinci

Big Funds, Big Brands, Big Data.

While institutional LPs know big changes are happening, most focus too much on 1) increasing/decreasing fund size or 2) marketing + branding as the major trends. Both are notable, but the more significant evolutions going on are: 1) a shift towards operators vs financiers as fund managers, along with growth of non-investment staff, 2) use of technology and scalability in how investments are made via tools, data, teams, and process, and 3) the emergence of branded guilds as dominant entities / communities that attract the lion’s share of new deals and talent.

It’s no coincidence we designed 500 Startups with these evolutions in mind, altho none of the required strategies have been easy to execute and we are still refining our approach. However, all three shifts are related and can be summed up simply as: Geeks are Taking Over Venture Capital. Or, as my friend Marc Andreessen might say, Software Eats the Private Equity World.

Ok, let’s dive in and discuss in more detail.

Mega VC, Micro VC

In the past ten years there have been several dramatic changes in venture capital. While a flood of new VCs came into existence during the late 90’s internet boom, many had difficulty raising new funds after the crashes of 2000-2001 and 2008, and as a result significantly fewer fund managers exist now compared to a decade ago. Among the remaining survivors, there have been two notable types: huge Mega VC funds with over $1B under mgmt such as Andreessen Horowitz, Greylock, Accel, Sequoia, Benchmark, Kleiner, and Khosla; and smaller, more nimble “Micro VC” funds (typically <$100M) like First Round, Floodgate, Felicis, Harrison Metal, and SoftTech. (note: apologies in advance for the west coast bias; i’m in silicon valley)

These two divergent groups have optimized for very different market conditions and behaviors. Mega VC has focused on the challenges of the post-SarbOx IPO market in the US, and has discovered opportunity in offering larger amounts of growth capital ($10-100M+) to private companies with reduced access to public markets. Meanwhile, Micro VC has focused on sweeping changes in technology and consumer internet adoption that have enabled dramatically reduced capital requirements for building new software companies, as well as accelerated access to customers via search, social, and mobile platforms.

Micro-VC: The Artist Formerly Known as “Super Angel”

The “Micro-VC” funds (also known by the misnomer “Super Angel funds”), started as far back as the mid-90s with Ron Conway and earlier incarnations of his SV Angel fund. Many of these now-trendy Micro-VC funds began as individual angel investors who gradually grew up and started small funds (myself included). One of the earliest and most well-known of the Micro-VC funds was First Round Capital, founded in 2004 by Josh Kopelman, a former entrepreneur who sold to eBay in 2000. The major change Josh and his team recognized was that startup costs were dropping dramatically in post-crash early 2000s, and by investing in a larger # of smaller seed rounds at $250K-$1M, rather than fewer / later Series A rounds at $2-5M, they could capture more winners & success earlier in the funding lifecycle. First Round became a very active investor in consumer internet and e-commerce, on a rather lean investment budget, with several notable exits (including to Intuit in 2009 for $170M).

Other angel investors and smaller funds also copied this innovation, and many of these new Micro-VC fund managers (like me) came from operational backgrounds at companies like PayPal/eBay, Yahoo, Amazon, or Google, rather than finance backgrounds from investment banking or Wall Street. We were familiar with internet startups and technology platforms, and we had experience using email, blogging, search and social techniques for internet marketing. In short, we were a lot more geeky than the previous generation of fund managers, and we started blogging a lot about tech startups and best practices. One in particular i’ll come back to later was Naval Ravikant, who with Babak Nivi started Venture Hacks, a blog with tips & best practices for entrepreneurs, and later Angel List, which has dramatically changed VC.

As a result of all this Super Angel / Micro VC activity in the latter half of the decade, many larger, more prestigious Silicon Valley firms began losing some visibility and influence with the entrepreneur community, as that of First Round and Ron Conway and the PayPal Mafia and others similarly grew in influence. The defining jump-the-shark moment for this group was likely “AngelGate”, the Bin 38 dinner meeting of September 2010, where blogger Mike Arrington, founder of TechCrunch, famously accused many of us (yes, I was there) of attempting to collude and drive down prices of early-stage startup deals, especially those from Y Combinator, founded by Paul Graham. (and no, we didn’t. but the food was awesome, & the PR wasn’t bad either)

Rise of Y Combinator, 1st Branded Entrepreneur Guild

A few years before all this scandalous VC behavior occurred, in 2005 Paul Graham started Y Combinator. YC began as a small startup accelerator program making very tiny (~$20K) investments, but in a few short years grew quickly to become the most famous (some would also say most dominant) program for aspiring young internet entrepreneurs. In its first 2-3 years, YC was viewed as a rather risky experiment in “spray-and-pray” investing, and PG was viewed as a maverick. However after Sequoia and Ron Conway announced their investment in YC in 2009, and after YC alumni DropBox and AirBnb raised capital on billion-dollar valuations in 2010-11, the program quickly became the gold standard among early-stage startup incubators. YC now runs 2 programs per year, with over 80 companies in the current batch, and is highly respected both by VCs and entrepreneurs all over the world (and their valuations reflect that as well).

However, while YC was growing in prominence & valuation, and scaling the # of companies it was funding every 6 months, something else happened. After the first few years of operations, some 50-100 companies had gone through YC, and many of them stayed in touch and supported each other as well as newer batches of startups that were coming into YC as well. This alumni network of YC founders became extremely helpful & influential, both online and off, and in many ways began bearing some resemblance to a modern-day guild – an association or union of craftsmen, or in this case a union of startups & startup founders that was unlike any other. And in addition to helping each other, they also started funding each other, and even helped YC select future batches of founders.

