The Future of Venture Capital Funding in High Tech

Like almost every aspect of the economy, venture capital financing of High Tech Hardware and Software startups was down during the Covid pandemic. A reduction in VC funding continues today.

There was pressure on most segments of the economy, and the worldwide financial system was no exception. The preferred exit strategy for Venture Capitalists, the IPO, really hasn’t come completely back. Financial returns at Venture Funds took a hit like everything else financial. VCs without impeccable track records are not in a good position to attract new capital. LPs at VCs are generally not happy. Things look not so great for many in the VC business, outside of the very top firms by reputation and investment returns.

There have even been suggestions by a few people, including some prominent VCs, that the long-running and revered Venture Capital financing business model is “broken”. Among the criticisms include the 2/20 VC fee structure and the almost sole reliance on “unicorns” to prop up portfolio returns. Check out John Cowan’s LinkedIn Newsletter for one such “voice in the wilderness” on how the VC business needs to change.

As we sit here in 2024,  what is going to happen in the Venture Capital business in the long run?   The last couple of years have been difficult for both investors and entrepreneurs seeking capital. Will fast-growing software and hardware companies be able to fund their company via the VC route in the future? Or will it continue to be more than the usual struggle, as it has been the last year or two? Let’s take a look at some of the things that might happen.

SHORT TERM AND LONG TERM IMPLICATIONS

First of all, I don’t believe the Venture Capital business is going away. In the short term, all but the best-performing VC funds may have a difficult time raising money. Startup capital will remain tight, valuations will be lower and the whole experience of raising money will be even more painful than normal (and it’s always painful).  But make no mistake, there are SaaS and hardware companies closing funding rounds every day. There is still money out there in the short term for deserving businesses. And in the long run, the economy will rebound and things will go back to some new version of “normal”. I do believe that the Venture Capital business needs to make some adjustments, however. So it will probably be a “new normal”.

HOME RUNS VS. SOLID SINGLES AND DOUBLES

One of the staples of the Venture Capital financing business model has been finding “home runs”, also known as ‘unicorns. By this I mean those companies that can grow large enough for an IPO and these days have even a private valuation exceeding $1B. These are few and far between when considering all of the startups in the world. VCs have always said they would gladly invest in 5 to 10 failures to find that one big hit.

The IPO market is still very depressed by historical standards for the time being. This puts a lot of pressure on the basic premise of how to make money as a VC. I’ve always thought the “big hit” model was lunacy. From my perspective as an early-stage tech advisor, I find it akin to throwing darts at a board. It’s SO hard trying to pick out who these huge winners are going to be in the startup stage. There’s a lot of luck involved in a company getting to an IPO, and even more luck involved in picking out those select few at birth.

LACK OF IPO EXITS CHANGES THE GAME

This strategy seemed to work fine when the markets were consistently heading up and to the right. Under these circumstances, quite a few companies could do an IPO and get a billion-dollar market cap. But I’ve always thought the very basis of investing and company building is in finding those companies that can give you a return on your money, skillfully balancing risk and reward. When considering those companies that have truly developed a strategic advantage and a sound business plan, some of them may get very big, others not so much.

A lot of this depends upon the specifics of their target market and business. But there are many other factors, including luck!  VCs for years have been basing investment decisions in large part upon huge markets and the potential for the biggest hits, to the exclusion of everything else. I think this approach led to some lazy investing. IMO, that part of the Venture Capital financing business model may need some adjustment.

In fact, some “seed” and other non-traditional, smaller VC funds have popped up to fill the void for all of those “non-unicorns” in the last decade or so who profess to be happy to invest in singles and doubles. Some of these look like a hybrid between an incubator and a VC fund. There are lots of variations out there and I think there is still a search for a winning formula. There aren’t enough of them yet, but I think this is a big step in the right direction.

VC COMPENSATION MODELS

As VC fund size and limited partner returns increased during this golden era of VC funds, so too did the compensation to the General Partners of the fund. When returns were out-sized, limited partners swallowed hard or looked the other way. It’s analogous to a mutual fund with a hefty management fee. When the returns are great, it’s no problem. But in lean times, the small fees associated with an index fund look pretty good compared to that underperforming mutual fund with active, expensive management. Unfortunately, recently VC returns have lagged even the returns of the stock market.

