The Diffraction of Venture Capital

European Straits #182

Hi, it’s Nicolas from The Family. Here’s a new round of reflections about the future of venture capital, including a new concept to describe what’s going on.

⚠️ Last week’s essay on France, As Revealed by its Elite has drawn a lot of interest. If your preferred language is English 🇬🇧, you can read additional essays and access the reading list on the topic in the paid section of this newsletter. If you speak French 🇫🇷, you can also listen to me discussing the topic further with my wife Laetitia Vitaud in a podcast that’s part of our family project Nouveau Départ: Ce que Castex nous dit de la sociologie des élites françaises [subscription required].

1/ Today I’m writing about a new concept, what I’ve decided to call the ‘diffraction of venture capital’. Here’s the definition of diffraction:

The process by which a beam of light or other system of waves is spread out as a result of passing through a narrow aperture or across an edge, typically accompanied by interference between the wave forms produced.

We can see VC as a system of waves, namely the waves of capital being deployed in tech startups worldwide. The concept of ‘diffraction’ helps us realize that this system is now changing as a result of passing “across an edge”, which produces various wave forms:

  • VC per se, as practiced by proud craftspeople such as Benchmark Capital

  • venture debt, an old but still marginal complement to equity financing

  • revenue-based financing, with related products such as that designed by Indie.vc

  • private equity which, unlike VC, is focused on already-profitable businesses

  • hedge funds and many other forms of alternate financing

I’ve already written a lot about VC (see here, here, and here). I’ve also shared a first round of thoughts about private equity for tech companies [for paying subscribers]. And later this week, I’ll do the same for revenue-based financing, before eventually following up with venture debt and hedge funds.

Before that, let me set the stage regarding the diffraction of VC, what it means, why I think it’s happening now, and what opportunities it provides to us in Europe.

2/ I mentioned an “edge” with regards to the physical phenomenon of diffraction. But what is this specific edge in the case of VC? Borrowing from Carlota Perez, I think it’s the “turning point” of the current technological revolution—the Entrepreneurial Age reaching its “synergy phase” (the one that’s about “supporting the expansion of the new paradigm across the productive structure”).

Here’s what Carlota wrote in Technological Revolutions and Financial Capital, describing the fundamental distinction between two categories of invested capital:

Financial capital is mobile by nature while production capital is basically tied to concrete products, both by installed equipment with specific operational capabilities and by linkages in networks of suppliers, customers or distributors in particular geographic locations.

Financial capital can successfully invest in a firm or a project without much knowledge of what it does or how it does it. Its main question is potential profitability (sometimes even just the perception others may have about it).

For production capital, knowledge about product, process and markets is the very foundation of potential success. The knowledge can be scientific and technical expertise or managerial experience, it can be innovative talent or entrepreneurial drive, but it will always be about specific areas and only partly mobile. 

In other words, traditional VC (“financial capital”) was fine for funding the installation of the Entrepreneurial Age. But now that rudimentary form of financial capital is in the process of expanding, diversifying, and specializing, which gives birth to a whole new financial services industry whose goal is to serve an ever increasing number of tech companies across various geographies and industries. This marks the rise of “production capital”—and this is causing the current diffraction.

3/ Why now? Traditional VC remains the best approach to financing a software-driven business because of one simple feature: increasing returns to scale. Such increasing returns don’t only exist in the tech sector. But the nature of software is such that returns keep increasing up to a scale much larger than anything ever reached by manufacturing giants in the past. 

The consequences from a competitive perspective are quite radical, and call for a specific type of financing. Because returns keep increasing almost forever, on each market there’s usually one clear winner, with all the others lagging far behind or going bust—what Fred Wilson calls “winner takes most”. And because all contenders on the market know that there’s only room for one champion, they’re ready to do anything in the scaling up phase to make sure they come out on top.

High risk, high reward: This is more easily seen at the scale of an entire portfolio, because you need that one big winner to compensate for all the losers. And this is why venture capital exists and thrives when it comes to startups that are all about software.

4/ Now, venture capitalists cannot deliver success all by themselves. They need certain conditions to be in place for their investments to generate returns. More precisely, traditional VC can only deliver as an industry in the presence of two other key elements—one up the stream, and the other down the stream. VC occupies the intermediary step in building up tech companies that dominate at a large scale:

  • Up the stream, you need basic research funded by either the state or large companies so that technology becomes robust and abundant. When this is present, VC can enter the scene and fund a tech startup, mostly to cover the risk of entering the market and marketing and distributing the product at a large scale. If there hasn’t been enough basic research up the stream, on the other hand, venture capitalists have to cover two risks at the same time: conducting research and development as well as entering the market and selling the product. That’s one risk too many, as seen throughout the 1990s (when digital technology was neither robust nor abundant enough, which explains the dotcom bubble bursting in 2000).

