How do VCs react to a broken industry?

“Venture Capital is broken” — A term gaining a lot of momentum in the past years. Practitioners and researchers have been criticizing the current VC model and its embedded problems like portfolio size, biased decision-making leading to missing diversity, and decreasing returns, to name just a few. Nonetheless, the VC industry grew in terms of invested capital with a CAGR of 19% from 2004 to 2018 to reach its peak of $308 billion invested worldwide. Respectively, the number of active funds increased as well with a peak of 1,403 in 2018. The logical consequence of this development is an industry becoming more competitive. Therefore, providing capital as the sole resource to start-ups does not differentiate your VC from the one next door anymore.

To counteract the broken VC model and stand out from the crowded VC landscape, I researched innovative approaches to Venture Capital and summarized my findings by mapping them along the investment cycle (Figure 1).

1 ) Investment approach

• Characterized as “Solo Capitalists” by Nikhil Basu Trivedi, investors like Elad Gil, Joshua Buckley, and Lachy Groom start to lead investment rounds on their own by writing checks up to $5 million.
• The index investing approach tries to eliminate bias, diversify risk, and ensure stable returns by heavily increasing the VC’s portfolio size beyond 100+ portfolio companies. VCs following this approach are e.g., 500 Startups, Loyal VC, and Crowdfunder.
• By relying on Venture Capital as a Service (VaaS), corporates do not have to build up their own fund but can easily outsource this process. VCs with extensive industry experience like e.g., Redstone take over the whole investment lifecycle from sourcing to operative portfolio work according to the corporates’ preferences.
• As capital became a commodity in recent years, some VCs differentiate themselves by providing other resources than capital in exchange for equity ownership. 4 Channel Ventures and Ad4Ventures offer advertisement channels for growth companies instead of capital injections. Another example is Sweat Equity Ventures that follows the approach of investing time and expertise for equity.
• The number of VCs specializing in specific verticals and stages grew recently. For example, Senovo only invests in early-stage B2B SaaS companies. On the other side, however, there are still plenty of big VCs that are stage and vertical agnostic like Sequoia, Accel, or a16z. A good read about this topic can be found here.

2 ) Fundraising/fund structure

• AngelList recently introduced rolling funds. This concept implies a fund being always open to LPs to commit capital on a quarterly subscription basis. Additionally, GPs do not have to wait until reaching the first closing anymore but can rather start investing the capital right away. Thus, the time-consuming fundraising process becomes leaner and both LPs and GPs are more flexible.
• To also use the technologies they invest in, SPiCE VC established the worldwide first fully tokenized fund. They spun off the platform Securitize to ensure efficient and regulatory-compliant processes. By doing so, LPs' interests in SPiCE can be tokenized.
• By leveraging blockchain technology as well, Stacker Ventures democratizes early-stage investing. A community-driven protocol invests pooled capital on Ethereum. This means that everyone owning an Ethereum wallet can participate in Stacker Ventures’ investment activities.
• ADV introduced “patient capital” for early-stage companies. They argue sustainable growth, which can take up to 20 years, is hard to achieve within a typical fund’s lifecycle of 5 to 7 years. To solve this conflict, patient capital was designed to support ambitious start-ups in the long run.

Figure 1: Innovative Approaches to Venture Capital

3 ) Sourcing

• InReach Ventures invested more than $3 million into their technology backbone called “DIG”. The goal is to leverage machine learning algorithms to automate and speed up the process of identifying and sourcing early-stage start-ups. Let the number speak for itself: With the help of DIG, InReach Ventures was able to source 55,000 (!) start-ups within 12 months.
• Hatcher+ developed a VaaS technology platform in 18 languages and 50 currencies offering 20 APIs. The platform emphasizes AI-based deal scouting, as well as portfolio management and reporting. Additionally, “H+ Research” sheds light on 600,000 venture transactions from the past 20 years by applying deep-learning algorithms.

4 ) Screening & Diligence

• Does assigning voting rights in a boardroom to an algorithm sound crazy to you? That is exactly what Deep Knowledge Ventures did. The AI-based algorithm “VITAL” (Validating Investment Tool for Advancing Life Sciences) was announced to be part of Deep Knowledge Ventures’ board of directors to put more weight on data-driven investment decisions.
• EQT Ventures, similar to InReach Ventures, built their own technology platform called “Motherbrain”. The goal is to support investment decisions by using Motherbrain’s prediction score on an investment opportunity that ranges from 1 to 340. So far, the platform has been directly involved in seven investments.
• A new way of deploying capital was introduced by Social Capital’s “Capital as a Service” (CaaS) model: “[…][E]ntrepreneurs submit their transaction data to our automated diligence engine and we can make funding decisions in a matter of hours”. Only within the pilot phase, Social Capital was able to screen more than 3,000 start-ups from all over the world and invest in a couple of dozens. Most interestingly, concerning the beforehand mentioned diversity problems within the VC industry, the autonomous and data-driven investment approach led to financings of start-ups with CEOs being 42% female and the majority nonwhite.
• Follow[the]Seed also leverages the power of data to validate their investment decisions. Depending on the industry, they use two different approaches: First, when assessing B2B start-ups, they use “reverse problem-solving” to understand if the venture solves an industry pain point. Second, when analyzing B2C start-ups, Follow[the]Seed relies on the “RAVINGFANS®” model to predict users’ behavior.

5 ) Support

• The platform/community approach, pioneered by a16z, (further readings here, or here) is not new. Offering operational support to your portfolio has rather become the new normal than being something extraordinary. But there are a few players that have put this approach on a new level. Daphni, for example, developed a platform connecting investors, portfolio founders, experts, and academics from all over the world. This collaboration does not only allow Daphni to get extensive feedback on potential investments from industry experts but also enables portfolio companies to get feedback on their products, find new customers, or even secure follow-on funding from new investors. To put it in a nutshell: Every single stakeholder on the platform benefits from participating. Another example of evolving the platform approach is Backed VC. For their portfolio companies, they offer a founder development platform, access to the backed community, active board presence, a network ranging from angel investors to corporate customers, hiring support, a portfolio jobs board, and in-house brand and comms expertise (for details). Sounds like something especially every first-time entrepreneur would dream of, right?
• Next to well-known incubators and accelerator programs, so-called “Venture Studios” have emerged in the last years, to combine the advantages of both. Like in an incubator, venture studios help with idea generation and building a feasible business model. But after that, they do not stop. Often, they act also as co-founders and start scaling the business like in an accelerator program but without any time restrictions. Additionally, the venture studio deploys funding. Popular examples are Expa or Forward Partners.

Figure 2: Overview of Innovative VCs

Figure 2 clusters all innovative VCs by the aforementioned categories I could identify during my research. Obviously, VCs being innovative regarding sourcing, screening, and diligence prevail. The emergence of these data-driven VCs started nearly a decade ago when pioneers like Google Ventures (GV), Correlation Ventures, or SignalFire first publicly spoke about their usage of data in the investment process. If you are interested in further readings about data-driven VCs, I can recommend articles from Francesco and Bartosz. Not surprising but worth mentioning is the distribution of the identified VCs being innovative. Unchallenged in the first place is the US (65%) followed by the UK (13%) and Singapore (4%). I guess the main drivers for this result are the (still) dominant VC hot spots in the Bay Area or the Bos-Wash Corridor.

In the next step, I will use the gained insights to have a closer look at Germany’s VC landscape and its openness to innovative approaches — so stay tuned!

In the meantime, feel free to reach out in case you have any questions, remarks, or suggestions for further research topics. Happy to discuss and collaborate!