Startups have gained a cult following among Millennials and Generation Z with over half of these young professionals displaying an interest in entrepreneurship and eventually founding their own company. However, one of the lesser reported tales from Silicon Valley is how difficult it is to raise venture capital for a company. It follows that without funding to pay the bills, the doors close and the company folds.
In order to understand how best to get funding, it is important to understand what the venture capital industry looks like and where the money is going.
What is Venture Capital?
Since 2004 the number of venture capitalists and venture capital funds has gone down from around 8,900 to 5,600 and 1,800 to 1,200 respectively. Despite this decrease in players the number of funds raising money increased from about 200 to about 250 and the number of first-time funds stayed about the same around 35. Finally, the average amount of money under management by any single fund went from about $275M to $190M. What all of this indicates is that there is a broad trend of contraction and down-sizing in the venture capital industry.
Venture capital funds are structured as limited partnerships with a set of general partners (GPs) who are the investment managers, such as Marc Andreessen and Ben Horowitz, and limited partners (LPs) who put up the billions of dollars that the venture capital industry invests annually. A typical venture capital firm will continue to raise more funds and some of the largest institutions such as Greylock and Sequoia have over 5 funds a piece each with a variety of portfolio companies.
How do VC’s Think?
The dot-com boom era was characterized not only by a virtual land grab to claim domains and start Internet companies, but also a surge of venture capitalists. These firms would be fairly industry agnostic and invest in any good opportunity that crossed their desk. Additionally, as companies had fairly high expenses and the hype to find the next big thing was real, companies saw astronomical valuations. Investors overlooked revenue and cared about “growth.”
However, the bust followed and many investments such as GroupOn, Twitter, GoPro, and others proved even reaching IPO status was not necessarily an indicator of long-run success. Companies such as Yo and YikYak proved markets can truly reach saturation, and users do not always translate to value for investors. All of a sudden, LP’s began to have some doubts.
What most people do not realize about venture capitalists is that only 15% of their time is dedicated towards deal sourcing, whereas 85% is focused on growth of the portfolio companies. Combining this fact with an increasing number of founders transitioning over to become funders (i.e. AndreessenHorowitz and Founders Fund), LP’s began to wonder whether it was smarter to trust their massive amounts of money to a broad investment agency or to an industry-specific fund much more able to find synergies and add value to the portfolio.
Limited Partners had more opportunities to invest in venture capital and with many choices, those with experience in growing ventures and seeing what works and does not, prevailed as the best bets. It no longer made sense to go the shotgun approach and hope financiers could read through the noise and risk of early stage ventures in a multitude of industries, when founders with market-tested experience in a specific industry were available.
Evolution of Venture Investing
This trend has brought about the rise of the micro-VC, which project themselves to prospective investors similar to how startups do. When a first-time fund is brought about, the GP’s need to develop a unique value proposition, which translates to their investment thesis. They need to think about why they are well suited to secure the best deals in a subsector and add value to these deals compared to other venture capitalists in the Valley. Once they do this, if they prove enough success, they can raise a larger fund off of the proven track record. Sounds sort of like bootstrapping.
Furthermore, the amount of money in venture capital has gone down tremendously over the last decade. This has resulted in investors being much warier of the companies they choose to invest in and a larger emphasis on revenue generation early on. Gone are the days of raising massive rounds of funding to propel a user-growth model and lackadaisically suggesting ads will be the only monetization mechanism necessary
Investors want to know the founders have at least contemplated monetization strategies and can get to cash flow positive quickly. Not only does smaller investor pockets mean the investors are stingier, but it also means if a company fails to raise a Series-B, growth potential without revenue is not sufficient; so, risk for ventures and investors is up as well. Simply put, founders need to worry about revenue creation more than before.
How Can Founders Get Venture Funding?
Hopeful founders need not be discouraged by this data. These changes mean investors more aligned with their industry are waiting by to fund their businesses and actively help them grow. What they need to understand is that as the number of startups increase and the amount of funding and funders decreases, they need to increase their quality, standout against industry competitors, and prove an ability to monetize fast.
For those looking to enter the venture capital industry, experience trumps education. Every LP is going to ask why they deserve money over AndreessenHorowitz or other market-tested funds with track records. Unless an aspirational investor can prove they have the ability to add value to a specific industry and sculpt out a unique value proposition and investment thesis, they will likely fail to complete with the increasing number of funds looking to raise for a smaller pool of money.
Venture capitalists are often viewed as the gatekeepers of entrepreneurial heaven. After all, money is power. However, with an increasing amount of smaller, niche funds, LP’s are in fact the ones with the power. Whether you are an aspiring venture capitalist or founder, understanding these trends for funding will be pivotal for getting past the gatekeepers and starting the next big thing.
This post is part of our contributor series. It is written and published independently of TNW.