The deep irony about the venture business– a business that lives and dies by innovating/disrupting other industries– is that it hasn’t experienced much change since General Georges Doriot aimed to get veterans back to work after WWII.
That’s changing now. Crowdfunding and new software platforms are commoditizing the primary activities of a venture fund (sourcing, fundraising, assisting companies). In the first roughly 70 years of the business, firms have set themselves apart with access to capital and/or proprietary access to deals. As these advantages erode, funds that do not adapt will slowly die out.
The equity crowdfunding site Angellist is a primary force provoking change for several reasons. One, it’s a true exchange where seed deals happen. Two, it was one of the first sites (second to Crunchbase) to have extensive and reliable data on startup companies and their traction. Three, it has developed software to appeal to institutional venture firms (in my opinion, it has the potential to serve as the backoffice and fundraising operating system for VC funds). Equity crowdfunding, while it has limitations in the short-term on its market share, has quickly grown to be a meaningful portion of the venture capital market, and is projected to continue growing much faster than the market as a whole.
Mattermark, Crunchbase, Pitchbook, CB Insights, Funders Club, Circle Up, SeedInvest, E-Shares, and many others are also attacking these opportunities. Here is how these platforms are commoditizing each of a VC fund’s primary activities:
Angellist in particular has given wide exposure to startups raising capital. Equity crowdfunding also spurred the creation of data services to track information on startups. Investors can now sift through hundreds of thousands of startups around the world that meet their criteria. Compare this approach to the tradition: large funds hired a lot of smart people out of undergrad and had them call and email 100 startups a day. These smart but inexperienced individuals would determine which startups were interesting and the filter process would iterate as deals made their way to a partner.
Today, a fund of much smaller scale can compete– it doesn’t need to hire an armada of smart people. It needs one smart person to sift through the data. That one person can cover a wide geography, a greater number of companies, focus attention faster, and can monitor companies a lot more efficiently. This was not realistic five years ago and was possible but hard three years ago. Smart VC firms will transition gradually from touting “proprietary deal flow” to “proprietary algorithms.” VC firms that don’t take advantage of this change in cost structure are going to be challenged.
Two years ago, at Origin, we decided to build our own software to ingest a variety of data feeds, allow us to filter and apply themes against these data sets, and use various calculations to determine “quality”. It has enabled us to approach several deals that we may have missed using traditional networking approaches. We built our own software because as Mattermark, et. al. innovate their data platforms, we wanted to be able to develop a unique scoring system and intake many different datasets rather than relying on one.
Traditionally, on the founder side, to raise capital an entrepreneur has to know VCs or someone who knows VCs. Distribution is closed off and secretive. Equity Crowdfunding is quite the opposite: it is global, open, instantaneous, and non-discriminating for both sides of the marketplace. These platforms are not without limitations (more on that below), but it feels inevitable that they will play a larger role in the future, much like the residential real estate market has evolved.
As recently as 30 years ago, to sell a house, you had no choice but to hire an agent and pay them a large commission because they had relationships with buyers and other agents. Eventually, the agents and their brokerages built databases to keep track of their listings, that later were shared across brokerages and eventually with the public via companies like Zillow and Redfin. That market went from “of course you have to hire the best broker and there is no alternative” to “you’d be an idiot not to list your home online, where you’ll get the best distribution and best price, leading to you the best buyer.” The seed financing world has largely made the same transition from “you have to know an angel investor” to “you’d have to be an idiot not to list your company on Angellist.” In fact, many seed-stage companies build a profile on Angellist even if they raise capital in the traditional manner.
It’s easy to dismiss crowdfunding as confined to seed investing. It’s even easier to suggest that companies that turn to crowdfunding platforms represent adverse selection because they couldn’t raise money “traditionally”. This was probably true when online dating platforms were introduced, but they eventually became so mainstream that today, people set up dates in a few swipes while waiting in line for a burrito.
Equity crowdfunding is set to roughly double each of the next few years. It’s hard to deny its impact on the overall VC market.
A VC fund pitching their proprietary deal flow is like a real estate agent saying “I know a lot of clients and I don’t need technology” without accepting that any agent or customer can hop online and see all the listings too. Transparency and a single meeting point for a market is really powerful. This is not to suggest that the personal relationships and reputations won’t matter in venture deals. But to survive, all but the top VCs will have to leverage newly-available data to be more efficient in sourcing in addition to their relationship building. It will become increasingly hard for founders to justify not being on a crowdfunding platform.
