If the world of venture capital were to be set to music, Bob Dylan’s “The Times They Are a Changin’” might be chosen. The venture capital industry has changed in important ways over the past few years. We believe change will continue over the next decade. We expect venture capital investment over the next decade to reflect these major themes:
- Industry structural changes — bigger deals, greater concentrations of capital, new sources of venture capital, new investment intermediaries
- Growing venture capital investment especially in artificial intelligence, automotive/transportation, advanced robotics, and pharma/biotech
- Broadened geographic participation in venture capital, with emerging centers outside of traditional California and Northeast markets providing access to early stage deals for individual investors
- Information – more of it, more accessible, and more actionable
Let’s consider each of these broad themes in some depth.
Industry Structural Changes
Following the dotcom bubble burst in 2000, venture capital investment contracted sharply for a few years. It then followed a pretty stable course for the next decade.
More recently, however, changes have begun to emerge. We think the underlying factors behind those changes, and hence the changes themselves, will continue and even accelerate over the next decade. Let’s look first at the simple, quantifiable changes.
As shown below, while the reported number of venture capital deals has flattened and even declined a little, the dollar volume of those investments has increased sharply, as deals have grown larger.
Source: Pitchbook-NVCA Monitor, Q2 2018
The percentage of reported deals by deal stage hasn’t changed too much, though there has been a moderate drop in the share of angel/seed deals.
Percentage of Deals by Deal Stage
Source: Pitchbook-NVCA Monitor, Q2 2018
The trend to greater dollars/deal, however, has been notable at every deal stage. The share of late stage venture capital dollars accounted for by $50+ million mega-deals has increased dramatically, as venture-funded companies are remaining private longer before plunging into the IPO waters.
Average/Median Amount Raised ($M’s) at Time of Deal
Source: Pitchbook-NVCA Monitor, Q2 2018 *Average **Median
Percentage of Late Stage (Post-B) Deal $’s by Deal Size
Source: Pitchbook-NVCA Monitor, Q2 2018
There are a number of factors behind these trends that we believe will continue and even increase.
- Awareness of the potential riches from venture-driven innovation has grown broadly. Entrepreneurship has become revered. This has attracted more of the best talent to start-up ventures. No longer are innovative start-ups limited to driven college drop-out rebels. Now the nation’s best educational institutions, such as Stanford and Harvard, are fertile start-up hothouses. Start-up opportunities are luring experienced professionals as well, including serial entrepreneurs who have already succeeded, some several times.
- While the reported numbers point to fewer angel and seed deals, industry heavyweights such as Kleiner Perkins’ Eric Feng believe otherwise and suggest there is especially robust start-up activity. We suspect that the reverence now accorded entrepreneurs and start-ups is driving greater friends-and-family cash accessibility, helping start-ups go further before needing more formal support. Also, technological advances are facilitating early progress.Initial formal funding is now going more toward early commercialization/expansion, where the dollar requirements are greater than in early development stages that previously required seed or angel funding. As a result, first financings (and then, as shown before, the Series A deals that follow) are getting bigger. Essentially today’s seed and angel fundings are more like yesterday’s Series A, today’s Series A is more like yesterday’s Series B, etc.
Seed and Angel Average Dollars (Millions of $’s) Per Deal
- The larger deals across all stages also reflect fundamental supply-and-demand. Smart investor money is leaving old, established industrial icons for the wealth generation opportunity seen in innovative leaders.For example, GE’s market cap drop from $600 billion 18 years ago to only about $100 billion today hasn’t been lost on smart investors. While some of that decline has resulted from GE divestiture of its NBC network television business and most of its finance businesses, roughly $175 billion of the decline has taken place over the past two years in its current set of businesses.Look at the US automotive industry. 18 months ago, in April 2017, Tesla market cap (then $51.0 billion) first edged ahead of GM’s $50.9 billion and Ford’s $44.8 billion. This was despite 2016 revenues of $166 billion for GM, $152 billion for Ford, and just $7 billion for Tesla. While Tesla’s market cap has since eased to $43 billion, due in part to investor discomfort with the mercurial Elon Musk, so too market cap has declined for GM ($43 billion) and Ford ($37 billion). One could go on and on. There’s Uber valued at roughly $70 billion. Or Airbnb, whose market cap of $38 billion approaches Marriott’s $42 billion. How about Amazon’s trillion dollar market cap versus Walmart’s $277 million . . . while Macy’s limps along at $10 billion and Sears/Kmart prepares to file for bankruptcy. The smart investor money gets it.