  • Down the stream, you need liquidity. It takes so much time to breed a winner able to take most of its market that when it’s finally done, steady dividends are not enough to swiftly return the capital that’s been deployed along the way. You need the asset to be sold without delay, either to an acquirer or to public investors (IPO), so as to generate capital gains that are large enough to return the fund. If, on the other hand, there isn’t enough liquidity down the stream, you end up with, well, Europe. As I wrote back in September last year,

Historically, the rise of venture capital was made possible by the frequent and early opportunities to take companies public. For those who didn’t make it to an IPO, the fallback was the likely opportunity of being acquired by a larger company. But Europe is lagging behind on both these fronts, creating what I would argue is one of the central problems for the European tech ecosystem: the difficulty of an exit.

5/ The past 15 years have been a period when everything went rather well for global VC because the conditions on both ends of the stream were perfect: technology became more robust and abundant by the day (thanks to open source, AWS, no-code), and liquidity wasn’t a problem, especially given the macroeconomic context following the 2008 financial crisis. However, nowadays it’s less and less the case, and we’re witnessing the diffraction of venture capital for precisely those two reasons:

  • Software eating the world leads tech founders to consider entering fields where technology is not robust or abundant enough: ‘deep tech’ startups; startups entering more tangible industries (WeWork); and startups entering more regulated markets (all of fintech, or healthcare). Theranos was quite an extreme case: a ‘deep tech’ startup trying to enter a tangible industry (blood tests) to serve a regulated market (healthcare). No wonder it didn’t work!

  • Meanwhile, the scarcity of exits (fewer IPOs and acquisitions) leads tech companies to aim for profitability sooner. It’s not a bad thing per se, but it also means those companies raise less capital to invest in growth and try to reach profitability sooner. Thus they have a harder time reaching a scale at which they can generate returns high enough to satisfy the VCs who back them.

All in all, both trends contribute to degrading the scalability of tech businesses, which in turn contributes to degrading returns in traditional VC. Of course, I’m not saying there’s no money to be made there anymore. I’m saying that new opportunities to build great tech companies are now in those difficult segments where returns are lower, which calls for variants to traditional VC—hence, the diffraction.

6/ Let’s take an example: Indie.vc, the new approach to VC pioneered by O’Reilly AlphaTech Ventures (OATV). The goal is to be able to deploy capital in tech startups at seed stage while preserving the option for the founder to reach profitability early instead of raising several more rounds so as to try and fuel exponential growth. Here’s how OATV’s Bryce Roberts initially described the effort:

Although I admire the approach and the willingness to stick their neck out, I don’t think that OATV coming up with this new approach is what’s prompting the new “wave form” represented by Indie.vc. Rather I think that Bryce and his partners have an excellent sense of timing. Somehow they sensed that we were now reaching the “synergy phase” and that it was time to provide founders with a new breed of VC that would let them reach profitability sooner—and, yes, generate lower returns. 

Indeed, if you can’t count on returns that are as high as in pure software, the sooner you reach profitability, the better. And the lack of extraordinary returns from just a few portfolio winners can be compensated for by the increased knowledge of how profitable companies can be built in more difficult industries with lower returns. In turn, that will attract new investors from outside VC and contribute to further diffraction, thus creating a better environment for “production capital” to flourish.

7/ Let’s take another example: revenue-based financing in SaaS. Here’s a quote that I love from The Partnership, a book about Goldman Sachs:

The public securities markets, both debt and equity, had always been carefully based on the balance sheets and the capital assets of the corporations being financed — which is why railroads were such important clients. To expand, United Cigar needed long-term capital. Its business economics were like a “mercantile” or trading organization’s — good earnings, but little in capital assets. In discussions with United’s half dozen shareholders, Henry Goldman showed his creativity in finance: he developed the pathbreaking concept that mercantile companies, such as wholesalers and retailers — having meager assets to serve as collateral for mortgage loans, the traditional foundation for any public financing of corporations — deserved and could obtain a market value for their business franchise with consumers: their earning power.

Quite simply, what we’re witnessing these days with the rise of revenue-based financing in SaaS is something similar to what Henry Goldman figured out for retailers at the beginning of the 20th century—except this time it’s for SaaS companies. Like United Cigar at the time, such companies don’t have assets that could serve as collateral for borrowing money from a bank. However, the now-robust discipline of SaaS metrics provides a kind of predictability in these fields: it’s now possible to forecast recurring cash flows and use them as collateral.

As in the case of Indie.vc, knowledge attracts different kinds of investors and gives rise to a specialized form of production capital. That means the entire SaaS sector is about to leave the realm of traditional VC, and this, too, contributes to the diffraction.

8/ Let’s take a final example, which I have already developed for paying subscribers: private equity, which is engaging more and more with tech companies. Let me just quote the ‘Round 1’ essay on that topic available in the paid section:

We all have the impression that IPOs are coming back. Still it’s not that easy: there are still the regulatory barriers, and there’s the dread inspired by the poor performances of the likes of Uber (which is understandable) and Slack (which is harder to explain considering the boom of remote working). Many tech companies, however mature, prefer to remain private for the moment.

