Is venture capital harming entrepreneurship? At first blush, this seems like an odd question. VCs have been the lifeblood of virtually every successful tech startup for generations, enabling entrepreneurs to create and refine innovative products and rapidly scale to self-sustaining profitability.
And there’s been more venture capital flowing into the startup sector than ever. VC investments last year set an all-time record in the US ($132 billion) and globally ($342 billion). Moreover, deal sizes have been steadily growing across all stages of venture development. The median gestation period from seed to IPO has lengthened from 3.2 years in 2000 to nearly a decade at present. It’s clear that entrepreneurs have become more reliant on venture capital than ever.
But if you look behind these numbers, two paradoxical questions suggest a growing disconnect between the priorities of VCs and entrepreneurs. First, why has the number of seed funding rounds—the entry point for most entrepreneurial journeys—declined so sharply over the past five years, despite the fact that the cost of launching new ventures has never been lower? And second, why are so many companies still unprofitable at IPO, despite the lengthening gestation period from first VC funding to exit?
Some personal history helps answer the first question. When I launched a startup in 2000, my one and only institutional funding round of $15 million was largely consumed by the need to buy and maintain servers and storage devices, to write highly customized code for every business process, and to build market awareness through expensive, inefficient mass marketing channels. Launching that same venture today would probably cost 90 percent less, thanks to modern enabling technologies: open source computing, rapid wireframe and product prototyping tools, contract manufacturing, fulfillment-as-a-service, web-store design, cost-effective social media customer targeting, and cloud-based services.
During the first 15 years of the new millennium, the number of angel and seed deals rose steadily. But over the past five years, entry-round investments have declined by more than 40 percent, while average deal sizes have risen. The primary reason is that early-stage VC funds generally have found it more lucrative to place fewer, bigger bets, rather than spreading investments more thinly. This practice delivers a big win when the bets pay off—particularly for seed VCs with higher ownership stakes. But now, more than ever, entrepreneurs find themselves folding for lack of seed funding.
The trend toward fewer, bigger bets has been transforming capital allocation across every stage of the venture lifecycle. Data indicates that while early-stage (B-round or earlier) funding has been flat to declining in recent years, the number and deal sizes of late-stage rounds has surged. In 2018, for example, two to three supergiant rounds of over $100 million closed every business day, accounting for 56 percent of total global VC investment worldwide.
This is problematic to the extent that venture capital allocation decisions are driven more by the VCs’ urgency to deploy capital than by real business needs. In a world awash in capital from sovereign wealth funds, deep-pocketed Asian investors, and other highly endowed institutions, VC’s have increasingly embraced the philosophy of “blitzscaling,” in which investing unprecedented amounts of capital is believed to convey winner-take-all (or most) competitive advantage.
For example, when on-demand dog-walking service Wag sought to raise a $100 million D-round from a syndicate of US VCs in 2017, the Japanese-based Softbank Vision Fund swept in with a preemptive solo investment of $300 million, quadrupling Wag’s market value just nine months after its prior funding round.
It wasn’t clear then or now that a dog-walking service warrants an investment or valuation on this scale. Likewise, the business strategy wasn’t apparent last year when Softbank led a $240 million C-round investment in direct-to-consumer company Brandless, which has subsequently struggled to scale.
On a grander scale, coworking office-space startup WeWork secured over $10 billion in single-source funding from Softbank over the past three years. While Softbank’s largesse has enabled WeWork to achieve market leadership in many metro markets worldwide, the company’s losses have been accelerating even faster than revenue, calling into question its artificially inflated valuation. The company’s IPO filing is currently under SEC review.
Under the right conditions, a blitzscale investment can be a game changer, but only if the recipient’s underlying business model is highly scalable, defensible, and enjoys inherently high operating margins that improve with strong network effects.
The problem: Few ventures actually exhibit these characteristics, and the consequences of investing too much, too soon in unproven businesses can be catastrophic. Such investments often compel ventures to rapidly replicate a flawed business model on a global scale. Arguably, these are exactly the dog-wagging-the-tail circumstances that led to Uber’s and Lyft’s broken IPOs.
