Reflecting on recent VC history and where we go from here
January 28TH, 2021
The venture capital industry historically reinvents itself every few years, and 2020 accelerated that cycle significantly. As we enter 2021, we’ve seen the deployment periods for many seed funds shorten to 18 months. There is a sector-specific seed fund for every sector imaginable. Traditional Series-A firms have grown into full-stack shops with massive $1B+ funds to invest, capable of investing all the way up the capital stack from Series-A to IPO. Seed funds have become the primary top of funnel deal flow sources for the full-stack investors, and participation from the best seed investors is seen as signal. The size of the most successful seed funds has gotten bigger, and it’s not uncommon to see $100M+ seed funds. This makes the return math difficult, because these funds need to write large checks to put that capital to work. As a result, the most competitive seed stage opportunities are not syndicated because one seed investor will take the entire round.
With mega-funds moving down the stack from late stage and competing at Series-A, and Series-A funds moving up the stack due to raising larger funds, we’re left with a universe of full-stack mega-funds competing aggressively on valuation at all stages post-seed. Thus, once a company demonstrates traditional Series-A KPI traction, suddenly every post-seed fund wants in and uses valuation to get into deals.
I deliniate between Seed and Post-Seed, because a clear line has emerged between Seed firms and Series-A firms (and full-stack firms), in that the latter will rarely invest prior to seeing KPIs that demonstrate product-market fit. The skill-set required to invest in the absence of product market fit- i.e. that of the Seed stage investor- is entirely different. Series-A investors invest in KPI data. Seed investors invest in people. While we’ve seen some full-stack funds essentially take options at the Seed stage, there’s no indication that any full-stack fund has become proficient at it yet due to the significant difference in skill-set requirements.
Looking at exit activity, startups on the whole have become far more valuable. The number of billion-dollar exits has grown approximately 8x since the emergence of the first-wave seed funds. A large driver of this is the maturation of the venture investing landscape. Founders now have access to high quality sophisticated investors at the seed stage followed by full-stack funds providing support all the way to IPO. The rate of increase in billion-dollar exits suggests that we’re only scratching the surface relative to the value creation this new, mature venture capital industry can generate.
Those tailwinds are compounded by COVID which was a catalyst that forced the entire market to realize that it had underappreciated the TAM for many technology companies, as well as the power these companies can exert when they reach a certain scale. This led to some significant valuation increases for public tech companies, spanning social to SaaS, and largely validated the views on TAM that many of the larger late-stage and full-stack VC funds already understood.
What this valuation environment and TAM realization surrounding tech also did was open up the IPO window via both the traditional approach and a previously underutilized approach- SPACs.
The recent SPAC explosion has allowed companies to access public markets sooner than they otherwise would have been able to. The average time from founding to SPAC for the most prominent SPACs of 2020 was 5 years, versus 10 years for the most prominent IPOs of the same period. Private markets are spawning Unicorns faster than ever before, decacorns are still taking 10 years to generate massive IPOs, but SPACs are bringing companies public 5 years after founding at single digit unicorn valuations.
This causes an interesting shift in the makeup of a VC’s job description. With portfolio companies going public sooner, thus achieving less value creation in private markets, VCs are forced to become public equity managers. They can, of course, sell once their lockups expire, but that entails potentially leaving a significant amount of value on the table, given some of the valuation increases we’ve seen following recent IPOs and SPACs. Holding and managing those public positions requires a different skill-set than investing in private companies. Managers will be forced to operate in a market where they don’t have insider information, have significantly less ability to impact the company’s direction and must conform to public market regulations in order to trade those positions (no small feat). Learning this skill-set has significant upside, as most 2020 IPOs and SPACs traded significantly up after their initial offering. Selling too early would have been a costly mistake.
From an LPs perspective, they will now have to assess whether a fund manager can effectively perform his/her traditional job of identifying promising early stage companies, while also generating value as a manager of a portfolio of public entities. As any GP knows, this will come with some pressure from the LP base for sitting on liquid value.
So what does all of this mean for the next few years of venture capital? I believe the COVID induced realization that TAMs were undervalued and the power of tech companies at scale, is here to stay. This means VCs have more room to compete on valuation, because exit valuations are increasing, and I think we’re only seeing the beginning of the recent increase in unicorns and decacorns minted every year. So, while competition- especially post-seed stage- has increased, the overall size of pie that VCs are competing over has also increased. As long as public market valuations hold and the IPO/SPAC window remains open, this should result in an overall healthy investing environment for VC investors. At the same time, a lot of VCs are going to see their job description change over the coming years. As competition increases at the Series-A stage and beyond, some of those investors will need to develop Seed stage investing skills that allow them to identify promising teams- no easy task. At the same time, VCs across the entire stack better get comfortable with managing a portfolio that contains significantly more public equities.
As happens with every Venture Capital re-invention cycle, there will be managers who adapt and survive and those who do not. If I were to put on my LP hat, I would be looking for managers that are not stuck in their ways, have recognized that the tide is shifting and are preparing accordingly.
