An Asset Class by Any Other Name

“GREAT question.”

Recently an Austin-based fund named Think3 launched to target venture-backed software startups whose growth has slowed. Their approach is unique in several ways. They replace the startup’s founding team post-investment and then invest into that team’s next project — all while not even requiring those founders to sell equity in the next project. It feels like turnaround investing in a venture wrapper. Rolling up gross margin-profitable businesses and streamlining operations is an interesting strategy for private equity, but those types of businesses don’t have nearly as much product/market risk as startups. The formulas used to turn around more established companies may break down at the quantum level.

However, what also makes Think3 unique compared to other venture funds (or private equity for that matter) is that they intend to “run them [the companies] forever” and “not look to ‘flip’ the companies but instead plan for a longer term horizon on how to make the company successful.” This seems to indicate it’s a permanent capital vehicle, which does in fact give them the flexibility to not be pressured by limited partners to generate cash distributions.

Related to limited partner pressure, Think3 is also working with venture capital funds to “review their portfolios and determine which companies fit the criteria”. What the founders of Think3 may not have included in their criteria, but for which they’ll be adversely selecting, are the oldest startups in venture capital funds’ portfolios. These are the investments that venture funds’ limited partners inquire about during annual meetings and periodic portfolio update calls (if they’re doing their job), the ones that were made earlier on in the commitment period (or in prior funds), the ones whose continued presence in the portfolio is negatively impacting the fund manager’s ability to work on new (more exciting) investments. These elder, mid-to-late 2000s-era venture funds realize the need to at least return their investors’ capital back, which the median fund from those vintage years has not yet achieved. You did not hear it hear first, but venture capital does have a liquidity problem.

Think3 has raised a large amount of capital to invest into startups, but it’s ultimately a small fraction of the total raised to invest in venture or software-focused private equity. Focusing further on venture, the amount actually invested into deals globally has increased every year since 2013, from $58 billion to $182 billion in 2017 — and that’s excluding add-on acquisitions, grants, mergers, secondary purchases, and venture debt. There’s a lot of capital swirling around and it’s not just dry powder, it’s already invested, waiting to one day be reunited with its investors on the trading floor of a stock exchange as the opening bell rings.

Didn’t even bother attempting to draw this one. All credit to Preqin in pulling together this chart/report.

Perhaps investors are becoming less patient waiting for those initial public offerings. Let’s see how average deal sizes have moved in venture capital over this same time period.

Onwards and upwards!

So the later stage rounds are receiving massive amounts of capital, to the point where the average deal sizes have more than doubled (or tripled in the case of the Series D and later) since 2013. Now let’s see whether later stage rounds made up a significant portion of those deals.

Yes, I’m aware this chart’s Fig. number comes before that of the prior one.

These increasing capital flows into venture capital seem like a not-so-positive signal for the asset class, and a really negative one for those later stage rounds — and a really, really negative one for deals in Greater China.

So this is an example of where “up and to the right” isn’t necessarily good.

While the aggregate value of venture capital deals in North America has almost doubled since 2013, Greater China has experienced growth several factors beyond that. Inflows like these may be indicative of a venture ecosystem flourishing abroad — or of a region experiencing a period of over-excitement and over-valuation.

This chart is technically out of order too, I know.

Additionally, while the number of deals completed in other regions has either stabilized or increased, in North America it’s actually decreased since 2014. Capital is flowing into the larger later stage deals in North America, not the smaller early stage ones. And, if opportunity exists, it would exist whereever capital flows are moving in the opposite direction.

There were 2,784 Angel/Seed financings in 2017 (26% fewer than in 2016) for $3.8bn in aggregate value — a decline of $364mn compared to 2016

The observation to be made from that quote and those colorful, well-designed charts (all from here) is that as later stage deals become massively over-invested, the earliest stage ones are falling just a touch out-of-favor. Which in the near-term should 1) make the earliest stage of venture capital economically more attractive, and 2) create opportunities for investment vehicles like Think3 to clean up after disappointing later stage deals.

Venture capital as an asset class is deified in ways that others are not — like say, fixed income. This is probably due to venture begetting companies like Intel and Amazon, while requiring its practitioners to continually watch the horizon for the next big thing (before it becomes a big thing). Founders Fund may argue that many of those practitioners don’t in fact watch the proverbial horizon — regardless, they are still evaluating companies at their infancy, and those companies do not become Intel or Amazon in a day.

I used to think of venture capital as just a subset of private equity, but that’s too simplistic: it’s also a form of distressed investing. As Steve Blank wrote, “a startup is a temporary organization designed to search for a repeatable and scalable business model.” And they are temporary, typically running out of capital before finding that repeatable and scalable business model. While the company may be young and selling a product that will make the world a better place, the clock is ticking and founders are very much aware of the need to raise funding — either from customers (revenue) or investors (equity/convertible notes). If the founders aren’t able to bridge that funding gap with revenue, then investors become a requirement. And, if a company cannot survive without outside investment, it is distressed.

Even though the earliest stage of venture should be an attractive opportunity, the earliest stage companies are the ones who best fit that definition of distressed. The failure rate of these companies combined with investors starting to recognize the opportunity in slowed-growth startups tells me that the startup playbook, as written by professional investors, needs to be revised. Software startups are theoretically capital-efficient yet they receive so much capital, limiting their exits and leading them to not-so-useful ways to spend their cash. The fact that a fund like Think3 exists to invest capital in the “right” operational areas for startups would seem to prove this.

I’ve begun to wonder more and more whether venture capital should be directed to capital-inefficient opportunities, the real problems that require a longer timeline for reaching a solution. I mentioned Founders Fund before, but Lux Capital and Bolt also come to mind as investors searching for the founders addressing those opportunities. There need to be more, and I’m definitely working to find out who those investors are. As for the more capital-efficient opportunities, I do believe in some situations when other types of funding can be more appropriate than equity. Lighter Capital and OATV/Indie.vc should interest software startups who are growing and actually have product-market fit — i.e. a customer base paying real money to solve an unmet need. Raising equity can be expensive, especially when it’s spent chasing customers who don’t actually need your product (and can duct-tape a solution in Excel), or if it’s spent in the “wrong” operational areas (like poorly-designed t-shirts).

Venture capital may not be broken, but its playbook needs to be revised. Where investment is directed, how it’s spent, and the value created by that capital need to be better understood by all parties: the companies receiving investment, the venture investors, and their limited partners. Aligning all three could meaningfully affect the liquidity problem — and maybe turn that distress into just stress.