Innovation in Venture Capital: Identification and Validation of Innovative Approaches within the German Venture Capital Industry
TL;DR
Besides its ever inherited diversity problem, the Venture Capital (VC) industry faces new challenges: First, VC firms are willing to pay sky-rocking valuations and deploy significantly more capital per financing round. Second, investors from other asset classes push into VC financing rounds, drastically intensifying the VC industry’s competition. To master those challenges, this work fundamentally hypothesizes that innovation within VC firms themselves is needed.
Hence, to validate the above hypothesis for the German VC industry, I first suggest appropriate definitions for innovation within VC. Second, taking the proposed definitions as a reference, this work identifies four VC-innovation-clusters, namely (A) Investment Approach, (B) Fundraising and Fund Structure, (C) Data-driven Investment Decision, and (D) Post-investment Support by researching VC practitioners’ approaches globally. Third, I formulate ten precise Hypotheses, incorporating the findings of the VC-innovation-clusters, that are tested empirically for the German VC industry by conducting expert interviews with investment professionals of German-headquartered VC firms. Fourth, the study leverages a scaled structuring content analysis and inductive categorization to derive insights from the expert interviews. For academic literature, this work composes the baseline framework for researching innovation within VC that can be referenced for future analyses. For VC practitioners, the results suggest that focusing on superior Operational Support bears the potential to cope with increasing valuations and deal sizes. Further, I identify that Differentiators help to deal with increasing competition. Those Differentiators allow VC firms to outsmart their competition and thus potentially secure contested deals. Moreover, this study finds that Data-driven Investment Decisions crystallize to solve VC Germany’s diversity problem by eliminating human bias from investment decisions if trained with adequate data samples. Last, based on the experts’ insights, I find a fifth VC-innovation-cluster, namely (E) New Exit Strategies.
VC’s current Challenges
Considering the latest developments, one might ask whether VC is still a sustainable way of financing growth for entrepreneurial companies. VC firms, which act as a financial intermediary to deploy investors’ capital in such young companies in exchange for equity ownership, currently face various challenges, as illustrated in Figure 1.
First, the VC industry is becoming more competitive, thus capital a commodity. This trend can be derived from the number of active VC firms and their willingness to deploy more capital and pay higher valuations. Within the last year, active VC investors globally grew by 9%, from 28,044 to 30,625. In addition, median deal sizes increased from $1.67 mn in 2020 to $4.00 mn in YTD 2021 (as of 18th of July), and median post valuations jumped from $15.00 mn in 2020 to $32.00 mn (!) in YTD 2021. Therefore, VC firms must deploy more capital and pay higher valuations to secure deals and cope with increasing competition. However, paying higher valuations bears the risk of losing financial returns if such over-payments cannot be realized when exiting the investment. Eventually, VC firms may not be able to return the promised benchmark to their investors, which would mean the demise of those VC firms.
Second, investors from other asset classes push into VC financing rounds, putting even more pressure on the VC industry. For example, Tiger Global, who used to be a hedge fund and asset manager, launched a $6.7 bn venture fund at the beginning of 2021. Everett Randle argued that Tiger Global’s current success is based on two factors that differentiate itself from other VC firms: maximum deployment velocity and cheap capital for founders. The rationale behind maximum deployment velocity is that albeit absolute returns might be lower due to rushed due diligence processes, faster capital deployment can increase the yearly returns. Cheap capital implies that Tiger Global tries to distract entrepreneurs as little as possible by keeping the due diligence process fast and light and incentivizes them by paying high valuations leading to lower dilutions for founders. In addition, the competitive pressure within the VC industry is further reinforced by highly reputable VC firms launching new funds going upstream or downstream to exploit new investment stages, putting, again, pressure on VC firms already active in those stages. For instance, HV Capital, which historically focused on early-stage investments, launched a €535 mn growth fund to finance non-portfolio companies in this stage.
Last, VC has a two-folded diversity problem: first, research from Gompers and Wang (2017) showed that VC firms lack investment professionals being female or from ethnic minorities. Second, studies from Greene, Brush, Hart, and Saparito (2001) and Brush, Greene, Balachandra, and Davis (2017) revealed a significant gender gap between female and male entrepreneurs receiving VC financing in the US. Additionally, a report from Crunchbase (2020) found that Black and Latin founders raised only 2.4 percent of funding in the US from 2015 to August 2020. Taking those considerations into account, what can a VC firm do to cope with increasing competition coming from within and outside the VC industry and solve VC’s diversity problem?
