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The Biggest Forces Holding the Venture Capital Industry Back
The venture capital industry has undergone several pivotal changes in the past decade. While funding volumes are at all-time highs, the prospects for the industry are not entirely rosy. According to research by Cambridge Associates, venture capital returns have been far from stellar. While there’s a lot of potential, the asset class has underperformed public markets and private equity, with ten-year returns falling below 15%. Adding fuel to the fire, it's becoming harder for venture capitalists to differentiate themselves and win the favor of promising entrepreneurs. The surge of new funding alternatives, including crowdsourcing, has ballooned.
Moving forward, in order to survive and thrive as an industry, venture capital firms will need to address several key factors that have recently been impediments to success and growth.
1. Lack of fund diversity
It's hard to deny that there's a diversity problem in venture capital. According to data from Richard Kerby, a partner at Equal Ventures, a mere 1% of venture capitalists are Latinx, while 3% are black and 18% are women. The lack of diversity is underscored by the fact that 40% of venture capitalists attended either Stanford or Harvard University.
Addressing this lack of fund diversity isn't just a social and moral imperative, it’s a financial one. Research published in Harvard Business Review found that the financial returns of homogeneous venture capital partnerships are far inferior to those of more diverse partnerships. The researchers found that the effect of shared ethnicity among venture capital partnerships reduced an investment’s comparative success rate by a staggering 26.4% to 32.2%.
Venture capital firms need to commit to improving the diversity of their firms.
2. Decline in seed stage funding
In recent years, the concentration of venture capital funding has changed markedly. Venture capitalists have doubled down on the amount of capital they are injecting in Series A ventures. But this has meant that seed stage funding has waned. In 2018, seed activity, as a percentage of all deals, declined from 31% to 25% percent, which represented a decade low. On the other hand, the share and size of late-stage deals increased to record highs.
The earlier venture capitalists invest in promising startups, the higher the potential outcome. Being an early check writer is a clear way to help ensure success. If seed stage investments continue to plummet, innovation will be stifled and the success of promising cash-strapped entrepreneurs will be inhibited. Anand Sanwal, CEO and co-founder of CB Insights, has explained, “The migration out of seed won’t be felt now, but it will have impacts on the venture ecosystem in the coming years...If we have fewer and declining seed stage deals, it means fewer companies available for those bigger later stage deals in the future."
3. Failing to add value-added resources to portfolio companies
No longer do entrepreneurs make decisions about taking venture capital based on the size of the check. According to a study spearheaded by Wharton management professor David Hsu, when raising capital, less than half of startups accept the best financial offer.
Entrepreneurs tend to gravitate towards VCs who can provide them with value-added resources. The “TOPSCAN” framework outlines the scope of resources through which VCs can inject non-monetary value into their portfolio companies.
- Team Building (“T”): Helping portfolio companies recruit and hire new talent.
- Operations (“O”): Helping portfolio companies manage operational priorities, including administrative, operational, accounting, and legal affairs.
- Perspective (“P”): Helping portfolios plan and strategize for the future, including with respect to strategy, competition, and market position.
- Skill Building (“S”): Helping portfolio companies, especially the management team, build critical new skills and competencies.
- Customer Development (“C”): Helping portfolio companies pinpoint and access the right customers.
- Analysis (“A”): Helping portfolio companies report on key business metrics and measure growth.
- Network (“N”): Helping portfolio companies gain access to new lucrative business opportunities by accessing their network.
The “N”, network, is arguably the most valuable resource a VC has to offer. VCs have an extensive network and can leverage this network to empower their portfolio companies for success. Using Affinity’s Alliances, VCs can grant portfolio companies access to their network and allow them to unlock new opportunities, including introductions to prospective customers, introductions to thought leaders and industry experts, and introductions to potential new talent.
The venture capital industry has experienced several years of record-high valuations. Yet the industry's success is far from guaranteed. Financing structures are changing and entrepreneurs are laser-focused on finding partners who are committed to diversity and inclusion, funding startups throughout their lifecycle, and offering value-added resources. In order to thrive, venture capitalists will need to refine their approach and ensure that they are priming their portfolio companies for success.