The Changing Face of Venture Capital

Mod Note (Andy): Best of Eddie, this was originally posted in October 2013.

The venture capital business has gone through a lot of changes over the past decade. Most recently we've seen regulations implemented that give regular Joes access to deals only institutions and accredited investors could touch previously, and the swelling ranks of Dot Com and Web 2.0 millionaires (and billionaires) have elbowed out a lot of traditional venture capital shops.

That trend looks like it's only going to continue, and the latest proof of that is the expanding role of angel investors in the startup ecosystem. To wit: AngelList is offering a new program called AngelList Syndicates, where successful angel investors are no longer constrained by their own net worth. By allowing angels to pool their resources into a unified fund, they're about to have a profound impact on the way venture capital is deployed from here on out.

At the heart of the matter are the fees. As in, there are none. Angels get to kick in their money and invest in companies fee-free, and don't have to worry about paying anything until they get an exit. VCs get paid (typically) much like hedge funds with a 2 and 20 model. So they make 2 points a year just for showing up. That adds up quick.

Exit fees are basically the same. Where a VC fund would take 20% on the way out, the lead member of an AngelList syndicate takes 15 points and another 5 kick back to AngelList itself.

The other advantage angels have over the big VC funds is access to deal flow. VC funds need to deploy big money, which is why you never hear of them kicking in a $100,000 investment so a hot new startup can Rackspace some servers and change the world. That's the purview of angels. And some big name angels are leveraging that access right off the bat.

Jason Calcanis is not a guy I particularly like, but I have to admit a grudging respect for him. And he's got AngelList Syndicate wired. So much so, that he's able to offer startups up to a million dollars over a Hackathon weekend. Let that sink in a minute. You show up at a hackathon, code something really cool, and walk away with a million bucks two days later. That's stout.

One thing the Internet has done pretty much since Day One is squeeze out the middle men. I saw this firsthand as a stockbroker. We used to make bank; now brokers might as well be asking customers if they want fries with that. Then bid-ask spreads tightened across the board. Then fractions became digits. All in an effort to make things cheaper and better for investors.

This is no different. Will there still be big VC firms who ring the register? Sure, of course there will. But there won't be many little ones anymore. Think about it: if an AngelList syndicate can put together $40-50 million, why would you ever go VC?

 

I agree with the fact that as a VC now the onus is on you to provide value. I think that there will be less early stage VC funding because AngelListist can cover that with less equity demands. The only thing I am worried about is the vetting of investors. I've invested in a friend's start up and signed up on AngelList as an "accredited investor" and there was no security check or anything. I could just be some yahoo with champagne dreams. How are they going to make sure that the syndicates are actually funded as they claim to be? They have to make sure that the people in the syndicate are liquid and circumstances certainly change...

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VCs might be entirely eliminated. The Bay is changing at an even faster rate than the tech scene is. The money is staying in the Bay. Most companies aren't shooting for billion dollar valuations, they are staying lean, building real businesses. There are enough companies for VCs to fund still, however the money required to build a company with a hundred million dollar valuations no longer takes millions of dollars of infrastructure to start.

Follow the shit your fellow monkeys say @shitWSOsays Life is hard, it's even harder when you're stupid - John Wayne
 

How many companies in the bay area do you even know about? Facebook, twitter, snapchat? There are hundreds if not thousands of tech start ups in the bay area at any given time. Most of these you have never even heard of, most of them aren't making pointless iOS games. You have more and more service oriented tech start ups kicking off. These companies do everything from optimizing outside sales staff technology with cloud integration. To companies that do cloud analytics and optimization. There are start ups that are making little networked integrated soil and moisture testers that help farmers plant crops in more efficient ways. There are companies that working on apps that will allow trucking companies to pick optimum times and routes to run their trucks based on real word traffic data.

If you think the entire bay area is making angry bird clones you should just 1) shut up or 2) go stick your head in the sand to prevent making a fool of yourself.

Follow the shit your fellow monkeys say @shitWSOsays Life is hard, it's even harder when you're stupid - John Wayne
 
Best Response

Here's where a Liberal Arts education just might trump a STEM background....

I'll explain: the fund structure is one of the oldest risk-return models in existence. It basically dates back to the year 1000 AD with the maritime republics like Venice,Genoa, Amalfi... While most of Western Europe was starving, these tiny Italian maritime city-states flourished thanks to a relatively simple fee structure for high risk investments.

The "Contratto di Commenda," as it was called, basically offered wealthy merchants (read Limited Partners) the possibility of making high returns by pooling their capital with a ship's captain (read General Partner) and finance a trade voyage to sell to the eastern Mediterranean and return with rare spices and fine cloth, among other wares. They did this risking their own capital, but not wanting to risk their own skin (read limited liability) These voyages were difficult to organize and very risky (bad weather, pirates, creditors, and the fluctuations in prices of silk and pepper). They took time to travel, trade, and travel home. They often took 10 or more years as the typical voyage (read venture investment). Most VC funds have a ten year (+ 2) duration from organization, deployment, management, exit to distribution.