Innovative Approaches within VC to tackle those Challenges
To answer the above question, I fundamentally hypothesized that innovation within VC firms is needed to tackle those challenges. Hence, after suggesting appropriate definitions for innovation within VC (see Figure 3), I researched innovative approaches used by VC practitioners globally. Google, Reddit, and Twitter were used as search tools to identify those innovative approaches within VC. The underlying publication channels mainly were Medium, Forbes, Techcrunch, Wall Street Journal, Podcasts, Conferences, and the VC firms’ homepages themselves. The identified innovative approaches within VC are split into four VC-innovation-clusters, including ten precisely formulated Hypotheses as outlined in Figure 2. For an in-depth analysis of the innovative approaches within VC behind the Hypotheses, you can check out my post summarizing the research results. Furthermore, there has not been a scientific approach to researching innovation within VC. Consequently, this work additionally represents the baseline framework to analyze innovation within VC.
Summary of Findings for the German VC industry
To evaluate the identified Hypotheses for the German VC Industry and analyze their potential to solve the current challenges, I conducted expert interviews with investment professionals of German-headquartered VC firms. The results of the expert interviews, which I derived by applying qualitative content analyses as suggested by Mayring (2015), are two-folded:
First, as illustrated in Figure 4, I adjusted the Hypotheses based on the experts’ opinions. For cluster (A) — Investment Approach — I find a duality for early-stage German VC firms to either focus on increasing their portfolio size or their operational involvement within their portfolio companies. Additionally, the gap between Agglomerates and Specialists, who predominantly focus on early stages, will further increase within the German VC industry. Last, the analysis shows that Venture Capital-as-a-Service holds the potential to replace German CVCs. The findings for cluster (B) — Fundraising and Fund Structure — reveal that there is currently little momentum for the German VC industry: neither Rolling Funds nor the Tokenization of Funds have a substantial impact on changing the fundraising process or fund structures. Within cluster (C)— Data-driven Investment Decisions — I find that data-driven investment decisions can solve VC Germany’s diversity problem if trained by unbiased data samples. Furthermore, the sourcing process will be mainly automated within the near future. In contrast, automated investment decisions will be only applicable for later-stage deals containing enough quantitative data points within Germany. Finally, cluster (D) — Post-investment Support — reveals that post-investment support is already a key differentiator within the German VC industry, which will gain importance in the future. However, Venture Studios will not replace (Pre)-Seed VC firms but co-exist within Germany.
Second, the central finding derived from further innovative approaches within the German VC industry suggested by the experts is the fifth VC-innovation-cluster New Exit Strategies, including SPACs and Acquire-Hires as specific innovative approaches. Moreover, I find that other innovative approaches within the German VC industry are mainly about Differentiation. Independently of the underlying VC-innovation-cluster, the innovative approach is primarily about differentiating itself from the competition. For instance, Revenue-based Financing offers a new investment approach to finance entrepreneurial companies also non-dilutive and thus founder-friendly. Next, enabling retail investors to access VC investments changes the fundraising process and allows for a different LP structure. Then, offering Founder Carry, more Convertibles, or Legal Standardization to start-ups differentiates a VC firm within the actual investment process. Last, providing synergies to start-ups by participating in Platform Portfolios is, again, a Differentiator. A holistic overview of all further innovative approaches within the German VC industry suggested by the expert is shown in Figure 5.
Implications for the German VC Industry
To close the loop, the following section discusses whether this work’s results have the potential to positively influence the VC industry’s challenges. More precisely, I discuss the impact of innovation within the German VC industry on (i) the development towards larger deal sizes and higher valuations, (ii) the competitive pressure coming from within and outside the VC industry, and (iii) VC’s diversity problem, as illustrated in Figure 6.
First, the German VC industry must be considered isolated in developing larger deal sizes and higher valuations. As illustrated in Figure 7, German median deal sizes and post valuations also increased from 2020 to YTD 2021 (as of 18th of July).
However, the jump is more subdued than US developments (see Figure 8). German median post valuations jumped to $23.9 mn in YTD 2021, whereas US median post valuations jumped to $48.9 mn in YTD 2021 (as of 18th of July). While German and US median deal sizes show a minor deviation of $0.5 mn in YTD 2021, the American median post valuation for YTD 2021 exceeds the German median post valuation by $25.0 mn (!). Consequently, American VC firms must be willing to pay a higher pre-valuation than German VC firms.
