“…most often the very skills that propel an organization to succeed in sustaining circumstances systematically bungle the best ideas for disruptive growth. An organization’s capabilities become its disabilities when disruption is afoot.” – Clayton Christensen, The Innovator’s Solution
In November 2005, Paul Graham wrote an essay titled “The Venture Capital Squeeze.” It had been over five years since the Nasdaq peaked in March 2000, and it was becoming apparent that VC firms were having trouble deploying the tens of billions of dollars they raised during the boom years. Graham argued that the proliferation of money combined with the decreasing costs to start a business were making the VC job more difficult, prophesying significant changes for the industry. He was right.
Over the years, venture capitalists have been some of the most ardent students of disruptive innovation. Large pools of capital have been funding risky ventures since antiquity (for example, when the wealthy Marcus Crassus backed an upstart Roman general named Julius Caesar). The industry was born in its current form, however, when the first venture capital firms were founded in the middle of the twentieth century. In a relatively short time, venture-backed companies have grown to account for over 20% of US GDP today. The best VCs have successfully identified major industry disruptions before they occur. Nevertheless, recent attention garnered by start-up accelerators, micro-VCs, and angel investors has led to a new debate: is there a wave of disruption in venture investing itself?
A key constraining resource in traditional venture is a VC investor’s time. This means that a performance metric every investor must consider is time spent / capital invested. Hedge fund investors who deploy capital in large and liquid markets can scale their time well. Bill Ackman‘s hedge fund Pershing Square, for example, has $9 billion in assets under management and fewer than ten investment professionals. VCs, on the other hand, are finding it increasingly harder to scale because the declining cost to start a business means that VCs must invest in more companies just to deploy the same amount of capital. In response, they can choose to participate in more deals or bigger deals. Often, the latter wins because most VCs will spend a substantial amount of time evaluating a deal, regardless of deal size. Money scales, time spent on analysis does not.
The business model innovation of accelerators is that they have a systematized selection process that is akin to the application process for college. Because of the limited investment that accelerators offer companies (usually less than $40,000), they can evaluate business plans and founding teams more quickly than traditional venture investors with arguably less risk. Accelerators with a handful of full-time employees and no limited partners will accept dozens of companies each year. Where accelerators fall short is in leading investment rounds deep into the company’s lifecycle, the purview of traditional venture funds. However, accelerators are capitalizing on thedecreasing costs of starting a business, new thinking on how to run startups, and the increasing importance of mentorship to take companies further down the path towards success — even with smaller check sizes. Organizations such as Y Combinator and TechStars have become magnets for some of the most talented US entrepreneurs by providing expert guidance with limited funds. Additionally, being anointed by a top accelerator is a mark of achievement, similar to attending a top university, that propels the credibility of the founders.
Ultimately, industry disruption will be measured by the ability of accelerators to capture an increasing proportion of industry returns. This entails accelerators moving upmarket. Y Combinator and TechStars have demonstrated that systematized programs are highly effective for startingcompanies, but it is unclear whether they will ever be effective for growing companies. By nature, accelerators will be able to place more bets than traditional venture firms, but accelerators cannot yet place the big bets that generate the lion’s share of industry returns.
Companies that successfully graduate from an accelerator program still need significant amounts of additional capital to grow. Though a VC might invest in hundreds of companies, most returns come from finding and growing a handful of startups, such as Facebook, Groupon, Zynga, and LinkedIn. There are parallels with the music, publishing, and movie industries where returns are still largelydriven by blockbusters rather than the long tail. Firms with the appetite to maintain their ownership stake through follow-on investments will capture significantly higher aggregate returns (though lowerinternal rates of return) on the blockbusters, even if they enter in later, higher valuation rounds.
To disrupt the larger ecosystem, accelerators will need to evolve their models to push companies through later stages of the business lifecycle. Accelerators might be able to accomplish this task by raising internal funds (which can be tricky) or establishing non-traditional funding partnerships. On the latter, we will be carefully observing how developments such as Yuri Milner’s Digital Sky Technologies — and, more broadly, the entrance of hedge funds and large institutional investors — will affect the landscape of startup financing.
In classic cases of industry disruption, such as in steel or airlines, incumbent firms have tens of thousands of employees. But VC firms are small places, and even the largest ones only have a few dozen investment professionals. They are acutely attuned to disruptive innovation, and their size makes them nimble. Still, being astute and agile does not guarantee immunity to disruption. Darwin puts it best: “It is not the strongest of the species that survive, nor the most intelligent, but the one most responsive to change.”