They say that “bad things come in threes.”
For those working in and/or observing the world of venture capital, this week provided some good fireworks, with two early stage powerhouses announcing power moves. It also happened to coincide with a week where investors in the Bay Area congregated at a small handful of well-timed annual events and fireside chats, often hosted by LPs (and very much off the record), so these moves became a big part of the backchannel conversation. In the press, on Twitter, and in many of these backchannel discussions, it is easy to see why an immediate reaction of a traditional investor could be one of disbelief or dismissal, or why someone in the press could tie this to the “disruption of venture capital.”
I’m writing this post to share my views on the news, and to make a slightly counter-intuitive point: The moves this week by AngelList and Y Combinator may not be great news for many VCs, but it is great for the VC “ecosystem” overall. These bottoms-up funds and movements show us all new examples of how atomized venture capital can work, how the next generation of founders may want to finance their businesses, and how software and networks can potentially provide more transparency and efficiency to each participant in the ecosystem of LPs, VCs, founders, and employers.
The moves by AngelList and Y Combinator shake the trees. These are good things.
The week started off with a bang.
On Monday, AngelList made a few announcements, the biggest of which was the creation of a new dedicated seed fund (“CSC Upshot”) backed primarily by The China Science & Merchants Investment Management Group, or “CSC.” The power in this move is that (1) demonstrates the ability of AngelList’s to empower institutional LPs to invest directly on the platform without having to back a traditional fund in the traditional VC model; and (2) now early-stage investors with access to entrepreneurs can theoretically scale up their total check size with a larger fund helping round out a syndicate.
First, we should acknowledge that LPs having more direct access to startups (as a mechanism to save on fees and/or gain more access) won’t necessarily work across the board. Second, there is a potentially perverse incentive in how Syndicates are currently structured with deal-by-deal carry (versus the pooled risk in a fund) that could lead to more syndicates being formed because there’s no natural governor to modulate it. All that said, I am not worried about those risks because (1) AngelList has implemented numerous controls to protect against this behavior; and (2) I view this as the first of many small steps in how venture capital is being reorganized and restructured (read Ben Thompson’s excellent breakdown on the similarities between AWS and AngelList), and it will take a long time to shake all the trees. These visible experiments help the industry step in that direction.
Second, a platform like AngelList is set up to help make the business of being an LP more efficient. By using software to automate many aspects of reporting, analyzing metrics, and streamlining back office administration, LPs can cut down on the cost of the capital they deploy while also gaining access to more real-time, standardized information about their portfolio, perhaps relative to what they have today. From the point of view of Syndicate Leads, AngelList in general and this new CSC Upshot fund specifically gives those with the early-stage eye and/or relationships the opportunity to invest with more leverage, to build an independent track record, and to leave behind the hassle of filling out rounds and fund administration to software and networks rather than costly human labor and way too much email.
The week also ended with a bang.
By Friday, news had leaked (though everyone in venture already knew about it) that Y Combinator was going to announce a $700m growth fund, “Continuity.” YC has always had a somewhat adversarial relationship with traditional venture, and this move to compete for growth rounds in the ecosystem is definitely a power play move. To date, YC has grown its network and brand by investing a little money but mostly their time and know-how to earn equity in a basket of companies it can pre-select from. In the YC model (to farm black swans), they can leverage their own network of founders, software, and global brand to attract about 250 or so companies a year, out of which they just need one or two to hit. It’s gravy if it’s more. At the same time, they are liberated from trappings that hold many VC firms back — YC can have a high failure rate, YC can invest in many companies in the same category (whereas VC firms cannot), and YC remains an “investor of record” with its brand in the winners.
This is where a challenge sets in, and where an opportunity emerged.
As a company progresses out of the YC accelerator, it can attract angel funds, seed capital, venture capital, and eventually growth capital or, lately, late-stage pre-IPO capital. Traditionally, YC wasn’t either able or interested to participate in the future financings of their companies, leaving an opportunity to traditional VCs. YC helped solve a discovery problem for VCs in a time when the cost of starting up decreased and the amount of new companies formed and new markets opened up increased (and continues to).
The critical components of the new “Continuity” growth fund are worth examining. First, the fund size: At $700M, the fund can follow the traditional Series A and/or Series B rounds where companies are valued around $500M, give or take. Second, the fund may lead (as it appears to be doing with YC alum Checkr) or it may follow-on where the terms are set by another lead. Third, $700M is likely just the beginning for an inaugural fund. I’ve heard from multiple sources who were directly considering an LP investment that the initial target was around $1.5B, and while the headlines grabbed that superstars like Mike Bloomberg and institutions like Stanford were offering some of the initial capital as an uncapped note into a priced round post-Demo Day, what isn’t reported is that some of the world’s largest institutions, sovereign wealth funds, and families were in play for the fund. Expect them to participate in Continuity II.
