The Evolution of Venture Capital: Past, Present & Future — A bird’s-eye view.

February 9, 2021 · Reading Time: 10 minutes

Venture Capital is an industry that is built on funding innovation. But how has the industry itself evolved since its inception?

Short Overview

  • VC is an industry that has existed for over 70 years, and in the last 20 years, has seen several stages of innovation
  • Several sectors sprung up alongside VC, namely: Incubators, Accelerators and Venture Studios
  • VCs can now be split into 3–4 generations of VC funds
  • VCs have started to provide a variety of financial instruments (equity, debt, revenue share, SEALs etc); digitise various aspects of VC work, and integrate incubators, accelerators or venture studios to form end-to-end funds

VC 1.0 — The Origins of the Industry

Venture Capital (VC) is a form of early-stage financing provided to startups at an early stage that are predicted to have high growth potential. VC plays a critical role in the commercialisation of innovation by increasing liquidity and providing cash to invest in growth.

Historically VC funding has been more accessible to startups than banks (who required collateral) or lending services (which increased the debt presence for a given startup — making further lending risky)

When a startup is still ‘very-early stage’ it has a few financing options besides VC:

  • FFF: Friends, Family and Fools — people who buy the idea or just like the company or the founders very much
  • Angels: Where a high-net-worth individual provides financial capital to the startup directly, usually in exchange for an ownership stake
  • Equity Crowdfunding: Where instead of an individual, people pool together to buy small ownership stakes

Despite all these options, Venture Capital is still an attractive financing source for companies as with the right partner, things go much smoother.

So in effect, venture capital, in its traditional form, is not the planting of a seed, but the water and fertiliser you use to help a sapling evolve into something greater.

The first Venture capitalists came into being in the post-WW2 USA. There, early practitioners, mostly wealthy individuals like the Rockefellers and the Phippses would become the first-adopted of the new ‘VC asset class’.

The first iteration of venture capital firms, starting with the ARDC and the J.H. Whitney & Company in the mid-1940s and lasting from the 1950s all the way to the present day, explored a typical, hands-off, ‘passive VC’ model, where VCs would mainly serve a function as an investor and board advisor. Considering the returns in the industry and the widely supported conclusion that most VCs cannot guarantee high returns with a limited portfolio, this has led to greater consolidation in the industry and larger fundraises among venture funds. Consequently, it has become increasingly difficult for emerging VCs to attract funding when competing with the increasingly consolidated passive VC space.

Examples of 1.0 VCs that continue to thrive include small VCs targeting sector niches like Martle and larger VCs like Amadeus Capital Partners and Hoxton Ventures.

Note: J.H. Whitney & Company still exists, and has transitioned to a more later-stage private equity x VC institution.

VC 2.0 — Accelerators, Incubators & Venture Studios

Passive VCs were the rulers of the ecosystem for a while, but as the competition intensified and the money was searching for great investments new models emerged, that focused less on the capital itself, but on everything else that could make a company successful.

The need for innovation birthed ‘Incubators’ — where corporations and academic bodies position themselves as micro-entrepreneurial ecosystems and ‘Accelerators’ — hands-on venture firms providing services in kind, in return for equity stakes. As these models became successful, a new concept was also developed: ‘Venture Studios’ — Startup factories who started to standardise the venture creation process, allowing founders to focus on their visions.

If only VCs actually competed like this over deals…

The Arrival of the Incubators

Incubators, first gaining traction in the late 1960s with ‘Idealab’, created a subsector of early-stage financing, called ‘incubation industry’. This involved more service-focused support, where portfolio firms wouldn’t necessarily receive funding. This worked well in parallel with venture capital and therefore spawned a whole aspect of startup consultancy, which has diverted significantly from the core raison d’être of capital provision towards service provision to decrease the startup failure rate. As such, most business incubators, while influencing VC firms to be more hands-on, did not fundamentally change VC as an industry.

Growth of the Incubator Ecosystems

In the UK for instance, this ecosystem has grown rapidly, with government estimates from post-Brexit Britain suggesting that there are currently over 300 incubators directly working with 12,000+ businesses, providing an ecosystem for growth without a guarantee of funding or hands-on service provision.

Formation of Accelerators

Accelerators grew to form a bridge between the early-stage work of incubators, venture capital firms and later-stage PE funding. Unlike incubators, which existed to help early-stage ideas develop, accelerators provided access to investors, support and mentorship to stabilise businesses, with most business accelerator companies being post-MVP stage startups hoping to enter the next stage of their lifetime. Acceleration, like incubation, varied significantly from venture capital’s core investment focus, as the main premise laid in the provision of service or service in kind, rather than financing. At the same time, most accelerators (with notable exceptions) would also take a stake in the company’s ownership, usually ranging between 7–10%.

