If you found the late-90’s Dot Com bubble confusing, buckle up for the current state of the VC market. The venture capital industry has undergone rapid changes in the past five years, and many are left wondering what’s next as investors are more selective than ever.
Let’s look at last year alone. According to a recent study:
- In 2017, there was $84.2 billion in deal value (the most since the Dot Com era), which was allocated to a total of 8,076 deals across the board.
- While deal value was up, deal volume actually decreased.
- Less than one percent of the deals took up 23 percent of the total VC investments and more than 50 percent of those deals consisted of $50 million or more.
- Additionally, in 2017, only 769 exits were completed, lowest number since 2011. However, exits are increasing, with 2017 hitting highest median exit amount in a decade and highest year-over-year increase ever.
There is a direct correlation between the drop in exits and the rise in mega-round funding, meaning companies are staying private longer — and need the necessary funding to make it to a liquidity event. This shift poses a challenge for VCs. They now have to continue funding business well beyond their optimal return curve so companies can continue operation, which is stressing the term limits of their funds.
With the focus shifting to more developed deals, what does the future look like for early-stage startups and investments?
Before we look into our crystal ball, let’s review how early-stage companies gain capital from the traditional venture model.
Understanding the Early-Stage Investment Process
First, early-stage founders must decide if they’ll pursue outside capital for expansion and product validation or if they’ll attempt to go at it alone. Typically, most startups generate enough capital for the earliest stages of development and then seek outside investment. The early-stage investment hierarchy consists of four well-defined stages:
- Stage 1: At this stage, founders invest their own funds into ensuring their passion project comes to life. They’re using the funds to build out their proof of concept and a business plan.
- Stage 2: After building out the pilot product, as well as a roadmap to what growth looks like for their company, founders seek out friends, family, and as a great investor once mentioned, fools for their next round of capital. Typically, at this stage entrepreneurs need to continue testing the idea and hone in on the specific problems the product solves.
- Stage 3: This is where things get exciting as an entrepreneur. The company at this point will continue to raise money from friends, family and fools with the intent of bringing the business to a point of early market validation. During this time, founders are focusing on creating a more robust prototype of the product and business. Stage 3 is important because this lays the foundation of attracting investors, which leads us to stage 4…
- Stage 4: The next source of available capital for early-stage companies are angel investors. Typically, angels provide the bulk of early-stage funding for startup companies, and networks of these investors can be found throughout the U.S., Asia and Europe. On average, angels allocate around $25-$50k per deal and the networks themselves invest around $250k per deal. In order for a founder to raise more than $250k, they would need to syndicate across multiple angel networks.
Angels and angel networks do more than provide startups with access to a variety of investors. They also serve as a resource for the investors, giving angels a platform to source deals, get support on due diligence, mentor early-stage companies and provide capital.
There’s a new class of investors that early-stage founders can research called super angels. Super angels (also known as micro-VCs) invest in startups, write bigger checks and have a robust network of relationships that can help cover the $1 million threshold of a seed round. In some cases, the lead super angel continues to support the company as it hits major milestones and needs further capital.
The early-stage investment dynamic has seen its fair share of transformation over the years, but understanding how traditionally early-stage companies seek capital will help us understand the challenges they’re facing in the current market.
How Mega-Rounds Impact Early-Stage Investment
Increased inflow of capital into a market is typically a good thing. Too much money, however, is a problem. Given this dynamic, it’s fair to expect that when more money is invested into VCs, the size of checks they’ll write will also grow, causing the funds to move upmarket. At this point, there is greater capacity to absorb the influx of capital.
Unfortunately, the number of deals is actually shrinking. This, combined with a growing deal value, means investors will primarily focus their investments into one arena: late-stage deals.
For an early-stage company to even be considered for allocation in this current state, they need to prove growth metrics and their viability of churning high valuations. This is making it nearly impossible for early-stage companies to break through the threshold of stage 3 in the traditional investment process.
With angels limited ability to fund beyond seed rounds, early-stage companies, entrepreneurs and founders lack the necessary resources to make it through the “Valley of Death.” Without adequate funding, companies are unable to fund growth, commercialize and hire the right talent.
Why Early-Stage Investors Should Focus on Venture Development
While early stage investing is facing uncertainty, that doesn’t mean investors should write off all early-stage investments entirely. Rather, investors should focus on “venture development” investments. Venture development is a model that focuses on early-stage companies that have smaller funding needs and a high chance of significant returns without the need for large rounds.
Venture development focuses on the following:
- Leverage Existing Research: This tactic seeks out companies and technologies that have been vetted by leading research institutions and are reinforced with significant R&D investments. Since the technologies from these early-stage organizations are developed through universities, shareholders can expect less dilution as operating the business costs less. To find organizations that are heavily supported, investors should leverage the vetting process of a Startup Nursery.
- Heavy Involvement: According to the Kaufman Foundation, strong due diligence and heavy involvement are key determinants of future returns. The venture development model is set for success if investors are heavily involved in the launch and operations of the business. Becoming personally invested will ensure that the business will succeed as there will be more at stake. Additionally, the model permits investors to achieve founder level equity — which is rare in traditional VC.
- A Look Beyond the Coasts: Investors are just beginning to penetrate the innovation that is being harbored in the Midwest, and there is untapped potential waiting to disrupt markets. The Midwest – the largest economic region – takes 25% of total US R&D investments, but less than 4% of venture capital investments are allocated to the region. In comparison, California in attracts 55% of VC investments. With breakthrough technology, access to world-class talent and other resources at the fraction of the costs of the coasts, Midwest early-stage businesses are positioned to grow with less funding. This means high ROI for investors.
- Build to Exit: Given the current exit dynamics, the venture development model poises early-stage companies to become acquisition targets. Keeping in mind a clear “build to sell” focus, these companies are fast-growing but attractive to potential acquirers within their respective market.
Currently, the VC industry as a whole is in a difficult position, and the traditional VC model as well as early-stage companies will suffer if deal and exit volume continues to decline. The venture development model is poised to help early-stage companies, all while reducing risk and shareholder dilution for investors. Without shifting focus, the venture capital industry will continue to underperform.
Flavio Lobato is Principal and Co-Founder of Ikove Capital Partners. Previously, he was an Executive Director at Liongate Capital Management, a $7 billion alternative investment manager based in London and New York. He was also a founder and CIO of Swiss Capital Asset Management in Lugano, managing over $1.5 billion in hedge fund investments for institutional clients. Prior to that, he was a VP at Goldman Sachs & Co. and a Director at Credit Suisse First Boston. He is a student advisor to the Harvard Innovation Lab (I-Lab) and Co-Head of Fintech for Harvard Angels of NYC.