Raising capital is also getting democratized because crowdfunding platforms have, well, crowds. This was initially illustrated by Angellist syndicates and today investors can raise their funds with institutional Limited Partners (LPs) on the platform. This essentially means that a good investor can create their own fund with much less overhead. Stop and think about that. The power that stems from access to capital in the traditional world is eroding because a great investor with a reputation can now build a following and an investor base.
These software platforms and data feeds now allow a VC fund to gain substantial efficiency. It can consider a large number of deals and track companies easier. As Angellist and E-Shares become the operating system for VC funds, reporting, sourcing, accounting, infrastructure, and Investor Relations (IR) all gets automated and a lot cheaper. It seems inevitable that some funds will start charging lower management fees as a result. Will LPs follow?
They won’t follow just for lower management fees. The process of building trust will remain. However, if VC funds which adopt data-driven approaches indeed generate better returns for lower managements fees, absolutely, LPs will follow. If these platforms allow LPs to get better diversification (through newly-possible indexing strategies) and access to the best managers, yes they will.
Greater efficiency and indexing approaches may be the kindling that leads to margin compression in the business. Given the predilections of the institutional LP market, this may take some time to be meaningful, however, and may be the last activity to commoditize.
Being value-add to portfolio companies is an age-old way for a fund to convince an entrepreneur to take their capital. Although most funds disclaim that they are “value-added investors,” there is a wide dispersion of how much funds really help due in part to a limit in scale of the venture business model (the number of boards an investor sits on, raising money, new deals, mentoring, administration, etc.). Helping a company is the true differentiator for funds and I think it’s how funds are going to survive against newer approaches in the short and medium terms. Value-add is a force multiplier: your fund is good at adding value and that is going to increase your returns. That success will bring more capital and buying power. It will attract better entrepreneurs, which in turn will produce better returns. You get the idea. The nature of the crowd and the nature of early stage investing mean that angels are not as involved in the company. A16z took the value-add approach to an extreme, but now platforms like Angellist are addressing it too by placing a large number of engineers and other functions into startups in its talent marketplace. How Angellist will evolve to beef up its offering here will be interesting. Perhaps a marketplace for exits?
Investment size is a limitation. Limitations on the number of investors, or in some cases the amount of capital that can be raised, mean that for now, traditional funds have a size advantage. This has confined crowdfunding to seed stage investments. If regulations do not change, innovation on the platforms will be required for to encroach on the traditional venture capital model in a larger way than through the availability of data and operating efficiencies.
What will not change is that this is a people business. While automation can surface interesting companies, there is no substitute for meeting founders and doing careful diligence– just like you might discover a home on Redfin but you will insist on getting an in-person tour of the property and will have a professional inspector examine it. Current crowdfunding platforms rely on “social proof” and the assumption of the diligence that the lead investor has done. That’s a dangerous proposition and one that the platforms may try to address either by providing research, benchmarking or collaboration tools. I suspect, however, that this will continue to be a traditional process and there are limitations to how much crowdfunding can accomplish.
One way in which this market is very different than real estate is confidentiality of data on the assets. Homeowners are willing to divulge most details about a house for sale. Startups are more complicated, and often it is confidential details that are what set companies apart and make them attractive investments. Angellist realized it was too liberal with how it handled data initially and made significant changes. Confidentiality will also limit the usefulness of the data services until such services can safeguard the distribution of the information to the satisfaction of the startups.
How to Respond
Darwin’s quote applies here: “it’s not the strongest to survive, but the most adapted to change.” In the wake of this commoditization, funds need to refine their approaches to continue generating competitive relative returns.
This is harder than it sounds: funds are set up for the General Partners (GPs) to get fee streams for 10+ years. Even if the fund makes lousy investments, the GP is guaranteed to get that fee stream. This engenders complacency. This also makes it even more appealing for funds willing to adapt to do so.
LPs can now consider new data-driven and indexing strategies. Margin compression may reduce fees. As the democratization of deal flow occurs, and advantages of scale erode, the criteria upon which investment decisions are made may be reconsidered.
It will be interesting to see the market that enables disruption to be disrupted itself.