Now this might sound like a minor development, but actually it’s something that is changing the entire playing field. While some attribute YC dominance to Paul Graham’s excellent selection of founders, or his ability to coach founders to raise at ever-higher valuations, or the branding of YC overall, i would actually argue that none of these is as powerful as the network of YC alumni, and their willingness to support, mentor, & fund each other to success. IMHO, this is what is really valuable about YC, and why it’s difficult for others to copy.

YC is a VC fund that looks and operates like a guild of geeks, and hardly looks anything like a traditional fund comprised of VC partners with MBAs or finance degrees. They are operators, through and through.

Investing in Non-Investment: The “FULL SERVICE” VC

Along with the trend towards hiring VC partners with more operational experience, we are also seeing substantial growth and investment in non-investment staff at several funds, particularly those that focus on early-stage companies. Some of the more notable examples of this include Mega VC Andreessen Horowitz, which has invested considerable resources in growing its in-house recruiting and business development functions. Another new firm that is growing non-investment resources is Google Ventures, which has specialized in several areas including design and data analysis. One other firm that doesn’t always get a lot of popular acclaim but has a ton of operational expertise & widely global reach is Rocket Internet.

And of course then there is our own fund, 500 Startups. From the beginning, we focused on “Design, Data, & Distribution”, recruited hundreds of mentors around the world with operational expertise in these areas, built close relationships with major internet platform companies like Google, Facebook, Amazon, Twitter, LinkedIn, YouTube, PayPal, and others, and created and run our own conferences on focused startup topics like Design, Marketing, and Monetization, among several others.

But why are we all doing this? What’s the benefit in investing in people who don’t write checks or make investment decisions? Why bother with all the extra costs, people, programs, etc? Isn’t this just a lack of focus? Well, we don’t think so, and we’re pretty sure the other firms mentioned above don’t think so either. For many early-stage companies still working on their product or developing customers, most of their challenges do not require large amounts of capital nearly as much as they require expertise – particularly in engineering, design, and marketing.

Funds that offer serious expertise and mentorship in these areas have a substantial advantage – both in being able to attract higher quality founders and companies who want access to those resources, as well as the potential to improve financial outcomes by amplifying traction. As founders come to understand which funds are making serious investments in their own operations, they will become more selective about which VCs they choose to work with, and there will be an inevitable flight to quality.

Tools, Tech & Data: Social Platforms, Quora, Angel List

Of course as venture funds scale up and expand their operations, as with any other industry, technology and data can be substantial advantages. While many funds still use faxes and snail mail regularly, 21st century firms are investing in tools & technology that will allow them to move faster, more efficiently, more inexpensively, and ultimately with greater confidence than those that do not.

In fact, it’s rather ridiculous and hypocritical for VCs to be investing in technology companies, pushing them to scale, and still not practicing what they preach themselves. Yet even some of the most basic tools such as social platforms like Facebook, Twitter, LinkedIn and other critical information services such as Quora or Angel List or SlideShare are not readily familiar to many VCs. Hell, there are still plenty of VCs who don’t even have a blog or use twitter, and many more who have no idea on how to use data services to analyze and collect metrics on their own portfolio. Aside from the branding and marketing advantages great blogging VCs like Fred Wilson, Brad Feld, Mark Suster, and Chris Dixon get from telling stories and communicating, there are many other online tools that can benefit VCs.

While there will always be need for smart, thoughtful, trustworthy and domain experienced VCs who come from traditional investment backgrounds, it is also true these good people will be challenged by others to embrace the same digital techniques and disruption with which our portfolio companies challenge existing market incumbents. Why should VCs be any different?

So if you believe we are moving towards investment platforms that function like other web services, you should certainly be evaluating and using tools like Angel List, Gust, CapLinked, Trusted Insight, Second Market, and many others now emerging as a result of the JOBS Act and financial services innovation. So far, I’d say Angel List has had the most substantial impact on how we do business as investors – we use it almost every day to evaluate new companies, cross-reference other investors, and encourage our own portfolio companies to use it when raising future rounds of financing. My hat is off to Naval & Nivi on all they’ve done to innovate and grow their service into the juggernaut it is fast becoming. They are truly changing the face of venture capital in very positive ways, for both founders and investors.

Scaling Up & Out: The Valley is Flat (and Global)

Finally, I’d like to bring up how important it is for venture to expand its horizon beyond Silicon Valley, and beyond the US market. Most firms don’t have the appetite to invest outside their backyard, but there are tremendous opportunities and talent to be found in multiple geographies all over the world. While it will always require local market cultural fluency and expertise to take advantage of this growth, at the same time many of the platforms and techniques for which Silicon Valley is famous have now gone global. There are now billions of people on Google, Facebook, Twitter, Apple & Android, and the ability for communication and commerce to bring us all closer together is more amazing than ever. Entrepreneurs can be found in every corner of the globe, and emerging market consumers and businesses are growing and connected everywhere.

With programs like our GeeksOnaPlane tours to guide us, 500 Startups has been a frequent investor outside the US – we now have over 50 companies in our portfolio spread across 5 continents and 25+ countries. Our founders have immediate connections to other entrepreneurs, investors, partners, and customers in almost every geography on the planet, and we will keep expanding our reach. Our family is one of many colors, many languages, many currencies, and many wonderful flavors. And we wouldn’t have it any other way.

(for those of you who’ve stuck with me until to the end of this post, I’d like to thank you profusely, and apologize that i don’t have a better editor… -DMC)


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