Protocols, tigers and unicorns

2021 is a time of change for entrepreneurs raising venture capital, and for the firms providing it. For founders, there has never been a better moment to start a company and seek funding. Dan Ouchterlony, EVP Financial Services and Ventures, looks into an exciting future.

Venture capital is booming. In the third quarter of 2021, a whopping 158.2 billion USD was invested into start-ups at various stages, according to CB Insights. This is more than double the investment compared to the third quarter 2020 (which itself was a strong quarter!) and the highest number on record for a single quarter.

The driver was the volume of large rounds, totalling 409 investments of more than 100 million USD, up from 173 in Q3 2020. However, at the end of the funnel, exits have only increased 13 percent in 2021, as compared to 2020. Thus, an increasing amount of wealth is tied up in start-ups.

This prompts many questions. What are the driving trends in the industry, and why is interest booming? Who are the movers and shakers? And what is happening on the fringes? Is the rising tide lifting all boats, or are some players at risk of losing out?

Masayoshi Yasumoto was bullied as a child. Despite being third generation Japanese, he was considered ethnically different. In his adolescence he agonised over his identity to the extent that he seriously contemplated taking his own life. Today he claims, somewhat credibly, that he is the Rothschild of the Internet era. But you know him as Masa-san – the CEO of Softbank and chairman of The Vision Fund, the world’s largest venture capital fund.

Masa and The Vision Fund came blazing on the venture capital scene on 20 May 2017, with the announcement that they had closed 93 billion USD of commitments to the fund. Compared to the 153 billion USD of venture capital invested in 2016, this was a staggering number by all accounts. By September 2019, all the funds were deployed, except a small reserve, and venture capital was changed at its core.

The Vision Fund changed the game by being more aggressive than other venture capital firms, both in terms of how much capital they deployed into their investments and by threatening to fund rivals. Established venture capital funds lost out on deals, as Masa-san was willing to raise valuations, and effectively bought his way into deals using both carrot and whip. Seen as a king maker in the segments they entered,founders and CEOs jostled to stay behind, rather than in front of, what Dara Khosrowshahi, Uber’s CEO, famously called “the capital cannon”. What happens if Softbank funds my rival, wasn’t a rhetorical question.

The canon has not reloaded

Softbank and The Vision Fund also played a different game in the public arena. Whereas many established venture capital players relied on building relations, understated communication, and thought leadership in their industries, Masa-san went on stage with slogans like “happiness for everyone” and slides with pastel-coloured unicorns and golden geese.

The Vision Fund’s capital cannon has not been able to reload, however. And due to the poor financial results (so far) of Vision Fund 1, Vision Fund 2 has shrunk dramatically in comparison. With the aim to raise 108 billion USD, the fund has only raised 30 billion USD to date, all of which is committed from its owners at Softbank.

Was it then a historical blip on the radar? Some of what happened might be told as a cautionary tale for the next generation of venture capitalists during fireside chats. But one thing is for certain. Masa-san is not finished. He is not a stranger to failure after losing some 70 billion USD of personal wealth in the dotcom crash, and rising taller from adversity, as exemplified by changing his family name from their Japanese-assumed name of Yasumoto back to his family’s original Korean name Masa Son.

One thing that seems to have permanently changed in the wake of The Vision Fund is the speed of execution in large deals. But today, the velocity of deal making is no longer the hallmark of the “Unicorn Hunter”, but that of the “Tiger”.

But today, the velocity of deal making is no longer the hallmark of the “Unicorn Hunter”, but that of the “Tiger”.

Tiger Management was one of the largest hedge funds of the 1990s. After a bout of poor performance, it closed in 2000. Out of the ashes of the fallen fund, some 30 young managers in the team were staked to start their own hedge funds. One of them was Tiger Global Management – the Tiger that we know and talk about in the venture capital business today.

Tiger is, so far during 2021, closing about 1.2 deals per business day. This speed is unusual even for the predator: according to Crunchbase, 240 investments have been made as of 11 October 2021, up from 80 deals during the whole of 2020, and 86 deals in 2019, during the same period. In other words, Tiger is running three times their already high speed.

Pundits are commenting that Tiger is “indexing” the venture capital market, in a move characteristic of a hedge fund. Not a cannon perhaps, but a machine gun. The theory goes that if they spread their bets widely enough, they will hit enough success cases to generate returns.

What does this mean? First, let’s look back. The venture capital business is traditionally based on long-term relationships, which in and of itself means investing a lot of time per deal and trying to add value after the deal is done. It’s a model taken “to the next level” by Andreesseen Horowitz, who famously built the largest support staff in the business and financed it by forfeiting their own management fee. Despite Tiger’s extremely big staff, doing and supporting 240 deals in three quarters is just not sustainable on this conventional model. So how does Tiger do it?

Tiger does not build relationships

They do it by effectively employing the opposite of the conventional wisdom. Tiger does not build relationships in advance of sending term sheets. Tiger does not want a seat on the board. Tiger does not want to do heavy due diligence. And Tiger does not try to support you operationally after the deal. This indexing of bets has already happened to some extent in the earlier stages, where organisations such as Ycombinator and 500 Start-ups have tried to spread their bets very widely by speeding up investing. But with the sheer amount of early-stage rounds happening, the index will never be even close to complete. Tiger, on the other hand, has a real shot in the later stages.

The result of Tiger’s approach for founders is better, faster and cheaper capital, according to Everett Randle of Founders Fund. Start-up founders can spend less time raising funds and can for good and for bad, take capital without giving up control. This is attractive for many, and only the biggest, most successful venture brands will survive long-term with the established relationship model, according to Everett. The mid-sized firms will be squeezed by Tigers and the like, who are forging ahead with extreme conviction.

