In the mid to late 1800s, capital flowed to the Silicon Valley of the time, New Bedford, Massachusetts, to take advantage of an investment opportunity that could return massive annual profits to investors. These startups of the time were comparable to the unicorns of Silicon Valley in that they had small highly-skilled teams that took massive risks to return profits on investments. The VCs of the time, companies like Gideon Allen & Sons, by investing in these startups, were able to achieve stellar returns of up to 60% per year, returns that any VC today would find difficult to match. What’s more, that booming startup industry of the time, like Silicon Valley, was also concentrated in the United States.
This booming industry, the genesis of modern-day venture capital, was whaling. Much as that boom led to the birth of unicorns and million-dollar ventures, today, venture capital, especially in the United States, follows the same ground rules of the time, seeking and creating unicorns to invest in with the hope of returning extravagant returns. However, that was 150 years ago, and yet the industry has been slow to adapt to the rapid disruption being brought about by digital transformation. As Luke Kanies asks in a piece published on Medium, “As much as the system of venture capital is built on success, we must ask: Where is it failing?” As with all other industries that are ripe for disruption, we see disruptive digital technologies exploiting these gaps. In this article, we look at three digital innovations that are disrupting venture capital.
In 2009, Quid AI was challenged to use machine learning to pick a list of 50 hitherto unheard-of startups that were set to dominate the business world. That list contained companies like Evernote, Etsy, Spotify, Zynga, Cloudera, and Palantir, all of which today, some nine years later, have billion-dollar valuations. This experiment demonstrated an interesting irony about the current state of venture capital. While most venture capital firms are increasing their investments in AI startups, very few VC firms are utilizing AI to pick winning startups. This disconnect represents a massive opportunity for VCs that choose to adopt a disruptive startup mentality. In fact, according to a leading fund of funds approached by Bloomberg Businessweek to analyze the basket of 50 companies picked, the firm noted that if the companies represented one VC company’s portfolio, it would be the second-best performing portfolio of all time. (The best performing portfolio rode the dot-com bubble.)
AI is poised to disrupt traditional venture capital as it can analyze hundreds of thousands of deals and millions of other data points to find patterns that point to successful bets. These data points include past VC investment patterns, startups that received investments within a certain period, industries and technologies those startups focused on, global market and technological trends, among others. By combining these data points in millions of ways, it is possible that an AI VC can successfully pick winning startups to invest in, handily beating traditional VC picks.
Cryptocurrencies or cryptos are another digital innovation that has the potential to upend traditional venture capital. This disruptive potential is evident from the massive popularity of Initial Coin Offerings or ICOs. ICOs create massive decentralized VC funds that anyone can invest in, bypassing traditional VCs who act as gatekeepers. While a majority of these ICOs are considered scams, the trend cannot be brushed aside. Cryptos, a democratized currency, not only represent a means of democratized investing, they represent an entirely new way of how global financing can work.
What may be standing in the way of sweeping disruption is perhaps the lack of legislative frameworks to regulate cryptos. While this may be taking time, there is no doubt that once these legislations are in place, the world of finance will look very different. VC funds that fail to embrace this trend in good time may find themselves locked out of a trillion-dollar opportunity that will allow billions of people across the world and from all walks of life to invest in whatever promising businesses they choose to invest in. Such an opportunity can only be grasped if VC funds begin to experiment and invest early in startups working on related solutions.
Venture capital is pattern based. It is perhaps the reason why VCs are called lemmings. This pattern-based behavior is not without cause. Most VCs are tasked by investors to find the best investment opportunities and act fast on them. No VC wants to be known as the one that passed on the next Facebook or Google. However, this pattern-investing has created a systemic issue with traditional venture capital that is ripe for disruption. While most VCs look for prototypical unicorns, the vast majority of startups will not achieve a billion-dollar valuation, or a short exit horizon, a prerequisite of most VC firms.
Pattern-investing has created an opportunity for alternative funding in the form of equity crowdfunding. As retail investors become better educated and better connected to startups through digital crowdfunding platforms like Wefunder and Indiegogo Equity, more of these non-unicorn startups are turning to crowdfunding. With the introduction of Regulation Crowdfunding by the SEC, startups and investors can build more sustainable and mutually-beneficial funding relationships that are not heavily influenced by the pressure that comes with traditional VC money. In this way, digital transformation, as with other industries, has put the power of investing squarely in the hands of the masses, creating a powerfully disruptive disintermediation trend that has the potential to disrupt traditional VC.
While VC in the United States is enjoying one of its best run rates in recent history, the reality is that disruption begins from edge case scenarios. While most traditional VC firms chase after unicorns and billion dollar exits using a 150-year-old funding framework, there will emerge new digital-first VC firms that will tap into the massive potential of startups that do not fit this investment pattern. As with the story of taxicab companies resting on their laurels and ignoring the frustrated masses only to be disrupted by digital-first Uber, here is presented a situation where the venture capital industry has become ripe for disruption, and the companies that disrupt it will be the next billion-dollar or even trillion-dollar VC companies of tomorrow.
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