I’ve spent the bulk of my career working in the clouds. Not as a pilot but on the technology side. The reason cloud computing continues to grow, with no signs of slowing down, is that it has fundamentally changed the way IT departments do business. I think there is an element of this new approach that could be brought to venture capital and startup investing.
One of the reasons that cloud computing is so attractive for companies of all sizes is that it’s on-demand and you pay-as-you-go. Historically, in the world of hardware, you needed to buy an expensive, physical appliance, called a capital expenditure. You had to fight for budget and make a heavy up-front expense. You had to find physical real estate and rack space, connect it to your network, without knowing for sure whether or not you would fully need its full capacity or capability or not. Since you were locked in and the purchase was already made and depreciating, there wasn’t a lot of flexibility, and you were up against the clock.
Software-as-a-Service (SaaS) and cloud computing changed all of that
Now you could pay-as-you-go and it was easy to spin up resources if you became an overnight sensation or developed a strong customer base in a region of the world you weren’t anticipating. This change in mindset revolutionized business and ushered in an unprecedented era of hyper-growth startups.
Yet, that mentality has not trickled down to the venture capital and startup investing firms. Still today, a startup investment firm is judged by how much money it raises in its fund. How much money it can deploy, and what returns it can yield over the life of that decade long fund. This big, expensive, upfront investment is not all that different than buying a large piece of hardware. Suddenly, you’ve raised all this money and made all of these promises.
Well, you need to deploy it. Your limited partners demand it. So these firms either convince entrepreneurs they need more funding than they probably do or they spray and pray across a bunch of different startups hoping that one in 50 hits is big enough to get their money back. So then they can go out and raise the next, even larger fund and repeat the cycle all over again. And along the way these firms are taking 2-3% management fee per year, making it’s partners and firms rich before they even realize any returns on dollars invested.
But is this best for the entrepreneurs?
A $15M, $25M, $50M exit should still be considered a roaring success. Yet our startup culture has minimized this result for founders. Instead we have created an obsession with the paper unicorn – a company that, on paper, is valued at $1 billion or more. It begs the question of how much of these companies the founders or entrepreneurs even own after all of the outside capital and dilution that comes with it. As a result, entrepreneurs chase these vanity metrics because finding a unicorn makes or breaks the investors. Which causes the investors to still live in the age of legacy hardware.
This is why it is so important to remind every entrepreneur you meet that when they fundraise they aren’t just raising capital to fuel growth. They are selling pieces of their company to financial firms. The game completely changes. There are other ways of doing it. But no one cares about what it really takes to build a business these days because frankly, especially in B2B SaaS, it’s methodical, boring, and not sexy day to day.
Yet, from the mundane rise the envied.
The Cloud-Like Approach
One startup I backed sold for $20M with the CEO/Founder at 80%+ equity. Another sold for $10M and the CEO and his co-founder owned 90%. Another sold for $40M and the CEO/founder owned 45%+. His two co-founders had 25%. My last example does $10M+ in revenue and spits out $3M/year in profit. He won’t sell. These are all winners! For more of these stories to exist, more investors and venture capital firms need to support that model. The only way they can do that is by embracing a cloud-like approach to investing. The future of this is not by raising massive funds but instead on-demand investing. Leveraging online and offline syndicates built to be evergreen from the outset.
There are three major benefits to leveraging a syndicate – a loosely bound group of individual investors investing via a single legal entity – one signature, one row on the cap table.
The first is that it creates an on-demand model for the investment firm. Suddenly, they don’t need to let the fact that they have money they need to deploy drive their investment strategy. The deals can take the lead. What is best for each entrepreneur and startup is different with each deal. Having a syndicate that you can ramp up or down allows the investment firm to tailor its investment based on the needs of the startup creating a more mutually beneficial agreement.
The second positive is that syndicates democratize startup investing. There is a limited pool of potential investors who can pony up the cash to be part of a huge fund. There is a much larger percentage of people (accredited investors, of course) who can pledge $2,500 to a specific deal. What this does is it allows more people access to the high upside of startup investing, which can raise up the overall economy. Additionally, in an industry that has been dominated by a very small group of people, it will hopefully create a broader mindset, a more inclusive culture, and new perspectives. This will lead to more innovation and disruption. A cycle that is actually good.
The final benefit of this strategy is that it is difficult. Because the investment firm doesn’t have all of that money on-hand, it forces them to be good at their jobs. They must prove over and over again to their syndicates that the deals they’re bringing to them are winners. That opt-in model puts pressure on the investment firm to not only find the best and the brightest but to work with those entrepreneurs to help them succeed. Big funds don’t have this issue and so working directly with the entrepreneurs is less of a priority. Instead they’re more often focused on capital deployment, power law and raising the next fund. Like a politician constantly running for office more concerned about winning re-election than governing.
Of course the downside of the syndicate model is that you do not have the consistent cash flow from management fees to cover your operational expenses.
So how would these types of firms be funded?
The answer, in many ways, is another reason why entrepreneurs would want to work with this type of firm to begin with: they have to get creative and be entrepreneurial. While there are a lot of ways to earn revenue there are two that seem most obvious for this new type of venture capital firm.
First, in addition to being an investment or venture capital firm, become a consulting/advisory firm. By doing this you’re showing your expertise in a certain area. If a startup is willing to pay for what you know, then you obviously know something valuable. By sharing that valuable knowledge with your startups, you will certainly add value as an investor. Suddenly your investment dollars become “smart money.”
Additionally, if you charge a nominal fee for your advisory/consulting services to the companies you invest in, you are helping to hedge the bet your syndicate has made with you. By being intimately involved in your area of expertise with your startups you can help ensure they’re as successful as possible or, at the very least, learn of any potential surprises.
The second way for a management fee-less venture capital firm to cover their expenses is by building and selling their own products or platform. This route makes a lot of sense, especially if those products are tailored toward entrepreneurs and other investors. By selling a product, you will want to create a large audience to whom you can market your products to. This will be helpful in building your brand reputation for your firm and exposing it to other entrepreneurs.
Additionally, as a venture capital firm you talk with hundreds of entrepreneurs. But you simply can’t invest in all of them. Having a product you’re selling that you think will ultimately help them ensures that there is never a wasted meeting or introduction. It also allows you to reach more entrepreneurs than you could personally.
Lastly, building and selling a product means that you’re walking the walk and not just talking the talk. When you talk with other entrepreneurs you can give them fresh advice from the school of hard knocks. You won’t just be relying on your accomplishments from years ago.
A lot of people see a lack of a management fee as a major problem. I see it as an opportunity to become even more valuable as an investment firm.
Just as the cloud disrupted the status quo, the future of startup investing is being re-invented right now. Those who embrace the cloud-like model could become the Salesforce.com or Amazon Web Services (AWS) of startup investing. Those who stubbornly cling to the past could be left behind. One approach is innovative. One approach is institutionalized.
Who do you think entrepreneurs will want to align with?