Once startups prove their business model, the opportunity to grow requires some heavy-lifting finance mostly provided by Venture Capital (VC) firms. However, VC as an industry has been in dire straits. Since the crisis, the VC industry in the United States has failed to match the previous high of US$ 28 billion raised in 2007. According to the Organization for Economic Cooperation and Development (OECD), the level of venture capital investments in most countries are around 60 percent of what they were in 2007. This is largely due to the dismal performance of the VC asset class in the last decade, underperforming, on average, both private equity funds as well as public markets. In a study by the Kauffman foundation, only twenty of about a hundred funds generated returns of at least three percent in excess of public equity markets annually.
Adding to the misery of paucity of funds available, the process of raising funds from VCs can be very resource intensive and often takes up to six months. The dispersion of median returns between the tier one funds and everyone else in a 15 year look-back is 62.6 percent. This makes it critical to do proper due diligence and pick the right VC firm. Finally, it is difficult for entrepreneurs to figure out which funds are still making active investments. According to CB Insights, although there were slightly more than 450 active VC firms in 2012, only 190 of them made more than 10 investments in the year. For an industry that supports innovation, the business model for VCs themselves has not evolved for almost three decades.
Thankfully, we are seeing four major disruptions to this antiquated business model. Firstly, Naval Ravikant, the founder of AngelList, is trying to democratize the financing of technology companies through his platform. AngelList enables angel investors to invest in curated technology startups, lowering the cost of the search process. In its newest experiment, AngelList has unveiled a US$ 25 million fund named Maiden Lane that will invest about US$ 200 thousand in the startups invested in by the top angel investors on the site. This generates leverage for angel investors to write bigger checks while ensuring lower cost access to promising startups for limited partners (LP). In 2012, angel investors in the US invested a total of US$ 22.9 billion compared to US$ 26.5 billion invested by VC firms. Platforms like AngelList could tilt the balance towards angels as a primary source of innovation capital.
Secondly, new VC firms like Google Ventures, Correlation Venture and Right Side Capital are beginning to take a more data driven approach to early-stage venture capital. They hope to speed up the decision making process and improve the odds of making the right calls. Correlation Venture, for example, makes investment decisions in less than two weeks, does not seek control through board seats and is much more flexible on investment sizes. Despite being a new player with just US$ 165 million under management, it hopes to generate superior returns leveraging its predictive model that analyses exhaustive data from all venture investments in the US over the last two decades.
Thirdly, as investment in VC funds has declined from LPs, corporate venture capital funds are stepping in. The top 30 public technology companies have US$ 180 billion on their balance sheets and they have started flexing their muscles when it comes to deal flow. According to CB Insights, corporates have participated in 40% of the largest 100 tech deals in 2013 compared to just 22% in 2009. This has generated protest from traditional VCs with Fred Wilson of Union Square Ventures recently saying that “corporate strategic investor’s objectives are generally at odds with the objectives of the entrepreneur, the company, and the financial investors”.
Finally, just as the Small Business Investment Act of 1958 led to the birth of the VC industry, the passing of the JOBS act in April 2012 has signaled a new era in capital formation. It has introduced the possibility for non- accredited investors (investors with less than US$ 200 thousand in salary or US$ 1 million in assets) to participate in private offerings. According to the Crowdfund IQ report, over 58 percent of the US population has a high interest in potentially making an investment via equity crowdfunding platforms in startups. Early estimates of this market by Kauffman foundation puts the funds available at close to US$ 120 billion.
All these separate initiatives are opening up and transforming a largely static and closed industry. As an entrepreneur, get creative with how you can source smarter capital to help you build your technology company and scale globally.