Venture Capital’s Changing of the Guard

“VC is broken!”

It’s an increasingly common refrain in the post-ZIRP environment. Look on social media these days and you find plenty of calls for venture capital to be reformed, refactored or replaced outright.

Ignoring the fact that most of these posts come from folks who either have a bone to pick with VCs or stand to benefit from its demise, the reality is that venture capital overall isn’t broken. In fact, by many measures it’s as strong as it’s ever been.

Let’s start with the basics. Historically, the median VC manager has outperformed the public markets — with even bottom quartile managers coming close (the chart below is from JP Morgan’s 2021 biennial review of alternative investments):

Of course, a lot has happened since 2021. But the reality is that the amount of dry powder continues to grow. This chart depicts the amount of committed capital (“dry powder”) held by US VCs as of the end of Q1 2024:

That’s not to say that everything has been roses and rainbows. VCs across the board have struggled with liquidity in the past two years, as IPOs and acquisitions have been few and far between.

This lack of liquidity has made it harder for many VCs to raise new funds, as many LPs are waiting for distributions before committing to new investments.

But these issues have affected all of private equity — not just venture capital — and absolutely no one is claiming that private equity is dead.

So, no, venture capital is not broken. But it is evolving.

On the supply side (VCs), we’re seeing a consolidation of venture capital funds into a barbell, with megafunds on one end and small, focused funds on the other. This is leaving many mid-sized funds — particularly those without meaningful differentiation — struggling to figure out their path forward. I recently wrote about why VCs care about ownership, and this dynamic is a direct result of that. Undifferentiated mid-sized funds are too small to compete with megafunds for the top deals and too large to take off-the-beaten path risks. Many such funds are now struggling to adapt to a new reality where the historically linear path of startup funding (Pre-Seed to Seed, then Series A, Series B and so on) is no longer the only way.

And we’re seeing the impact in a dramatic drop in the number of such new funds raised:

Alex Kolicich of 8VC noted the uniqueness of these shifts in his recent Q3 2024 State of Venture Update,

It’s remarkable to reflect on the unique moment we’re experiencing in the venture world. The number of individual investors is shrinking, opportunities have dwindled, exits have stalled—yet we have more dry powder than ever, increasingly concentrated among the top firms. What a world.

On the demand side (startups), we’re seeing considerable changes as founders reconsider how they view venture capital. For starters, there’s a growing awareness amongst many founders that VC (probably) isn’t right for you — and that’s a good thing. But that’s not all.

When VC funding started tightening in 2022, those of us old enough to remember “the old days” responded to founder complaints about how difficult it had become to raise capital with some version of “this is how it’s supposed to be.” Investors and founders alike were tripping over themselves about a “return to normal” in startup funding. But a funny thing happened: many Gen Z founders who had never experienced “the old days” refused to go along with this narrative. Rather than begrudgingly accept that startup funding had become more difficult and move on, many founders rejected the self-serving notion that VCs could demand higher and higher levels of progress and traction in exchange for funding.

As a result, in contrast to prior cycles, the proverbial pendulum hasn’t fully swung back to investors. Rather, an increasing number of founders are taking “door number 3” and rejecting the notion that their path should be dictated by a treasure map drawn by VCs.

Some of these founders have tasted the sweet, sweet nectar of revenue and have decided to grow based on that. Many are simply managing their cash flow in a way that would impress even our depression-era grandparents. I know of many companies that continue to operate off of a single round they raised 2-3 years ago while making impressive gains. Bryce Roberts of Indie VC first highlighted the trend of “one-and-done” rounds back in 2017. Back then, it was something of a rarity, but these days a considerable number of founders are intentionally pursuing that path. At a broader level, the best founders today are raising fewer rounds with less dilution and/or skipping rounds altogether.

And many VCs are struggling to come to terms with this.

Firms with mediocre returns that don’t have much of a differentiator or positioning beyond “solid, inoffensive fund that’s a good fallback if you can’t raise from a top tier VC” are struggling to raise new funds or closing up shop entirely. Many individual investors who are later in their careers or who don’t have the inclination to reinvent themselves are opting out of venture capital as a career. Others who are refusing to adapt are being managed out by their firms.

At the same time, the best VCs are embracing the challenge by going back to the basics while focusing on new ways of investing in and supporting founders. From YC’s move to 4 batches to the return of Indie VC to new firms like Chemistry, we’re seeing an incredible amount of creativity when it comes to VC offerings. And with so many GPs having left established firms to create something new, there’s undoubtedly much more on the horizon.

There’s a changing of the guard underway in venture capital. And that’s great for founders and investors alike.