For venture capital this means many more people want to get involved

Another phenomenon on the rise, both in general and especially among the young, is decentralised finance. Technical terms such as blockchains, crypto currency and non-fungible tokens (NFT) are becoming mainstream. There are two things going on at the same time: First, access to and interest in capital markets are on the rise generally, boosted by players such as Robinhood and the get-rich-quick FOMO in the longest of bull markets. Second, entirely new technologies that decentralise and democratise finance – defi in short – are on the rise. One example is investor-entrepreneur from generation Z, Jacob Clearhout, left his firm to “do a start-up” at the intersection of VC and defi. In a fantasy football game for start-up shares called Visionrare, fake shares are minted as NFTs, sold for five USD each, and then made investable in a game of I-told-you-so.

For venture capital this means many more people want to get involved, both as venture investors, builders, speculators and commentators. One particularly interesting topic is the attack on the existing power structures in venture capital. As an industry that typically builds on apprenticeship, personal networks and significant personal wealth, it is somewhat uncomfortable to have young talent discuss tips for “breaking into VC”, “discrimination of non-white founders”, and why it is time to “ban the warm introduction”. According to Del Johnson, who launched the proposed embargo, the network-based approach of personal introductions is not only anti-founder and discriminatory, but even worse, it leads to subpar performance. Why? Because you miss the opportunities outside your network.

What is even more uncomfortable for many are defi structures that emulate and disrupt the venture capital firm itself. On the bleeding edge of development there are venture capital initiatives on the blockchain, structured as decentralised autonomous organisations (DAOs). Either these new structures appear for a special purpose, such as when the digital artist Pplpleasr auctioned off one of his works. And the winning bid was placed by some 30 individuals who organised on social media, gathered the funds, and formed a joint investment DAO in the matter of days. Incorporating an investment firm is a much slower process.

Votings are held in public

Pleasr-DAO has since invested in art by Snowden and Wu-Tang Clan’s album Once Upon a Time in Shaolin, which they bought from the US Department of Justice, who in turn seized it from original buyer, pharma profiteer Martin Shkreli.

Another type of DAO can be a more general “VC on the blockchain” structure, such as when Singaporian cryptoexchange Bybit launched the 540 million USD investment vehicle Bit-DAO in September 2021, with external funding from Peter Thiel and Founders Fund among others. To be clear, this is a half billion-dollar VC firm in a protocol where partnership meetings (voting) are held in public, investment proposals are openly scrutinised (in a forum) and the governance model itself is defined by code.

The idea is not new. In April 2016, the first DAO named “The DAO” was launched, raising about 150 million USD worth of crypto currency from more than 11,000 investors through crowdfunding. At the time around 14 percent of all Ether in issue was owned by The DAO, with plans to become a fully decentralised venture fund. However, the code running this particular firm was flawed, and after losing a third of the capital to a hack, The DAO was delisted, and the project was disbanded. To recoup the losses, the actual blockchain underpinning The DAO was split in two, and the transactions were annulled. If not for the false start, many believe DAOs would have had a much more prominent role today.

As if this wasn’t enough, traditional venture capitalists also face a new generation of investors who are starting out their careers with a new focus and modus operandi, which just might be the future.

Meagan Loyst, investor at Lerer Hippeau is the founder of Gen Z VCs, a network of more than 10,000 who identify with the community of investors and entrepreneurs born after 1995. On her Medium page she published that the number one trend this group is interested in is the creator economy (Roblox, TikTok, UGC, etc.).

Their takeaway is that people see the path to becoming a creator as more institutionalised, and from a young age. Is the same happening to VC in general? The lines between entrepreneurship, investing and creating are certainly blurring. Many entrepreneurs are also angel investors and vice versa. Young VCs are obviously not afraid to network, entirely on the outside of the traditional pipelines of the firms; they are not afraid to make their voices heard; and topics of sustainability, inclusion and equal opportunity are on the rise.

If you are a venture capital firm today, your cosy corner of the market is under attack from many sides: Hedge funds trying to index your asset class “from above”, angels and young VCs banding together online, and blockchain tinkerers trying to democratise your privileged access “from below”. And there you are stuck in the middle. What will you do?

You could adapt and beat Tiger at their own game, like Sequoia China seems to have done. While Tiger takes the media headlines, the semi-independent Chinese arm of industry titan Sequoia made ten more deals in Q3 2021 than Tiger did, according to CB Insights. Does this mean entrepreneurs who take Sequoia China on board as investors will not get the gold standard support of Sequoia?

Only time will tell. In late October 2021 Sequoia announced they will go even more in Tiger’s direction by dropping the traditional a 10-year fund-circle, staying post IPO in the most promising companies. In practice they are becoming a hedge fund.

You could also double down on the current strategy, like it seems Andreesseen Horowitz has done in the crypto arena, by building out its investment and
support teams with roles such as crypto counsel, protocol specialist and crypto network operations. At one point, A16Z Crypto recruited so fast, it became a Twitter meme. According to the Information staff has almost tripled in four years.

Who will succeed? Will Tiger be able to show good returns on their massive bet and reload their capital machine gun? Can the established firms catch up? Or will doubling down on the proven approach work best? Over time, might the coming generation build new kinds of protocols and networks, making the firm itself obsolete?

2021 is a time of change for venture capital, and for founders there has never been a better time to start a company and raise capital.