A version of this article previously appeared in Forbes.
There are two macro trends occuring within venture capital (VC) which are combining to have a transformative impact. The VC landscape has morphed into a barbell structure, with lots of small funds on one hand and a handful of large, megafunds on the other end, with few moderate-sized funds in between.
As shown in the graph below, the number of funds comprised of less than $100 million more than doubled from 2013 to 2015.
Graph via CB Insights
These small, seed funds tend to be highly fragmented, targeting specialized and narrow niches. In contrast, the handful of megafunds (e.g., Founders Fund, A16Z, Sequoia, Kleiner Perkins, Benchmark, Bessemer, IVP, etc.), are relative generalists, investing in a wide variety of industry sectors.
A New Frontier Around Every Corner
The other significant trend is the emergence of frontier tech, which CB Insights defines as encompassing drones, space, augmented reality and virtual reality. During the 18 months from January 2014 to June 2015, CB Insights notes that $3.15 billion was invested in such companies, across 183 deals.
Unlike past investment waves, such as nanotech, photonics and cleantech, frontier tech is not monolithic. The deals often do not fit into an industry-wide movement. For instance, Apeel Sciences and senseFly are both considered “ag tech” (as in agricultural technology) deals, but they represent very different solutions. Apeel is an organic chemical compound that extends the shelf life of flowers, fruits and vegetables, while senseFly is a fixed-wing drone that enhances crop yields. (Note: I am a very small Angel investor in Apeel)
Individually, these two macro trends are interesting, but the real impact becomes apparent when the trends coincide.
The creation of numerous smaller, highly-focused funds allows for specific vetting of frontier tech deals, which are often difficult to assess, given the relative newness of the solutions. By putting a relatively small amount of capital into “off-road” frontier tech deals that the smaller funds have unique capabilities to evaluate, the most qualified deals get funded and those which are less likely to succeed are forced to bootstrap themselves or go out of business.
Most frontier tech deals, because they are not only solving problems in new ways, but often also creating new markets, ultimately require relatively large amounts of capital. Thus, the combination of small, specialty funds and large, generalist funds is an ideal match for the emerging world of frontier tech.
Despite the power of these trends, their long-term impact on VC returns is unexplored territory. A number of questions will only be answered over time, including:
- Will the small funds do an adequate job of picking the winners, and if so, can they maintain meaningful ownership positions as the large firms inject massive amounts of capital into their deals?
- As evidenced by the recent SpaceX mishap, many of the problems frontier tech companies are attempting to solve are extremely challenging. Will some of them prove to be beyond the reach today’s solutions? If so, will these failures sour the market as happened after a handful of high-profile clean tech companies filed for bankruptcy?
- Will the small firms have adequate capital to allow their frontier tech portfolio companies to prove their value prop sufficiently to attract the attention of the megafunds?
- Will mid-tier funds become irrelevant as the larger funds continue to invest earlier and earlier in companies’ life cycles?
Given that the average time to exit for a venture backed company is five years via M&A and seven years via IPO, we are still several years away from knowing the full impact of the bifurcation of the VC market’s impact on frontier tech investing. However, there is little doubt that the collision of these two trends will result in the creation of a handful of companies that will have an outsized, global impact.
You can follow John on Twitter: @johngreathouse.
Image credit: EMMANUEL DUNAND/AFP/Getty Images