The decade that completely transformed venture capital

Over the past 60 years, the venture capital industry has expanded from a few, small partnerships primarily located in Silicon Valley and Boston into a global industry that invests more than $250 billion per year. By nearly every measure, the venture industry has boomed. Firms are raising funds 10x the size that they used to and opening offices around the world. Venture-backed startups are raising rounds that are 10x the size of rounds a decade ago, creating an ever-larger group of unicorns around the world. If there is one word that can sum up the state of the venture industry it is: growth.

In many ways, the reason for that growth is simply that success begets success. As investors have made money with venture capital, they’ve wanted to invest more. As they have invested more in venture funds, those funds have wanted to invest more in startups. As those startups have taken on more investment, they’ve been able to grow bigger and faster — making more money and continuing the cycle.

But growth means change, as any startup founder can attest. As venture capital grew up, it didn’t just do more of the same—it was transformed, and not entirely for the good.

The shifts in VC have far-reaching impacts—well beyond the venture firms on Sand Hill Road. Yes, the growth of venture capital has created many more startups which provide new job opportunities and innovations that benefit society as a whole. But it also perpetuates inequality by concentrating capital deployed and investment gains. Because most people can’t invest in private companies—by law, in the US—the financial returns from VC aren’t broadly shared.

The growth of the venture industry has created more, larger private companies, which stay private longer, hoping to reach unicorn status before moving on to the public markets. “The most significant change in our ecosystem in the past 12 years we’ve been doing this is the doubling of time to a significant exit,” Michael Borrus of X/Seed Capital says. “Companies stay private longer, they need more capital to stay private longer, and they need to get to bigger outcomes to justify the capital they’ve raised.”

The venture industry invested more than four times as much capital in 2019 as in 2010, providing a significant amount of monetary fuel for the startup economy. But while the industry invested four times the amount of capital, it only invested in twice the number of companies. This means that the venture industry is providing twice the fuel to each company and a select group of founders are capturing a disproportionate share of the gains.

Twenty years ago, the investment gains after a star company went public would be captured by public-market investors. Now, as star companies wait to go public with valuations at 10x or 100x those in the past, those gains are captured by a small group of founders and investors.

The overabundance of capital mixed with lack of regulatory oversight that comes with staying private contributed to the mismanagement of companies ranging from Theranos to Uber to WeWork.

In this state of play, I’ll explain how we got here. Elsewhere in this guide, I’ll cover what needs to change.

A short history of venture capital

The modern venture capital industry began in the mid-twentieth century, but its origins go back much farther. In VC: An American History Harvard Business School professor Tom Nicholas traces its origins to the financing of whaling expeditions in New England in the 19th century. Creative Capital, by Spencer Ante, traces it to Georges Doriot, a Harvard Business School professor who founded American Research and Development, arguably the first modern VC firm, in 1946.

“Doriot’s vision was not one of ‘making money’ but rather financing ‘noble’ ideas,” wrote Paul Gompers—yes, another Harvard Business School professor—in a paper on venture’s origins. “The first investment made by ARD in 1947 was in High Voltage Engineering Company. The firm, founded by several MIT professors, was established to develop X-ray technology in the treatment of cancer.”

“They [High Voltage Engineering Company] probably won’t ever make any money,” MIT’s then-president Karl Compton wrote to Doriot, “but the ethics of the thing and the human qualities of treating cancer with X-rays are so outstanding that I’m sure it should be in your [Doriot’s] portfolio.” Eight years later, the company went public and ARD made 9x its original investment.

Other than ARD, venture investing was primarily limited to a small number of wealthy families like the Bessemers, Rockefellers, and Whitneys through the 1950s. The Small Business Investment Act of 1958, which provided low-cost loans to investment firms that would, in turn, invest in small businesses, spurred the founding of many of the venture firms still in operation today, including Sutter Hill Ventures, Greylock, Venrock, Charles River Ventures (now CRV), Kleiner Perkins, and Sequoia Capital. These firms invested in the early successes of the technology industry, like Atari, Fairchild Semiconductor, Genentech, Intel, and Tandem Computer, creating new wealth and new venture capitalists as well.

