There is nothing short of a tectonic shift taking place in the world of venture capital, according to Chris Douvos, CFA, of Venture Investment Associates. The combination of regulatory changes and technological advancements has permanently altered the way capital gets into the hands of entrepreneurs.
Historically, many venture capital models were designed as mechanisms for institutional investors to invest in young entrepreneurial companies. At the entrepreneurial level, the venture capital firm acted as a hub-and-spoke system in which they hosted many discrete relationships with individual entrepreneurs. Consequently, many venture capital firms viewed their expertise and coveted relationships as closely guarded intellectual property. In essence, many venture capital firms acted as gatekeepers to whom entrepreneurs came in desperate need of capital.
The creation of the JOBS Act in the United States has greatly increased access to investment capital for entrepreneurs. Now unqualified investors can invest in start-up companies and entrepreneurs are no longer limited to close friends and family. Through crowdfunding tools on the internet (e.g., Kickstarter), young entrepreneurial companies can now circumvent venture capital firms for raising money, particularly for early stage capital. This phenomenon forces venture capital firms to rethink their business models. In Douvos’s view, the venture capital industry is very overcapitalized and perhaps as many as two-thirds of venture capital firms will not survive.
Technology is also dramatically altering the economics of start-ups. Once again, thanks to the internet, a wide range of web-based services have arisen that enable start-up companies to rent rather than build the tools necessary to build a business. Consequently, Douvos said, the cost of proving the entrepreneur’s hypothesis has decreased dramatically, falling from $5 million or so 10 years ago to as little as $250,000 or so now. Naturally, such declining costs also alter the economics of investing in start-ups. Whereas previously an investor could invest in one company for $5 million, that same $5 million can now be spread across 20 investments. The internet has truly revolutionized the speed, cost, and time to discovery of success or failure, not to mention the marketing and the pace of growth for those companies that are successful.
On the other side of the supply chain, these internet tools also enable institutional investors to circumvent venture capital firms entirely. Large institutions and plan sponsors can now invest directly in start-up companies and do not necessarily need to hire a venture capital firm. In fact, this is already happening. So the venture capital industry is facing pressure from both entrepreneurs who may not need them for capital and from institutional investors who may not need them for access to investment opportunities.
Facing disintermediation, venture capital firms are now forced to provide more value-added services or face extinction. In short, the venture capital business model is evolving dramatically. Leading-edge venture capital firms see themselves as the nexus of the vital relationships that entrepreneurs need to be successful, providing technical expertise, relationships with trusted service providers, and access to other entrepreneurs who can help earlier stage entrepreneurs avoid the many, many pitfalls facing new companies.
Like in so many other industries, technology and regulation are opening up both opportunities and risks. While the outcomes are far from certain, one thing is clear. Maintaining the status quo is not an option.
Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.
Photo credit: W. Scott Mitchell