Consolidation: the Face of Venture Capital Post COVID-19

Abstract: In venture capital, the increasing disruption by mega-funds is driving many VCs into the classic innovator’s dilemma: I need to raise bigger funds to survive, but doing so will eventually dilute my returns which will ultimately kill me. The now-classic example is SoftBank who’s founder Masayoshi Son raised $100 billion dollars to invest “unlimited cash” in innovation-crazed companies. Based on my experience navigating three different innovator’s dilemmas, I see two main reasons for this disruptive trend and three ways VC firms might respond. As we’re all navigating towards a new normal, post-COVID-19, these responses will define a new industry direction, and I believe the natural endpoint will be increased fund consolidation activity.In venture capital, the increasing disruption by mega-funds is driving many VCs into the classic innovator’s dilemma (originally described by Clayton Christensen). For today’s VC, the dilemma looks like this: I need to raise bigger funds to survive, but doing so will eventually dilute my returns which will ultimately kill me. The now-classic example is SoftBank who’s founder Masayoshi Son raised $100 billion dollars to invest “unlimited cash” in innovation-crazed companies. Unfortunately, SoftBank has been slammed with a slew of recent bad news and questionable returns on its Vision Fund.Based on my experience navigating three different innovator’s dilemmas, sometimes successful (at Facebook), sometimes not (at Nokia and Siebel), and from dozens of interviews with industry insiders, I see two main reasons for this disruptive trend and three ways VC firms might respond. As we’re all navigating towards a new normal, post-COVID-19, these responses will define a new industry direction, and I believe it will play a dominant role in the near future.“More money”: Mega-funds Invest Too Much, Too FastIn 2017, SoftBank cut a check for $4.4 billion and commissioned WeWork to invent and scale its co-working model at light speed. The goal was to capture dominant market share in what they believed to be the future of work. But at an early stage, innovation is more about hurrying up the development of ideas, refining what works, and eliminating what doesn’t—rather than turning a profit. Therefore, the risk-reward ratio on multi-billion dollar investments is not attractive.The startup invested heavily in research and development. This would have made sense if the company had a portfolio of products at different stages of maturity along with some established cash cows. However, WeWork had only one product that was unrefined and unprofitable.By milking a single, immature product, WeWork was left with only one option to show revenue growth: plans hatched to deliver even bigger returns farther out into the future. So much cash and so many expectations ended up driving company leadership crazy. Eventually, reality always catches up. In November of 2019, WeWork announced to investors it lost $1.25 billion in a single quarter.One of the reasons that compels companies like WeWork to raise so much money prematurely is the war for talent. In a market operating at near 100% employment, talent is scarce. One of the strongest hiring and employee retention tools is a huge funding round, especially in Silicon Valley. The result? A recent study by my partner Jennifer Azapian shows that surprisingly, startups may actually pay more than large companies like Google.“Me, Myself and I”: The Micro Fund ProliferationThe recent IPO wave which brought great wealth to many early tech employees gives rise to another key trend: micro-funds sprouting up like mushrooms. The micro-fund is the solo-preneur of the venture capital industry. They invest a small amount of money in a narrow niche where the fund adds value because of past experience.Once they’ve raised a first fund, they’re too occupied with helping portfolio companies to be able to raise a second fund. By the time they might be in position for a follow-up, the first fund’s returns may not be strong enough to justify additional capital allocation. Or they miss their window of opportunity. They have limited growth prospects since they rely mostly on their founder’s reputation and personal network, so they struggle to build a lasting VC firm. So what happens? The fund becomes a “zombie” and its founder gets hired by one of its portfolio companies.Between these two trends—mega-fund splurging and micro-fund proliferation—is where I see the opportunity to crack the innovator's dilemma. It entails changing the rules of innovation and creating non-cash value. I call it the ecosystem play.For instance, Fifth Third offers its portfolio companies special access to a large US commercial retail space footprint—a huge value add to any proptech startup. Another example is Mighty Capital, which offers exclusive access to one of the largest global networks of product managers—they represent a captive pool of early adopters, potential hires, and customers. Here, VC firms who differentiate beyond “more money” or “me, myself and I” are the most likely to win the chess match.Check MateWith consolidation ahead, the VC industry dynamics will ramp up significantly over the coming years. There are three types of moves we can expect:

• Offensive move: In order to scale, ecosystem-based funds might seek to consolidate by absorbing some of their micro-funds colleagues. Or they might hire managers of their mega-funds colleagues to beef up financial footing and operations.
• Defensive move: Micro-funds who can’t raise additional funds may turn to mega-funds and set up arrangements to sell their portfolio at a discount to generate liquidity. The infamous Dave McClure is already raising a fund specifically designed to capture that opportunity.
• Portfolio approach: Some mega-funds will segment themselves into specialized funds to create the illusion of smallness or niche. For instance, Andreessen Horowitz has raised funds dedicated to life sciences, to blockchain, and so on.

New Game, New RulesWhat’s to come out of these arising VC industry trends in a post-COVID-19 environment? The natural endpoint will be increased fund consolidation activity, but it goes deeper than that. This new reality will return us to sound investment principles that made this industry so great in the first place. Success will mean investing in businesses with strong leadership teams, proven product-market fit, and a clear go-to-market strategy.SC Moatti | Managing Partner, Mighty Capital | sc@mighty.capital | 415.867.7512SC Moatti is the managing partner of Mighty Capital, a Silicon Valley venture capital firm, and Products That Count, one of the largest and undoubtedly the most influential network of product managers in the world. Previously, she built products that billions of people use at Facebook, Nokia and Electronic Arts. Andrew Chen, General Partner at Andreessen Horowitz, called SC “a genius at making mobile products people love.” For more information, visit ProductsThatCount.com.