The Great Unbundling of Venture Capital 2021: Emerging Trends, Challenges and Opportunities
The emergence of new early-stage venture capital firms is critical for the inclusive and diverse future of tech innovations
It’s not a secret that angel and seed investments were jeopardized the most when the whole world went remote as a result of COVID-19.
As an emerging independent fund operator with 15 companies in my early-stage portfolio that have successfully raised over $650 million — as well as a longtime mentor at industry-leading accelerator Techstars, which has accelerated over 2,500 startups and raised close to $12 billion — I’m well-acquainted with the unique challenges and opportunities that come with this stage of investment.
In my experience, the earlier the stage of a company’s development, the more we rely on meeting founders in person and understanding team dynamics when making investment decisions, as there’s little data, traction or market validation to inform our assessment.
Indeed, angel and seed valuations were the only stages to see a decline in the median pre-money valuations from 2019, with 2020 marking the first time seed valuations had waned since 2009 as per Pitchbook - NAVCA Venture Monitor. As seed-stage and first-time financing activity fell sharply, new entrepreneurs, female founders, and entrepreneurs in the middle of the country who have traditionally been underrepresented in VC funding definitely felt the impact of investors largely allocating capital to existing portfolio companies or known relationships.
On the other end of the investment cycle, in Q4'2020 late-stage companies accounted for 28.8% of total VC deal count and 66.7% of value in 2020. Mega deals reached annual record highs for deal count and value (321 mega-deals closed in 2020 vs 242 in 2019 for a total of $70.9B), helping to drive up median deal size across all investment stages. Investors have increasingly concentrated capital into mature companies: for the first time ever, investors deployed over $100B in a single year to late-stage companies, which represented a record 66.7% of total US VC deal value.
On the venture capital side, of $73.6 billion raised in traditional VC funds, established VC firms secured nearly 75% of the total capital raised for venture funds in 2020, marking it the highest share this cohort has held since 2012, while emerging managers have had difficult time raising capital.
What the above tells us is that the industry is becoming increasingly concentrated, and that outcomes for established players and newcomers are vastly different. There certainly has never been a greater time to bring the great unbundling of traditional venture capital stack to a whole new level. Massive multi-stage traditional funds remind me of broad horizontal platforms (think CraigList or LinkedIn) whose inherent weaknesses are being exploited by players and tools designed around structural needs of particular groups of users, from Angellist, Rolling Funds, Super Angels, and Solo GPs to SPACs and direct listings.
Based on my ten years of experience in early-stage investing across the spectrum of tech sectors, from consumer, healthcare-tech and food-tech to cybersecurity, financial software, and B2B e-commerce in Singapore, India, the UK and the USA, here are some trends that I think will continue to evolve in 2021 and beyond:
1. Traditional multi-stage VCs will go downstream
Big institutional players — like Sequoia Capital, GGV Capital, Kleiner Perkins, and others — will continue to expand their early stage and seed investment portfolios, changing the funding landscape for new founders and seed funds alike. These larger venture capital funds are devoting more institutional resources to identifying and cultivating early-stage investments, raising specialty funds (like GGV’s $460 million Discovery Fund and Sequoia’s scout program) focusing exclusively on pursuing seed deals, a trend I see likely to progress in 2021.
As valuations of Series A+ companies continue to soar, super early stage investing represents a uniquely lucrative opportunity for large funds to make venture capital unit economics work and deliver target IRR and cash-on-cash multiples: a smaller seed investment represents a minor fraction of the fund’s overall assets, yet can yield a substantial return down the road if the venture succeeds. The lure of getting an early stake in the next Airbnb or Slack will continue to grow as graduates from these industry-defining startups begin to found their own companies, taking what they’ve learned there to their new ventures.
2. Disruption of the early-stage investment ecosystem will accelerate innovation among emerging managers
Despite facing considerable challenges in the current industry environment, there remains significant potential for emerging managers to make outsized returns by working side-by-side with founders and LPs to spur creative technological and business solutions. Emerging fund managers are driven by the desire to fill funding gaps, looking for underserved markets and founder classes to make and cultivate innovative early ventures. Specialist emerging managers with significant expertise in dealing with particular founders’ profiles, industries, and/or geographies will survive and thrive, scaling their operations and attracting more institutional capital.
As Kauffman Fellows wrote here, we could expect to see a $20B+ investment opportunity in the emerging manager and micro-VC subclass in the coming year. Identifying, assessing and supporting high-potential managers thus represents both a challenge and a unique opportunity.
3. Emerging managers will continue to deliver comparable or higher returns than traditional VCs
Though often overlooked in favor of brand-name VC firms, data shows that emerging managers and smaller funds tend to outperform established players: the Kauffman Foundation has found that new and developing funds have consistently constituted the majority of top 10-ranked VC performers over the past 15 years.
Emerging managers also represent a far more diverse pool of VC talent than established firms, which remain overwhelmingly white and male, with Black and Hispanic fund managers respectively comprising just 3% of investment managers at larger funds. Such homogenous teams have been demonstrated to yield less successful outcomes overall. In contrast, the NAIC shows that diversely owned firms generate 15.2% median net IRR versus 3.7% for all private equity firms in their portfolio; diverse first time portfolio managers have shown higher IRR and multiples. This incredibly strong past performance is likely to stimulate the inflow of Family Office and institutional LP capital to high-potential emerging managers.
4. Founders will have increasing choice and power to counter-select investors particularly in early stage
So where does all of this leave new founders looking to fundraise in the coming year? It’s true that larger capital funds provide unique advantages to an early-stage venture. The cachet of securing early support from a big-name venture firm can serve as a vote of confidence within the industry, making further investment more attractive to potential partners. In addition, multi-stage funders with portfolios across the spectrum of company life cycles pose the opportunity to secure lead renewal investments as one’s venture matures, a significant advantage in later-stage fundraising.
Yet these opportunities also present notable downsides, leaving ample room for innovative pre-seed / seed investors to provide unique value to newer founders. I spend about six hours a week talking to my portfolio companies and helping them solve their most important short- and medium-term issues most frequently related to go-to-market strategies, customer discovery and follow on fundraising design. This is very time-consuming: large firms without specific focus on early investments may have less bandwidth to cultivate first-time and early founders, or to guide them through the common pitfalls of launching a new venture.
In addition, taking early funding from a multi-stage investor far from guarantees future rounds of their investment — which potentially signals underperformance and undue risk to other potential investors, making later-stage fundraising at attractive valuations more difficult. These firms also (still) tend to invest locally, potentially shutting out promising ventures led by founders from a broader array of backgrounds and geographical locations.
Emerging VC firms run by women, immigrants and underrepresented minorities are hungry and laser-focused on finding great founders, amazing humans who address a very specific need of a very specific market vertical thus offering new founders standout expertise in early-stage company development, sustained personalized attention more likely reserved for mature investments at larger firms, and an openness to promising ideas that come from the margins rather than the center of the tech industry.
I see more founders choosing seed / early-stage firms ran by people who can feel their pain, relate to the cause and wrap up their sleeves to add value from ground zero.
