How a New Generation of Innovative Funds Can Lead to the Disruption of Early Stage Investing

I set out to raise my first venture capital round in 2000. VCs told us that unless we could demonstrate a “growth path” to a billion-dollar valuation within 24 months, we weren’t fundable.

Just 28 years old, I was an inexperienced CEO surrounded by a dynamic team. Not only were we optimistic and true-believers in our technology, we were also good story-tellers.

Fueled by a billion-dollar benchmark and naïve enough to go along with it, we genuinely told the story of how we would get there.

Ours was a compelling story of a young but capable tech company that was rubbing shoulders with billion-dollar strategic partners.

We closed a $10m round and were off to the races.

Today, however, re-branded as MarginPoint, the company is lucky to be among the living.

Back then, we thought we’d be building a profitable company with our fresh capital.

What we didn’t understand was that, when we accepted VC, we adopted a new set of objectives. Suddenly, the intention to build a healthy company was overshadowed by an investor-led push to legitimize our story and accelerate “growth.”

It’s easy to see why the company never reached its full potential. By attempting to fit into a mold that venture capital created to suit their business model, we unwittingly damned the company we loved.

CAMOUFLAGED INEFFICIENCY

Contrary to common thinking, venture capital as an industry doesn’t succeed by investing capital in start-ups and early-stage companies. They succeed by placing very large bets on young companies who have proven themselves.

Seed and modest Series A investments from a VC firm are for them, experiments that can be cast off without a flinch or wince. It’s play money. This leads to an enormous amount of wasted capital.

Consider some baseline statistics from the 2017 PwC/CB Insights Money Report. U.S. VC invested $72b across 5,052 companies in 2017. There were 22 unicorns valued in excess of $1b and there were 109 mega deals worth $100m or more, which represented 36% of all invested capital. The mega deals averaged $235mm each. 27% of the capital was allocated to seed stage companies and 26% to early stage companies. Seed deals averaged $2m each and early stage companies, $7m.

From another perspective, of the 5,052 companies funded, approximately 4,041 never yield a positive return and approximately 3,536 of them died-off.

That is a staggering loss.

And despite the many commendable, well-publicized VC-led start-up success stories, this is a broken business model.

It survives because venture fund after venture fund is propped up by an excessive flood of capital from trusting limited partner investors.

We’ve learned by now that access to a firehose of capital allows for excessive waste and also covers a host of blemishes unless tempered with an awful lot of discipline and patience.

How many thousands of young companies with the potential to grow into something great will continue to drown in the wake of the current system?

The next multi-billion-dollar opportunity in early stage investing lies within those 4,041 failures. It’s a landscape that’s ripe for disruption.

When fund managers can finally tap into that opportunity effectively, billions of what is now lost capital can be turned into billions of net gains.

Perhaps, it’s finally time for institutional investors to take the lead, shake things up, and shift some of those mega-fund, unicorn-betting-billions toward new and innovative funds who are dedicated to the disciplines of the long-view and making every penny count.

PRECISION AND PATIENCE

The truth is, there are many more visionary companies that have risen to greatness outside the VC mechanism.

Nordstoms, Shopify, MailChimp, Geico, Qualtrics, BaseCamp, Veeam Software, Lynda, and many others have grown with a different formula.

They’ve become icons in private and public markets, including the majority of the companies on the Fortune 1000. They employ tens of millions of people.

It seems rather glaring that the way to build a new generation of healthy companies is to embark on a precise, disciplined, slower-paced approach. The same approach that’s produced the visionary companies just mentioned.

With this approach in mind, a new crop of innovative funds are emerging. For example, Expa, Rocket Industries, Frost Data Capital, and the AI Fund each demonstrate a more precise and disciplined approached to the vetting of new models, growth pace, and the quality of founding teams. Taking it a step further, in the case of the AI Fund, they avoid outside founding teams all together, rather, building each company from within, from scratch.

It’s still early days, but these funds appear to be on track to defy the sleepy notion that 20% of the portfolio will carry the day. Rather, these funds believe and expect that each company will become a definitive success.

In 2017, we launched our Sunray I Fund with similar expectations. We even went so far as to operate within an entirely new category called an Operating Growth Fund (OGF).

The idea behind the new investment class is to better delineate between the traditional early stage approach and the non-traditional.

Key differentiators of the new-non-traditional are funds who depart from a reliance on the competitive “access to deal-flow” approach and instead independently identify and validate viable business models, and then proceed to launch them with or without an outside founder.

This is an approach with distinct characteristics designed to increase portfolio strength while also decreasing investment risk to limited partner investors. Because again, real disruption will only occur when limited partner investors begin to shift many billions from the traditional, to the new; to the disruptive.

Whether it’s called an Operating Growth Fund or something else, these disruptors will distinguish themselves and attract large pools of capital by managing themselves with updated terms and by launching companies who can demonstrate new strengths, for example:

Superior Experience at Launch: From the start, these portfolio companies are managed by experienced operators with proven leadership skills.

Superior Equity Strength: Funds who launch from within should hold much more equity from the start, creating a distinct benefit that yields a higher multiple upon exit.

Absolute Success Mindset: Imagine this…these funds live with the expectation that each portfolio company will succeed vs. the oddly accepted expectation that only 20% will carry the day.

A Precise and Patient Approach: These funds operate with speed and efficiency within natural timelines instead of unrealistic or uninformed benchmarks.

The Runs Batted In (RBIs) Strategy: These are efficient funds, focused on moving every portfolio company into a scoring position vs. obsessively swinging for the fences. Healthy singles, doubles, and triples compliment the occasional home run or the elusive Unicorn.

Commitment to Performance Investing: Beyond capital, these maintain a focused commitment to investing in:

a. The leadership strength of management teams, constant recruitment of exceptional talent, supported by world-class performance development systems; and

b. The strength and viability of each business model in an evolving marketplace, and a dedication to steady growth, and profitability.

Pay-Per-Performance Partnerships: If they’re authentically innovative, then compensation isn’t based on the traditional 2% and 20% fee schedule. Instead, for example, an annual operating budget that meets the needs of management while remaining below 2% of the fund size is acceptable. Instead of a 20% cut of profit that’s paid upon each liquidation, perhaps a waterfall payout that returns 2x before fund managers participate is how to step up the fund performance game.

Whatever the details of the innovation, the disruption of early stage investing is long overdue.

The chatter for early-stage disruption has persisted for nearly two decades. It’s ironic that, as an industry full of entrepreneurial innovators, a disruptive shift for the better hasn’t yet happened.

Luke Kanies, founder of Puppet, had this to say in a recent series on VC, “…I’m convinced that a firm that directly invested in reducing its failure rate would have as many Unicorns, but it would also have more positive returns throughout its portfolio, and in the midst of building more companies and making more money, it just might do a little good at the same time. That would be a nice change.”

I agree wholeheartedly.