There has been discussion over the last few years that the VC fund Annual Management Fees which are typically 2% will be reduced. Or maybe even go away entirely. Whether this has been happening at some funds, I’m not sure. I’ve always thought that the also standard 20% “carry” would probably hold.  LPs won’t mind the carry if they are realizing good returns. The carry also aligns the General Partners of the VC fund with their Limited Partner investors. What does this mean for the software/tech entrepreneur? It may not mean much, on the surface. But I do think it requires VCs to be more thoughtful about their potential investments. Could this possibly give an edge to those entrepreneurs will less dramatic, smaller business plans but better risk profiles?

THE OXYMORON OF “LATE STAGE VENTURE CAPITAL FINANCING”

I’ve always thought that the idea of “late-stage” venture capital financing was kind of silly. However, the Venture Capital business has been moving in this direction for quite a while. Part of the reason is that as many VC funds have gotten so big that it’s hard to deploy all of the money with “real” startup investing. And also it’s a less risky way to get to that big IPO payoff.

But these late-stage funds have gotten pretty similar to Private Equity firms, except their time horizon may be shorter. So maybe these investors should just be re-classified. In many ways, they don’t look anything like their early-stage VC brethren. At this stage, there are usually many other potential sources of capital, including many other financial giants. I believe that this late-stage segment of the venture capital business is the least important economically and may shrink over the long term as a result.

CAPITAL-EFFICIENT BUSINESSES VS. KISSING FROGS TO FIND THE “BIG ONE”

I hope that the long-run Venture Capital financing business will trend back to true startup investing. Also, the VC business will reduce its reliance on the long home run as its basic method of making money. The early stage is where they add value to the “business-creation value chain”. What I’d like to see, and there has been some discussion about this, is a renewed search for businesses that are “capital efficient”. This means companies that will turn an invested dollar into a high multiple of that investment, in terms of revenue, profits, and valuation.

You might say this has always been true. But the key difference, I believe, is that venture funds will be smaller and as a result will feel less pressure to fund high-risk, high-ceiling businesses. Where huge amounts of capital need to be deployed, matching the needs of extremely large VC funds. As I stated earlier, VCs with very large funds have previously felt that the economics of their business demanded this approach. With smaller funds, one can hope that capital-efficient businesses in smaller markets that have lower ceilings but higher floors will no longer be ignored. Solid singles and doubles may come into vogue!

IS MONEY REALLY “SMART”? OPERATIONAL EXPERTISE VS. FINANCIAL GUYS

I’ve always felt that the idea of “smart money” has always been a fallacy. Or at least one that was greatly overblown in the Venture Capital financing business. I know that there are A LOT of people who will disagree with me on this point. A lot of startup advisers will tell you that it’s imperative to raise money from investors who will provide much more than cash. In many cases, I think it’s a bunch of malarkey. No doubt that many experienced, skilled, and very well-connected VCs can provide a strategic advantage to entrepreneurs who are fortunate enough to attract them as investors. But with money being a commodity, this is mostly about a VC firm PR, trying to differentiate as providing a value-add.

Fundamentally, the need for capital and the need for advice/business assistance aren’t tied at the hip. Both are often needed, but they don’t need to come from the same place. They are important, but separate ingredients to the successful startup recipe. If you can get both in one package, that’s great. But too many VCs present themselves as experts in areas where they’ve just been investors. Again, some of them ARE experts. But many are not.  Frankly, entrepreneurs need to be careful of utilizing faulty advice. That’s regardless of whether it comes from someone who has put money into their company or not. Having money in a pocket should not be confused with operational knowledge or expertise.

WILL VENTURE CAPITAL FINANCING FADE AWAY?

As I stated earlier the answer is “no”. However, I do think that the excesses of a long-running venture capital bull market have exposed some weaknesses in the Venture Capital financing model. There will be adjustments to it. Just like there will be adjustments in many other businesses, as a result of economic duress.  But will it really change? And if so, how? I’ve offered some thoughts to get the conversation going. Please feel free to disagree or otherwise add to the discussion. What’s your view of where the VC business is heading?  I’d welcome readers to post a comment with your take on this always interesting topic.

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