“If you can’t invent the future, the next best thing is to fund it.”
— John Doerr, Kleiner Perkins Caufield & Byers
I was catching up recently with a friend who had just celebrated her 15th year as a venture capitalist. We were sitting on a bench in San Francisco’s South Park and during the course of the hour chat, 9 different tech investors we both knew and frequently collaborated with happened to walk by at different intervals.
Pure coincidence, but by no means a rare coincidence, as South Park has in recent years become home to more than a dozen investment firms making it the de facto capital of venture capital in the city. The Sand Hill Road of San Francisco if you will. Or perhaps more accurately, Sand Hill Road may be the South Park of the Peninsula given investors have put about 2 times more capital into San Francisco startups than their Silicon Valley counterparts this year.
As each familiar face passed that South Park bench, we would politely wave and resume our conversation but after the fifth interruption or so, my friend couldn’t help but stop and make a comment. “That’s what’s changed most in the past 15 years. When I started out, I didn’t interact with all these others investors because there wasn’t anyone to interact with. Now there are hundreds of investors I work with, and that number grows every year. I wonder why there are so many more investors now?”
Let’s find out.
Planting seeds
“Seed investing is the status symbol of Silicon Valley.”
— Sam Altman, Y Combinator
To understand as well as visualize the changes that have happened in the venture capital industry over the past 15 years, I’ve pulled together some metrics courtesy of Pitchbook. The first chart below is the number of new US-based VC funds that have been raised each year since 2003. From 2003 to 2011, an average of 157 new funds were raised each year. But from 2012 onward, that average rose to 223, or an impressive 42% increase. More funds equals more active investors working at those funds.
Looking closer into what types of funds are being raised, I’ve taken the same data but broken out the US-based investment funds by seed funds versus non-seed funds (i.e. venture and growth stage funds). The rate of non-seed funds raised each year has been relatively stable for the past 15 years at about 90. But the rate of seed funds raised has jumped dramatically. Between 2003 to 2010, an average of 58 seed funds were raised each year but in the past 7 years, that average spiked to 137 (or a 2.3x increase). Put another way, all the recent growth in the number of funds raised has been from seed funds, not venture or growth funds. And since 2011, a whopping 60% of all funds raised every year have been seed funds (compared to less than 30% a decade ago).
There has been an even bigger increase in the number of seed investors active in this country because of the disproportionate growth in the number of seed funds raised each year. So if it feels like there are thousands of new investors in the industry, particularly seed investors, that’s because there are.
Wheeling and Dealing
“A lot of capital does disrupt venture capital, which is the problem we’ve had as an industry.”
— Sarah Tavel, Benchmark
Now that we’ve established there are indeed a lot more investors with a lot more funds to invest from, what’s happening with this capital? A very obvious answer: it’s being invested.
In the past 15 years, the amount of money invested by US-based VC firms into startups grew more than 4x to almost $85 billion dollars last year. Before 2011, an average of $28 billion was deployed each year but in the past 7 years, that number has jumped to $62 billion invested annually. Not surprisingly the number of deals has seen a corresponding sharp increase. From 2003 to 2010, the industry averaged almost 3,800 investment deals per year. But since 2011, the average number of deals per year has shot up to more than 8,700.
When you look at the dollar amounts deployed, venture and growth stage deals (i.e. non seed deals) have accounted for over 90% of the capital and that ratio has been consistent over the past decade. So even with the sharp influx of seed funds, the vast majority of the dollars are still invested by traditional venture and growth funds.
But by examining the total number of deals (and not the aggregate dollar amounts), a different story emerges. While the volume of non seed deals is up 20% over the past decade, the volume of seed deals is up 400% over that same period. Since 2011, the average number of seed deals per year (4,300) is now about equal to the average number of non seed deals per year (4,500).
While the seed checks may be small (both individually and in aggregate), they are very frequent. And when combined with venture and growth stage deals, there are 3x as many funding events now than 15 years ago. Do the math and there’s now 1 venture capital investment being made every hour of every day, 7 days a week, 365 days a year.
Investors have been busy.
