All About Diffracted Venture Capital
Today: The whole financial services industry looks more and more like venture capital. That’s what I call the ‘diffraction’.
The Agenda 👇
What diffracted venture capital is all about
Investors joining the dance and providing liquidity
Private equity firms, hedge fund managers, value investors
Revenue-based investing in the SaaS sector
How venture capital is changing as a result of this diffraction
A recurring topic of this newsletter is what I decided to label The Diffraction of Venture Capital (July 2020):
Traditional VC ([Carlota Perez’s] “financial capital”) was fine for funding the installation of the Entrepreneurial Age. But now that rudimentary form of financial capital is in the process of expanding, diversifying, and specializing, which gives birth to a whole new financial services industry whose goal is to serve an ever increasing number of tech companies across various geographies and industries. This marks the rise of “production capital”—and this is causing the current diffraction.
Before I settled on the term ‘diffraction’ to describe the idea of venture capital expanding in many different directions and planting its seeds in various other parts of the financial services industry, I had already first discussed it a few months before in Sifted: see The fragmentation of venture capital (January 2020).
To understand why venture capital, its logic and its financial model are bound to transform every segment of the financial services industry, it’s useful to first get a clear understanding of what venture capital is all about. I wrote a lot about that over the years (see the curated list My Writings on Venture Capital, sent out in August this year), but the most recent synthesis is What Is Venture Capital? (March 2020):
What is venture capital? It’s a category of investing which fits two very important criteria:
Your investment target is exposed to one critical risk—that is, a risk that is either highly probable or has a significant impact, or both (criticality = probability * impact). From a business perspective, it means that this one critical risk can threaten the survival of the target. And so it is important to manage that risk by way of “assured access to cash and sufficient control of circumstances”, to quote Bill Janeway. It’s also important not to be exposed to other critical risks at the same time, because there’s only so much risk a venture can manage.
If the target survives exposure to that one critical risk, everyone will enjoy returns on invested capital that are potentially infinite. And this is what makes for the unique economics of venture capital. As we often hear, a VC can afford to lose money on nine companies in their portfolio if the tenth generates such massive returns that it effectively covers all those other losses. That one win makes it possible for everyone (the firm’s general partners, its limited partners, the company’s founders, and some employees) to become very wealthy.
One contributor to the diffraction, especially in Europe, is the hunger for liquidity. Here’s a list of all my essays related to this particular topic (liquidity and exits for VC-backed companies):
Investors in European startups need a clearer path to exit (September 2019)
You're Gonna Need Bigger Exits (October 2020)
Round 2 on Liquidity & Exits (October 2020)
IPOs: Will the Next Generation of Founders Choose to List in Europe? (October 2020)
Debriefing Our IPO Panel (November 2020)
How exactly does the search for liquidity lead to the diffraction of venture capital? Quite simply, it invites investors that are not vanilla VCs into the venture capital value chain. One example is private equity firms, who contribute to generating liquidity by buying out late-stage tech companies. I wrote about it in Can Private Equity Firms Make Money in Tech? (June 2020):
What should happen when tech companies are still private and yet have cap tables harboring early-stage investors anxious for an exit, while at the same time there are those private equity firms sleeping on giant piles of money like the dragon Smaug? A match—and those firms redeploying their funds and upgrading their investment techniques so as to be able to make deals in the tech sector. And the reason I’m interested in this is because maybe it could be a solution for the lack of a clear path to exit for investors in European tech companies.
Another alternative to traditional venture capital is investors buying out exhausted incumbents and then turning them into tech companies. It’s still rather theoretical, but there are precedents—as I wrote in Rebooting Businesses for the Entrepreneurial Age (October 2020):
[I like] this idea of using an existing asset and refurbishing it so as to deliver a service that clears the bar in terms of what customers expect in the Entrepreneurial Age: more convenience, less friction—the Amazon way! It resonates because it reminds me of an early experiment we conducted back when we launched The Family in 2013: The Family Reboot.
The idea was simple: buy an incumbent business which owns assets that can be used in a different way, build up a new company by adding tech talent and resources on top of those assets, and make a hefty multiple on the initial investment by selling the resulting company to a higher bidder.
A third, promising alternative to traditional venture capital is revenue-based financing, which especially fits the SaaS segment of the market. I covered it across several essays published this year:
Notes on Revenue-Based Financing (July 2020)
Europe should lead the way on alternatives to traditional VC (October 2020—in Sifted)
SaaS Is the New Manufacturing (November 2020)
Beyond financial products explicitly presented as alternatives to traditional venture capital, the diffraction also means that the mechanics and mindset of venture capital permeate other segments of capital markets. Here are a few examples:
The stock market: What's Happening With the Stock Market? (February 2020)
Value investing: The State of Value Investing (September 2020)
Retail investing: Retail Investors in the Transition (September 2020)
An especially interesting sector in these times of diffraction is that of hedge funds. About those, have a look at the following essays:
Long/Short In a World Eaten by Software (April 2020)
A Thesis For Sector-Focused Hedge Funds (September 2020)
Shorting Companies in the Transition (December 2020)
On the other hand, there are directions about which I’m skeptical when it comes to being alternatives to traditional venture capital:
One is impact investing, as I explained in Here's the problem with 'tech for good' startups (July 2020—in Sifted)
The other is ‘deeptech’, which I covered recently in Is investing in 'deeptech' a good move for Europe's VCs? (December 2020—in Sifted)
The diffraction of venture capital doesn’t mean that venture capital itself has stopped growing. But as it grows, it takes different forms and raises new questions, as documented in the following essays:
The State of Corporate Venture Capital (September 2020)
What Determines VC Returns (September 2020)
VCs: Would You Rather Be Yahoo or Google? (October 2020)
Two Things About Venture Capital These Days (October 2020)
Here are more general essays which don’t mention the diffraction of venture capital but nonetheless reflect it as a trend:
Asset Allocation In a COVID-19 World (April 2020)
The Entrepreneurial Investor: An Overview (May 2020)
Why Is It Still So Hard to Raise in a Time of Cheap Capital? (October 2020)
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From Munich, Germany 🇩🇪
Nicolas
