The Cloud Changes Everything; Including Growth Capital
It’s been over 5 years since Mark Andreesen published his famous WSJ article, “Why Software Is Eating The World,” and in the years since, we’ve certainly seen the technology, venture and growth capital worlds evolve. While not every company or prediction mentioned proved successful, many did, and the prescient headline certainly has come true. Every day software appears to creep further into our world. Most consumers feel software’s impact daily and technology’s impact continues to grow within the business world.
Driven by the proliferation of connectivity, cheap computing power both in our pockets and in the cloud, and a robust API/cloud services ecosystem, it continually becomes cheaper and faster to bring whole software products to market. As a result, we’ve seen software explode across geographies, industries and marketplaces. In the B2B world, where I focus, we’ve seen software begin to move beyond IT and desk work and into the daily lives of workers wherever, and in whatever form, they may work. Data and connectivity have improved the capabilities of workers, and have reduced cost and improved yield through better information flows and automated capability. Entrepreneurs are broadening penetration of tech into an ever widening set of opportunities, and corporations from across the spectrum have taken notice. We’re seeing more investments and acquisitions from non-traditional tech buyers from ever before, with folks like GM, Kellogg’s and even Sesame street jumping into the game. It’s certainly been a good few years for the entrepreneurial tech scene.
When Pitchbook released its year-end summary of venture activity, it gave us a glimpse into how the venture market has reacted to these dynamics. As we pretty much all know, it’s been a heavy few years of venture investment. In fact, the past 10 years has seen steady growth in both the number of investments and the total dollars invested, although the latter dipped before rebounding strongly post-recession. Some of this growth was certainly driven by broader market dynamics (e.g. little return elsewhere with a “rich” stock market and interest rates near zero), but the investment opportunities wouldn’t have been there had it not been for the continued proliferation of software and the internet. As investors saw the potential of software to alter the trajectory of growth and fundamentals of profitability across a host of industries, money began to pour in. Venture fund-raising has been strong and continues to be strong against this background, and the past few years saw more and more “tourist investors” getting into the game as well (especially at the earliest and latest stages). With more money flowing into the latest stages, traditional growth investors pushed earlier and each part of the venture ecosystem saw significant growth. Traditional venture sectors like SaaS and Consumer Internet exploded, as did burgeoning markets like “On-demand,” “E-commerce” and Digital Media. However, nothing lasts forever, and the overheating finally impacted the market in late 2015, as the venture market hit it’s top.
In the back half of 2016, the contraction began. Since that point, we’ve seen fewer deals being done by mutual funds, hedge funds and non-traditional angels and it appears that traditional venture and growth capital investors are returning home. Across the various stages of the market, investors are generally returning to their preferred stages of investment and valuations are beginning to return to a more typical level. Here too there may be other market forces at work, but I think we all know that the venture market got a bit too far “over its skis.” Too wide of a set of companies raised far too much money at far too high valuations and under expectations far too heavy for their market potential. The up-rounds eventually ran out, while the extreme-multiple acquisitions didn’t materialize as fast as needed. Certain companies and sectors are in bad shape as investment declines, while others remain strong and after a bit of rationalization, should continue to grow.
But a cursory glance at the total market doesn’t give us the full picture. The first set of charts below highlight the slight difference in the shape of the dollars and deals chart above. While the number of deals has decreased quickly, the total dollars invested have reduced more slowly, concentrating capital into fewer companies. When you look at early-stage venture in particular, there has been only a slight decline in dollars invested as number of deals has declined to nearly 2010 levels. When we look at the charts below, we can see the median round size about-double from a 2010 low, and back to pre-recession highs. The average VC round size highlights this concentration even more sharply, with bigger deals driving averages much higher than ever before. The early stage has reached a high-point, and late stage averages have doubled off of their pre-recession high. Some of this capital expansion at the growth stage is likely tied to companies staying private longer and bringing in more capital at later stages, but the heights of the early stage show that rounds are getting done at bigger dollars than ever before. A Pitchbook search confirmed this for me, when I found that the average Series A was $8.4M, and the average Series B was $22.4M – both well above the $5-6M A and $10-12M Series B most of us think of.
When we look at this next chart, showing venture fund-raising trends, it becomes clear that this trend is unlikely to slow. US venture and growth capital funds hit all-time high fund-raising levels in 2016, meaning that there will be a lot of capital to invest over the next few years. Given that we’ve seen the number of deals (and therefore funded companies) drop in the past few years, in particular at the seed stage, it’s likely that we’ll continue to see a concentration of capital into fewer companies/deals over the next several years.
