Venture capital's old guard is under pressure by smaller, specialized competitors that are increasingly creating the first institutional relationships with entrepreneurs.
Entrepreneurs do not need as much capital as they once did, leaving brand-name venture capital managers investing later in the company's evolution, industry sources said. The good news that is the companies are more mature; the bad news is that the old guard no longer has the power that comes with being the first institutional backer.
"The early stage market ($15 million or less) is changing rapidly," said Paul Hsiao, co-founder and general partner at venture capital manager Canvas Ventures, which raised its first fund in 2013. "New names will rise to threaten the top five to 10 (venture capital firms)."
Micro funds are receiving record investments, albeit from a small base, Mr. Hsiao noted, and are becoming the first source of institutional funding for new companies.
Venture capital has provided an annualized internal rate of return of 14.6% for the five years ended Dec. 31; 9.64% for the 10 years; and 7.08% for the 15 years, according to Cambridge Associates.
Vintage year performance varies widely from a median net IRR of 5.2% for 2006 vintage funds to a high of 18.3% for 2011 vintage funds, according to London-based alternative investment research firm Preqin.
Funds raised between 2001 and 2006 had median IRR of less than 5%, Preqin data shows. It does not break out performance of micro funds.
Micro funds, raising $50 million or less, are set to raise a record amount of capital, according to the 3Q 2017 PitchBook-NVCA Venture Monitor, released Oct. 10 by Washington-based National Venture Capital Association and Seattle-based data research firm PitchBook. Some $273 million was raised by micro funds in the first nine months of this year, compared with $308 million in all of 2016.
These micro funds are making the first investments in what's called a seed round. Seed rounds are also coming later in a new company's life, right around two-and-a-half years, nearly a year later than in 2012. The rounds also are larger: up to a median of $1 million for the first time in a decade, according to PitchBook-NVCA data.
Series A, or early stage financing, the next round of financing after the seed stage, which is typically where traditional venture capital firms tend to come in, is much larger. And the traditional firms are still well established there.
According to PitchBook-NVCA data, median Series A deal size in the nine months ended Sept. 30 was $6.1 million, surpassing the $6 million median late-stage transaction size in 2010.
The firm that invests first has the power relationship with the company founders to influence pricing and the company's direction, Mr. Hsiao said.
Regardless of whether a venture capital firm is considered a micro fund newbie or old-line investor, the industry itself is under pressure by a brewing liquidity crisis. (See story at pionline.com/vc-liquidity.)
More venture capital is flowing into companies than is exiting — which could negatively impact returns. While secondary market sales and share sales on the private secondary markets are providing new avenues for some liquidity, other investments are trapped.
"If I am a pension fund, things look great on paper because companies are being marked up and I am one of the people marking them up, but there is barely any liquidity on the horizon," said Dharmesh Thakker, general partner at Menlo Park, Calif., venture capital firm Battery Ventures, which was founded in 1983. "They are going to be stuck in the asset class without the liquidity."
Changing of the guard
Tom Ciccolella, U.S. venture capital leader at PricewaterhouseCoopers LLP, said he is seeing a changing of the guard among firms.
It can take a long time for an emerging venture capital firm to grow into a top-tier manager, he said — five to 10 years to see some go up and others move down, Mr. Ciccolella said. "It's an ever-changing ecosystem of firms that are at the top of the heap."
However, Canvas Ventures' Mr. Hsiao said there is a new normal in venture capital land. When entrepreneurs are raising only $2 million to $5 million, they no longer feel compelled to go to the old guard, he said. And traditional venture capital firms haven't found a way to efficiently invest small amounts.
Traditional venture capital firms "are comfortable waiting to write $5 (million) to $20 million checks" to portfolio companies, Mr. Hsiao said.
"By the time entrepreneurs come to them, the old guard doesn't command the pricing power."
Smaller venture capital firms making the first investments "are the new power brokers," Mr. Hsiao said. "The old guard has to compete harder and are losing deals more often than they would like to admit."
Why? Because new companies can be started without a big capital infusion, he said. Instead, entrepreneurs are turning to micro venture capital firms that tend to have a high degree of specialization, he said.
Forerunner Ventures, which closed its first $40 million fund in 2012, has developed an expertise in consumer staples, including eyewear company Warby Parker and razor distributor Dollar Shave Club.
Precursor Ventures, which raised a $15.3 million first fund last year, specializes in funding women and minority-owned businesses.
Many traditional venture capital firms, including Canvas, are building relationships with these micro firms for deal flow, Mr. Hsiao said.