Why Venture Capitalists Must Specialize

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.

Macro forces shaping the VC landscape will compel this specialization. After the halcyon days of the 1990s internet boom, average VC returns have compressed, according to a recent study by Morgan Stanley's MS Michael Mauboussin. Venture capital fund returns are highly dispersed, and there's a big gap between the top and bottom quartiles of funds. 

But on average, VC investment returns have been roughly equivalent to the S&P 500 over the past 20 years, giving limited partners no extra reward for locking their capital up in illiquid companies for years at a time. What's more, U.S. venture capital fundraising continues to grow, topping $50 billion in both 2018 and 2019; flush with capital, investors will bid up valuations even higher, making it still more difficult to find the growth needed to generate returns. That's already happened in private equity, where average EBITDA multiples paid for companies are now 11.5x, according to Bain's 2020 private equity report.

"Since 2000, public listings have declined by almost 50%," said Ty Findley, managing partner at Ironspring Ventures, an Austin, Texas-based firm focusing on early-stage investments in the industrial supply chain. "Public companies were already trading pretty high and now there's a lot less opportunity. Combined with interest rates near zero, that's driving up historic amounts of dry powder into the private markets. No matter what you might have thought COVID was going to do, private market dry powder is already piled up on the sidelines and only going up."

(Chart: Bain & Company)

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. 

Public equity investment is highly specialized, with sell-side analysts and buy-side portfolio managers who cover a narrow universe of stocks, and private equity firms have specialized in sectors like real estate, oil and gas, telecommunications, and retail for decades. But most VC firms are still generalists. And while typical venture capitalists may be able to identify a good software company and might have an edge on future consumer behavior, they don't tend to have domain expertise in specific verticals. After all, many VCs are former coders.

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."

"It's natural to believe that there's a movement for VC firms to specialize," said Santosh Sankar, founding partner at Dynamo Ventures, a Chattanooga, Tennessee-based firm focused on pre-seed and seed investments in supply chain and mobility. "But that specialization might look like a barbell, concentrated at early stages of investment and pre-IPO stages. It's really hard, if you're a $1 billion fund, to deploy the check sizes necessary to invest in specific stages of growth within one sector."

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. 

In 2011, Union Square famously defined its mission as investing in "large networks of engaged users, differentiated through user experience, and defensible through network effects." That led to successful investments in Tumblr, Twitter, Etsy and Soundcloud. But just a few years later, the firm ran out of large, engaged, defensible networks and pivoted to investing in "enabling technologies," which turned out to mean far more obscure digital infrastructure companies like MongoDB and Cloudflare.

"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.

"We've seen that viral, blitz scale growth based on solid unit economics doesn't really happen in the industrial environment as more investment has come into the space since 2016," Findley said. "Pure revenue ramp can be a lagging indicator to more industry-specific leading indicators like data access, for example, which legacy companies don't just hand out. Even getting a master service agreement signed can be a big feat — it doesn't come with immediate revenue recognition, but now you quietly have a 12-month jump on anyone else trying to go down that path."

"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.

"I have made a lot of successful customer, talent and investor introductions, but those should be table stakes," Counihan said. "I am prouder of the moments where I have meaningfully contributed to a company's strategy. In early conversations with Anshu Prasad, CEO of [Schematic Ventures portfolio company] Leaf Logistics, we had been discussing the company's complex financial structures which allowed Leaf to create an innovative freight product. It was in those discussions that I coined the term ‘Flex Dedicated' to shift the message from the ‘how Leaf does it' to the ‘what Leaf does for the customer.' Leaf's Flex Dedicated product combines the precise capacity of spot freight with the price and service advantages of dedicated freight."

How Sector-Based Funds Gain An Edge

(Chart: Morgan Stanley)

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.

"I'm hearing directly from founders now seeking out a much more diversified investor base at the earliest stages that includes sector-based support, even if it's a brand-new fund without much splash or pizazz," Findley said. "Founders are realizing, ‘if I hit my metrics, there will always be more than enough capital for growth, so how can I bolster my support earlier with sector-based funds that are deeply studying my environment?'"

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.

"We build relationships with a lot of research teams at big strategics in industries relevant to our theme," Stallman explained. "They're doing early proof-of-concept work and testing out ideas and relationships with startups. They might not do direct investments, but they share feedback on things they find interesting. Our portfolio companies appreciate that we're operating in the same ecosystem as they are — we know their customers and partners. Serendipitous encounters are more frequent when you're specialized."

Sector-Based Doesn't Necessarily Mean ‘Strategic' Or ‘Corporate Venture'

To some extent, a number of venture capital investment shops are already focused on specific sectors or industry verticals; they're just housed in large incumbent corporations. Typically called "strategic" or "corporate venture capital" investors, these funds are supported by both the business units and the direct balance sheet of their parent corporation and invest in companies they may have a "strategic" — not merely financial — interest in.

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."

Understanding the difference matters particularly in the early stages, where it's quite common for startups to find traction in unexpected places, make pivots, and invest in new areas of the business as they evolve from executing a founder's vision to attacking their customers' problems. Those pivots, though, can lead a startup in a direction that diverges from the initial strategic interests of a corporate venture capital investor, whether it's a new customer base or business model, or a different way of thinking about the product. Those changes in direction may ultimately leave the corporate venture capital portfolio with a purely financial asset that is no longer aligned with the strategic mandate of the corporation.

"Not all corporate venture capital groups approach the market the same, and there are actually some very novel structures being deployed within that ecosystem, but at the end of the day the difference comes down to tracing long-term incentive structures," Findley said. "Corporate venture is typically deploying capital directly off of one corporate balance sheet as needed — there is no external legal fund entity with a pooled investor base — with incentives that are aligned to the current outlook of that corporation's interests." 

That model of investing can prove challenging for corporate venture investors because the financial return is usually immaterial to the corporation, and the fortunes of the venture group rise and fall as executives move in and out of the C-suite. But independent funds with a typical 10-year deployment cycle are permanently structured to drive a financial return for their pooled investor base. There can be some confusion on the part of founders, though, because the limited partners of independent sector-based VC funds can often be corporations in the same space. In those cases, the diversity of the funds' capital base makes sure that the VCs aren't beholden to a single corporate strategic interest and that their long-term incentives align with those of the founders.

"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. 

(Chart: Morgan Stanley)

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. 

"While for some founders it makes sense to go for a larger round earlier, often alongside a bigger fund that needs to deploy a larger check size that aligns with that fund's dynamics, we tend to have a different outlook on balancing short-term and long-term fundraising dilution through a lens of early capital efficiency in certain sectors that simply do not move as fast as others to adopt innovation," Findley said. "There is no right or wrong answer, and what's really great about all of this discussion is that founders now have many different paths to pick from when it comes to capitalizing their business at the earliest stages."