Is Venture Capital Dead? A Realistic Outlook

A Discussion on the Future of Venture Capital

Recent conversations among venture capitalists have centered around an article published by The Information, entitled “The End of Venture Capital as We Know It.” While headlines often simplify complex issues, this particular piece, authored by Sam Lessin, presents several valid arguments.

However, a complete alignment with Lessin’s ultimate conclusions isn't shared. This discussion will explore the reasons for this divergence in perspective.

Nuances Within the Argument

The core of the debate revolves around potential shifts in the venture capital landscape. Lessin’s analysis suggests a fundamental change is underway.

It’s important to acknowledge the insightful observations made within the article. The points raised deserve careful consideration.

A Relaxed Friday Perspective

This exploration will be conducted in a spirit of open dialogue, fitting for a Friday discussion. The intent is to be both relaxed and respectful in examining the topic.

For those interested in a more extensive conversation with Lessin, a lengthy podcast featuring his participation from the previous year is available.

Further Considerations

• The article prompts a re-evaluation of traditional venture capital models.
• Understanding the underlying assumptions is crucial for forming an informed opinion.
• A nuanced approach is necessary to accurately assess the future trajectory of the industry.

Ultimately, while acknowledging the validity of certain points, a differing outlook on the long-term implications exists. This stems from a different interpretation of the evolving dynamics within the investment ecosystem.

A Surge in Capital Availability

According to Lessin, venture capital firms historically undertook substantial risks by investing in companies with a high failure rate. To compensate for this elevated risk, successful investments needed to generate exceptionally high returns to sustain the venture capital model.

Consequently, venture capitalists demanded a premium for their capital from founders. Historically, the equity stakes acquired by venture capitalists in rapidly expanding technology startups dwarf the gains realized during Initial Public Offerings (IPOs); the primary beneficiaries of a tech company’s public debut are the VCs, with investment banks securing a comparatively smaller share.

Shifting Dynamics in Software Development

However, the landscape began to evolve over time. Founders gained the ability to utilize services like AWS, reducing the need to allocate equity to infrastructure costs such as servers and data center space. The process of software development and market entry became more streamlined and accessible.

Furthermore, the adoption of recurring revenue models, as opposed to one-time software sales, altered the revenue profile of software companies. This shift moved them away from the episodic release cycles characteristic of video game companies, where success heavily depended on the reception of each new product.

The rise of Software-as-a-Service (SaaS) resulted in sustained, dependable revenue streams alongside robust gross margins. Revenue predictability improved significantly for software businesses.

Naturally, this led to increased valuations for both public and private software companies.

Increased Investment and Reduced Risk

The advancements in software development and distribution – encompassing higher-level programming languages, smartphones, app stores, SaaS, and on-demand pricing via APIs – facilitated a greater influx of capital into companies focused on software creation. This reduction in risk made startup investing attractive to a wider range of capital sources, initially at later stages, but increasingly earlier in the startup lifecycle.

With a broader spectrum of capital sources showing interest in private technology companies, driven by diminished risk, pricing dynamics shifted. As Lessin observes, the improved ability to quantify startup opportunities and risks has led to a more standardized valuation approach across the investment landscape.

This trend suggests a potential weakening of the traditional venture capital model, where expensive capital is exchanged for the prospect of substantial returns. Lower risk translates to reduced pricing power for venture capitalists, potentially impacting their return profiles as cheaper capital fuels higher valuations.

The Changing Role of Venture Capital

The culmination of these factors is highlighted by Lessin’s central point: “By 2022, for the first time, nontraditional tech investors – including hedge funds, mutual funds and the like – will invest more in private tech companies than traditional Silicon Valley-style venture capitalists will.”

The influx of capital into areas previously dominated by venture capital firms means that VCs are now frequently competing for deals with new, and often better-capitalized, investors.

According to Lessin, this situation necessitates that venture capital “firms that grew up around software and internet investing” either adapt to competing as smaller players in a larger market or seek opportunities in niche areas.

A Critical Look at the Changing Venture Capital Landscape

A common objection to Lessin’s thesis is one he acknowledges himself: its limited applicability to seed-stage investing. As he notes, the impact of his argument on seed funding is “far less clear.”

This is a valid point. While the traditional venture capital model may be evolving, it isn’t disappearing entirely. As long as capitalism persists, there will always be a need for investors willing to take risks on early-stage ventures.

The advantages that facilitated success in later-stage SaaS investments become less pronounced when examining earlier-stage startups. This effect is amplified when considering companies outside the software sector; applying the same reduced-risk assumptions to biotech, for instance, is likely to lead to unfavorable outcomes.

Consequently, Lessin’s argument carries less weight in seed-stage and early-stage investing, and even less so when applied to non-software businesses.

Despite the prevalence of code in modern startups, some venture capitalists continue to invest in companies that aren’t primarily software-focused. Numerous avenues exist for building successful startups, particularly within the technology realm. The evolution of SaaS investing doesn’t automatically translate to a similar reduction in risk for other models, such as marketplaces.

Therefore, the notion of venture capital’s demise is less accurate for seed-stage and non-software startups.

However, is Lessin correct in asserting a fundamental shift in the dynamics of middle- and late-stage software investing? Undoubtedly, the landscape has changed, but his interpretation of reduced risk in private software markets may be flawed.

Firstly, even with a lower risk profile, private software investments aren’t risk-free. Many software startups will inevitably fail or achieve only modest exits. While the number of such outcomes may be lower than before, they will still occur.

This underscores the continued importance of astute investment selection. While discussions focus on increased competition and higher deal prices, venture capitalists can still maintain an advantage through careful evaluation of potential investments. Effective selection can mitigate downside risk and potentially yield substantial returns.

Anshu Sharma of Skyflow – previously with Salesforce and Storm Ventures, where I initially connected with him – recently articulated a related perspective with which I concur.

Sharma posits, and I agree, that successful venture-backed companies are achieving greater scale. Previously, billion-dollar private companies were uncommon. Now, they are created frequently. Moreover, the most valuable software companies now command valuations in the trillions of dollars, exceeding the peak valuation of Microsoft between 1998 and 2019.

In essence, a more favorable risk-reward profile in the software market means that exceptional companies are becoming even more exceptional. This presents an opportunity for venture capitalists who make discerning investment choices, particularly at earlier stages, to generate impressive returns – potentially even greater than before.

This aligns with the performance data I’m currently observing from certain funds. If Lessin’s argument were entirely accurate, we would likely see a decline in returns at top-tier venture capital firms. However, this isn’t the trend I’m witnessing. (I welcome any contradictory evidence.)

To reiterate, venture capital is undergoing transformation, and larger funds are increasingly resembling different types of capital managers than their predecessors. Capitalism itself is reshaping venture capital, mirroring the broader evolution of the financial world. Value-added services were once a key differentiator for VCs, and a point of competition, though this was less discussed during the height of the “Services Wars.”

However, even highly active firms like Tiger Global can’t invest in every opportunity, and not all their investments will succeed. Investors might find greater value in allocating capital to smaller funds with a more deliberate investment pace, relying on trusted fund managers to strategically deploy capital and seek superior returns.

Ultimately, this is the core of the venture capital model.