Just a few years ago, large venture firms were incubating companies for months. During the incubation period, the founders wrote 70+ page business plans, which described the market opportunity, the execution plan, along with the five year financial projections. The plan was a proof, a risk management tool, used to justify that the idea has legs and will work.

But this isn't true anymore. You can't afford to be in stealth mode for months. Your can no longer build realistic projections for five years. The only way to create a technology company in this market is to evolve it.

If the way in which a company is built has to change, the way in which it is funded needs to change as well. What are the new rules for tech venture capital? Where and how should the money be allocated? In this post we take a deeper look.

How Old VC Worked

In the good old days, startup funding was a well a understood process. The founders would write the business plan. Typically it would be a lengthy document including opportunity, market analysis, competitors, description of the business, execution strategy staffing and five year financials. With this plan, they would then knock on the doors of different venture firms - usually through connections, as sending the plan by mail or email was not likely to turn people on.

If all went well, they would score a pitch and get to present to a few partners. Large firms would take their time to make sure the plan was solid. They would bring in consultants, typically founders of already funded startups, to look at the idea - to poke at it from different angles. Then, if all added up, they would invest - typically 5M+ in Series A - and get the ball rolling.

After the technology was built and looked promising, they'd line up for series B with 10M+ and bring in more VCs. The typical series B was aimed at shifting focus from engineering to business, so a new CEO would often come on board at that point - as well as an army of sales staff. All of this would take years and cost massive amounts of money.

Why New Is Different

Among the factors that caused a major paradigm shift in technology investment, two stand out: 1) a drastic drop in initial startup costs, and 2) the increasing willingness of the public to pull technology into the market (i.e. try it, adopt it, champion it).

In the old days, $1M was needed to even get a technology off the ground - but these days, it can be done with $100K. Because the hardware is cheap, the web infrastructure (like Amazon Web Services) is in place and software libraries are abundant, creating new software is dramatically simpler. It is all about the idea, whereas before it was all about the infrastructure.


Image via Cogdog blog

The social web made people more receptive to new technologies; it taught us how to love new tools and services, and made a major step towards curing the public's technophobia. People realized that software does not need to suck, that it can be fun and more importantly useful. 'Build it and they will come' turned from a joke into a reality.

If the bottom-line costs of getting a tech startup off the ground are a fraction of what they used to be, then the old approach to funding no longer makes sense. In the old days, top-tier VC firms would do 5M+ series A in exchange for 40%+ of the equity. Today, a typical series A is just 1-2M for 15-25% of equity. As it is cheaper to build the company, large VC firms find it harder to get into series A. The market has created an opportunity for smaller size funds.

Big Firms vs. Small Firms

Large VC funds have hundreds of millions and even billions of dollars under management. Because they engage individually with each investment (like any VC firm), their most valuable asset is time.

For these funds, having a lot of small investments is just not possible, they are not setup that way. Instead, they are designed to methodically research and identify the best opportunities and then deploy large amounts of money in each of them.

Because of the way this equation plays out, they also need to make sure that they own a substantial stake in each company, typically at least 20%.

Smaller funds do not have this problem. They are agile and flexible and look to invest much smaller amounts. And they do not necessarily need to own 20% of the company. Fred Wilson, the managing partner of Union Square Ventures, explains in his blog that the "need" to own 20% of a company is no longer true.

What is going to happen next?

Lots of people have already acknowledged and recognized the coming change. Here are some examples:

  • Y Combinator is creating tech companies with a tiny (10-20K) seed investment;
  • Charles River Ventures started a Quick start program;
  • Jeff Clavier launched a 12M fund for tech startups.

Maybe not all that we are seeing is real and going to stick, but certainly reactions are rolling in. To be able to get into the game early, large firms need to re-think their play. Doing smaller rounds for less equity is certainly an option, but the question is - can this scale? Since a VC partner's time is finite, the answer seems to be 'no'.

There is an interesting dynamic brewing in the technology VC space. Since the last bust, IPOs have been scarce. Only recently have some companies gone public, but at large this is still far from a good opportunity. The big exits have been far and a few between. YouTube and MySpace are the exceptions, not the rule.

Now, putting it all together, leads us to conclude that large venture money is going to migrate away from technology. Specifically, this is what is likely to happen:

  • We will see more smaller size funds and they will be successful
  • Large firms are going to focus on series B deals and will have to pay premium for the same equity
  • Big firms will focus less on tech, shifting to alternative energy, healthcare, etc.

Conclusion

The markets are endlessly fascinating. If a few years back someone would've claimed that big VC firms would face a tough tech market, people would've simply laughed. Yet, here we are and it is true. This change has led to a new category of smaller tech funds, as well as some shifts of big money from tech into other sectors.

But just because big money cannot be deployed, does not mean that big money can't be made. A company can become big and successful with much smaller investments. del.icio.us, Flickr and StumbleUpon are a few such examples. But even though the return multiple is the same, the scale is going to be different. 10x return on 1M cannot be compared with 10x return on 10M; and this does fundamentally change the business.

At the end of the day, the winner of all this turmoil is going to be the consumer. Because there will be more smaller funds making many small bets, the result is going to be fierce competition and superb products. So here is to change, endless innovation and technology improvements!

Disclosure: Union Square Ventures is an investor in Alex Iskold's company AdaptiveBlue.