Further, venture capital money is now coming from different sources than historically. New sources include the mega-wealthy who made their fortunes in the old economy, professional corporate money managers such as private equity firms and broader investment/wealth managers, internal venture capital funds within traditional industrial companies, and leading Asian strategic investors. We expect this substantive structural change to continue and increase over the next decade.
Some of these new sources are able to invest huge sums. We expect them to leverage that capacity to strategic advantage increasingly over the next decade, to buy into particularly attractive ventures as well as to address their own long-term strategic issues.
The Wall Street Journal reported on August 4, “Some old-economy billionaires have a new calling: venture capitalist. Having made their fortunes in industries that are increasingly being upended by technology, many of the world’s wealthiest individuals and families are turning to venture investing as a way to bet on the future at a time when fewer startups are going public. Some are backing young companies in hopes of spotting the next potential threat to their core business. Others are lured by the promise of high returns and bragging rights when a startup makes it.”
Traditional professional money managers such as private equity firms and broader investment/wealth managers are jumping in as competition for middle market buyouts has constrained PE firm returns and as the declining number of publicly traded companies limits broader money managers’ traditional options. JP Morgan Chase has been a notable participant in this activity. Most recently, Bloomberg reported that Goldman Sachs’ Petershill unit was close to reaching a deal for a stake in venture capital firm General Catalyst Partners.
According to Jesse Hurley, Head of Global Fund Banking, Silicon Valley Bank, in an interview included in the Pitchbook-NVCA Q3 2018 Monitor, “Some of the larger PE firms are carving off smaller pieces of their growth funds to focus on seed or Series A deals. This strategy helps deal sourcing and identifies potential (future) investment opportunities. As those younger companies mature, the PE fund may have a good vantage point from which to consider making a later investment from its larger growth fund. With such rich valuations in growth and middle market companies, funds are chasing better returns and investing in earlier stages.”
An interesting application of this strategic approach is PE leader Blackstone’s early October agreement to purchase Clarus, an investment firm focused on life sciences. According to the Wall Street Journal, Blackstone plans for Clarus to serve as a platform for future acquisitions and partnerships in life sciences, a sector which Blackstone believes often struggles with accessing adequate capital. It was suggested that Blackstone’s initiative signals an intention to move into what is termed “growth investing,” focusing on companies at an earlier stage than traditional private equity. Growth investing appears to be akin to later stage venture capital investing, often making available larger investment monies than have been associated traditionally with venture capital
Internal corporate venture funding is also growing sharply, focused on strategic investments, as traditional industrial corporations recognize the importance of adopting new technologies being developed by smaller private ventures. According to the Q3 2018 Pitchbook-NVCA Monitor, corporate venture capital investment has soared from $15 billion in 2013 to $39 billion in the first nine months of 2018. They report that deals including participation from corporate investors currently account for 47% of overall venture capital investing, up from 32% five years ago. Software, including especially artificial intelligence, and biotech lead this area, with financial services leaders also becoming more active investors in areas such as blockchain technology.
To illustrate, Toyota led two of the 3rd Quarter’s largest venture capital deals. One was a $500 million investment in Uber in a partnership directed toward Uber’s ultimate deployment of a fleet of self-driving Toyota vehicles. The other was a co-investment along with SoftBank in a $300 million Series D for Getaround, an online car sharing service.
Growing corporate venture investment is taking place as well in less technologically driven sectors. An example is Kraft Heinz’s launch of a $100 million venture fund, Evolv Ventures, to pursue venture deals in the food industry. Kraft Heinz appears serious, luring away Lightbank veteran Bill Pescatello to head this new fund.
Finally,the surge in huge venture capital deals has been fueled as well by Asian powerhouses who have recently begun investing in the US as well. This includes most notably Softbank, with its $92 billion Vision Fund, and Tencent, along with other substantial Asian VC funds. According to the Wall Street Journal, 40% of global venture capital investing is now coming from Asian investors. No longer do America’s leading venture capital firms have exclusive first crack at high potential American ventures.