More broadly, the trend toward bigger, late-stage VC investments has fueled a drive for growth at all costs. That helps explain why 81 percent of the US ventures that went public in 2018 were unprofitable in the year leading up to their IPO—a record high matched only in 2000, a year before the dotcom bubble burst.
While there is little reason to expect another tech bubble, there are signs that VCs are rethinking their headlong rush into blitzscale investments. The retrenchment began in China, which saw an overall decline of VC investment by 31 percent from the first to the second half of 2018. That pattern has continued this year, particularly in the number of supergiant rounds, which declined more than half in the first two quarters of 2019 relative to the prior six months. In the US, total VC investment experienced its first quarter-to-quarter decline in Q1 2019 after a year of steady growth. The number of supergiant rounds fell has been flat in the first half of 2019, after enjoying 35 percent per-quarter growth over the past two years.
The IPO market appears to be sending a strong signal that VCs and entrepreneurs should take to heart. The two worst-performing IPOs this year are Uber and Lyft, which collectively raised $29.6 billion and lost more VC money prior to going public than all 55 other companies that IPO’d in the US this year combined. In contrast, two of the best performers have been Zoom, which was profitable at IPO and raised only $161 million in prior VC funding, and Beyond Meat, which raised $122 million in VC capital, achieved rapid growth, and saw declining, modest losses this year.
If we learned anything from the dotcom bubble at the turn of the century, it’s that in an environment of abundant capital, money does not necessarily bestow competitive advantage. In fact, spending too much, to soon on unproven business models only heightens the risk that a company’s race for global domination can become a race to oblivion.
In fact, some of the most remarkable startups of our generation succeeded on the strength of their technology and business model, not venture capital. To wit, the total VC capital raised by Amazon ($108 million), Google ($36 million), and Salesforce ($64 million) prior to their IPOs and subsequent value creation would barely register as a single supergiant round in today’s blitzscale funding environment.
VCs and entrepreneurs would arguably be better served by rethinking today’s venture capital allocation priorities in three areas.
- Seed/early-stage VCs should widen the funnel of entrepreneurial ventures receiving funding support. Given the relatively low cost of launching new ventures with open software architectures and cloud-based tools, the likelihood of nurturing the next generation of game-changers could be enhanced by casting a wider net over nascent ventures receiving initial capital support. While only 20 percent of seed/A-round ventures are likely to make the cut to second-round funding, starting with a larger initial pool of smaller first-round investments may yield better returns than prematurely placing bigger bets on fewer first round startups.
- Late-stage VCs should recognize that very few ventures meet the rigid requirements for turning winner-take-all market dominance into a sustainable, profitable competitive advantage. Not Uber, not Lyft, not Doordash, not Bird, not Wag, not Brandless, and most certainly not WeWork. Thus, VCs need to be far more discriminating in identifying true blitzscale opportunities. They should avoid overinvesting in ventures with unproven business models that only serve to accelerate a mad dash for profitless growth.
- Entrepreneurs should weigh the pros and cons of accepting massive infusions of venture capital. In this regard, Uber CEO Dara Khosrowshahi (who secured a $9 billion capital infusion from Softbank in 2017) noted, “Rather than having their capital cannon facing me, I’d rather have their capital cannon behind me.” The advantages of sizable capital reserves are obvious, but only if all the characteristics for blitzscale success are in place: an underlying business model that can deliver a clear and defensible path to profitability, an addressable market big enough to support the explosive growth required to generate an adequate ROI, and the capability to execute a massive ramp-up in operational scale. If not, entrepreneurs (and VCs) would be better off pursuing a more measured growth trajectory.
There is a flurry of public offerings on tap this year, including WeWork, Airbnb, Postmates, and Peloton. Their success—or lack thereof—will demonstrate whether the VC strategy of massive, late-stage investments in unprofitable ventures can result in rewarding IPO valuations.