Back to the Future in Venture Capital: Small is Beautiful

The Macro is the cost of capital going up. Baby boomers are retiring and their capital will be going to more conservative asset classes instead of something risky like venture capital. No surprise either as LPs returns haven’t been destroyed because of markdowns in the recent year. A big come down from the insane exuberance of 2020-21. 

Instacart went public at $9.9B when their last private valuation was $39B. Or Stripe getting their valuation gutted by 50% from its peak of $94B. If this is happening to the best private tech company in the world, what do you think will happen to the almost 1400 so-called Unicorns in the last few years? 

There is another trend happening at the startup level. There is a new major Refactoring of startup costs. whereas you needed $5M USD in 1999 to build a product, due to new SaaS tools, cloud services like AWS and new distribution platforms like the Apple AppStore, new startup costs dropped to around $500k in 2008-2010.  Yes, the multitude shrinkage of startup costs led to an explosion of new and awesome startups over the last decade. 

I posit that we are entering a new inflection point now. There is a rise of even more cloud services, open source developer tools and plenty of low/no code tools as well as the plethora of amazing new AI-tools. Scenario or Midjourney are good examples on the Gen Ai side. Or think of what Bubble or Softr have done for prototyping products.  Startup costs will be a fraction of what it was before. 

 You probably only need $50-100k in 2023 to get an amazing product out the door. Tech is giving new founders even more leverage. 

This has huge ramifications on the VC industry. 

I could not articulate this at all until I heard an interview with Sam Lessin of Slow VC. The “Factory line” model of VC is over. Seed VCs packaging for Series A investors. Series A investors packaging startups for Series B. On and on goes the factory line until the company is packaged to go public. Works great during boom times but this factory model has broken down as the inventory has rotted and is being worked through. Ie. big valuation markdowns in the private market as the IPO market has shut down or set much lower clearing prices at exit. 

Which means that all the lessons that we learned of venture and startup land in the last 11 years are now obsolete. Worth watching the entire Turpentine VC interview here: https://www.youtube.com/watch?v=py7IPmDKjb4&t=64s

This discussion on the State of Seed Investing with investing legends Sam Lessin, Jason Lemkin and Frank Rotman is also very valuable too: https://www.youtube.com/watch?v=ZUrKr8g8cqw

It has ramifications on the founder’s side. Terence Rohan, said it best in his masterpiece: “Raise less build More:” 

“Today, there is a growing common awareness amongst founders that a VC-only path can put them out of business, from either too little capital or pressure to take too much capital. If their company doesn’t exist, the chance of success is zero. 

On the other hand, if they are constrained by just profitability, they might not be able to build what they need to build, or others can outrun them. Bootstrapping alone can also impede. 

I’ve had similar conversations with dozens of founders on this topic, and I’m seeing them quietly start to pursue a new path – one that doesn’t perfectly fit within the lines prescribed by Sand Hill Road.

They are seeking to combine the growth of targeted venture funding with the durability found in bootstrapping (i.e. profitability).  

Their goal is to build a viable business first, while also harnessing the growth, network, and brand benefits of strategically raising capital from top investors. 

It’s a new hybrid path, and one that maximizes their odds of survival and breakout success.”

Source: https://trohan.com/2023/08/20/raise-less-build-more/

Notion, Calendly, Vanta, Zapier, Etc are good examples here. Rounds will be skipped or companies will go to profitability sooner. Bootstrapping will be en vogue and more popular, especially for 2nd time founders. 

The big implication for the venture capital industry overall is that it will become even more of a barbell structure. 

This has already started happening in Hollywood: Blumhouse which focuses on cheap but well crafted horror movies versus big studios like Warner, Sony, Disney et al. and their big expensive and well marketed blockbusters. 

In the Big VC world, we have A16Z, General Catalyst, Sequoia which will have the big massive funds, playing the AUM game side of the barbell. 