When, and especially, if the ship returned, profits were divided thus: 80% went to the wealthy merchant investors (LP's); 20% went to the ship's captain for organizing, managing, and most of all, risking his skin and using his unique skills, knowledge, and balls to pulling it off. Of course, a crew had to be engaged to manage the day to day business of the ship, fighting pirates, trading with foreign merchants, exacting payments, record keeping, etc. The "Contratto" provided for a 2% annual payment to cover the costs of managing the voyage from origination to exit, and liquidation (read Management Fee).

I personally found this fucking amazing. Especially when you negotiate the terms of your fund, you will find that despite bubbles, crisis or wtf else the 80-20-2 structure has been around for more than a 1000 years. Guess theses Italians nailed the perfect fee structure for high risk ventures.

What we have today is nothing new. The 70's and some part of the 80's had relatively small pools of capital in silicon valley. When $100 million dollar funds appeared by the late 80's and early 90's, the institutions (CalPERS, and of course government intervention as a result) had moved in. Personally, I think billion dollar venture capital funds are a scam. They're playing paintball with artillery, and losing.

A guy from Sevin-Rosen (they funded Compaq-the first IBM PC clone) told me that VC rankings and institutional MBA run pension funds would kill the goose. He wasn't that far wrong. Maybe the Angels are just resetting the game.

 

Thank you for sharing and awesome perspective on the maritime ventures. In fact, some limited partnerships and ventures go back even further to the Greeks and before. There is a book called Money Changes Everything that views finance as a technology and was written by one of most notable financial historians Will Goetzmann from Yale. Great read.

 

VC is not going to go away. Angels may be good for seed-level investments, and some syndicates could cover Series A and B, but scalability in still extremely expensive even if you just use lean marketing techniques. In the end, your $10 million dollar Series B/C growth rounds are still going to exist, and they're too big for angels. They'll have to be covered by institutional VCs.

As for VCs participating in angel rounds, yeah - that might go out the window. Maybe the same with Series A. However, I feel that it'll more be consolidation than Darwinian elimination - firms like KPCB, A16Z and Sequoia still have incredible amounts of wisdom to offer just in terms of human capital and connections.

 

I feel like VC will have to adapt to this changing roles. I can think of two potential scenarios: the one described above where VC keep their current fee structure and size, but get involved at later stages; or VC's change their fee structure to become more competitive with these Angel funds allowing them more opportunity at earlier stages.

Either way, I hope one day to get more involved in the VC industry.

The error of confirmation: we confirm our knowledge and scorn our ignorance.
 

My question: why would a start-up want to sell equity stakes to regular Joes? Most legit VCs take pseudo-operational roles to help the founders grow the business. Anyone can write a check. Greylock and Sequoia and Andreessen offer you connections, advisors who have been there before, etc. I mean, if I was starting a company, I'd want Reid Hoffman's advice, wouldn't you? Even if he asked for a bit more equity than Joe the Plumber. Plus, good start-ups don't have much trouble attracting funding. If you read the industry press, you'll see that even at the early stages, the great companies have a lot more dollars chasing them (by the big names, like Andreessen, KPCB, etc) than they need. Like, there was never a point at which you or I could have invested in Square. Jack Dorsey never needed the help. He knew the right people to ask. Same goes for like, most companies with good founders (i.e., companies likely to succeed).

So I see an adverse selection problem here. The companies that are willing to take money from just about anyone are the companies I don't want to give money to.

And Eddie, when we're talking angel investing, we're talking like $1-2M max, right? $40-$50M is like, Series B size. People writing checks that big aren't going to do it through AngelList.

 

Angel investors are typically not your 'average Joe'. They are usually established entrepreneurs and offer tremendous operational and strategic insight by themselves, in addition to massive networks. At a very early stage, it becomes pointless for an actual VC to commit capital, and economically more sense to approach respected angels instead.

There are tons of garbage venture firms out there. They will never see great deal flow because nobody would trust them. That's why brand name and people are such important assets to VCs.

 

@"LBJ's hair" Greylock and Sequoia and Andreessen have nothing to worry about in the new paradigm, but the legion of zombie VC funds out there just marking time and collecting fees are pretty much fucked. The average person with a passing interest in startups and the market in general will only hear about the big firms and the Jack Dorseys and the Andreessens, but they are so much the exception and not the rule that it isn't even funny. The plurality (I daresay the vast majority) of the venture world is populated by junk firms that offer no value.

Who wouldn't want Reid Hoffman on their board? It's a no brainer. But you or I have a better shot at getting Reid on the phone than a lot of VC fund principals do, because their reputation is shit and they haven't deployed capital in a decade and are just sucking up management fees waiting for some portfolio company to fuck up and do something right so they can exit.

 

I'd say I agree with LBJ's hair. Even junk VC funds might be a better partner choice for inexperienced entrepreneurs than having random people around the country thinking they own an exotic stock that will 500x their capital in just about 3 days and potentially asking you things like: "Can I get my money back?" "Why aren't you facebook yet?" "Why do you lose money?!" "You want more money?!?!"

Very good point initialsCG and interesting historic piece. That's where Capitalism as we know it was born (Italy) and made its very first steps with key legal properties such as: limited liability, division of ownership, anonymity. Societe Anonyme, Societa per Azioni, Aktiengesellschaft are the legal structures that brought the massive economic change that has happened ever since. Such an ugly word by the way the English world is using "Corporation" or "Incorporated"

Colourful TV, colourless Life.
 

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