Powered by an increasing number of startups, this complementary industry to venture capital has thus also grown significantly all over the world. As suggested by Ester, driven by the success of the startup-accelerator-vc relationship in the US, and especially in Silicon Valley, accelerators have been appearing all over the world and scaling their operations. Just using the UK as an example, the number of startups going through accelerators has grown from 1,100 in 2014 to 3,660+ by 2017, even as new models of product-specific or BD specific accelerators have been introduced driven by the # of successful track records of Y Combinator and TechStars, with accelerators like Newchip Accelerator and Open Water Accelerator — bootstrapped remote accelerators, operating with firms across the world and deploying predominantly human capital to grow already ‘established’ startups, showcasing the latest evolution in the VC — Accelerator crossover space. While the benefits of such crossover in the de-risking area clear, not all VCs have accepted the value in adopting acceleration methodologies. That said, based on the growing adoption of synergies between the Accelerator and VC models, it seems likely that more VCs will pick up elements of accelerator support, even as more accelerators seek to develop a financing arm.

“Being online — we managed to scale a lot faster. Remote recruitment allows accelerators to scale a lot faster. This is the main advantage, and allows OWA to tap into talent that are otherwise overlooked…I think the future of accelerators is hybrid or remote talent from tech hubs around the world” — David Bromberg (Founder, Open Water)

Growth of the Accelerator Ecosystems

Now, using the UK as an example, the number of business accelerators continues to grow year-on-year, with corporates creating accelerators to empower innovation. Simultaneously, business accelerators like Amazon’s small business accelerator are now keeping more established accelerators on their toes, further prompting internal growth. At a high level, the UK accelerator market has grown significantly in the last 10 years, with new accelerators launching nearly every month in the wider European market and more than 180–200 in operation already.

Only in the UK, the number of significant incubators and accelerators has grown 5x over the last 10 years. Image Source: Wired’s Accelerator and Incubator Report

At this stage we can already see that venture capital had evolved significantly beyond the passive provision of financing:

  • Venture Capital Firms offered a source of funding
  • Incubators offered a safe environment for startups to grow without intervention
  • Accelerators offered human capital and complementary services to speed up growth

While accelerators would typically focus on spreading small amounts of capital across a wide array of startups, with the expectation that most would fail, “venture studios” would take a different approach, focusing considerably more resources around opportunities that they believed were ripe for a startup to capture.

With accelerators, incubators and venture financing firms working side by side towards the early 2000s, the industry looked like it had developed sufficiently, however, more evolution was to come. In the late 2000s, multiple seasoned entrepreneurs came together to found new companies.

Creation of the Venture Studios

A Venture Studio is a complicated concept and one that is better explained by an incumbent. Fundamentally venture studios could be split into two structural models: Independent vs Corporate.

Independent studios, like Atomic, Expa, Rocket Internet have provided an in-house vertically integrated venture capital ecosystem, providing elements of incubation, acceleration and venture financing. In contrast, corporate venture studios like Prehype, focused on taking a majority stake in a new business — providing a method for the parent company to bring in external startups to promote research and development, while still pulling the strings.

Venture Studios offered greater security against startup fail rate but were capital intensive and involved years of handholding — attracting more risk-averse investors in the VC space and spawning ‘tailor-built firms’ like FoodPanda and Jumia, with venture studios like Rocket Internet making returns in excess of $335m per year by developing firms from scratch and leading them to public exit. These were born from the idea of merging early financing with hands-on support, and effectively formed a bridge between incubation and venture capital financing.

Seeing the success of this new form of startup support, platform conglomerates like Amazon, Google and Facebook have sought to create startup studios to compete against the venture studios out there today.

These have only served to further validate the proof of concept of this model, with Google X, Amazon’s, Facebook’s and Uber’s innovation arms investing heavily into the growth of in-house startups. As shown by the 625% growth rate in # of venture studios since 2013, driven by returns and greater security in the startup’s success rate, now, more and more VCs turn to partnering or creating their own venture studios, to compete at an early stage with the platform or corporate powered startup studios.

Now Venture Studios in and of themselves are still a rapidly changing sub-set of Venture Capital. They continue to evolve, and, driven by the unmatched deployment of human capital hours, thought leadership and in-house support, the rise of Venture Studios is near undeniable in the short-and-medium term, as evidenced by the birth of startup-studio communities like GSSN. This is excellently covered in blogs, reports and books like Attila Szigeti’s “Startup Studio Playbook”, so do check those out if you are new to the concept and are interested in finding out more.

