Equity On Demand: What Is The Future Of Venture Capital?
Venture capital (VC) — the business of buying and selling startup equity — is about to change dramatically. Just as VC disrupts other industries, it looks like VC is about to be disrupted (again). The industry is facing a simultaneous squeeze from above and below, and the key to thriving and turning this disruption to an advantage lies in understanding and mastering it. So what’s going on?
The coming disruption is hardly unprecedented. Similar changes have swept through several industries lately, and the music industry provides a well-documented example. Remember record companies?
Twenty years ago, record companies made over 90% of their revenue from selling physical media. Over the course of a decade, however, new technology and business models — Silicon Valley’s specialties — significantly cut the record companies’ revenues from physical media.Now many people born in this millennium need a complicated explanation as to why they’re even called “record” companies. Revenues have rebounded only recently as record companies have learned how to deal with revolutionary change.
The analysis is simple. In every non-artisanal industry, there is a gap between the makers and the market. Someone somewhere — Guangzhou factories, gig-economy workers, musicians in a studio — is working hard to make something of value. At the end of the line, customers buy their valuable products. In the gap between the beginning and end of the value chain are the distributors and marketers.
Since the intermediaries typically have much lower costs than producers, they tend to have juicy margins. Roughly speaking, their margin varies in proportion to the width of the gap between the makers and the market. The harder it is for an electronics manufacturer to determine what kind of computer consumers want and the harder it is for consumers to buy a computer directly from the manufacturer, the bigger the opportunity available for the distributors and marketers in between them.
For decades, the record companies had a nice, wide niche. But other distributors and marketers that scale efficiently, like Spotify and Apple Music, have followed Jeff Bezos’s advice: “Your margin is my opportunity.” They moved in and narrowed the gap between the makers and the market, nabbing the incumbents’ margin in the process. (Side note: The gap is still wide. The makers are lucky to clear 12% of what the market pays.)
The VC Squeeze
Only recently, with 360 deals and licensing to services like TikTok have record companies managed to reinsert themselves into the gap.
The key lesson from the example of the music business is that there is a gap between the makers and the market, and whoever owns that gap reaps the margins. So who’s squeezing the VC gap?
From a certain perspective, every startup — from a two-person garage operation to a private decacorn — makes the same thing: equity. Whatever their app or widget may be, they all make shares. The market is where they seek to exit, where their equity gets priced. In between the garage and the exit are the distributors and marketers, the world of private equity and venture capital. VCs own the gap between startups and stock markets.
Just like the music business, though, the gap between the makers and the market is shrinking. Perhaps it started with crowdfunding, but that proved to be far more sizzle than steak in my view. I’ve seen lists of “wildly successful” crowdfunded startups that don’t feature a single household name, and crowdfunding generates relatively little capital in aggregate.
SPACs are arguably shrinking the gap from above by giving more people the opportunity to participate in exits. Similarly, direct listings are increasingly cutting institutional investors and underwriters out of the IPO exit path, again reducing the gap between the public market and the equity makers. Though both are well established, the growing popularity of these two forms of exit are lowering the upper limit of the VC gap.
The secondary market for startup equity is not new either, and it is growing too. Indeed, I think it looks more and more like the public market every year. However, the secondary market hasn’t closed VC’s gap so much as made the activity in that gap far more dynamic. It hasn’t really changed who has access to the equity, but it has made that equity far more liquid.
Preparing For The Future
Perhaps the biggest change is just now emerging on the horizon, and it could dissolve the entire concept of “exit” from below. The secondary market looks set to go retail, which might largely erase the difference between the public and private equity markets. If anyone with some extra income and a smartphone can invest in startup equity, does that make everyone a VC? Will existing VCs be priced out of their own market? If startups have access to unlimited public finance while still in the garage, what would “exit” mean? Where’s the gap? Will Sequoia meet the same fate as the once-mighty record company EMI?
I believe the VC squeeze will catalyze a couple of radical changes. First, regulation is coming. I predict it will only take one crash for retail investors to push regulators to control private equity. Second, there will be a cull of VCs. The number of VC funds of all sizes has been growing for years, but I think slimmer margins will force consolidation, just like in the music industry, and smaller, less prepared VCs will perish.
VCs who can read the terrain may prevail. As the gap shrinks, VCs will need to outcompete players on the secondary market who are providing “just money” because money will no longer be scarce. VCs should aim to provide extra value either to the startups looking to sell equity or to the limited partnerships looking to buy it on better terms than the public. Some gap will remain, but not for amateurs.
Only those who resist change and aren’t paying attention need to fear disruption.
Originally published at https://www.forbes.com.