Moreover, in our own homeland, money has begun flowing in the other direction too, with major US venture capital firms raising large funds for investment in Asia. Sequoia has been particularly active in this area. According to TechCrunch, “Beyond being one of the premier VCs in the U.S. and China, Sequoia also enjoys a top-tier reputation in Asia and, more recently, in Southeast Asia, where it has accelerated its presence in recent years.” A couple of months ago, Sequoia announced the close of its fifth India/Southeast Asia fund, this one raising $695 million.
One shouldn’t ignore, though, emerging governmental regulations that could slow the opportunities for Asian, especially Chinese, investment in US ventures involved with sensitive technologies. On October 11, the Wall Street Journal reported that “(US) Treasury officials issue rules requiring all foreign investors in certain deals involving critical US technology to submit to national security reviews or face fines as high as the value of their proposed transactions.” This is expected to bring more transactions under the purview of the Committee on Foreign Investment in the US. Previously, this committee focused only on deals where foreigners took controlling stakes in US businesses. This could significantly constrain investments in the US by Chinese VCs as well as Chinese tech giants such as Tencent, Alibaba, and Baidu. Our guess is that administrations following the current Trump administration will pursue this issue less vigorously, and so its impact may be relatively short-lived and not persist over all of the next decade.
Combined, the rise of non-traditional venture capital investment sources will likely change the investment opportunity landscape for accredited individual investors. Access to individual venture deals may diminish, though as we will discuss a little later, other developments in the venture capital industry are expected to open new venture investment opportunities, particularly in early stage deals. We will come back to that.
We do, though, expect that individual accredited investors will be able to invest more broadly in the venture asset class through funds made available by some of the new venture capital participants such as PE firms and traditional investment/wealth managers. We expect some of these firms to serve as intermediaries offering easier access to the asset class than has been available traditionally through the major institutional VCs. They may, for example, offer funds with manageable minimum investment requirements, just as some PE firms have begun doing in the private equity asset class and as some major wealth managers have done through limited partnerships in other asset classes.
Net, we believe the venture asset class will remain relevant to accredited individual investors, but accessed differently than in the past.
Venture Capital Investment Sector Focus
As shown below, venture capital investment has become less active in a number of sectors, while remaining strong for Software and Pharma/Biotech. While available data sources don’t break out reliably most of what is included below in “Other” sectors, we believe that there has been strong recent growth in importance for Automotive/Transportation, Fintech, and Robotics investments that are not classified as Software.
% of Venture Capital $’s by Industry Sector
Source: Pitchbook-NVCA Q2 2018 Monitor
* Healthcare **Includes small shares (consistently <5%) for Media, Healthcare Services & Systems, and Consumer Goods & Recreation, along with a larger “Other” classification
Average deal size has grown, and is expected to continue to grow over the next decade, for most sectors for reasons discussed earlier. Recent deal size growth has been particularly marked, though, for Software and Pharma/Biotech. We believe that in the case of Software, the increasing deal sizes reflect in part heavy investment in artificial intelligence, where expenses for development and then for early commercialization tend to be higher than for more “traditional” software ventures. For both Software and Pharma/Biotech, the growth in dollars per deal also reflects the increased importance of non-traditional venture investors, particularly internal corporate venture funds, which have the capacity to invest larger amounts in individual deals.
Average Deal Size (M $’s) by Sector
Source: Pitchbook-NVCA Q2 2018 Monitor *Healthcare
Over the next decade, we are forecasting continued strong venture investment growth in Software and Pharma/Biotech. Software dollars will be fueled by accelerating development of increasingly powerful artificial intelligence technology and applications. Pharma/Biotech venture investment will be driven by the trend for the major Pharma leaders to rely increasingly on external ventures as a substitute for costly internal R&D, at least through early clinical trial stages. This substitution will help to sustain and grow immediate earnings, while subsequent acquisition and licensing deals can be treated as asset acquisitions on their balance sheets.
In addition, we forecast increasing investment importance for Fintech, Automotive/Transportation, and Robotics.
- Fintech investment has just recently begun to take off, due in part to recent convergence of important societal trends including reduced use of cash/increased digital payments and online banking. Ventures in areas such as innovative payment systems and online banking will require substantial investment to meet capital reserve requirements and achieve practical scale quickly.
