A large corporation recently requested my advice on how to set up and structure its venture fund, based in California’s Silicon Valley. This corporation had initially set up a venture fund in the late 1990s to invest in internet startups. By 2002 it had closed down the fund after determining that its portfolio companies had lost their financial value and had created little intellectual property of interest. But the startup activity of the past four years and the disruptions startups are causing in the company’s industry is leading it to re-establish its fund.
This example, and many similar ones, demonstrates a recurring theme of the past three years – corporations from a variety of industries are establishing, or re-establishing, venture funds in Silicon Valley, and other innovation clusters, and are aggressively participating in startup financing rounds. According to Global Corporate Venturing, 1,100 now corporations have active venture funds. The number has doubled since 2009, and 475 of them have been established since 2010. VentureSource reported that corporate venturing units invested $5bn during the first half of this year, a jump of about 45% from a year earlier and the highest level since the dot.com era. The emergence of corporate venturing as a major source of startup funding has been the result of two factors, the first accidental and the second intentional.
First, because institutional or independent venture capital (VC) is being disrupted, corporate venturing is able to fill some of the void and emerge as an important startup financing source. Second, as was previously discussed, corporations intend to access externally developed disruptive innovations by participating in the financing of startups. This article examines what corporate venturing units need to understand about the institutional VC disruption in order to capitalise on the opportunities it will create. In the next article I will explore how to set up a corporate venturing unit so that it can provide the corporation with impactful, over-the-horizon visibility to technologies, business models and startups that can help it achieve its innovation goals while becoming a trusted and value-added partner to entrepreneurs.
Institutional VC disruption
I am not the first person to comment on the disruption experienced by incumbent VC firms. However, I want to use my 15-year experience as an institutional investor and the data I collected from my more recent interactions with large corporations and their corporate venturing units to introduce my perspective on how corporate venturers can capitalise on this disruption and become long-term, value-add contributors to the evolving investor ecosystem. Corporate venturing units will need to continue relying on and collaborating with VC firms in order to achieve their investment goals. They must understand what is causing the disruption, as well as the venture investment ecosystem that is emerging as a result of the disruption.
VC firms have been disrupted for three reasons. First, disappointing returns from early-stage investments made by them over the past 10 to 12 years led institutional investors (limited partners – LPs) to make smaller venture allocations to these investors, causing many of them to shrink or close down their firms, or completely change their investment strategy. Second, new types of investor, as well as a new generation of VC firms, are introducing innovations that are disrupting incumbent VC firms. Third, entrepreneurs are demanding more than money from their venture investors, and are increasingly working only with investors that can address all their needs.
Corporate venturing units can also become disruptors. For the most part they do not have to worry about investment returns. They must be able to innovate, fit in the emerging venture ecosystem, and try to meet the needs ofthe new generation of entrepreneurs, as the other new types of investor appear to be doing.
LP disappointment
In 1991, I started working with VC firms as an entrepreneur. In 2000 I joined a venture firm as a partner and have been a venture capitalist since then. Through these two different lenses I saw that until four or so years ago there had been little innovation in the institutional VC model. A venture partnership would raise a new fund every three to four years from LPs that usually included endowments, foundations, pension funds and family offices. The basic terms underwhich LPs invested remained unchanged from fund to fund – 10-year fund life, with a five-year investment period, 2.5% annual management fee, and 20% carry (a form of performance fee). During the period 1995-2000 – the dot.com era – the model kicked into high gear. Many new firms were established, including around 500 corporate venturing units, and more, and bigger, institutional funds were raised (see the first graph). Unfortunately most of these funds produced lacklustre venture returns for over a decade following the 2001 recession.
As a result, most LPs moved away from the venture asset class, leading many incumbent VC firms to start shrinking and changing investment strategy, becoming private equity or growth equity funds, closing down altogether, or becoming “zombies” on their way to closing down. Flag Capital estimated that by 2010 only about 75 of the IVCs that existed in 2000 were able to raise new pools of capital (see the second graph). Of the 500 corporate venturing units established during the dot.com era, 200 had closed down by 2004. Not all the incumbent VC firms were affected by the shrinking LP venture allocations. In fact, the firms included in the barchart are actually split into two groups – the top-tier group and the second-tier group.
New venture investors
These days an entrepreneur can start an IT-based company for significantly less capital than was required five or so years ago. This capital efficiency combined with the abundant capital available globally and looking for a place to get above-market returns, and the interest by LPs in new investment ideas and structures, have led to the arrival of new types of investor that today compete with incumbent VC firms in general and the second-tier group in particular. Vartious types of competitor have emerged:
- Crowd-funding platforms such as Kickstarter and Indigogo.
- Accelerators.
- Superangels that also use platforms like AngelList through its Syndicates feature to support their efforts.
- Micro-VC funds that raise smaller pools of capital than VC firms, typically less than $50m, and invest in seed-stage companies. These firms bridge the gap between angel and series A investments, and often have a single GP. CB Insights estimates that today there are already 135 micro-VC firms.
- Emerging venture managers – for example Emergence Capital, Shasta Ventures, Union Square Ventures and Greycroft Partners – that raise $100m to $200m per fund primarily from institutional LPs and typically build their firms around deep sector expertise – for example, software as a service, digital media and consumer internet.
- LPs, both institutional and family offices, such as TopTier Capital Partners and Aeris Capital, that have set up direct investment groups or are expecting to invest side by side with the GPs they support.
- Different ways to generate dealflow. These investors create dealflow by reaching out to entrepreneurs, often using big data methods and other technology-enabled approaches their portfolio companies use to sell their solutions.
- Providing value-added services to each portfolio company, developing community and maximising collaboration among the portfolio companies to allow entrepreneurs and management teams to learn from their successes and failures.
- Different ways of managing portfolio companies. Create larger portfolios of smaller investments, but always be ready to quickly terminate support to underperforming portfolio companies and increase support to the ones that perform well.
- New types of GP. New-style GPs tend to be former entrepreneurs with technology or product backgrounds and knowledge on how to start and build companies in today’s business environment. They want to share the risk and the upside of making each startup a success.
- Concepts such as lean startup, minimum viable product, business model canvas, agile development and design thinking that are revolutionising startup creation are being broadly embraced by new-style VC firms and their portfolio companies.
To appreciate why I consider these as innovations you need to understand that the majority of the old-style VC firms develop their dealflow either with inbound requests for money or by networking with other venture investors they know well, bankers and other intermediaries. To entrepreneurs they emphasise their investment experience and legacy, financial expertise, willingness to support their portfolio no matter what, hands-on governance style, and thought leadership in the VC ecosystem. These investors tend to interact with their management teams primarily in board meetings.
Finally, they often continue investing in portfolio companies even when these are underperforming over the long term, because of a belief that abandoning such companies will negatively impact their reputation. In fairness, there have been situations where long-term support of a venture-backed company that was underperforming for some period was handsomely rewarded by the market, but these cases are exceptions.
In several private conversations with LPs and venture investors I also heard first hand what appears to be developing as a trend over the past three years – while the institutional LP appetite for the venture asset class is starting to increase, there is a definite preference to support smaller funds ($80m to $200m – see graph) that invest in new ideas – for example, consumerisation of the enterprise, big data infrastructure and consumer internet. These funds allow for better LP-GP alignment and demonstrate good returns more consistently. For this reason, I expect we will continue to see the creation of new micro-VC firms and emerging venture manager firms.