US Venture Capital Fund-raising by Quarter
So how does all of this data correlate to the beginning of this post, where I suggested that it had become cheaper and faster to bring whole products to market? In some ways, it actually correlates quite nicely. With less expense to build, test, iterate and scale software, we’ve seen it penetrate a broad range of new markets and opportunities. Delivering software that improves intelligence, capability and automation has the power to change the paradigm of efficiency and performance. Connectivity and cheap computing can take this value to new heights, and the ability to efficiently distribute software over the Internet can allow a company to quickly scale. Of course, it also means that competitors, both upstarts and adjacent players can quickly follow suit to chase employee talent, customers and the good market opportunity. Where a company is well positioned to take on a big market opportunity, with defined processes, pouring as much “fuel-on-the-fire” as possible makes a ton of sense. The faster it can grow to scale, the harder it will be for others to attack it and the faster it’ll reach it’s potential. For venture investors with the opportunity to invest behind a company in this position, it’s certainly reasonable to invest as much as is prudent. For the company, if they are truly confident in the opportunity, it also becomes a clear decision.
However, there are many costs to a big growth round that hinder it’s viability in other situations. First, for all but a very small sliver of companies, financings take time. They can distract from the CEO’s focus on the business and can take months to put together. Second, and perhaps most significant, is that they come with expectations – an immediate expectation of high-growth, an expectation of exit within an appropriate time-frame (usually 3-7 years) and with an expectation of that exit generating 3-10x return for the investor (depending upon stage). Lastly, it typically means a relatively large amount of capital to the size of the business and fairly significant dilution. The capital needs to be sufficient to cover the expected cash burn that will generate out-sized growth, and must be sufficient that the investors own a “meaningful” stake in the business. Usually this means 20-30% dilution for the existing shareholders, who see the opportunity to own a bigger piece of pie by owning a smaller piece of a much larger pie. For companies ready to grow at the pace growth capital dictates towards the market opportunity growth capital and the valuation hurdles it typically ascribes, growth capital can be a wonderful tool.
For other companies though, and for many at a particular time in their lifecycle, a big venture or growth capital round might not be the right fit. In a world where products can be built, scaled and distributed more cheaply than ever before, a smaller amount of capital, with more flexibility is sometimes the better fit. In the B2B tech world, where a company can begin to generate revenue fairly early in it’s lifecycle, we see this situation frequently. Often companies in this situation have raised a couple of million dollars to build a focused product that addresses a specific opportunity within a broader market. On the back of that first investment, they’ve found product/market fit and have begun to generate single-digit millions of revenue and nice growth, with limited cash-burn that allowed for runway to prove-out the opportunity. They want to expand and grow more quickly, and/or expand their market opportunity but haven’t yet tested the market to prove that those expansion strategies will work out. Because the base-business is working well, they need a smaller investment, with greater flexibility, to prove it out. However, what are available are ever-bigger growth rounds. Given that they haven’t yet hit proof points in their expansion strategy, most VCs are reluctant to invest (especially at today’s bigger round sizes) and if growth capital is available, the company is reluctant to commit to the expectations of that growth round.
For these companies, the expectations associated with the round might create more challenges than the extra money in the bank can offset with advantages. However, they aren’t bad companies, but often just the opposite. In many cases they’re delivering value to their customers, are headed toward profitability and are growing nicely – just not quite as fast as a VC would require. But if the company isn’t a great candidate for a growth capital round, there are few alternatives that can bring capital into the business and the company can get stuck in a bit of a financing “no-man’s land.” Without any form of growth capital, the company is forced to move further towards profitability and grow only from organic cash-flows, rather than investing behind the business and moving further from profitability for a period of time. This likely means slower growth and product development trade-offs, which will make it difficult to raise a growth round when they are eventually ready. That can be a difficult cycle to break and can limit the company’s ability to meet it’s true potential.
For all of the innovation in the tech ecosystem, there has been little innovation in the financing options for tech companies. A hole has developed and as rounds continue to stay large, and perhaps grow larger, that hole will likely grow. To fill these gaps and help companies reach their full potential, there is need for new financing alternatives that help fuel growth through smaller and/or more flexible infusions of capital. The good news is that we’re starting to see new come to market and entrepreneurs beginning to embrace these new financing formats. I have high hopes that moving forward we’ll see further innovation in the financing side of the technology world, just as we’ve seen it on the product side. Venture and Growth Capital will continue to be great financing options for some companies, but it’ll be exciting to see what alternatives arise to help every tech company maximize its opportunity