Growth of the Venture Studio Ecosystems

Out of funds, incubators, accelerators and studios — the latter still remains the rarest and smallest of the affiliated VC sectors. That said, Venture Studio popularity has continued to grow exponentially, with the number of studios rising from ~5 in 2008 to >500 by 2018. With ~10% failure rate among startup-studio-created startups, the number of corporate-sponsored or independent studios continues to rise year-on-year all over the world. Assuming current growth rates it would not be untoward to assume that by 2022, more than 750 venture studios would be in operation.

“Of the 415 companies that startup studios have created, only 9% have failed, 3% exited, and the rest are still active”

Rapid growth in the number of venture studios. Img Source: GSSN 2020 Studio Report

VC 3.0 — Operator VCs

As a result of the growth and success of incubators, accelerators and venture studios, venture capital firms have been forced to evolve.

As shown by this 2015 snapshot, early-stage investing has significantly morphed away from solely venture capitalists’ funds to now function as a set of interconnected sub-sectors:

An example of how interconnected early-stage venture sectors has become. Image source: Thibaud Elziere on Medium

This process, covered excellently by Samboursky, has led to two fundamental evolutions in the core VC industry. An evolution of the Operating model and evolution of the Financial instruments VCs would provide.

VC 3.0 — The Active Operator VCs

Driven by inter-fund competition and largely encouraged by the evolving needs of startups, since the early 2000s, a new segment of venture capital, the so-called ‘Active or Activist’ VC model came about.

This was the first major evolution in VC models, with ‘VC 2.0’ leading to the increased involvement of VCs in the growth of companies, and a greater focus on the impact money had in the growth of a firm, (See Kapor’s analysis). With greater operational support for portfolio firms, this redefined the fundamental role of VCs as a ‘partnership’ rather than just provision of finance, allowing experienced investors and entrepreneurs to compete with funds that carried a much higher AUM, as justified by the unique experiences of these novel fund managers. This has allowed innovative hands-on VCs, like DigitalDx Ventures to evolve, which have combined technological, financial and sector-specific expertise, to carve out a niche for themselves.

“Even the smartest people in the world aren’t necessarily the best CEOs. What matters is — are these people actually capable…do they have the operational skills to take the company further?” — Michele Colucci (Founding Partner, DigitalDx Ventures)

The knowledge base that many industry experts have in entrepreneurship is very unique. As many ex-founder VCs come to realise, states Michele, “the industry insights people accumulate are incredibly important for these new founders”. As she explains, “a lot of industry investors have often been somewhat distanced from the operational practice”.

Having had personal close exposure to imaging technology and poor cancer treatments, Michele would look out for companies who would be ripe for disrupting the sector. This would lead her to develop a thesis of finding firms that identified and diagnoses diseases earlier, and more accurately, leveraging personal experience to evaluate and pattern match the outliers in the medical space. In this case, it was her experience in these sectors that would come to help her develop an AI modelling engine, to triage DigitalDx’s dealflow.

Drawing on this kind of founder, operator or management experience, these new type of Operator VCs would then apply sector-expertise towards developing models for stronger screening and better opportunity identification. It is this exact drive to efficiency that seems to now prompt the more innovative incumbent Venture Capitalists, in turn, to adopt more hands-on involvement and seek out digitisation in VC.

One of the main reasons that have supported this trend was the difference in language between what startups presented and what passive investors would see. While previously, investors would seek to use the founder’s information and their own predominantly financial experience to make their judgements, now, more and more early-stage investors draw on their own founding experience to take a more operational investor role — honing startups to present in an investor-friendly way and providing their portfolio investments with continued weekly support.

As explained by Colby, co-founder at Angelfund.ai, a lot of founders are quite niched in their speciality and they often need support in understanding the investment side of things. Ultimately, this is a case where having a network is a great value-add, and it is only by combining this industry experience with investment appraisal experience, that a VC can understand how a startup is trying to solve a problem.

Previously, the core acumen for a VC investor would be a financial background and a great MBA, and without that financial background — investment seemed risky. Now, however, many early-stage VCs around the world increasingly value operator experience more than financial acumen, as this not only helps a prospect investor relate to a startup but can also help them problem-solve together. That said without any financial know-how, risks, like inflated valuations and poor fundraising records remain. Nevertheless, the general trend does seem to favour operators, and now, more and more VCs are increasingly developing operator-experienced investment teams.

Now, this is a story often seen among 3rd Generation VCs. With the increased adoption of ‘hands-on VC 3.0’, this clearly marked a separation from the initial passive VC landscape, where new VCs now often need to be industry experts or to have already cultivated their own connection with the markets, the demographic or their investment niche, to really analyse and identify the potentially significant innovations.

Most VC’s now fit the VC 3.0 category, and these include funds like MMC Ventures and VC ‘mega funds’ like Sequoia or Kleiner Perkins.

To be continued…

Special Credits to: