Much has been written of the difficulty in building “another Silicon Valley.” To be sure, many countries and regions have tried, seeking to assemble the perfect mix of willing investors, eager entrepreneurs, and ready-made markets that will produce the sort of self-perpetuating ecosystem that will lift the region, country, nay, the world to a new level of prosperity and modernity.1 The problem is that like most real-life systems Silicon Valley is non-linear: it is impossible to break it down into component parts that can be reproduced, and no one can know for sure what a small change in inputs will mean for the outputs.
Moreover, one of the most important stories of the last several years is how the structure of Silicon Valley itself is changing, particularly when it comes to funding. Instead of traditional venture capital firms investing in startups from PowerPoint to IPO, there are angel investors and seed rounds on one end and traditional public market investors investing in private unicorn rounds on the other, with venture capital firms somewhere in the middle. And no company is more responsible for this radical transformation than Amazon: the company changed the inputs, and the butterfly effect is upending the entire system.
Venture Capital as Arbitrage
There’s a tendency in tech journalism to view venture capitalists as the moneymen (I always try to use gender-neutral terms on Stratechery, but it would be dishonest to even make an attempt here given the pathetic fact that only 4% of partner-level venture capitalists are women). In truth, though, middlemen is just as appropriate: the actual money comes from limited partners like family trusts, university endowments, pension funds, sovereign wealth funds, massively wealthy individuals, etc. Limited partners have highly diversified portfolios of which venture capital is only one part — the high-risk high-return part — and the reason they “hire” venture capitalists is for their skill in identifying and investing in new companies about which LPs have neither the expertise, time, or knowledge to invest in by themselves. Moreover, they pay handsomely for the help: venture capitalists usually charge around 2% of the fund per year2 in fees and keep about 20% of profits (fees are often but not always subtracted from the final payout; however, if the fund loses money the fees aren’t repaid).
I point this out to highlight the fact that at a basic level venture capitalists are arbitrageurs: they have access to more information than those with the capital, and access to more capital than those with information, and they profit by exploiting the mismatch.3 And to be clear, this is not a bad thing! Our entire economy is predicated on middlemen: no one grows their own food, to take an extreme example; rather, we depend on an entire supply chain of middlemen that results in $4 toast from wheat that costs $4/bushel.
In the case of startups, during the 45 years after Arthur Rock founded the first venture capital partnership in 1961, the vast majority of new firms needed significant funding from day one. Hardware startups of course needed specialized equipment, the funds to make prototypes, and then to set up actual manufacturing lines, but software startups, particularly those with any sort of online component, also needed to make significant hardware investments into servers, software that ran on said servers, and a staff to manage them. This was where the venture capitalists’ unique skill-set came into play: they identified the startups worthy of funding through little more than a PowerPoint and a person, and brought to bear the level of upfront capital necessary to make that startup a reality.
Amazon Web Services and the Angels
In 2006, though, something changed, and that something was the launch of Amazon Web Services.4 Because a company pays for AWS resources as they use them, it is possible to create an entirely new app for basically $0 in your spare time. Or, alternately, if you want to make a real go of it, a founder’s only costs are his or her forgone salary and the cost of hiring whomever he or she deems necessary to get a minimum viable product out the door. In dollar terms that means the cost of building a new idea has plummeted from the millions to the (low) hundreds of thousands.
In turn this has led to an entirely new class of investor: angels. There are a lot of people in the San Francisco Bay Area especially who have millions in the bank — enough to live comfortably and take some chances, but nowhere close to the amount needed to be a traditional limited partner in a venture capital firm. On the flipside, though, these folks have a huge information advantage: they are still a part of the startup scene, both socially and professionally; they don’t need someone to make deals for them.
Previously these individuals would have probably tried to join a VC firm and chip in some of their own money to a fund alongside traditional limited partners. However, thanks to AWS (and open-source software) and the fact starting companies no longer needs millions, these angels are able to compete for the opportunity to fund companies at the earliest — and thus, most potentially profitable — stage of investing.
In fact, angels have nearly completely replaced venture capital at the seed stage, which means they are the first to form critical relationships with founders. True, this has led to an explosion in new companies far beyond the levels seen previously, which is entirely expected — lower barriers to entry to any market means more total entries — but this has actually made it even more difficult for venture capitalists to invest in seed rounds: most aren’t capable of writing massive numbers of seed checks; the amounts are just too small to justify the effort.
Instead, venture capitalists have gone up-market: firms may claim they invest in Series’ A and B, but those come well after one or possibly two rounds of seed investment; in other words, today’s Series A is yesteryear’s Series C. This, by the way, is the key to understanding the so-called “Series A crunch”: it used to be that Series C was the make-or-break funding round, and in fact it still is — it just has a different name now. Moreover, the fact more companies can get started doesn’t mean that more companies will succeed; venture capitalists just have more companies to choose from.
Indeed, one can absolutely make the argument that the advent of angels has been good for venture capitalists: now, instead of investing in little more than a Powerpoint and a person, firms can invest in real products that have demonstrated traction in the market. And to be sure, startups still need the money: it may be easy to get off the ground, but that means it’s just as easy for potential competitors. The new competition amongst startups is about scaling and marketing and sales, all of which are expensive and require expenditures months or years ahead of expected profits, which is exactly what venture capital makes possible.
The Disruption of Venture Capital
If you’ll forgive a brief digression, one topic I cover quite frequently is publishing. My reasons, though, go beyond the fact that’s the business I myself am in; publishing is ultimately about text, and text, by its very nature, translates perfectly from analog to digital. And so, from the very first days of the Internet, the publishing industry has been like a canary in the digital coal mine: whatever befell it is likely to portend what might befall other industries once some essential part of their business is impacted by the Internet.
In the case of publishing, what happened is that the Internet was, at least at first, a huge boon: suddenly newspapers were reaching millions of people all over the world that they had previously had no access to. That breaking down of geographic barriers, though, ultimately undermined an entire business model predicated on arbitrage between readers seeking information and advertisers seeking attention.
I think there are parallels to be drawn to venture capital: sure, it’s nice to be able to invest in products instead of PowerPoints, but the tradeoff is the loss of proprietary knowledge about which startups have outsized potential and which don’t, and the influence on founders when it comes to everything from hiring to follow-on funding to when is the right time to go public. That influence is now increasingly gained by those investing in the seed stage, whether it be angels or incubators like Y Combinator.
Moreover, just this week came two pieces of evidence that some of these early stage investors are interested in encroaching further on venture capitalist turf:
- First is AngelList, which just raised $400 million from CSC Venture Capital, the U.S. arm of China Science & Merchants Investment Management Group.
AngelList is the most systematic effort to date to give structure to the world of angel investing. Angels who source a deal can form “syndicates” in which other angels invest in the sourced deal for a share of the investment’s returns commensurate with their investment. AngelList’s new fund aims to make this even easier: qualified investors can make firm offers knowing that AngelList will fill in the funding gap between sourcing a deal and recruiting other angels to join a syndicate. And, more importantly, AngelList can partner with syndicates to fund follow-on rounds in the best companies. In other words, Series A and beyond.
Second is the aforementioned Y Combinator, the incubator that has seed funded startups worth a combined $30 billion, including Airbnb, Dropbox, Stripe, and a whole host of other companies you’re probably familiar with. Just yesterday, Y Combinator reportedly led a Series B round in Checkr, which automates background checks. The funds were from Y Combinator’s new Continuity Fund, which supposedly would be making pro rata investments at <$250 million valuations in all of Y Combinator’s startups gaining additional funding, but the question as to whether or not Y Combinator has reversed its previously stated policy for the fund is less interesting than the fact the firm is also moving up market.
It is, in some respects, a classic disruption story: angels and incubators were happy to get down in the mud with the huge number of new startups enabled by Amazon Web Services and open source software; meanwhile, said startups’ low up-front costs didn’t provide an adequate return on a venture capitalist’s time (or check). Instead venture capitalists fled up-market, only to find the folks they were so happy to benefit from moving on up into their space.
The Venture Capital Squeeze
The story doesn’t end there: the trouble for venture capitalists is that they are getting squeezed from the top of the funding hierarchy as well: a new class of growth investors, many of them made up of traditional limited partners like Fidelity and T. Rowe Price, are approaching unicorn companies on a portfolio basis. I wrote in a Daily Update last June:
If you wait to invest until startups are already unicorns, or nearly so, you can be invested in a portfolio of unicorns! Just look at the portfolios of some well-known late-stage investors (all data from Crunchbase):
- T. Rowe Price has invested in 16 unicorns, including 3 of the top 10, and 7 of the top 25
- Fidelity has invested in 10 unicorns, including 5 of the top 10, and 8 of the top 25
- Tiger Global has invested in 13 unicorns, including 1 of the top 10, and 3 of the top 25
- DST Global, who in my opinion have the most responsibility for starting this trend, has invested in 10 unicorns, including 3 of the top 10 (and 5 of the top 12)…
You could make the analogy about all of these growth investors to venture capitalists: they are investing relatively speaking small amounts of money into a portfolio of unicorns, and all they need is for one or two to make it to a major liquidity event to profit.
Sure, this is relatively dumb money, but that’s where those angel and incubator relationships come in: if startups increasingly feel they have the relationships and advice they need, then growth funding is basically a commodity, so why not take dumb cheap money sooner rather than later?
The Internet Impact
Interestingly, just as in every other commodity market, the greatest defense for venture capitalists turns out to be brand: firms like Benchmark, Sequoia, or Andreessen Horowitz can buy into firms at superior prices because it matters to the startup to have them on their cap table.5 Moreover, Andreessen Horowitz in particular has been very open about their goal to offer startups far more than money, including dedicated recruiting teams, marketing teams, and probably most usefully an active business development team. Expect the venture capitalist return power curve to grow even steeper.
The more important takeaway, though, is that this upheaval is happening at all: even a seemingly impenetrable clubby human interaction-driven industry like venture capital is susceptible to change that, in retrospect, is really quite radical. You see it in industry after industry: hotels presumed that people wouldn’t stay in strangers’ homes, television networks presumed that programming schedules were constrained by time, and, speaking of Amazon Web Services, enterprise technology companies presumed that servers and software would live on corporate premises. Once that premise is removed, though — ratings commoditized trust, streaming commoditized time, scale commoditized data centers — everything else that you didn’t think mattered does. Airbnb has better selection and often cheaper prices, Netflix is cheaper and has a broader selection, Amazon offer customizability and flexibility.
So it is with venture capital: once startup funding requirements were reduced, the superior information and the willingness to hustle of angels and incubators earned the trust of the big companies of tomorrow, reducing more and more venture capitalists to dumb money hardly worth the 20% premium. The inputs to the Silicon Valley system have been changed, and we’re only now seeing the effects, and that should be a cautionary tale for just about everyone who thinks they and their industry are safe from the Internet’s impact.
Or, as critics may counter, a new level of commercialism and intrusiveness. But I’m an optimist — and a realist ↩
Usually for 10 years, the traditional life of a fund ↩
To be sure, the best sort of VCs do more than generate “deal flow”, as it’s called: they offer advice, help with hiring, make connections, find additional investing partners, and perhaps most importantly, at least for the most well-known firms which capture an outsized share of venture capital returns, validate the startups they invest in with potential employees, customers, and partners ↩
Obviously AWS in 2006 — which was just the S3 storage service — wasn’t capable of supporting a startup; it took several years to add the necessary services. Moreover, I am unfortunately giving short-shrift to the role of open-source software, which is the left hand to Amazon’s right ↩