How to win in venture when the rules – and geography – of the game are changing?
Katapult Group CEO, Fredrik Winther assesses the fast-changing landscape of venture, and why venture investors need to re-think strategy.
The venture capital industry broke all records in 2021, and it led to systemic changes as to how it operates.
Not long ago start-ups fought for the investors, these days investors are fighting to get a seat at the cap table of great founders. In 2021 alone venture investing grew by 110% globally, and competition for tech startups intensified just as much.
According to CB Insights, global venture funding reached a record of $621 B in 2021, up from $294 B in 2020. At the same time, the tech startup playbook has become “common knowledge”, and as a consequence, venture is becoming industrialized. This all leads to some fundamental system changes for venture capital.
As the pandemic hit all corners of the world, so did venture capital.
Emblematically, in 2021 more than 100 tech startup ecosystems around the world produced two unicorns or more. This signals one of the most impactful changes over the last year. Unicorn production, which used to be a Silicon Valley (and China) domain of startups backed by Sand Hill Road investors, has moved to more than 100 corners of the world. Just a few years back, to grow a billion dollar startup out of the EU was considered exceptional. This is backed by the numbers, showing that just a handful grew out of Europe. In 2021 this figure rose from just above 20 in 2020 to 65.
A signal of accelerating change, and accelerating changes is where to look for what’s next. If you look for impact and climate startups the numbers are even more skewed.
It also means that the accepted method of deal sourcing from your local network and geography, based on in-person relationships that secure quality is no longer sufficient to stay ahead of the game. Setups and sourcing methods that are able to source from different ecosystems will win. Katapult has spent 5 years building this outreach and dealflow systematically, and has so far invested in 108 startups in more than 35 countries, plus 30 direct investments including 3 impact tech unicorns. For each investment we do on average 100 screenings, in total over 10 000 over the same period, and that apparatus will just generate more value as this global trend accelerates. Some of our best performing companies come from Lat-am, the African continent, and Europe. Adding to that, the pandemic has further accelerated the number of startups founded outside Silicon Valley.
In general, all regions saw record funding, and illustrate the very recent and accelerating globalization of venture capital.
Adding to new geographies, is the global competition for the best companies. This also represents a system change with new consequences. The very script of financing is changing, tables are turned, and it is upsetting an industry that has almost been exempt from innovation and disruption for over 30 years.
Right now, the change is being driven by giants such as Tiger Capital, Sequoia, Softbank and a16z. In 2020 this occurred at a rate equalling more than one investment per day pr. VC! How do you even organise for that?
Investments are made in hours instead of weeks and months. Analyzes of companies are outsourced to “management consultants” and early-stage seed funds. The struggle to get a seat at the table and to invest creates higher valuations, and lower returns. And perhaps most importantly for the entrepreneur, the requirement for a boardroom, favoring term sheets, and similar control will prove too timely- and cost-consuming.
For Katapult, we have taken these insights seriously and built up expertise both in the investment phase before this ‘machinery’ arrives, rather aiming to serve this market – and deep sector expertise in fields where the world faces major challenges.
It’s fair to predict, where the last decade was about tech-disruption, the next is about impact tech-disruption.
5 fundamental changes that affect the development of the venture.
In the last 30 years, there has been limited innovation in venture financing as a mechanism. Venture is one of the few industries that has been exempt from disruption. Both the investment mechanisms and the institutions behind them have remained remarkably similar. That is going to change.
The first modern venture capital company emerged from post-war America, and the US version of European “Research Councils” – American Research and Development Coalition (ARDC). A concept firstly presented as a politically initiated way to secure investments in technology investments in a post-war period that, for natural reasons, had a very limited risk appetite.
The difference from European Research Councils was that they made direct investments in private technology companies – not just funding universities and research- departments, and institutions.
For that reason ARDC became an economic success, and a significant contributing factor as to why the United States has led the way in technological development.
