This is the third and final article of this series. So far, the title seems more than a little misleading as the Venture Capital Industry does not seem to be facing any sort of disruption in its relationship with LPs nor with its portfolio and prospective portfolio companies.
But there is a sector that has undergone substantial change and continues to do so: Seed Funding.
Traditional Venture Capital has been moving out of the earliest financing stages in investments for digital businesses and has been replaced by a combination of Accelerators, Company Builders, Angels/ Super Angels and Crowd-Funding.
There are many reasons for this shift in stages. The main one is that it has become much cheaper to start Internet and Software companies; making the tickets too small for a hands-on Venture Capital. If the VC funds made their usual 10-20 investments in the early stage with the amounts currently being raised, they would have a very small fund, with very little management fees and, consequently, not enough resources to consistently add value.
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The most common starting point for most VC-style digital companies today is being accepted into an Accelerator. These programs provide financing (USD 10-50k) and coaching for start-ups for a short 3-6 months period as well as access to key players in the industry (Angels, VCs, Lawyers, Digital Marketing). The key difference with VC Funds is that they invest less capital and add value more intensively during a much shorter period. Since the investment is smaller and the time-frame for adding value is shortened, Accelerators invest in a lot of companies taking a new "class" every year or semester.
This approach is superior to Early Seed VC Funds because the resources offered to the entrepreneurs are standardized and optimized across classes, the size of the investment and the time-frame are the appropriate ones to test the business models and the extra-diversification is consistent with the much more skewed distribution of returns at this stage.
There are three main problems with Accelerators: the valley of death, the returns and the exit.
After finishing their program the start-ups have accomplished their MVP (Minimum Viable Product) and are ready to expand; but since most digital companies do not grow organically, they need financing. The need for extra capital is the biggest difficulty companies face after their acceleration because there operations are financed for a very short period of time and they struggle to survive this valley of death. Accelerators work hard on demo-days and luring investor to solve this shortfall. The rise of Angels and Super Angels is helping a lot at this stage.
The second issue is that the economics of Accelerators remain uncertain for its investors. Although they are rather new enterprises, as of today, very few ones have reported good returns. As we discussed in a previous entry, average VC returns are not very good. By investing in so many companies, it is hard for accelerators to outperform this average. Obviously, this issue could eventually be addressed by changing the terms of investment or having a side-car fund. So, returns are in no way a limit to the existence of Accelerators but a reflection of its current market dynamics.
The latter problem is more structural since Accelerators do not seem to have a proven exit path. Investors do not know how or when are they getting their money back. The most conventional view is that they could pay dividends after a series of successful exits of their portfolio companies or pay back all the capital and investment and raise money again after a few years. However, none of this is contemplated at the moment of investment, putting investors in a difficult situation. Nowadays, most investors consider their investments as a way to gain strategic access to portfolio opportunities and not as a financial play. This has to change for Accelerators to survive.
To sum up, Accelerators are a superior approach for early stage investing that still needs to refine its financial model.
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A new force that has emerged with strength coupled with Accelerators is that of the Angels and the Super Angels. This are individual investors that commit 10k - 100k (Angels) or 100k - 250k (Super Angels) per venture.
These investors have emerged from a very successful generation of entrepreneurs that remained involved in the ecosystem once they had cashed-out of their companies at a very young age. This phenomena coupled with a general distrust in the financial system after the 2008 financial crisis has spurred this form of direct investments.
Angel Money covers the capital gap between accelerators and fully fledged Series A VC Funds. They usually do not come with as many demands as VCs and help with some introductions and general counseling, but they do not offer the same degree of hands-on approach VCs usually do. At this stage, start-ups face the challenges Accelerators trained them for: product development, traction, etc.
These investors have emerged from a very successful generation of entrepreneurs that remained involved in the ecosystem once they had cashed-out of their companies at a very young age. This phenomena coupled with a general distrust in the financial system after the 2008 financial crisis has spurred this form of direct investments.
Angel Money covers the capital gap between accelerators and fully fledged Series A VC Funds. They usually do not come with as many demands as VCs and help with some introductions and general counseling, but they do not offer the same degree of hands-on approach VCs usually do. At this stage, start-ups face the challenges Accelerators trained them for: product development, traction, etc.
Angels do not have the same screening capacity a Seed VC Fund has, so they rely on recommendations and, yes, accelerators to get a level of deal flow they can handle individually. That is why, even if accelerators might not be great investments per se, they provide the deal flow Angels need to invest correctly and get good returns.
Accelerators+Angels have created a Lean Symbiotic Ecosystem for early investments that is more appropriate than the standard Seed VC Fund approach.
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Crowd-Funding is a practice where many people invest/ donate very small amounts into a project, most likely via a webpage. According to Massolution, more than 1.7 billion dollars were raised in 2012 using this mechanism. However, most of those funds were donations, geolocated projects or loans. The Equity Investment Crowdfunding niche is still under development because the SEC has not yet regulated the JOBS Act that opened the door for the mechanism that was prohibited before in the US.
Accelerators+Angels have created a Lean Symbiotic Ecosystem for early investments that is more appropriate than the standard Seed VC Fund approach.
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Crowd-Funding is a practice where many people invest/ donate very small amounts into a project, most likely via a webpage. According to Massolution, more than 1.7 billion dollars were raised in 2012 using this mechanism. However, most of those funds were donations, geolocated projects or loans. The Equity Investment Crowdfunding niche is still under development because the SEC has not yet regulated the JOBS Act that opened the door for the mechanism that was prohibited before in the US.
Crowdfunding gives small investors the opportunity to invest in projects they would otherwise not be able to; increasing the overall availability of funds for early stage ventures. That´s great!
However, there are a number of concerns. The first and most significant one is that there is a high probability of fraud. To avoid this, crowdfunding sites have to make a lot of due diligence that makes the investment process more expensive than it would otherwise be and they have to use standardized equity contracts to avoid malpractice that diminish the flexibility. Also, equity investments into startups cannot be algorithmically studied the way loans are with your credit score. Consequently, it is really hard to help uneducated investors to invest in endeavors with fair valuations and the returns could be dismal. Finally, early stage investment is a high-risk / high-return game. If investors are not properly advised, they could end up losing more money than they were willing to.
In conclusion, Crowdfunding is a great idea, but only people with some understanding of the industry should get involved in it. A lot of money coming in through crowdfunding could have negative effects on the long term for the VC Industry as returns fall and the industry gets a bad rep.
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Company Builders are a new trend that has emerged over the past few years. They are companies that create start ups from scratch by recruiting the founders team to address a problem or copy a business model in other part of the world. Usually, the Managing Partners are former entrepreneurs with a lot of operational experience. The aim of this company builders is to take their companies all the way through their seed stage and then get a Series A round.
I am very bullish about the success of this business models to create copycats in Emerging Markets. The Managing Partners have the skills to correctly identify the business models and they can recruit the best teams to execute them. Finally, their structure finances its companies all the way through the Seed Stage allowing them to execute faster then Accelerators+Angels, a key in these copycat business models.
Their ability to create truly innovative companies is a bit more questionable since the innovation process seems a lot like the failed Corporate Innovation Process.
To sum up, company builders have Team+Opportunity+Execution for Copycat Ventures, a winning combo. However, they might not be the most innovative ones.
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In conclusion, the Early Stage Investment world is mutating very fast with a lot of new business models. Only time will tell which ones survive.