Exit stage right
“Good VCs are great pickers”
— Josh Kopelman, First Round Capital
Investing is only one side of the venture capital equation. The other side is the returns on those investments. So as investment activity has increased significantly over the past 15 years, how have returns faired? As a whole, pretty good. Total number of exits (startups going public or getting acquired) are up 2x in the past 15 years, and the value of those exits is up 3x averaging $50 billion per year in returns since 2015.
But that growth in exits is misleading because the total volume of deals and capital invested is also up. The true measure is when you compare exits not in absolute terms, but relative to investments. And when you do that, the outlook is more challenging.
Below are two charts that compare returns to investments. In the chart on the left, I’ve plotted the total dollars returned for a year divided by the total dollars invested for that same year, and included the trendline. This ratio approximates the return on dollar invested, and it’s pretty much flat showing that venture returns have not increased relative to dollars invested, but instead held constant. Now holding constant is a good thing as it points to the venture industry being able to sustain itself as more dollars have flowed in. In other words, return on investment is roughly the same now as it was 15 years ago despite having about 3x as much money in the system. Venture capital has been able to scale as an industry.
But the chart on the right is where things get tricky. Here I’ve plotted the number of investments for a year divided by the number of returns for that same year, and included the trendline. This ratio approximates how many investments you need to make before you can get a good outcome in the form of a return. 15 years ago, it was about 7 investments made before you got one return. Now that ratio now sits at 10 investments required to get one return. Today’s investor has a 10% likelihood of making a good investment (in a company that will generate a return on that investment), whereas yesterday’s investor had a 15% likelihood. That’s a 50% higher probability that yesterday’s investor would invest in the right company over today’s investor. To put it in perspective how meaningful that is, a 50% increase in accuracy is the difference between the best three point shooter in the NBA last year and the worst three point shooter (amongst 132 qualifying players).
Grand Slams
“Venture capital is not even a home-run business. It’s a grand-slam business.”
Bill Gurley, Benchmark
It comes back to the effect of more funds employing more investors deploying more capital into more companies. When the industry is making over 5,000 more investments each year compared to 15 years ago (with most of those being seed investments), there are just so many more funded startups for investors to evaluate to find the successes. The proverbial haystack has simply grown much larger.
Then what’s the draw of venture capital investing now if the dollar weighted returns are about the same yet picking startups is significantly harder? Why are there hundreds of new funds and thousands of new investors entering an industry that has become increasingly difficult to find the hits?
Because when those hits are found, they are bigger than ever.
To illustrate this, I’ve plotted two categories of startup exits over the past 15 years below. On the left are exits each year under $100 million in value, where the trendline is up only slightly. But on the right, I’ve plotted exits each year over $1 billion in value, and the trendline is up dramatically. On average, there are more than 7x the number of billion dollar exits now than a decade ago. The number of billion dollar exits last year was about 10% of the total number of exits, but this small group generated 60% of the total dollars returned.
As investor Marc Andreessen has said, “returns are a power-law distribution” with the majority of returns concentrated in a small percentage of companies. That’s true now more than ever, and one of the great promises of the venture capital industry that motivates and drives investors.
Yes it’s more competitive than before for investors. Yes it’s harder to identify great investment opportunities than before for investors. But startups companies are also more successful, more transformative, and more valuable than before too. One of the reasons is directly because of the added investor funding available at the seed stage. Additional capital attracts more entrepreneurs who may not have started a company a decade ago. These entrepreneurs can pursue even more diverse and bold ideas that may not have been tried in a previous era. All this extra activity at the early stage may have crowded the investing funnel. But it’s also led to the companies that make it all the way through being some of the best ever.
So back to the original question posed on why the venture capital industry has grown so much? There’s a multitude of reasons but among them is the simple fact that the outcomes are more meaningful, and your next investment could lead the entire industry. Working with those types of stakes is a huge motivator. Because to continue the sports analogy, if you are that fortunate investor who backs tomorrow’s great company, what was a home run a decade ago now has a chance to be a grand slam.
And for many, that’s a game worth playing.