The venture industry had its first big growth spurt during the dotcom boom in the late 1990s. But even in 2010, the industry represented only 800 firms worldwide. Over the past decade, more than 2,000 new firms have been founded, and worldwide assets have grown to $1.4 trillion.

But the massive growth in assets held by venture capital firms has completely altered how startups are financed. Twenty years ago, startups would raise millions or tens of millions of dollars from individuals and venture capital firms to finance growth. Shortly thereafter—usually within five to 10 years—they would raise capital from the public markets through an initial public offering of tens of millions of dollars at valuations that were normally in the hundreds of millions. For instance, in 1997, Amazon.com raised $54 million in its IPO, giving the company a $438 million valuation. Amazon.com was growing rapidly but had only made $16 million in revenue in 1996 with $6 million in losses.

Today, startups raise hundreds of millions or even billions of dollars from venture capitalists before going public. IPOs are larger by multiple orders of magnitude. For instance, in 2019, Uber raised $8 billion in its IPO, giving the company a $80 billion valuation.

What’s going on? Why has there been so much growth? There are four big trends that have driven more money into venture.

Success begets success

The most important reason the venture capital industry has grown is simply that it’s making more money for people than the alternatives. Venture capital has dramatically out-performed public markets over the past 25 years, according to analysis by Cambridge Associates. Positive returns from venture capital funds have attracted more capital seeking high returns and, in some cases, created more capital for investors to reinvest in venture.

But high returns aren’t the only reason venture has grown. A strong stock market has created more capital to reinvest in other asset classes; some of that money has been reinvested into venture. And persistently low interest rates have dampened the relative returns investors can get from debt, making equity investments—including venture capital—more enticing.

Since 2012, venture firms have been returning more capital to their investors than they have been raising from these investors. That means that the limited partner investors are both a) happy about the venture industry and b) have more money to invest. The running theory in the industry is that this positive flow of capital will encourage investors to continue to invest more.

All of these factors have taken venture from a minor asset class a few decades ago to a prominent asset class for many large money managers. Perhaps no one has exemplified this transition as much as David Swenson, the legendary endowment manager at Yale University. Swenson took over the Yale endowment in 1985 when it had $1 billion under management, the vast majority in publicly-traded stocks and bonds. Over the past 35 years, Swenson has grown the endowment to more than $30 billion, largely due to the success of investing in alternatives like leveraged buyout funds, real estate, and venture capital. In particular, Swenson has increased the Yale endowment’s allocation to venture capital from 1% in 1985 to over 21% today which means the dollars allocated to venture capital have grown from around $10 million in 1985 to more than $6 billion today.

Swenson’s impact on the venture capital industry is much larger than the investments made by Yale, though. Swenson’s unconventional investment style has been dubbed the “Yale model” and has been mimicked by countless other endowments, pension funds and foundations, creating a large inflow of investment into venture capital funds. Due to the number of funds that try to replicate his success, it may be that Swenson has had more impact on the growth of assets allocated to venture capital than any other individual.

New sources of capital

Traditional venture capital firms aren’t the only ones investing in startups. Corporations and public-market investors (hedge funds and mutual funds) increasingly do, too. These investors are usually described as “alternative VCs” or “tourist VCs” because they tend to move in and out of the market. Unlike venture capital firms whose entire business relies on investing in startups, corporations and public-market investors invest when the market dynamics fit the rest of their business. In particular, corporations tend to invest in startups when the economy is good, giving them excess cash, and when they see good opportunities to invest in big new technology advances.

Ravi Viswanathan of NewView Capital says that, “In the 80s and 90s, public-market investors made the big returns, but now a bigger chunk of that value is going to private-market investors.” This means that investment firms that traditionally only invested in the public markets are investing in private companies with the hope of capturing some of the investment gains prior to an IPO.

