Equity on Demand?
Venture capital — the business of buying and selling startup equity — is about to change dramatically. Just as we disrupt other industries, it looks like we are about to be disrupted (again). VC is facing a simultaneous squeeze from above and below, and the key to thriving and turning this disruption to our advantage lies in understanding and mastering it. So what’s going on?
Learning from the Music Industry
The coming disruption is hardly unprecedented. Similar changes have swept through several industries lately, and the music industry provides a well-documented example. Remember record companies?
Twenty years ago, record companies made over 90% of their revenue from selling physical media. Over the course of a decade, however, new technology and business models — Silicon Valley’s specialties — cut the record companies’ revenues from physical media by two thirds and aggregate revenues by over a third. Now anyone born in this millennium needs a complicated explanation as to why they’re even called “record” companies. Revenues have rebounded only recently as record companies have learned how to deal with revolutionary change.
The analysis is simple. In every non-artisanal industry, there is a gap between the makers and the market. Someone somewhere — Guangzhou factories, gig-economy workers, musicians in a studio — are working hard to make something of value. At the end of the line, customers buy their valuable products. In the gap between the beginning and end of the value chain are the distributors and marketers.
Since the intermediaries have much lower costs than producers, they tend to have juicy margins. Roughly speaking, their margin varies in proportion to the width of the gap between the makers and the market. The harder it is for Foxconn to determine what kind of computer consumers want, and the harder it is for consumers to buy a computer directly from Foxconn, the bigger the opportunity available for the distributors and marketers in between them, like Apple and Nintendo.
For decades, the record companies had a nice, wide niche. But other distributors and marketers that scale more efficiently, like Spotify and Apple Music, have followed Jeff Bezos’s advice: “Your margin is my opportunity.” They moved in and narrowed the gap between the makers and the market, nabbing the incumbents’ margin in the process. (Side note: The gap is still wide. The makers are lucky to clear 12% of what the market pays.)
The VC Squeeze
The key lesson from the example of the music business is that there is a gap between the makers and the market, and whoever owns that gap reaps the margins. So who’s squeezing the VCs’ gap?
From a certain perspective, every startup — from a two-person garage operation to a private decacorn — makes the same thing: equity. Whatever their app or widget may be, they all make shares. The market is where they seek to exit, where their equity gets priced. In between the garage and the exit are the distributors and marketers, the world of private equity and venture capital. VCs own the gap between startups and stock markets.
Just like the music business, though, the gap — our gap — between the makers and the market is shrinking. Perhaps it started with crowdfunding, but that proved to be far more sizzle than steak. A list of “wildly successful” crowdfunded startups is without a household name, and it generates relatively little capital in aggregate.
SPACs are arguably shrinking the gap from above by giving more people the opportunity to participate in exits. Similarly, direct listings are increasingly cutting institutional investors and underwriters out of the IPO exit path, again reducing the gap between the public market and the equity makers. Though both are well established, the growing popularity of these two forms of exit are lowering the upper limit of the VC gap.
The secondary market for startup equity is not new either, and it is growing too. Indeed, it looks more and more like the public market every year. However, the secondary market hasn’t closed VCs’ gap so much as made the activity in that gap far more dynamic. It hasn’t really changed who has access to the equity, but it has made that equity far more liquid.
Perhaps the biggest change is just now emerging on the horizon, and it could dissolve the entire concept of “exit” from below. The secondary market looks set to go retail, which might largely erase the difference between the public and private equity markets. If any teenager with a summer job and a smartphone can invest in startup equity, does that make everyone a VC? Will existing VCs be priced out of their own market? If startups have access to unlimited public finance while still in the garage, what would “exit” mean? Where’s the gap? Will Sequoia meet the same fate as the once-mighty EMI?
What to Expect, What to Do
The VC squeeze will catalyze a couple of radical changes. First, regulation is coming. It only takes one crash for retail investors to cry foul and push regulators to control private equity just like they do public markets. Second, there will be a cull of VCs. The number of VC funds of all sizes has been growing for years, but slimmer margins will force consolidation, just like in the music industry. Smaller, weaker, wannabe VCs will perish.
VCs who can read the terrain will prevail. As the gap shrinks, VCs will need to outcompete players on the secondary market who are providing “just money” because money will no longer be scarce. VCs will need to provide extra value either to the startups looking to sell equity or to the LPs looking to buy it on better terms than the public. Some gap will remain, but not for amateurs.
Only the clueless and the archaic need to fear disruption.