BETA
This is a BETA experience. You may opt-out by clicking here

More From Forbes

Edit Story

Are We Entering A New Age Of Venture Capital?

This article is more than 4 years old.

The wind of change is blowing across Venture Capital. Not confined to a specific market or geography, the relationship between VCs and the companies they invest in has shifted culturally and economically. There is a sense that models are in need of a change to safeguard otherwise resilient sectors such as tech from the fated ‘bubble’ scenario that many sceptics see on the horizon, and with this, the deal structures and ultimately ROI is also changing. With a series of disappointing, or worse still, failed tech IPOs hitting the market over the past year, a rather grey cloud is beginning to shadow the world of start-up financing.

You needn’t look far to see how even the biggest names in the market have got it wrong; Uber, Lyft, Slack, and Spotify are all trading way off their initial listings – which for their venture backers isn’t boding well for forecasted targeted IRR. This comes at a time when funding start-ups is now arguably more capital intensive than it was five years ago.

At the same time, the millennial entrepreneurs at the helm are changing the business founder image, and VCs have been forced to adapt how they operate – after all it is the entrepreneur they serve, right? Perhaps not in Adam Neumann’s case.

So what is changing, and how are VCs adapting to keep pace with the evolving landscape to ensure consistent, whilst at the same time ‘market beating’ returns for the LPs and institutions who comprise many of the large VC funds?

Smart money becoming smarter

The tech sector and more specifically AI is an immense market opportunity for innovative start-ups and their VC backers. However, over the past five years there has been a flood of companies launch very similar products and services, and ultimately not all of them will become the next Deepmind.

Therefore it’s necessary to carry out even more extensive due diligence ahead of any funding offer, with a growing number of VCs hiring domain experts who really understand what they’re looking at – less of the shooting from the hip style of screening and more of the detailed data and technology analysis. There is also a growing number of firms who incorporate data lead strategies to source and vet their investments, leveraging software to more efficiently analyse opportunities and ultimate valuations and forecasted returns. Other benefits of using AI to determine investment opportunities include reducing bias which often plays a role in investment decisions.

Firms such as 645 Ventures, Correlation Ventures, and Ironstone are just some of the firms that have successfully leveraged the power of software and AI to build their current portfolios. Other VCs, including EQT Ventures, have built their own AI tools that scour the internet for market information and flags opportunities using predictive analytics. The company’s AI tool, Motherbrain, successfully predicted the rise and gain of Airbnb and Uber, for example.

Leveraging AI as an investment tool can be a great competitive advantage as well, enabling VCs to close deals with start-ups in different geographies before their competitors even knew they existed. While it can be a costly investment for VCs to develop their own AI tools – some plan on spending £1m on data a year – tools like Hadoop and Apache Spark make it possible for smaller companies to track basic investment factors, like how well companies are performing in the Apple Store. With about 1,500 businesses founded on a daily basis, a growing need to differentiate and gain a competitive edge at both ends of the funnel will no doubt continue to emerge.

Patience is a virtue

Until more recently, it was possible for many funds to provide returns to their investors with a five to ten year horizon due to the sheer volume of capital hitting the market, and the relatively short time needed for many start-ups to scale to a point of acquisition or IPO. However, with the number of unpalatable public listings of late and the rhetoric of the tech sector ‘bubble’ perhaps deflating slightly if not fully bursting, investors will need to be willing to sit on their returns for a while longer.

In fact, when Aaron Patzer sold Mint.com after two years for $170m, he immortalised himself in the phrase “pulling a Patzer”, which is still commonly used to refer to businesses selling out too early. If VCs are able to hold longer time horizons to enable their start-ups to continue to scale and provide real money returns in the form of demonstrable revenues and EBITDA, there could ultimately be a slice of a much bigger pie on offer for them. This was certainly true for Actifio, founded ten years ago, which has seen five funding rounds so far and is currently valued at over $1bn.

As markets regain confidence and corporate investments and acquisitions gain further pace, selling out too early due to a fund cycle could mean leaving a lot of value on the table. Many are now eyeing a long-term approach to maximise returns, and so there will certainly be more funds set up to do so over a longer time horizon.

Fuelling the scale up – cash vs value

For talented founders, the ability to build a world class management team supported by a strong product and a hand for playing the market are critical elements for success. Where VCs are able to add real value, however, is to founders who may have the optimal product and have found the prime market and timing, but lack the business acumen. Here VCs are able to nurture a scale up beyond simply providing cash in return for equity.

The model of embedding function expertise in the form of sales and marketing has been seen to pay dividends for both the VC and the start-up as the founders are able to focus on what they’re exceptional at whilst the VC helps to accelerate time to market and ultimately customer acquisition. There are a few models emerging in this space, one being the VC bringing the start-ups in-house similar to a traditional incubator or accelerator and provide access to engineering, sales, marketing, HR and charge back a rate for its services. Another is to negotiate more favourable term sheets with larger equity or a lower price per share – whereas others simply believe it’s a win-win situation for both the firm and the start-up and so are less prescriptive in seeking compensation aside from building a more valuable business more quickly.

A range of VCs have already set-up scaling programmes for start-ups they invest in, to support them particularly during the first three, crucial years of their journey, including Orios Venture Partners’ #Misfits programme, and Lightspeed Venture Partners’ Extreme Entrepreneurs programme. SuperSeed, an exciting seed stage VC in the UK is working extremely hard to add demonstrable operational value in addition to capital to grow portfolio companies’ revenues to the first £1m. This special form of nurture ensures that founders stay on track during the hardest years of building their company as their going through various series of funding rounds, and secures the VC a better return in the end.

All change? Perhaps not.

For some of the larger funds, including the likes of Softbank, it seems if it’s broke (but you’re so big) you don’t need to fix it, then the model looks relatively unchanged. Just load up and go again – with a renewed campaign to drum up support for a touted even bigger Vision Fund 2 which when first announced was estimated to be close to $200bn.

Throwing larger sums of money at companies closer to their IPO timebombs seems still one of the strategies for now, however for Softbank, as interest has been slow and money hard to raise over the past few weeks, perhaps even the industry behemoths will need to take a second look. For others who are willing to adapt and seek their returns from seed and early stage investments – the market looks to be primed for disruption and well on its way to entering a new age of venture capital.