- Automotive/Transportation investment is forecast to remain strong and grow further as selfdriving cars become a reality and the Millennials and urban population more broadly eschew individual automobile ownership in favor of car sharing and services such as Uber.
- Robotics is now in just its early stages. As artificial intelligence and technologies such as artificial vision and virtual reality advance further, opportunities for more advanced robotics to address today’s heavy work and labor drudgery are expected to take off. Aging populations and declining birth rates in the developed world should make robotics increasingly important and valued.
Broadened Geographic Participation in Venture Capital
We discussed a while ago a trend toward larger venture capital deals funded by larger, often nontraditional venture capital sources. We said we expected that trend to continue, and for some of those non-traditional venture capital investment sources to serve an intermediary role for accredited individual investors, similar to the way individuals today can invest in PE funds and in limited partnerships in other asset classes.
Well, we also expect a market for individual, smaller, early stage deals to emerge in geographies not generally thought about as major venture capital markets.
In earlier times, venture capital investing in the US was focused almost entirely in the Bay Area, Silicon Valley, and the Route 128 highway circling Boston. Due to financial industry and wealth concentration in the New York City metro area, that too emerged a while ago as an important center of venture capital investment. For the period from Quarter 1 2016 through Quarter 2 2018, California, New York, and Massachusetts still dominate, accounting for 53% of all US venture capital deals and 76% of all dollars.
The remaining 47% of deals and 24% of dollars represents a newer and growing phenomenon. Venture capital investing activity is now beginning to spread more broadly. For the ten calendar quarters through Q2 2018, ten other states have had venture capital investments totaling more than $2 billion, and another seven have had venture capital investment exceeding $1 billion. Our home state of Illinois ranks #6 in venture capital investment over that period, at $4.1 billion, and 5 other Midwestern states (Ohio, Minnesota, Michigan, Wisconsin, and Indiana) have all exceeded $0.5 billion. These Midwestern states combined have accounted for almost 3,000 deals over the past ten quarters — 9% of all US deals — and $9 billion, 4% of all dollars.
We expect the geographic broadening of venture capital investment to accelerate over the next decade, as more regions and metro areas establish meaningful venture capital eco-systems, with relevant educational programs, incubators, accelerators, and a network of entrepreneurs and investors. These newer venture capital centers have only recently begun finding their way onto the venture capital investment radar screen.
While the deals in California, New York, and Massachusetts are getting bigger and more institutional, these newer markets are emerging with a primary focus on smaller, earlier stage deals. Most deals are too small for major investment firms but suitable for smaller, local firms, providing early stage deal opportunities for individual investors.
Q1 2016 – Q2 2018 Venture Capital Investment by State
Source: Pitchbook-NVCA Q2 2018 Monitor
AmericanInno recently reported that coastal VC firms are beginning to come in earlier on Midwest start-ups as they reach outside their bubbles. This behavior is still somewhat limited, however, because the coastal firms simply do not have people on the ground in these other regions, close enough to those start-ups to have the knowledge and confidence to invest more frequently.
This is expected to change over the next decade, since some of these newer markets have posted investor returns exceeding the traditional California and Northeast markets. Investment dollars tend to flow where the returns are. There’s little reason that should change.
A Crunchbase News analysis of funding and exit data over the period 2008-18 showed return multiple on invested capital (MOIC . . . calculated by dividing startup exit value by the total amount of venture capital raised by that startup) being highest in the broad Midwest region (at 5.17x) versus MOIC of 4.29 in the West (primarily California) and 3.89 in the Northeast (including New York and Massachusetts).
Pitchbook’s 2018 Chicago VC Ecosystem Report, released in conjunction with ChicagoNEXT’s Chicago Venture Summit, found that the Chicago metro area in particular outpaces other U.S. venture ecosystems — including the Bay Area — in median MOIC. During presentations at the summit, it was mentioned that Chicago’s 1871 Center for Technology and Entrepreneurship is the #1 innovation hub in the world. One pundit writing for AmericanInno recently forecasted that within five years all the major American venture capital firms will have a presence in Chicago.
