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David Hirsch, managing partner of Metamorphic Ventures
With the selloff in some big tech names such as LinkedIn and Twitter, some investors are beginning to wonder if the golden age of the Internet and mobile is over. Given the uncertainty in the global markets, it make sense then that public market investors aren’t nearly as bullish on the future growth potential of some big tech companies as they were a year or two ago.
“Even as tech stocks and unicorns falter, it has never been a better time to be an early stage technology investor.”
At the same time, there are a number of VC-backed “unicorn” start-ups in the private markets. Due to a period of low interest rates, growing companies quickly realized that they could raise large sums of money, as investors lacked yield on their capital. This allowed companies to continue scaling operations without having to worry about short-term profitability and the microscope of the public markets.
But as technology becomes ubiquitous, affecting all aspects of our lives and jobs, category-killer winners will emerge in every market and business function, as well as those catering to new platforms that arise in the process. Think Google in search, Facebook in social, Amazon in e-commerce, and Uber in transportation.
Artificial intelligence, big data, drones, and robotics are all technologies that will disrupt traditional industries and create new markets beyond what we can imagine today.
These companies might not be playing in markets as big as Google or Facebook, returns can be outsized for disciplined investors. So, even as some tech stocks and unicorns falter, it has never been a better time to be an early-stage technology investor, provided that you have access to good companies and strong founders early on.
According to Cambridge Research Associates, “Seed and early-stage investments have accounted for the majority of investment gains in every year since 1995, suggesting that, despite the deep pockets of late-stage investors, early-stage investments hold their own on an apples-to-apples basis (total gains).” The same report said that, for the last 10 years, new and emerging managers have accounted for between 40 and 70 percent of VC gains.
Smaller venture-capital funds allow for investors to achieve returns, even if the rate of failure within a portfolio is high, because fund size allows for smaller exits to produce great overall fund results.
As funds get smaller and the asset class unbundles, the question then becomes: Why should investors invest in a fund instead of direct investing in companies themselves? Good fund managers understand the risk and therefore build a portfolio of companies, weighing the risks and potential outcomes of the portfolio as a whole so that the fund’s losses are recouped by an order of magnitude by the fund’s winners (which is why MOC — multiple of capital — is more important than internal rate of return in the early stages).
Round sizes also allow early-stage investors to build nice-sized positions with strong visibility to provide additional capital when the time is right. Limited partners in these funds can also access later rounds through “Special Purpose Vehicles” (SPVs) provided that the valuations are reasonable at that point in time.
Because the funds these limited partners have invested in have been close to these companies for a period of time, they have more data and visibility into the viability of the potential investment than investors who are approaching these companies for the first time.
Furthermore, the declining cost of technology makes everyone an entrepreneur. The effect this has on the ecosystem is an abundance of companies being started, with ideas that may have failed in the past or that have a number of competitors.
VC’s spend their time understanding industry dynamics and context in which these companies are being started. Over time, strong managers develop mental models to best evaluate these companies, which is what has commonly been described as “pattern recognition” given the amount of time they spend integrated in the ecosystem.
Because this wave of technology start-ups is disrupting traditional industries and attempting to build massive companies where nothing existed before, the companies can’t be evaluated in the same way that traditional companies are, let alone across the board of their counterparts in the technology ecosystem. So while many of these great companies may never reach $100 billion in market cap, they will still provide outsized returns for disciplined investors.
When shown an early-stage investment opportunity, individual investors should ask themselves, “Why am I seeing this deal?” In my experience, that has more often than not meant that the VC community collectively passed on the investment opportunity.
Remember that these funds are smaller in size and therefore don’t have the capital to fully heavy up on their winners. General partners will often show their limited partners opportunities to co-invest in later stage investments once they feel the opportunity is de-risked in a vacuum outside of the fund structure.
So, while technology investing can be quite risky, investing in the right manager in a right-sized VC fund is incredibly less risky even when adjusted for the necessary time horizon due to the risk spread across a large base of companies, the active and ever-increasing presence of technology in our lives and economy, and the reduction of necessary exit value to return large multiples on the fund.
Commentary by David Hirsch, managing partner of Metamorphic Ventures, an early-stage venture capital firm in New York City. Prior to MV, he spent 8 years at Google, where he was on the founding team that launched Google’s advertising-monetization strategy. Follow him on Twitter @startupman.
David Hirsch, through Metamorphic Ventures, is an investor in Talkspace and Thrive Market.