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Venture capitalists (VC) essentially invest in startup ‘experiments’, providing subsequent funding to refine these experiments. However, the VC investment model has evolved in fundamental ways over the last two decades, particularly in the early-stage financing of software. Early-stage investor strategy has historically been driven by technological shocks that have substantially lowered the cost of starting new businesses.
Cloud computing has made early ‘experiments’ for startups significantly cheaper, initially driven by the introduction of Amazon’s Web Services (AWS) in early 2006 - a breakthrough that radically lowered the cost of starting Internet and web-based startups.
Cloud computing allowed startups to ‘rent’ hardware space in small increments and to scale bandwidth, storage, and computing resources. This gave rise to startups in software-as-a-service (SaaS), social networks, and retail e-commerce websites. Data shows that startups that adopted cloud services, particularly in sectors benefiting most from the introduction of the cloud, raised considerably smaller amounts in their first round of VC financing. On average, the initial funding size fell by 20%.
During the emergence of cloud computing, startups faced technological and business model adoption risks. To overcome this they fused open-source technologies, new pricing, and subscription models to deliver products as services. Now, entrepreneurs take for granted the ability to scale-up as demand grows instead of having to make large fixed upfront investments in hardware, when the prospect of success is still low. Investors also take for granted the lower costs of initial experiments and the adoption of data-and-traction-led decision-making to evaluate investment risk.
The lower experimentation cost has led to the democratisation of entry into high-tech entrepreneurship - opening up a whole new range of investment opportunities that were not viable before, but also necessitating new ways of financing them.
VC’s over time have adapted and significantly changed their investment approach, leveraging the cloud, funding startups that avoid large initial capital expenditures, and instead “rent” hardware space and other services in small increments, scaling up as demand grew.
The “spray and pray” investment approach is a considerable shift away from the traditional ‘enhanced governance’ model during the early stages. VC’s, therefore, now, stage their investment across multiple rounds, and each round of investment can be seen as an experiment that generates information about the ultimate value of the startup. These “long-shot bets” are now viable. Even though the expected value and probability of success is lower, there is a greater potential of high return if successful. Household names such as Google, Facebook, Airbnb, and Dropbox were just such “long-shot bets” created by young, inexperienced founders.
The effect of such a shift in investment strategy on innovation and investing is threefold.
. Firstly, the falling cost of experimentation explains the view that VC’s are waiting longer to invest and expecting startups to have more traction.
. Secondly, it’s likely to increase the chances of radically new business models — companies such as Airbnb and Uber.
. Third, innovation is decreasing the cost of experiments in areas as diverse as agri-tech, biotech, and hardware, resulting in the need for smaller amounts of capital. Conversely, this shift in investment strategy makes it harder for complex technology startups, where the cost of experimentation is significantly higher, to gain early-stage investment.
New categories of investor have emerged who specialise in early-stage investing using such an investment approach:‘Micro-VCs’ and ‘Super Angels’. Typically, they provide a small amount of funding and limited governance to an increased number of startups, which they are more likely to abandon after the initial round of funding.
Digital startup founders are increasingly seeking strategic advice, to help with growth and funding. This has lead to the rise of Accelerators. The Average Internal Rate of Return (IRR) of startups using an Accelerator is 53%, as compared to 21.3% of a traditional startup. Accelerators such as 7 startup are founded by entrepreneurial leaders that know how to build companies and provide scalable, lower-cost forms of mentorship to inexperienced founding teams.