Just like the rest of the investing world, venture capitalists have had to adjust to rapid change during the COVID-19 pandemic. That includes long-term investors, who are increasingly turning to early-stage companies as a source of diversity for their portfolios and a way to access innovation at its source.
Monica Adractas, who heads CPP Investments’ VC activities from our San Francisco office, recently sat down with three of the best in the field: Alex Rampell of Andreessen Horowitz, Ali Rowghani of Y Combinator, and Sonali de Rycker of Accel. What followed was a spirited, virtual discussion on the state of venture investing. The conversation ranged beyond COVID-19, getting deep into the nature of VC investing and thoughts on where the field is headed next. We present selected insights from that conversation below.
The sweet spot for VC investors
The nature of risk and reward for VC investors is fundamentally different from that of equity investing. The risks of any individual deal are high—many early-stage companies don’t pan out—but the returns on those that do can be enormous. For investors who got in on Facebook at its inception, for example, the returns have been significant, more than enough to make up for a multitude of disappointments. That makes getting access to deal flow one of the most important jobs for the VC investor. For VC investors, not getting in on the next Facebook is what keeps them up at night. “One of the things we’re always trying to wrap our heads around is the kind of uncapped loss, if you will, if you don’t invest,” said one participant.
Sometimes investors simply can’t see the potential that an entrepreneur is targeting. When Uber emerged, many VCs trying to evaluate the size of the total addressable market, compared the venture to taxi cabs, not foreseeing that ride-sharing platforms could become a much more dominant, pervasive enabler of transportation and other services. One panelist described the emergence of Uber as a leap in consumer behaviour that now seems normal but in those early days was hard to imagine – getting into a stranger’s car.
That makes it essential to understand and invest early in the companies that are going to be truly transformative, and it’s why the sweet spot for VC investors is slightly different from that of equity investors. On the equities side, ideally, investors want to find a company that the market misunderstands and therefore undervalues. Our panelists called this “non-consensus right.” The non-consensus element is much less important for VC investors. Being present at the birth of a great company, even if you pay a rich premium at the time, is much more important. Thus, “consensus right” is a great place for VCs.
What drives the innovation cycle
It’s tempting to map great periods of innovation with economic cycles. Many reports, for example, have pointed to the Global Financial Crisis as a period that gave rise to disruptive companies such as Uber, Airbnb, Square and Venmo. Our panelists, however, had a slightly different view. Rather than economic cycles, they think in terms of platform cycles or the emergence of enabling technologies that allowed a host of new businesses to take shape. The internet, for example, was once a new platform that drove business creation.
It was the same dynamic in 2008-2009. “The reason you had so many great companies is because it was the beginning of a platform cycle, and that platform was mobile,” said one of our panelists, pointing to the explosion of apps that exponentially increased the utility of the mobile phone—and launched a constellation of new businesses, including those listed above.
So, what’s the next enabling platform?
It is critical to spot those disruptive new technologies and platforms early. Our panelists touched on a few that are on their radar, including cloud computing and mobility. One of the most surprising was fintech.
Every company is becoming a fintech company
“Every company is becoming a fintech company,” said one participant. A variety of startups are now offering innovative end runs around traditional banks by bundling customized services that are faster, cheaper and more convenient. These are companies that can effectively become the “operating system” for small businesses. In restaurants, there’s Toast, which offers tablets for servers to take orders digitally, as well as payments processing, lending and other services in the background that once would have taken place in a bank. Yoga studios and spas have MindBody, which allows customers to access a class schedule, sign in, and make payments.
Panelists pointed to the confluence of banking, lending, payments, crypto and other offerings that can now be transacted and protected digitally. This has led to the start of a challenger bank movement—a movement with the potential to disrupt the traditional banking sector. One panelist pointed in particular to the disruptive potential of cryptocurrency: “I think the notion of currency and money and custody and all these old-school concepts will be turned on their head by crypto.”