ARDC’s financial success created the foundational model for venture companies that still remain leaders today. The 1960s and 1970s ushered in Sequoia, Kleiner Perkins, Bessemer – and other mythical venture companies who were first to back Apple, Microsoft, and Electronic Arts, among others. The success also led to the large pension funds joining venture, capital flowing to advanced deep tech projects, and many of the global leading companies of today.
The tech-growth spiral was underway, and already in the 90s there were over 700 active venture companies, backing the first round of global tech companies such as Netscape, eBay, Paypal, Yahoo, Google and Salesforce. Then came the dot-com bubble. Unlike in large parts of Europe, venture financing continued to grow, but then with much more specialized models. Venture Capitals started to offer specialized knowledge within company building and technology to reduce their own risk – and to avoid new bubbles.
Among these early VCs, there was also a broad division into three investment philosophies and schools that still govern venture to this day: Simply put, those who invest based on great market opportunities, those who invested in cutting-edge technology, and those who invested in and prioritized solid entrepreneurs and teams.
As we know, what gives the best return is an ongoing debate you still can engage in wherever VCs gather.
Venture financing in the sense of the “Silicon Valley model” was thus established almost 70 years ago, was the backer of the most valued companies and impactful technologies of today, and has remained the main source of capital for more or less all the tech companies that dominate the world right now. This also applies to more or less all of the 959 unicorns in the world, whereof 517 were born in 2021 alone.
The VC model has hardly changed… For now.
Why are the rules of the game for venture changing right now?
If we are to understand system changes and fundamental shifts, we must first and foremost understand the areas where the rate of change is greatest. Where it accelerates. Within venture, there are 5 particular areas where this is the case.
1 Venture has become a game of quick decisions
According to Crunchbase, Tiger capital alone made more than 350 investments in 2021, and more than 1,3 investments a day in Q4.
Over time, all new profitable industries are thoroughly analyzed, dissected, and repeated so many times – and in detail. This means the patterns become clear and accessible to a growing number of investment analysts. The “recipe” and playbook for scaling and growth of tech companies is becoming widely known and risk is reduced accordingly.
More VCs are commoditising the returns in the venture space through quick decisions, higher spendings, and keeping more hands off. If you for instance look at the commonalities of super founders – as I did in this article– then there are some clear and common features that are mapped out of available data.
This process is only enhanced by increasing access to better structured data. You can analyse founders, business models, network effects, growth metrics, engagement, market development with tested and widespread models.
When pattern recognition becomes better and associated risks are reduced, then more capital flows in. Historically that has been the case for any new industry and asset class. That’s what we’re seeing now. With a little background, most 20-something investment bankers – and there are a lot of them in VC – can meet with a start-up company, apply their spreadsheet and check if the most valid criteria are met.
It does not of course eliminate all risk, but does so sufficiently to adjust risk returns through analyzes conducted in a few hours, and not months which has been the norm up until now. The data is easier to access and the method more aligned to other forms of investment. This applies particularly for companies in typical series A and B rounds where market fits and growth figures are readily available.
This makes it possible for a single fund such as Tiger Capital to surpass 350 investments in 2021. Although, only a decade ago, Tiger, operated as an average VC, took its time, and invested in 3 companies a year. Which suddenly feels like stone ages ago.
Venture has gone from playing chess to lightning chess, and new capital classes are joining in.
2 “Everybody” is moving into venture and the size doubles year by year
2021 represented a 110% growth into venture capital, and 2022 will be the year when more non-traditional tech investors will invest more in private tech companies, than the sum of traditional VC investments.
The start-up successes and the once rare and unseen unicorns have become so plentiful and visible that everyone wants a slice of the growing cake. “Family offices” enter the seed and early stages, traditional capital management enter before listing, and hedge funds that have never invested in startups before are moving full speed across the entire venture landscape. Hence, new sources of capital are coming in, challenging the long 10-year cycle of venture funds.
