Thursday, October 22, 2015

"Venture Capital And The Internet's Impact"

From stratechery:
Much has been written of the difficulty in building “another Silicon Valley.” To be sure, many countries and regions have tried, seeking to assemble the perfect mix of willing investors, eager entrepreneurs, and ready-made markets that will produce the sort of self-perpetuating ecosystem that will lift the region, country, nay, the world to a new level of prosperity and modernity. 
 The problem is that like most real-life systems Silicon Valley is non-linear: it is impossible to break it down into component parts that can be reproduced, and no one can know for sure what a small change in inputs will mean for the outputs.
Moreover, one of the most important stories of the last several years is how the structure of Silicon Valley itself is changing, particularly when it comes to funding. Instead of traditional venture capital firms investing in startups from PowerPoint to IPO, there are angel investors and seed rounds on one end and traditional public market investors investing in private unicorn rounds on the other, with venture capital firms somewhere in the middle. And no company is more responsible for this radical transformation than Amazon: the company changed the inputs, and the butterfly effect is upending the entire system.
There’s a tendency in tech journalism to view venture capitalists as the moneymen (I always try to use gender-neutral terms on Stratechery, but it would be dishonest to even make an attempt here given the pathetic fact that only 4% of partner-level venture capitalists are women). In truth, though, middlemen is just as appropriate: the actual money comes from limited partners like family trusts, university endowments, pension funds, sovereign wealth funds, massively wealthy individuals, etc. Limited partners have highly diversified portfolios of which venture capital is only one part — the high-risk high-return part — and the reason they “hire” venture capitalists is for their skill in identifying and investing in new companies about which LPs have neither the expertise, time, or knowledge to invest in by themselves. Moreover, they pay handsomely for the help: venture capitalists usually charge around 2% of the fund per year
 in fees and keep about 20% of profits (fees are often but not always subtracted from the final payout; however, if the fund loses money the fees aren’t repaid).
I point this out to highlight the fact that at a basic level venture capitalists are arbitrageurs: they have access to more information than those with the capital, and access to more capital than those with information, and they profit by exploiting the mismatch. 
 And to be clear, this is not a bad thing! Our entire economy is predicated on middlemen: no one grows their own food, to take an extreme example; rather, we depend on an entire supply chain of middlemen that results in $4 toast from wheat that costs $4/bushel. 
In the case of startups, during the 45 years after Arthur Rock founded the first venture capital partnership in 1961, the vast majority of new firms needed significant funding from day one. Hardware startups of course needed specialized equipment, the funds to make prototypes, and then to set up actual manufacturing lines, but software startups, particularly those with any sort of online component, also needed to make significant hardware investments into servers, software that ran on said servers, and a staff to manage them. This was where the venture capitalists’ unique skill-set came into play: they identified the startups worthy of funding through little more than a PowerPoint and a person, and brought to bear the level of upfront capital necessary to make that startup a reality. 
In 2006, though, something changed, and that something was the launch of Amazon Web Services.
 Because a company pays for AWS resources as they use them, it is possible to create an entirely new app for basically $0 in your spare time. Or, alternately, if you want to make a real go of it, a founder’s only costs are his or her forgone salary and the cost of hiring whomever he or she deems necessary to get a minimum viable product out the door. In dollar terms that means the cost of building a new idea has plummeted from the millions to the (low) hundreds of thousands. 
In turn this has led to an entirely new class of investor: angels. There are a lot of people in the San Francisco Bay Area especially who have millions in the bank — enough to live comfortably and take some chances, but nowhere close to the amount needed to be a traditional limited partner in a venture capital firm. On the flipside, though, these folks have a huge information advantage: they are still a part of the startup scene, both socially and professionally; they don’t need someone to make deals for them. 
Previously these individuals would have probably tried to join a VC firm and chip in some of their own money to a fund alongside traditional limited partners. However, thanks to AWS (and open-source software) and the fact starting companies no longer needs millions, these angels are able to compete for the opportunity to fund companies at the earliest — and thus, most potentially profitable — stage of investing....MORE
HT: Barry Ritholtz at Bloomberg