Hence, it can be concluded that the German VC industry is not yet affected as much by the developments regarding higher valuations — at least not to the same extent as the global average (as outlined in “VC’s current Challenges) and significantly lower than in the US. However, considering a statement regarding the development of European and US valuations by an interview expert, it can be argued that it will not take long until European valuations reach the US level. The interview expert illustrates that there is currently pressure from American later-stage funds like Index or Accel coming to Europe by deploying hundreds of millions in European early-stage rounds and thus increasing valuations and deal sizes. In addition, the interview expert sees Tiger Global as a reason for increasing valuations and deal sizes since a former hedge fund has the financial resources to over-pay prices in Seed or early-stage rounds. As a result, how can innovation within VC help to solve such price wars?
Based on the results of the adjusted Hypotheses, focusing on superior Operational Support and realizing cost efficiencies by leveraging Data-driven Investment Decisions have the potential to counter the problem of rising valuations. First, and most importantly, providing operational support to portfolio companies crystallizes as a central innovative aspect within the adjusted Hypotheses, underlined by Hypotheses A.1, A.2, and D.1. Looking at Hypothesis A.1, it becomes clear that focusing on providing operational support is a conscious decision reflected fundamentally by German VC firms’ investment theses. Next, the validation of Hypothesis A.2 shows that the German VC industry is segmented into Specialists, who focus on operational support, and Agglomerates. Additionally, the confirmation of Hypothesis D.1 highlights the role of post-investment support as a current key differentiator, which will gain importance in the future. Hence, based on the shift towards operational support, it can be argued that this offers a possibility to cope with rising valuations. Especially in earlier stages, the VC firm’s expertise and operational support could add more value to a start-up than providing solely more money through paying a higher valuation. Consequently, focusing on operational support could prevail over providing more capital by paying higher valuations and thus secure competitive deals. Second, automation within the fundraising process, as suggested by an expert, and investment process, as underlined by Hypotheses C.1 and C.2, bears the potential for cost savings. Hence, the freed financial resources allow paying higher valuations.
Additionally, as suggested by the experts, Data-driven Fundraising, Platform Portfolios, and exiting investments via SPACs contribute to solving challenges regarding higher valuations and larger deal sizes for the German VC industry. Data-driven Fundraising streamlines internal processes enabling cost savings, allowing reallocating those financial resources to pay higher valuations. Synergies within Platform Portfolios realize cost saving for the VC firm’s portfolio companies. As a result, the portfolio companies can use those cost savings, for instance, to expand into a new market. The enabled growth of the portfolio company will ultimately be reflected in the company’s valuation, which, in turn, justifies paying a higher valuation by the VC firm in the first place. Aiming at divesting a portfolio company via a SPAC from the very beginning also supports paying higher valuations by considering the following aspect: SPACs show a characteristic overlap with an IPO, which offers the financially most attractive divestment strategy. Hence, having the potential to realize outstanding financial returns via a SPAC justifies paying a premium when investing in the company.
Second, innovative approaches can help relieve competitive pressure in the German VC industry, which arises through players like HV Capital and Tiger Global that expand to new investment stages and push into VC from other asset classes, respectively. Again, it can be argued that providing Operational Support and being a Specialist, supported by mainly automated sourcing, could fend off those threats. For instance, considering Tiger Global’s value adds of fast deployment velocity and cheap capital, it becomes apparent that any involvement in portfolio companies is missing. Consequently, it is very likely that at some point throughout the earlier stages of a start-up’s life cycle, the founders would instead rely on a VC firm that also brings operational involvement and experience to help realize the start-up’s vision. Hence, operational VC firms should additionally focus on predominantly automating the sourcing process, as suggested by Hypotheses C.1, to recognize such opportunities as early as possible and thus stay competitive with players like Tiger Global. Further, as illustrated by Hypothesis A.2, a VC firm specializing in a specific stage can cope with players like HV Capital that push into those stages. The Stage Specialists have the advantage of knowing precisely what drives a decent investment decision in this particular stage, whereas VC firms newly pushing into this stage lack this expertise. An interview expert underlines this argument by pointing out that several early-stage funds, like HV Capital, were historically successful and thus raising larger funds, ultimately leading to growth investments. Nevertheless, the interview expert questions if a good early-stage investor like HV Capital is necessarily a good growth investor?