Then you will have the small funds on the other side of the barbell.  Specialists, niche and emerging funds practicing the artisanal model. The smartest funds are disciplined ones. Going back to basics. Bespoke.

Some that come to mind are: K9, Haystack, KP, Susa, Floodgate, Union Square Ventures. I’m also excited that Indie.vc is making a comeback. Indie.vc, if you don’t know, invests in software startups but allows the optionality for bootstrapping and getting fund ROI via revenue sharing or going down the VC “go big or go home” funding path as well. 

At the earlier stage of VC there will be a restructuring. Nicolas Colin wrote in September 2023, and worth reading the entire write up but here is sample:  

“Not only has the VC industry suffered significant setbacks in recent times, but the surviving VC firms are those that have adhered closely to the original VC playbook. To me, this implies that the trajectory of the VC landscape, rather than undergoing perpetual expansion and diversification (the “diffraction”), will consolidate into three distinct segments:

• A limited portion of firms will either maintain or revert to the traditional artisanal approach, assembling a compact team, raising small funds, investing in a small pool of companies at reasonable valuations, and maintaining strict control over cap table and governance in an effort to achieve improbable, outsized returns. These firms will concentrate on enterprises engaged in pioneering technologies, essentially returning to the foundational roots of modern VC.

• Another subset of VC firms will specialize in B2B SaaS startups—a domain where uncertainty remains high regarding the success of founding teams, thus making room for a VC-like approach. However, unlike the preceding group, this specialization won't revolve around technological breakthroughs. Instead, it will involve supporting top-tier teams from product and go-to-market perspectives, banking on their adeptness in executing a meticulously designed and well-documented approach. In this realm, innovation takes a backseat to execution.

• Lastly, a considerable proportion of investors will need to acknowledge their inability to rightly claim the title of venture capitalists. They will forsake the excitement, no longer envision themselves as the next Don Valentine, and revert to the role of standard, boring private equity investors—allocating funds to companies that adopt comprehensible strategies across a wide array of industries, with the aim of achieving profitability through conventional avenues. While this isn't a bad thing by any means, it certainly deviates from the realm of true VC.” (Source:  https://www.europeanstraits.com/p/startups-the-door-is-closing)

I am also very excited by the new breed of new emerging fund managers. Especially as they have no legacy portfolio companies to take care of and have a blank slate and relatively small fund to invest. Much easier to deliver returns on a small fund as veteran VCs know. 

Everyone stuck in the middle of these two models are toast or walking dead at least in this new world. 

I fall on the side of small funds. I firmly believe in small VC funds, SPVs (Special Purpose Vehicles), investment syndicates and especially the rolling fund model like the one I run with my friend Carlos at Diaspora Ventures (diaspora.vc). In a nuclear apocalypse or nature’s equivalent, it’s the scrappy and small body mass that wins. It’s the big dinosaurs that die off. Small funds will be the cockroaches that thrive during times like this. 

I’m going to let the brilliant Sam Lessin have the second last word here: 

“Even in the scenarios where the companies that run the gauntlet ‘up and to the right’, the dilution is so intense along the way it kills seed investors' returns.

Which creates an ironic situation ideal for a tweet … which is the absolute best seed investments are the ones that never need to raise an A — especially with the scaling leverage of Cloud, and now AI — you can do mighty things with a few folks and a million dollars (and a focus on building a great business that is profitable all the way through) — and when you do that, all capital after the seed becomes an ‘option’ rather than a requirement.

In those scenarios? well that is the best for your seed investors — because there is no dilution… they own what they own… they provided the high risk capital when it was needed, and that capital was maximally leveraged.

Multi-stage funds can’t do this model, because they are forced / their job is to deploy capital at scale as ‘asset managers’ rather than investors— they want founders to need lots of money (which they can then supply at scale) — but real investors / seed funds CAN and SHOULD BE VERY EXCITED to execute this plan.”

What an exciting time to be in Silicon Valley as we see a new Renaissance of startups and venture capital.