Tourist investing has grown rapidly; the percentage of venture deals that include an alternative investor rose from 40% to 66% over the past five years and the dollars invested by alternatives surged from $19 billion to $91 billion. Ed Sim of Boldstart Ventures says, “You’ve got this perfect storm because everyone is trying to figure out how to get into the big winners—and if they don’t get in early, they’re going to miss out.”

But this crossing over of public investors into the private markets isn’t new. Many of the same large funds also invested in private companies during the dotcom bubble of the late 1990s. Some investors created cross-over funds that were specifically designed to invest in late-stage private companies such as Integral Capital and Octane Capital. While these firms had very good returns when startups went public rapidly during the internet bubble, they had disastrous returns once the bubble burst.

The big question is whether the alternative VCs will stick around this time when the market cools. History suggests that tourists will exit the market when economic conditions worsen, but Viswanathan thinks that the structural change in how long companies stay private will mean the tourists will have “a prolonged presence” in the venture industry.

One alternative fund looms particularly large. Softbank’s $100 billion Vision Fund is the giant of the venture industry; we could do a whole other field guide just on its influence. The short version is that the Vision Fund’s proclivity for cutting giant checks has contributed to bigger rounds and inflated valuations, and in some cases pushed traditional VCs to raise larger funds. For more on the Vision Fund’s influence on the industry and the companies it invests in, here’s Quartz’s presentation on that topic.

The internet, cloud, and mobile

Then there’s the technology itself. Part of the increase in capital allocated to startups is due to the nature of the technology industry today. The venture industry was born in an era of slow-growing, limited market opportunity hardware companies, but it is now dominated by fast-growing, frictionless software companies that leverage worldwide distribution across cloud and mobile networks. “Software is eating the world,” the saying goes, and that is allowing startups to reinvent pretty much any existing industry and create countless new ones. For investors, this means simply that there are a lot more opportunities for a lot more companies to make a lot more money than ever before.

“The bar has changed because the markets are so much bigger and companies are growing faster than ever before. 20 years ago, we had dial-up internet, it wasn’t global, the sales offering for enterprise customers was top down and very expensive,” Boldstart’s Ed Sim says. “But, I think, with the cloud, with open source software, with product-led growth where people can download and try a product, these companies can grow faster than ever.”

Larger funds = more fees

It may sound cynical, but some of the increase in assets invested in venture capital is due to the reality that the larger the fund, the larger the fees paid to general partners. Each new fund raised creates new management fees and the possibility of more carried interest. As firms have grown from small partnerships to larger institutions, they’ve been able to manage more capital with larger teams. That benefits the most senior partners, in particular, who decide how large the firm’s next fund should be.

What’s the effect of all this new capital? Here’s how the three main types of investments—seed, early stage, and late stage—have changed.

Seed: investing in teams and ideas

At the earliest stage—when a company may be just an idea—founders have traditionally raised their first capital from individuals, called angels. Over the past decade, though, as more capital has tried to get into companies at the earliest stage, angels and institutions have started pooling funds for this stage, called seed. Boldstart’s Sim says, “Before, it used to be angel money and then a Series A and then the category of seed started and now there’s a whole institutional seed market.”

In many ways, these seed funds look like the venture capital funds of a couple of decades ago: tens of millions of dollars under management, making single-digit million-dollar investments in startups that may simply be a prototype and a founding team. Over the past decade, 1,600 venture funds were raised in the US with less than $100 million in assets (a size that normally focuses on seed and very early-stage investing). The number of these funds started each year has grown from only 32 funds in 2009 to 295 funds in 2018.