Furthermore, the experts suggest innovative approaches within the German VC industry that can be grouped as Differentiators. Hence, those Differentiators also hold the potential to cope with increasing competition coming from within and outside the German VC industry. For example, providing Revenue-based Financing as a VC firm can secure competitive deals since founders are incentivized not to dilute while receiving funding. Additionally, offering Founder Carry incentivizes founders to decide for the respective VC firm because the founders would also benefit financially in a successful future exit of the VC firm. Next, Legal Standardization and Convertibles differentiate in time-critical investment decisions. Legal Standardization of term sheets and shareholder agreement documents streamlines the investment process and leads to faster funding. Providing funding via Convertibles also results in speedier funding since the shareholder structure is initially not affected by accepting such a debt-like instrument. Further, Platform Portfolios offers portfolio companies access to network effects, which illustrates another strong argument for winning competitive deals. Last, Institutional Pre-Seed VC firms differentiate themselves by participating in financing rounds covered mainly by BAs historically but still provide the advantages of a VC firm like post-investment support and access to an extensive network.
Third, the clear result of all experts validating Hypothesis C.3 highlights the potential of Data-driven Investment Decisions to solve one pillar of VC’s two-folded diversity problem for the German industry. The experts are convinced that funding would be distributed equally and finally find increased founders being female or ethnic minorities by relying more on unbiased data and algorithms than on biased human perceptions. However, as mentioned by the experts, the crux to achieving such a result lies within feeding the algorithms with unbiased data because an algorithm can only be as unbiased as its input data. Therefore, the quality of data input is of utmost importance to not even worsen the diversity results. Moreover, Ambassador Programs and Community GPs can also positively influence the diversity of founders receiving funding. Launching an Ambassador Program which covers various stakeholders from the industry and universities in different geographic areas complements the sourcing process and may lead to a more diversified funnel of investment opportunities. Also, a Community GP may result in more diversified investment decisions since this approach incorporates more opinions than a usual VC firm, reducing personnel bias within investment decisions.
Conclusion
In a nutshell, this work represents (i) the baseline framework for researching innovation within VC and (ii) suggests opportunities for German VC firms to cope with increasing competition and partially solve VC’s inherited diversity problem by leveraging innovative approaches.
First, the baseline framework composes appropriate definitions for innovation within VC that are mapped along the VC value chain. Under consideration of the proposed definitions for innovation within VC, this work identifies five different VC-innovation clusters: (A) Investment Approach, (B) Fundraising and Fund Structure, (C) Data-driven Investment Decision, (D) Post-investment Support, and (E) New Exit Strategies. Hence, the five VC-innovation-clusters paired with the suggested definitions for innovation within VC function as a starting point for future research within this area.
Second, this work identifies innovative approaches within the German VC industry that hold the potential to master challenges regarding (i) increasing valuations and deal sizes, (ii) intensifying competition, and (iii) VC’s diversity problem. First, I argue that providing superior Operational Support and Automated Sourcing are key elements to cope with increasing valuations and deal sizes. Furthermore, Data-driven Fundraising, Platform Portfolios, and exiting investments via SPACs reveal to also positively impact this particular challenge. Second, this work finds that providing superior Operational Support as a VC firm also offers an effective way to fend off threats from players like HV Capital and Tiger Global that recently pushed into VC financing rounds in which they have not been active before. Additionally, various innovative approaches that can be grouped as Differentiators help to deal with increasing competition. Those Differentiators include being a Specialist VC firm or offering Revenue-based Financing, Founder Carry, Legal Standardization, more Convertibles, and Platform Portfolios. Each Differentiator allows the VC firm to outsmart their competition and thus potentially secures contested deals. Third, Data-driven Investment Decisions crystallize to solve VC Germany’s diversity problem by eliminating human bias from investment decisions if trained with adequate data samples. Additionally, Ambassador Programs and Community GPs can lead to more diversification within founders receiving funding.
Consequently, this work fundamentally suggests innovating the funding source itself, namely VC firms. This ensures that general innovation, driven by high-growth start-ups, remains sustainably funded in the long run. Otherwise, recent developments of increasing competition leading to absurd valuations paired with VC’s inherited problem of privileging white male founders may end in a bubble bursting that badly impacts the whole entrepreneurial ecosystem.
Click here for a visual summary (in high quality) of the work.
About this Work
The research was undertaken as part of my Master’s Thesis at the Chair of Strategy and Organization at the Technical University of Munich. Also, I would like to take this chance to express my gratitude to Isabell Welpe for her extraordinary supervision throughout the whole journey.
Feel free to reach out if you have any questions or remarks — happy to discuss.