What should happen when those tech companies are still private and yet have cap tables harboring early-stage investors anxious for an exit, while at the same time there are those private equity firms sleeping on giant piles of money like the dragon Smaug?  A match—and those firms redeploying their funds and upgrading their investment techniques so as to be able to make deals in the tech sector. And the reason I’m interested in this is because maybe it could be a solution for the lack of a clear path to exit for investors in European tech companies.

9/ All the examples above are part of what I call the diffraction of VC. There was a time when VC was a singular, standardized category in the investment world. But those waves of capital are about to be diffracted into many different forms that will only vaguely resemble VC as we know it. As in any industry first came the craftspeople and now come the industrialists—and the latter will bring forward what they always do best: knowledge, standardization, specialization, scale.

One question is: Will these various new approaches to financing tech-driven businesses be operated by independent, specialized entities, or rather by large multi-asset financial powerhouses? I think in the future, we could see a polarized market with players concentrating at both ends of the spectrum:

  • Boutiques of craftspeople will each remain focused on one narrow segment: either traditional VC, if there’s room for it (the Benchmarks of this world), or any other form of VC born out of the current diffraction (like OATV).

  • Then we’ll witness the rise of large, generalist firms integrating the different lines of financing (“interference between the wave forms produced”) as they will discover synergies either on the marketing side (same target with different needs along the way) or the financial side (like between equities and fixed-income in every large investment bank that serve clients with capital to deploy). As I wrote back in May last year, Andreessen Horowitz is clearly on that path.

Needless to say, everyone that tries to stand strong in the middle (not too big and industrialized, but not too small and craftsman-like either) will be wiped out. At least that’s my colleague Balthazar de Lavergne’s thesis: Why would any ambitious tech founder try to raise money from a mid-level firm that’s neither a boutique nor a multi-asset powerhouse with the ability to fund you over the long term and to bring operational support along the way?

10/ Why does the diffraction matter in Europe? Because, as always, we’re lagging behind! And because that’s the case, we’re imitating something that was relevant for Silicon Valley 10 years ago, but that might not be relevant today: a traditional, purist approach to VC—one that only dominated because we were pre-diffraction. So many of us have been fascinated by these first generations of craftspeople in venture capital that, for lack of imagination (or willingness to take a big leap forward), we’re still trying to emulate them—even as the Entrepreneurial Age reaches its “synergy phase”!

Instead, everyone in that world, especially in Europe, should keep two things in mind:

  • Software is eating the world, bringing tech founders into more difficult industries. This degrades returns and forces firms to reach profitability sooner. On paper it’s a boon for European tech companies that can’t operate at as large a scale as their US (or Chinese) counterparts due to the lack of a large domestic market. But in practice, we still lack the tools for financing more of those companies. And so we need to work on hastening the diffraction.

  • Meanwhile Silicon Valley itself is already moving forward and designing new financial products to serve companies with different needs: less scalability, more profitability. And this despite the fact that the large US domestic market makes traditional VC more sustainable than in Europe, even in more tangible industries and more regulated markets. The US VC industry is embracing the diffraction even though it would better fit the needs of tech startups in Europe!

So in conclusion: let’s speed things up, acknowledge the diffraction that’s currently happening, and diversify our approaches to deploying capital in tech companies. Europe, more than any other parts of the tech world, needs to adapt financing to a digital economy that’s growing more diverse by the day.

🎙 I’ve been a guest on several English-speaking podcasts over the recent period. Give a listen if you want to hear my voice rather than reading me 😉

🤓 Apart from Carlota Perez and Bryce Roberts, here are interesting contributors to the discussion on the diffraction of venture capital that I’ll highlight in my Friday Reads paid edition 👇

  • Alex Danco, who for a time worked with Social Capital’s Chamath Palihapitiya (himself a pioneer of the diffraction of VC), made a smashing contribution earlier this year to the discussion on the future of debt financing in the tech world.

  • Tim O’Reilly, who (among many other things) is Bryce Roberts’s partner in OATV, provides a great description of traditional VC, why it’s delivered so much in the past and why it’s now falling short in our transitioning economy.

  • Elizabeth Yin, of Hustle Fund, frequently writes down her thoughts to help founders decide between different paths as they raise funds. Her recent pieces highlight the broadening range of funding options in that regard.

👉🏻 To discover their articles and many others related to today’s edition, become a paying subscriber! The package will be sent to subscribers only with the forthcoming Friday Reads edition 🤗

From Private Equity and Tech: Time to Bridge the Gap (June 2020):

These days I’m working on private equity, in the narrow sense of the term—that is, buyout firms rather than venture capital firms. The end goal is to write an “11 Notes on Silver Lake”, to be published in a few weeks. In the meantime, I’m collecting my thoughts as to why private equity could be the key to the problem with late-stage liquidity in Europe. 

This is a hypothesis I first voiced while having lunch a while back with a friend who’s an investment banker in Paris. This is what he replied (essentially):

No way. PE guys wear suits and ties; tech guys wear hoodies. There’s simply no way those two groups can do business together.

Since then, I’ve been collecting articles, reading books, and talking to many people in the know, and I’m starting to collect my thoughts.

And in case you missed it:


From Le Havre, France 🇫🇷

Nicolas