Some experienced seed investors think this trend of new seed-fund formation is here to stay. Long-time angel investor Sunil Paul jokes that he’s lost count of the number of emails he’s received recently from other angels saying, “I always said I’d never raise a fund but I am now!” Paul attributes this to increased competition among investors to find the best investment opportunities. As more angels have created organized funds, the value of an individual angel has declined, which drives others to organize into funds to be more competitive. To the rest of the world, it might seem strange that individuals who can afford to invest $25,000 to $100,000 in dozens of companies are suffering from competitive pressure. But that is the reality of today’s venture capital industry.

The growth of seed funds has increased the size of seed investments. While seed and angel rounds were historically about the same size, seed deals started to increase in 2013 and are now four times the size of angel rounds, on average, driven by an increase in rounds over $500,000 which were just over half of all seed deals in 2009 but now represent about two thirds of all seed deals in 2019. Ed Sim says that “first rounds can be as small as $500k and as high as $8 million.”

Izhar Armony of CRV says that one third of his firm’s investments start at the seed stage. He thinks the growth of the seed industry has had some positive benefits: “You have way more capital that’s being allocated more fully and more democratically—those are very good things.” But he also sees drawbacks since seed funds are usually small, limiting the amount they can invest long-term. “In some ways, the seed movement has created unrealistic expectations for entrepreneurs. It was presented as ‘Hey, raise just enough money to get going, control your own destiny, it’s all good!’” Armony thinks the limited capital of many seed investors can “put entrepreneurs in a bind” as they try to grow and scale but don’t have enough runway to achieve the metrics follow-on investors now expect to see.

Some predict, though, that the institutionalization of seed investing will create a shift towards more hands-on involvement from seed investors to specifically address the gap Armony is concerned about. For instance, David Cohen, co-founder of accelerator Techstars says, “I think because the seed stage is professionalizing and maturing, my expectation is that seed investing will be a very active experience.”

Techstars has a particularly broad view since the accelerator operates in more than 150 countries and has backed more than 2,000 companies, adding 500 companies to its portfolio every year. Cohen believes that future success in seed investing will rely on a broad portfolio of diverse companies, hands-on help from investors, and a geographically diverse team. He says investors “can’t just sit on Sand Hill Road and wait for companies” to come see them, they need to “get out and participate in those communities” in order to find the best entrepreneurs and ideas. His model seems to be working as 30%-40% of Techstars’ investments go on to raise a Series A.

Early stage: investing in products

Early-stage venture capital investing comes after seed and angel investing and represents Series A and Series B investments. The definition of each stage of investing has changed over the years. What is now a “seed” investment was a “Series A” investment 20 years ago, but the current market generally agrees that a Series A is now an investment of over $10 million in a company with a proven product.

Other than the change in nomenclature, early stage investing has changed the least of the three stages of venture investing. Many of the most active firms have dominated the industry for decades, deal structures largely haven’t changed, and the way early stage firms source and manage investments is mostly the same. But there are a few big differences.

The biggest change is in valuations. A decade ago, 45% of dollars invested in early stage deals were in deals below $10 million and 80% were below $25 million. Today, those percentages have dropped to 15% in deals below $10 million and only 40% below $25 million. This upward shift has increased the average deal size from about $5 million in 2009 to over $14 million today. That has led people in the industry to say that what was a Series B is now a Series A — it’s like a form of grade inflation for venture capital.

Late stage: investing in growing companies

Late-stage venture, traditionally Series C and later, has grown more than any other category. Almost half of all funds raised in the past year were above $100 million and more than 15 funds above $500 million were raised in 2019. Several long-serving, traditional venture capital firms have raised funds over $1 billion including NEA, Sequoia Capital, Bessemer Venture Partners, and Lightspeed Venture Partners. Given the scale of capital under management at these firms, the distinction between venture capital and private equity is becoming difficult to determine.

Late-stage venture is growing for three reasons:

1.   Companies are staying private longer. The average late-stage investment is now made into a company that has been in business 9.4 years, up about a year since 2009. And startups are now staying private for more than 11 years, on average, up from five to eight years twenty years ago. All of that time creates a need for more capital to fund growth and cover losses.