COVID-19 and a new wave of health care innovation
A trend toward digital health care had been slowly grinding its way forward before the pandemic. That trend was thrust into high gear overnight by the health crisis. “The resistance from payers, the resistance from regulators, public affairs, etc., just disintegrated,” noted one panelist. While it took a decade for GP clinics in the U.K. to integrate WIFI, with the COVID-19 crisis looming, the National Health Service was able to put out a tender for a digital platform for their GPs in just 48 hours.
One panelist said the digital health care trend meets the ten and tenth test: telemedicine, for many doctor/patient interactions is ten times better than traditional in-office visits at one tenth the cost. With that cost/benefit ratio, it is unlikely that telemedicine will be rolled back when the current crisis ends. A new generation of entrepreneurs, for whom digital is a first language, will innovate around the idea of telemedicine with an array of improved offerings and adjacent services.
Other trends were also accelerated by COVID-19, for example online delivery services like Instacart. The boost from the pandemic overcame a lot of inertia and given the benefits and low cost, usage is likely to persist, even after the pandemic. In other cases, notably travel platforms like Airbnb, the effect from COVID-19, while severe, is likely to be temporary.
It’s the people — not the tech
When it comes to funding companies that are still at the idea stage, the idea and the technology matter. But people matter more than either.
At an early-stage company, you can try to look at data like total addressable market and project a future value, but for a company that has yet to earn its first dollar that’s very hard to do. One panelist estimated the person factor at 98% of the value of an early stage company.
Specifically, our panelists pointed to three traits founding leaders need: the ability to raise funds; the ability to attract talent; and the ability to imagine a different future. For the first, VCs look for basic charisma and storytelling ability, since the founder is going to spend a lot of his or her time wooing investors. “If you can’t fundraise,” said one panelist, “it doesn’t matter how good your product is; you’re just not going to get there.”
The next thing venture investors look at are the HR metrics. The ability to attract best-in-class talent at a very early stage carries a great deal of weight. When a company is creating its first products, access to the right talent can make or break the enterprise. The third factor, the ability to see connections and patterns and to develop a unique view of the future also matters. Investors want to partner with someone who can imagine a disruptive new view of the world, rather than just an improvement to the status quo. There was one other X factor that emerged from the conversation: the ability and willingness to learn. This requires intellectual capacity and resourcefulness as well as a willingness to invest in knowledge by drawing on networks and developing an ability to bond with other smart people. One panelist called this learning muscle “a great marker for extraordinary leaders.”
We’re beginning to see innovation in the way in which companies are built and managed—and that kind of innovation isn’t frequent.
Where companies set up shop matters, of course. The network effect in Silicon Valley, for example, where you can meet investors and technologists of every stripe on a simple coffee run, is legendary. But Silicon Valley also has one of the highest costs of living in the U.S., making it especially unattractive for young talent with families. Where workers set up shop also matters. For months now, a huge swathe of the global workforce has been working remotely, and many companies are making that arrangement permanent for all or part of their workforce.
While many have been ready to declare a wholesale shift away from traditional co-located working arrangements, our panelists had more nuanced views. One pointed out that In Europe, there is already a stronger tradition of companies starting out in Tier 2, 3 or even Tier 4 cities. As they start to scale up, traditionally these startups have moved to a Tier 1 city like Amsterdam or Berlin, but that’s beginning to change as technology improves and people become more comfortable with remote work arrangements.
As one panelist put it, “We’re beginning to see innovation in the way in which companies are built and managed—and that kind of innovation isn’t frequent.” While Steve Jobs famously insisted that every employee report for work on site every day to protect the chance encounters that spark innovation, some panelists thought that was no longer as necessary, pointing to startups that have worked remotely from the beginning and are starting to scale, such as InVision.
Some companies are pioneering distributed workforces that combine remote working with on-site working hubs in smaller cities. Some maintain only a sales presence in Silicon Valley. COVID-19 is accelerating these trends and our panelists expect new paradigms to emerge. “The remote revolution offers the best of both worlds because it allows companies to have a presence in the Valley but not have to be fully located there,” as one participant put it.
We will continue to monitor the venture world for insights and innovations that can enrich all of our global investment activities.