Let’s use Checkr as an example of how this near full-stack venture financing approach works in the world of YC. Checkr is likely funded by friends and families and founder money. They’re accepted into YC, and likely exchange 4-7% of common stock in exchange for joining the YC network. They also receive $100k-$150k in money (essentially grant money, but converts at a later round). Upon Demo Day, they receive Series A investment from well-branded Valley VC firms, and now with good metrics in a good space, get a lead investment from Continuity. YC has mentioned they won’t go after Series As and Bs to avoid signaling issues of not funding some of their companies, but let’s see what happens in practice.
Checkr is a very good company. Most Series B and growth investors may not have known the opportunity existed to invest in Checkr, and now with Continuity out in the market, it forces even more intense competition for these deals. Hypothetically, if Continuity came right out and offered Checkr a $300M post-money term sheet, it acts as a price floor for other traditional VC firms to beat either on price or by offering a more compelling partnership and/or services and/or network. If Checkr doesn’t like the other offers, it gets patient capital from a known quantity. It stays in the family.When you break apart the funding trajectory, YC can now create a disruptive price distortion in early stage (buying equity cheaply) and now late (by moving fast on asymmetric information on its own children). And, if we look into the future with a wider funnel of YC Research, YC Fellowships, the regular YC accelerator, and now YC Continuity, the funnel will get tighter and better for YC to be at one of the best seats in the world to see who and what our future will bring.
They say “bad things come in threes.” So, for someone in VC, what’s the third thing? I would argue, instead, that “good things in come in threes,” and that, counterintuitively, the news itself this past week from AngelList and YC are great forces to stimulate and maintain more health in the great venture capital ecosystem. That ecosystem is not just limited to VCs — it includes LPs, founding teams, and even employees. It is the third good thing.
It’s obvious that founders want many aspects of venture capital to change. Throughout history, most lenders of capital are not viewed favorably. But, spend some time with LPs and line-level employees at companies, and they too recognize that these bottoms-up movements like AngelList and YC, powered by new networks and software, inject a new level of transparency and efficiency into what was otherwise a very opaque business and business model.
Most of the immediate response, Twitter reaction, and backchannel chatter in reaction to this news was to point to how venture capital is being disrupted. Sure, it is in some respects, but why not also view these moves as opportunities? For instance, on AngelList, an individual investor who may have not been able to have a career in traditional investor could go directly to LPs and founders and make a name for him/herself, with a track record that can be verified by a ledger. Or, for example, with respect to YC’s Continuity, it may force traditional venture capital firms to focus their business on Series As and Series Bs where company building occurs. Firms which can credibly show a commitment to and track record of building teams, customer bases, and new market penetration can emerge to show real value outside what Continuity may bring, though of course they can grow that fund into a platform, as well.
When I write “shake the trees” it is a reference to the fact that the venture industry moves very slowly. When an institutional LP commits to a VC fund, they’re effectively committing for 3-4 funds (when those vehicles tend to get “sweet” and reap rewards), and perhaps even more funds for fear of missing a cycle and being cast aside forever by that fund. As a result, LPs don’t have great insight into all the funds they’ve invested in, don’t have much visibility into GP recruiting and hiring, and so forth. A platform like AngelList gives LPs worldwide a greater pool from which to evaluate potential investing talent. In the case of Continuity, it places more pressure on Series A and Series B funds which are tied to YC with a history of investment to forge greater partnerships with YC founders, though it’s worth noting that one can find amazing companies and drive returns in venture without ever touching a YC company or working through AngelList. It’s early days, however, so the future may be different, of course.
I’ll end this post by admitting that even me, as a very small, new investor, will face increased competition through these structures. Already, I missed participating in a seed investment in LA which went right through a Syndicate on AngelList (the founder didn’t want the overhead of meeting too many people), and then the founder went right past YC into getting a healthy Series A from a branded SF/Valley VC fund. That deal, which I found relatively early, in a sector where I have real experience and a portfolio to back it up, just passed me by. Whatever expertise or value I thought I had didn’t matter as much to the founder. The founder, in this case, wanted to minimize the noise fundraising can bring, he wanted to manage the lines on his cap table, and he used the networks and tools available to him to do so. Initially, feeling the sting of being late, my first reaction was to think his move to Syndicate 100% would backfire — but it didn’t. And, he was kind enough to invite me to his A round, which I ultimately decided not to participate in, though I appreciate the gesture. It’s a new world to adjust to, and I welcome the changes, because it’s those forces which motivate me to continue to refine the precision and speed with which I’d like to operate.
These are not bad things. These are all good things. And, I’m excited to see more of it, as it will force every investor to be sharper and more focused.