Metro Area Median MOIC per 2018 Chicago VC Ecosystem Report
Source: Pitchbook 2018 Chicago VC Ecosystem Report
Chicago is not alone as a growing venture capital center. As the unofficial commercial capital of the Midwest and largest Midwest venture capital center by far, though, it’s worth considering why it has already become significant to venture capital investing and why its significance, as well as the importance of other areas outside of California and the Northeast, is expected to grow over the next decade. Here are some of the reasons:
- The Chicago metro area and the broader Midwest host a rich range of industries, cultivating a commensurately rich range of technologies and technological genius. 30% of S&P 500 headquarters are in the Midwest, providing a rich range of technical expertise ripe for entrepreneurship and ripe with prospective customers for high tech ventures and prospective acquirers of those ventures.
- While Silicon Valley and Boston’s Route 128 may be thought of as the center of information technology and its practitioners, Midwestern universities account for 25% of all US computer science degrees.
- The cost of living, and hence the cost of housing and staffing start-ups, is much lower in the Midwest, including Chicago, than in the traditional California and Northeast venture hotbeds. This allows Midwestern ventures to develop at a lower cost and hence to require lower levels of funding, which accounts for the superior returns on invested capital.
While the Midwest and other regions away from the two coasts do not yet enjoy comparably robust venture investor demand, making venture investment fundraising (as well as paying for venture capital investment professionals) a challenge, innovative approaches to address this challenge are emerging. For example, VCapital is part of a Midwestern venture capital consortium which can pool capital and leverage combined manpower to cooperate and collaborate on investment sourcing, venture due diligence, investing, and managing investments. There are now eleven firm members throughout the Midwest, with combined capital of over $500 million. This cooperative and collaborative approach will help these smaller firms compete against the older, larger California and Northeastern firms.
In addition, smaller venture capital firms are increasingly working collaboratively based not only on geography but also on venture industry sector, deal stage, capital resources and requirements, and personal relationships. Just as with the geographically focused Midwest consortium, this more informal collaboration brings together capital and manpower resources to support competitiveness. For example, as we become aware of deal opportunities in an industry sector where we have less inhouse expertise, we may turn to a firm specializing in the particular industry sector to augment our own due diligence capabilities. Similarly, collaborating firms may together be able to raise funding levels that exceed any one firm’s capabilities, thereby competing more effectively for the most attractive ventures, which might otherwise be scooped up by the larger leaders on the coasts.
Information – More of It, More Accessible, and More Actionable
We earlier discussed how information technology has helped start-up ventures to accelerate development more efficiently and hence to go further before requiring formal venture capital funding. So too information technology is aiding venture capital investors and is expected to become even more important in the future.
Information is critical to venture capital investors, and we take for granted today a wealth of information far greater than what was available a decade ago. We are able to access publicly available information to amass considerable knowledge about specific industries and markets, the technologies behind them, competition, and even the venture’s key principals. The best venture capital investors, of course, still need to combine their information-driven left brain with their creative and more intuitive right brain. Keen perception of less researchable human factors will always be important.
Going forward, though, greater information availability and its timely accessibility will become increasingly important. Those with the resources and capabilities to tap into that information speedily and insightfully will enjoy market advantage.
This will likely cause venture capital investing to be less of an insiders club and more open to any entities with strong information gathering and analytic capabilities and adequate access to risk capital. This is expected to result in greater venture capital investment participation by large private equity firms and other broad investment management firms. It should also make collaboration between smaller venture capital firms more important to level the playing field and allow these smaller boutique firms to compete.
Within a decade, artificial intelligence may also play a greater role in the screening and assessment of ventures and deals. The nature of such artificial intelligence applications, though, is difficult to predict. Will they be based solely on quantifiable economic, market, and deal variables? Or will more qualitative human management factors also be included in the artificial intelligence algorithms? Will these artificial intelligence applications be developed by third party specialists and then made available to a broad range of investment firms on some sort of subscription or SaaS basis? Or will the largest venture capital firms or particularly committed, broader-based financial services firms invest in such capabilities for their own use and resulting marketplace advantage?
While answers to these questions are still uncertain, what does seem likely is that somewhere in the future, and possibly within the next decade, artificial intelligence will enable venture capital investment professionals to look further, dig deeper, and see more accurately.