The similarities between solid tech startups are no longer an internal tech founder or Sand Hill Road secret. This means that venture companies such as Tiger Capital, which has almost 100 billion dollars in the last fund, have to move at a speed that very few can compete with. They make an investment every day (1.3 / day in the last quarter), spend a couple of meetings on the investment decision, and have few special conditions for the entrepreneurs.
This is a necessity, because costs have to go down when competition goes up, and they also compensate with larger funds that accept lower returns. Closer to public market expectations.
3 The funds become larger and the accepted return lower
When competition becomes tougher, costs are reduced through pace and quick decisions, less involvement in companies – and larger funds.
Sequoia, Softbank, and Tiger Capital are good examples and are at the same time perceived as “founder friendly”. For many entrepreneurs, less involvement is considered an advantage. Quite a few have little faith in the contribution they receive from VCs, and quite a few experience that more is promised than what they receive.
This leads to skepticism about the added value beyond capital and “brand name”. In addition, successful entrepreneurs by nature have a penchant for relying more on their own expertise, than on a young, newly-graduated economist with Patagionia merch, and a background from a monocultural investment environment.
With companies like Tiger Capital, the entrepreneurs get access to the capital they need, without feeling that the fund has to enter and override, make strange benefit agreements, or bring in expertise their backers have not had enough speed and resources to maintain. It is also not certain that the cap table position they require is perceived as anything other than losing control.
Over the last 20 years, Andreessen Horowitz and a16z have taken the opposite approach by building very large service environments for startups. However, there are very few who can match a growth in the number of employees by 170% over the last three years. Many have tried, with a little too little and a little late approach. Adding to fixed costs that can be difficult to defend.
The return expectations for the funds are also declining, and with larger amounts, earnings will still be high, and in any case relatively higher than for alternative classes. Tiger Capital will invest $ 10 billion in its Fund15 in startups in 12-18 months. Very few are able to do anything like this, regardless of whether they have access to capital or not, and regardless of how they are set up organizationally. When the speed goes up, so does the error rate, and when they also pay more than competitors, then the return goes down. Tiger Capital and Sequoia’s new models are set up for just this development. With such large amounts, the gain can still be large – and greater than the alternatives.
The largest traditional funds today are also very small compared to PE funds and global financial institutions. When everyone goes into tech startups, and preferably earlier stages, it is the pace and scale that becomes the recipe, as the global venture playbook is being standardized – and industrialised.
4 Due diligence processes are “outsourced”, data science has arrived, and distributed network organizations are built.
In addition to accelerated due diligence processes, the increased competition to deploy capital has also led to outsourcing assessments to consultancy firms, applying data science and AI methodologies to do some of the work, and to apply new distributed network organizations with nodes all over the world.
This is necessary to keep up with the pace and volume of companies, and still have a variable cost structure.
If a lot of capital is to be invested in many companies in a short time, it is an advantage to have a solid control of dealflow. Regardless of size, you need access to far more investment opportunities than you enter.
Therefore, more and more people are looking for assistance outside their own structure. That could be accelerator companies and early stage seed investors, like for Tiger, who have set up tools and machines to screen large numbers of companies. Established “management consultants” have also gained new customers and are part of the solution for Tiger Capital. Atomico has similarly expanded its network with a founder program where former entrepreneurs get less money to invest, and thus use their already established network to bring in quality-assured companies.
In Katapult we have seen the same thing, there is great curiosity and interest in buying into the access of screening and analysis tools, and the extensive work in screening companies from all over the world before we invest and take companies into a program. It gains an ever higher value when the pace picks up and fewer people have the opportunity to build such structures, or even tap into the data science it requires.
In Katapult’s 138 investments have now been made, and for each investment, an average of 100 analyzes. It provides a great overview of and insights into what characterizes the best early-stage companies. The same companies that later benefit from increased competition from later stage investors.