2.   Companies are expected to grow at all costs. The winner-take-all mindset of today’s technology industry encourages companies to spend as much as possible to grow as fast as possible. Dubbed “blitzscaling,” the modern growth strategy pushes companies to raise more capital to grow faster and then figure out a profitable business model later.

3.   Investors want to invest more in venture capital, for all the reasons mentioned earlier.

Interestingly, the terms of late-stage venture funds may create a perverse incentive to invest more, faster. Unlike early stage venture funds which collect management fees on the total fund amount from day one, some late-stage funds only collect management fees on funds that have been invested in companies. For instance, Sequoia Capital’s latest $6 billion growth fund reportedly collects a 1% management fee on capital once it has been called, which means that the managers will only start collecting the full $60 million management fee once they have chosen to invest the entire fund. This creates an incentive for managers to make investments as large and as quickly as possible since each new investment could increase the salary they get from management fees.

As deal sizes have increased in early stage deals, they’ve also increased in late-stage deals—and by a lot. The average late-stage deal has increased from about $12 million in 2009 to over $42 million in 2018 — a 4x increase. The total dollars invested in deals above $50 million in size has also increased from about 20% of total capital invested in 2009 to 60% of capital invested today.

We won’t know for several years if venture firms can continue to produce the same overall returns for their investors with these large, late-stage rounds. On one hand, it’s harder to get as high of a return from an investment at a higher valuation than a lower one. But, on the other hand, investors in later stage companies should be able to avoid the percentage of failures at the early stage and have a higher hit rate. Either way, we’re experiencing a grand experiment in venture capital as the industry seemingly adds zeros everywhere—to the size of the funds, to the size of the deals and to the valuations of the companies.

The risks

Is all this growth sustainable? The first question to ask is: sustainable for whom? The people investing and seeking investment? Or, for the broader world?

Within the industry, the conventional wisdom is that growth will continue, even after a year with some high profile disappointments like the devaluing of unicorns after their IPOs and the failed IPO and dramatic restructuring of WeWork. Not everyone agrees, though.

There are those who think the current boom will inevitably bust, as it has in previous eras. This cycle of more capital needing more capital has increased the size of funds for leading firms from a couple hundred million twenty years ago to a few billion today. Venture firms now have hundreds of people on staff and countless portfolio companies.

Izhar Armony of CRV takes the more cautionary view: “The current state is unsustainable—the valuations, the amount of money, the competition—it’s assuming the bull market will last forever.” Venture follows overall economic cycles, so a recession might dampen the industry for a bit and add some rationality.

Even if the venture boom can continue to deliver for investors, there are numerous downsides for the rest of us. Venture capital has always concentrated power among a small group, but that’s even more true today as extra capital has inflated valuations more than it has expanded the number of companies that get funded. Founders and, to some extent, the VCs who fund them, are empowered. When it works, the result is new products and services that benefit a wide number of people. But the financial returns mostly go to a small number of people in a handful of cities. Less of the benefit flows to the average investor, since these investments take place in private markets. And even for the pension funds that do invest in VC, they pay far heftier fees for the privilege.

For venture capital to expand sustainably, the industry will need to improve in several ways at once. First, it needs to diversify, both internally and in terms of who it invests in. Second, it must find a way to re-engage with public markets. The goal of a VC investment used to be an IPO, now it’s often a sale to a tech giant. Some VCs are worried about this; the industry as a whole needs to play a role in fixing it. Third, VCs must put their feet down on deal terms and quit giving founders supreme control in the form of dual-class shares with excessive voting rights. Founders are critical to startups’ success, obviously, but so is reliable corporate governance that can check a founder’s excesses. Finally, VCs need to find a way to apply more capital toward more companies rather than just pouring lighter fluid on the ones they’ve already discovered.

Originally published in Quartz.