In the 2020s, venture capital as an asset class will mature and become more specialized as investors seek to gain an edge in an increasingly crowded market.
The prospect of intensified competition rushing into an industry already facing low returns will force investors to search high and low for great companies that can grow big quickly. But where to start? There are more than 18,000 venture capital-backed startups in the United States, compared to only about 3,600 publicly traded companies and 7,600 private equity-backed companies.
Specialization Comes With Trade-Offs
"Specialization was a necessary reaction to heightened investment competition," said Julian Counihan, general partner at Schematic Ventures, a San Francisco-based early-stage fund focused on technology companies in the supply chain, manufacturing, commerce infrastructure and digital industrial sectors. "Further specialization depends on whether the VC asset class continues to perform well and attract new funds competing for the same deals."
Chris Stallman, partner at Fontinalis Partners, a mobility-focused venture firm with offices in Detroit and Boston that invested in FreightWaves, agreed that sector-based firms have an especially important role to play early in a startup's growth story.
"Sector-based funds are inherently smaller than megafunds that are generalist in nature," Stallman said. "You're not going to see many sector-based funds raise $1 billion. The institutional investors who need to write $50-$100 million checks don't want to own more than 10% of the fund."
Specialist funds have to define their sector or theme in such a way that it stays relevant for multiple decades in order to keep limited partners interested and identify attractive investment opportunities in sufficient numbers.
"From day one, we defined our focus, mobility, as ‘technologies that enable the efficient movement of things,'" Stallman said. "If we're investing in a theme over 30 or 50 years, waves of innovation will occur, areas rise to prominence, and there will be emerging themes we'd want to invest in early on, but five years later the opportunity could be very different themes within the broader mobility thesis."
"We always refer to something Mike Maples said: ‘Your [assets under management] is your strategy,'" Sankar said. "The more AUM you accumulate fund after fund, the lower your capability to be a pure specialty shop. Our charge as fund managers is to be really disciplined about AUM; that's how we can stick to what we're good at."
How Sector-Based VCs Add Value
But smaller, sector-based funds that invest in startups at an early stage can provide differentiated support. Findley said that early-stage VCs with domain expertise in industrial supply chain understand that singularly evaluating top-line revenue growth isn't always the best way to measure the early traction of a startup deeply embedded in a complex vertical.
"The Silicon Valley way is to start with a product person, conceptualize the product, build it, launch and then spend money convincing people they need it," Stallman said. That can work for consumer technology, "but in a lot of industries where there's a workflow component or a deeper integration into a product built by someone else, you have to build and sell more thoughtfully and systematically."
Sankar said Dynamo adds value to portfolio companies primarily in three ways: deep context for how founders think about product and selling; making introductions for customer discovery and sales; and improving product-market fit as companies move toward series A rounds.
"We've developed programs like Founders Camp where we can bring a Walmart or a UPS to the table and catalyze things that are step-changes for a business that can alter their long-term fortunes," Sankar said. He also said sector-based investors are often crucial for helping to articulate a founder's vision in language that generalist VCs understand.
How Sector-Based Funds Gain An Edge
To put it bluntly, many sector-based funds can generate deal-flow simply by virtue of their sophisticated understanding of the industry a founder is trying to disrupt.
"Before an investment, sector-focused funds can make faster investment decisions given their familiarity with the market and ability to tap existing networks for diligence," Counihan said.
For high-quality founders and ideas, high stores of dry powder and easier access to capital have changed the supply-demand dynamic of venture funding. Many founders are in a position to be choosier about the firms they partner with and are looking for investors who can do more than write a check.
By specializing in one theme or sector, VCs can develop a deep network of colleagues in specific verticals.
"I started my career as a software developer working on warehouse automation for a large systems integrator," Counihan recalled. "When I joined a new venture fund seven years ago, I saw the writing on the wall regarding the rise in competition and the need to specialize as an investor. Supply chain was a natural fit for me—I had tough-to-replicate networks in the industry and a passion for supply chain technology."
Those relationships can help portfolio companies source talent and customers, but it can also give VCs an edge in identifying promising technology and understanding what kinds of problems legacy companies are struggling to solve.
Sector-Based Doesn't Necessarily Mean ‘Strategic' Or ‘Corporate Venture'
What does that strategic interest look like? The parent company wants a return on its investment, of course, but more than that it's looking for intelligence into new technologies, business model innovation, proof-of-concept engagements, and an outlook on potential M&A, and it is trying to stay competitive.
Findley, whose resume includes time at GE Ventures, emphasized the distinction between corporate venture capital and this new wave of independent sector-based investors.
"Both bring different and diverse strengths to the table for founders, no doubt," Findley said. "Within the venture ecosystem, though, there is a lagging maturity of understanding in defining independent sector-based funds differently from strategic investing."
"For founders at the early stages, this model is a win/win where they get both deep sector-based support and a venture investment fund that is permanently structured with a financial incentive alignment over the long term," Findley said.
"We say that we're a financial investor with a strategic value-add," Sankar said.
How Specialist VCs Can Help With Exits
It's often remarked that today fewer technology companies go public, and the ones that do stay private for longer and are on average much larger and older than typical companies that IPOed in the past. What's often left out of that observation is that many more startups exit through strategic acquisitions, where they're bought by incumbent companies, and those deals are often being done with somewhat younger and smaller companies.
Sector-based VCs can be a good fit for founders who realize that their company's best exit may be to a strategic buyer. Investors with a knowledge of a particular industry are already aware of and in many cases have close relationships with the companies in the universe of potential buyers. Those VCs can help guide a startup's decision-making so as not to shrink, but to grow that universe of acquirers.
"Strategic buyers have a different thought process," Stallman said, and portfolio companies want to know "what's going to help us and what's going to hold us back. We had a discussion with a company where a key customer was asking for exclusivity — not forever, but it was there and it existed. We knew it took a possible strategic sale completely off the table for three to four years, so it was effectively a nonstarter."
With those deep industry insights, sector-based VCs can also help founders think about the specific exit dynamics at play, and in turn, which capitalization strategy may be best aligned for a company, Findley explained.
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