As one of the few industries still to be disrupted by tech, the adaptation of technology has been remarkably slow for the VC industry. Over the last couple of years that has changed drastically. Today most VCs with some size are scraping the web, building databases, and training their data sets on internal and external sources. EQT venture has their Motherbrain, and similar projects are widespread. At Katapult we are engaging in a large research project with international partners for the same purpose. To train our algorithms on big datasets, and use machine learning to structure some of the massive amounts of data available.
In addition to moving faster, ventures also accepts ever higher prices as part of the competition. It is also a great advantage for seed and accelerator investors that competition increases in the market for the next investment phase.
5 The exception of the new rules is early stage- and impact investing.
If you cannot compete on speed what do you do?
You enter a space where speed is less of a differentiator. That is early- and seed stage investments, specialized sectors, impact, and deep-tech.
The “industrialized” playbook analysis primarily applies to software and tech areas where the scaling models are well known, and where the analyzes of growth metrics, product-market fit, user engagement, monetization, network effects, markets, etc. are easily accessible.
For companies in the earliest stage – and typical seed funds – it is different. In the earliest stages, little has been proven, and the data points that exist are infinitely more unstructured. Analysis then requires a different skill set.
It is far more complex to recognize quality, and you are even more dependent on being able to understand the messy dynamics of teams and people. It is harder to use the fixed model. At the same time, the investments are smaller, and if you need to deploy massive amounts of capital, the job will be impossible. Still it is the stage where success pays off better. It looks more like a traditional venture, where the risks are great, a few succeed properly, and you can de-risk through accelerator programs, data science – and based on information advantage, double down on the winners you know well.
The same applies to specialization in technology fields that are still immature, or particularly advanced research-based technology, and which therefore do not have equally established models. Katapult feeds off this advantage i.e by being the most active investors in specialized ocean impact tech.
Going back in time, it was in such areas that the American ARDC was created to invest in, and in that sense close to the original venture model. To finance technology companies with high risk and potentially high significance for technology development. It turned out to be profitable. Adding the megatrend of impact, this is also where Katapult operates and has specialised.
Last decade was about tech-disruption, the next is about impact-tech.
This is also why you need to specialise in impact tech that solves our biggest problems. The traditional venture model has elevated companies that brought software to the world – and ate it for breakfast. Both the most influential tech-companies in the present world, and the 969 unicorns of today are venture fueled. The tech revolution has solved many problems, and at the same time created many new ones. It is not going to stop. We have only seen the beginning of the tech revolution and the connected 100 billion VC funds are about to take over the innovation and digitization of yesterday’s industries.
With so much capital available in venture, it is easy to predict that the value investors bring to the portfolio company needs to be super clearer. For us it is a world leading impact tech accelerator program, sector expertise in ocean and climate, and a solid help in bringing the real purpose of true impact into the mix.
There is hardly a single asset management in the world that does not have sustainability on the agenda, the EU train with new regulations on sustainable investments is already incoming, and a lot of capital is to be invested in what are currently the world’s fastest growing markets. Black Rock’s Larry Fink might be right about his popular saying that the next 1000 unicorns will be related to climate.
Rather than compete on the quickest decisions, and apply standardized models and fight against the Tiger Capitals of the world, we believe serving this market with the best impact tech startups, at an early stage, is the most impactful and profitable position going forward. Profit then comes due to impact. Not as a bonus, but as the core of the problem solving business model.
The capital is available, the sustainability mandates are already in place, and the battle for the good companies is growing every day Tiger Capital makes a new investment.
In short, we have had a venture model that has funded pretty much everything that is of leading tech companies in the world – the very engine of growth and digital disruption. It has changed almost all companies and social institutions, for better and worse, and the venture model is already undergoing a similar change.
By nature, the world’s biggest problems will always be plentiful – there are enough problems for all – infinitely many new industries to be built. The starting point is seed and early stage funding, combined with sector specialization, and comes before the industrialized investment mechanisms take over.
After all, there will, by definition, never be a playbook for real disruption.