The venture capital (VC) industry faced significant challenges in 2017, signaling a potential turning point. This exploration sheds light on the root causes of these issues and evaluates pathways for VCs to adapt and maintain their relevance by leveraging big data, innovative fund structures, and enhanced platforms.
Executive Summary
- The VC industry seems to be at a pivotal moment.
- What underlying issues plague the VC landscape?
- What does the future of venture capital look like?
The Changing Landscape of Venture Capital
A Crossroads for Venture Capital
In 2017, venture capital began encountering disruptions that could reshape its traditional structure. Notably, trends like the rise of Initial Coin Offerings (ICOs) emerged as potential game-changers. Reflecting on personal fundraising experiences and broader industry issues, this article examines the shortcomings of venture funding and proposes strategies for its evolution across three dimensions:
- Reclaiming the information edge.
- Revamping venture fund structures.
- Raising the impact of platform strategies.
Four Macro-level Challenges Facing the VC Industry
- Underperforming Returns
Historically, the VC industry has struggled with sluggish returns. Data from Cambridge Associates shows that average venture capital returns fail to meet the typical 20% target, often falling below 15%. Many funds underperform relative to public markets or private equity. Moreover, top-performing funds dominate the space, while mediocre ones struggle, widening the performance gap. This disparity is causing a bifurcation within the industry. Elite funds continue business as usual, but average funds risk losing access to capital. Investors may become increasingly skeptical, withdrawing support from underperforming players. - Slowing Exit Rates
Exits—essential for liquidating gains—are taking longer, putting the entire industry under stress. IPOs, once a significant exit route, have diminished substantially in recent years. Venture-backed companies now take an average of 8.2 years to go public, with few signs of recovery in the IPO market. With more startups opting to stay private and sovereign wealth funds providing late-stage funding, the numbers of investments vastly outpace exits. This imbalance directly impacts internal rates of return (IRR) and investor confidence. - Cultural Crises and Scandals
2017 was marked by revelations of cultural issues within the VC space. Accusations of gatekeeping, favoritism, and exclusionary practices such as “warm introductions” called into question the meritocratic claims of the industry. Backlash from these issues leads to introspection—both from investors and startups—about the ethics and qualifications of their venture partners. Some may bypass the VC route altogether in favor of more transparent alternatives. - Increased Competition
The rise of new funding alternatives has stepped up the competition for VC firms. Institutional LPs are now engaging directly in startup investments rather than relying solely on VCs. Equity crowdfunding, corporate venture arms, and the rapid ascent of ICOs also present attractive alternatives to startups. Beyond this, sovereign wealth funds and retail investors are reshaping the funding landscape:
- Direct LP startup investments have doubled in the last decade.
- Sovereign wealth funds disbursed over $13 billion into startups by 2016.
- ICO fundraising in 2017 surpassed VC investments for early-stage funding.
With more funding options than ever, entrepreneurs no longer rely exclusively on venture capital, further fragmenting the market.
Root Causes of VC Industry Problems
Declining Information Advantages
Previously, VCs maintained informational advantages because of their networks and proprietary market data. However, these informational barriers have eroded:
- LinkedIn has replaced private Rolodexes.
- Media platforms like TechCrunch and directories such as Crunchbase democratize information.
- Social media serves as a new form of “elevator chatter.”
As a result, many emerging VCs lack a decisive edge over individual investors or other funding sources. This calls into question why LPs would pay steep management fees for generic services available elsewhere.
Incentive Misalignment
The typical VC fund model—a 10-year, closed-end structure—is increasingly misaligned with market realities. As exit timelines grow longer, funds face pressures to generate returns on an artificial timeline. This may lead to forced exits, sacrificing potential long-term value.
Furthermore, fee structures such as the “2 and 20” system incentivize fund managers to prioritize fund size over optimal performance, leading to bloated fund sizes and higher management fees rather than improving returns for LPs.
Entrepreneurial Alternatives and Changing Bargaining Dynamics
The influx of capital into the startup ecosystem has shifted bargaining power toward entrepreneurs, enabling them to negotiate better terms. Tools like ICOs allow founders to raise funds rapidly without sacrificing governance. This trend erodes VCs’ traditional value-add services, making it harder for them to justify their contributions.
Envisioning the Future of Venture Capital
Leveraging Big Data and Machine Learning
To regain their competitive edge, VCs must incorporate data-driven methodologies. Advanced tools like machine learning can enhance deal sourcing, due diligence efficiency, and decision-making. Examples like InReach Ventures and Social Capital showcase how technology can create scalable models for deal evaluation, cutting through biases and enabling faster market insights.
Extending the Talent Horizon
The earlier a VC can spot and finance a startup, the greater the potential reward. To distinguish themselves, some funds may go even further—identifying promising talent before ideas materialize. Offering financial backing in exchange for equity in “future ideas” could become a novel way of nurturing entrepreneurial talent at an early stage.
Rethinking Fund Structures
The VC industry would benefit from innovative fund models:
- Evergreen Funds: These structures allow funds to recycle proceeds and avoid time constraints associated with traditional models. Such entities could deliver stronger long-term commitments to LPs without the pressures of fund liquidation.
- Pledge Funds: An alternative for new VCs, pledge funds enable investors to selectively opt into deals, giving them more control over investment decisions and improving alignment between VCs and LPs.
Expanding Platform Services
Platform services—expert resources provided to portfolio companies—offer a standout differentiator in today’s crowded VC market. While larger funds can afford to scale these services, smaller VCs must leverage data insights, virtual advisory networks, or peer-driven portfolio platforms to maximize value without incurring massive costs.
Conclusion: Reinvent to Stay Relevant
Despite challenges, the venture capital industry remains vital. However, VCs must adapt to the shifting landscape by emphasizing innovation, transparency, and efficiency. For emerging or average funds, the future likely entails:
- Greater use of technology in sourcing and decision-making.
- A focus on early-stage deals or even pre-startup talent.
- Leaner and more specialized approaches to investing.
- Revised structures that better align with long-term market realities.
As trends such as ICOs grow, they will likely influence venture capital practices. To remain indispensable, VCs must act now to revamp and evolve their practices—not to only overcome current challenges but to thrive in future ecosystems.