The venture capital (VC) industry and the many angel groups that act like VC are a fascinating phenomenon. Since it’s official founding 74 years ago, it’s seen very little innovation. It still relies on good-ol-boy networks to find and evaluate startups and “gut feelings,” rather than data, serve as the primary drivers behind investment decisions.
It’s no wonder that only about 2% of VC investment goes to women-led startups (despite 39% of businesses being women-led), and only 3% of VC funding goes to black or Latino led startups. What’s more, 74% of VC funds have zero female investors and most investment is concentrated in California (which receives 54.13% of all VC investment in the US). And it’s extremely concentrated in certain industries: software (36.2%), biotechnology (17.3%), and healthcare (7.1%).
Given this super narrow focus is it any surprise that, even in spite of the unprecedented innovation that the world has seen in the last few years, the vast majority of VC firms are still unable to provide any returns?
It’s also important to note that back when VC was founded in the 1940s only “Accredited Investors” (basically, millionaires) were allowed to invest in startups by law. So the VC model only relied on attracting those folks who could invest in startups. And I think you can guess who the millionaires are in the USA…
About 4% of Americans qualify as “Accredited Investors,” and 80% of those “Accredited Investors” are white, 85% are men, and the average age is 62 years old. These are the folks whose money the VCs manage and those are the folks that the VC industry has a fiduciary responsibility to — not to startup founders.
I have nothing against 62 year-old white men (and I plan to be one myself one day) — but this is hardly the best demographic to be in charge of identifying and supporting innovation in the US and around the world. That is however the reality of the VC world and the core reason that VCs are objectively bad at their job, with the vast majority of funds unable to provide return to their investors, despite recent record economic growth.
Until recently, and despite all its well known problems, the VC industry has been the judge, jury, and executioner for countless innovation and disruption across almost every type of industry. When times are good, the power that the industry wields barely gets mentioned — let alone challenged.
But we’re of course now entering very challenging times, which is posing a serious threat to the VC model.
Why venture capital is already retreating from the market
The coronavirus crisis is changing things up in the VC world — and in a big way. The 74 year old way of doing business has become almost completely redundant with most countries in some form of lockdown. For the VC industry this means no ability to travel to the face-to-face interactions they rely on so heavily to court investors and startups.
Then there’s the unprecedented disruption to the portfolio companies and personal wealth of the VC industry.
This is creating a new found conservatism among VC investors, who are retreating from the market with a “wait and see” approach. And whatever innovation is coming out of this crisis will be truly innovative, not just iterative — meaning VCs don’t have any experts to evaluate it — and if they can’t evaluate it, they can’t invest in it.
The initial data we’re seeing come out of the investment industry makes clear the impact of these factors: VC firms have decreased their investments by more than 20% in Q1 of this year (with the first two months of Q1 January and February being business as usual, as the coronavirus wasn’t an issue at the time).
The investment landscape now versus the last crash
It’s certainly no secret that the instability and need that was created by the last cataclysmic economic event — the stock market crash of 2008 — gave birth to the most groundbreaking companies and business models that we call unicorns today.
A whole new breed of entrepreneurs with radical ideas were created. That chaos is what brought us Slack, Instagram, Pinterest, Cloudera, Airbnb, Venmo, Square, Uber, Yelp, WhatsApp, Groupon, and many more.
However, while the ’08 crash paved the way for the countless innovations that have upended so many industries, it didn’t fundamentally disrupt the old-boy network of VC investing. Back then, many VC funds were insulated from the economic shock, and startups had few alternate options when it came to funding rounds.
But this moment we’re now in is different. Equity crowdfunding (EC) has been slowly building in the background since it was unleashed by the JOBS Act in 2012 and has now delivered billions of dollars into early-stage startups. And alternative investment models like revenue-based financing are becoming more and more popular by the day.
The two leading EC platforms, Startengine and Wefunder, are reporting record Q1 investment volumes and record diversity in founding teams and industry focus. This means that startups aren’t dying and that innovation isn’t withering away. Every VC-independent indicator shows startups are still growing, while it’s the VC industry that’s in reverse.
As Jonny Price, the Director of Fundraising at Wefunder (a leading EC platform) recently put it: “March 2020 has been our best month ever already…..You can make a case that when the stock market is crashing, investors will seek alternative investment opportunities. And when conventional sources of capital dry up (e.g. VC), more founders might turn to their fans and customers for capital… High level — if there was ever a historical moment for a democratic and people-powered financial system, this would seem to be it.”
And even Kevin O’Leary (a.k.a Mr. Wonderful of Shark Tank fame), who recently defected from VC to join leading EC platform StartEngine, put it well when he observed that the VC industry has largely disappeared and that “[Equity Crowdfunding] is probably the most viable opportunity there is for raising capital given an environment that is in shock right now.”
What this means for the future of startup funding
The unprecedented market disruption caused by COVID-19 could be the turning point in finally reforming the world of startup finance. The incumbents face being displaced — while the innovators take over. And with every day that passes it seems ever clearer that the “disruptive change” and “new normal” that the VCs are so often talking about in terms of the industries they invest in is here and now… for their own industry. And it’s about time.
We have, in essence, seen this battle happen with the most groundbreaking business models of our generation. It’s a battle between the VCs who use next to no technology to automate, market, evaluate, or otherwise augment their offerings and make decisions based on personal connections and “gut feelings” — who’s fiduciary responsibility is to only represent the interests of millionaires (who are, again, just to hone in the point, 62-year-old white men).
While in the crowdfunding and other alternative marketplaces that bypass the traditional “relationship building” (and its in-built biases and inefficiencies), they use modern internet-based tools to reduce friction, reduce cost, attract, manage, and drive investors and startups online — whose sole responsibility is to connect all types of startups with all types of regular folks and help them invest.
The consequences of this shift away from a reliance on VC funding could be profound for the startup ecosystem.
How VCs need to adapt
Firstly, VC firms will be forced to innovate and adapt to this new normal. VCs are famously prickly when it comes to investing in startups that have previously raised capital through EC, not least because it threatens their business model.
But if we have an entire cohort of startups that are pushed into EC and other alternative funding methods due to the absence of VC during the crisis, then they will find themselves having no choice but to relax this policy if they want to invest at a later stage.
Secondly, with more startups now raising funding through EC we should start to see far greater diversity among founders and leadership teams, given that 44% of current EC funding goes to female founders or mixed-gender teams. Given that the startup space is routinely criticized for its male dominated leadership, this will be an extremely positive force for change.
Thirdly, on the investor side, small and medium sized investors will also find a far greater supply of promising startups to take a bet on, which will further democratize access to investments formerly reserved for the elites.
Moreover, this could be the beginning of a larger culture shift within the startup ecosystem, with more and more entering EC and other alternative funding channels and discovering first hand the benefits of this model. If this happens, then more and more startups could begin to question whether VC funding should be seen as the default funding option.
Ultimately, in the COVID-era, startups still need to raise money and investors still need to invest — but the early data paints a grim picture for the VC industry. This leaves the doors wide open for alternative funding and investing methods to fill the vacuum.
Considering the revolutions that VC funding has unleashed across countless industries, it’s their industry that’s now well overdue its own revolution. Are we ready for a world with a democratized startup funding system? I for one certainly am.