The VC industry is best understood as a value chain. At the top are angel investors who chase early opportunities on the market. The bottom is where the value is realised, in the form of fees and carried interest paid by limited partners to everyone else situated further up the chain.
In the middle of this chain sit venture capital firms, which impose limits and constraints on all the other links. Limited partners have to agree with the offered terms if they want access to the best-performing funds. And those at the top, the angels originating investment deals at the earliest stage, have to comply with what VC firms demand: tech startups with exponential growth potential and enough room in their cap table to deploy the huge amount of capital necessary to succeed.
With the competition heating up, however, the VC value chain is going through a long-term trend of vertical integration. VC firms (in the middle) used to rely on angel investors (at the top) backing companies at the pre-seed and seed stages; they just had to wait until the most promising startups were ready to raise more capital and were passed down the chain.
More firms now prefer not to rely on free agents to do the hard work up the chain. Those precious deals are just too important
But more and more firms now prefer not to rely on free agents to do the hard work up the chain. Those precious deals are just too important, and VC firms are taking matters into their own hands. They are beginning to invest from their main fund at an ever-earlier stage; they raise new funds dedicated to signing first cheques; they partner with incubators and accelerators.
More recently, this vertical integration trend has included the widespread creation of scout programmes. VCs entrust these scouts with (a bit of) money to chase early-stage deals that established firms have a hard time making in-house.
Oil, diamonds and garimpeiros
In this regard, venture capital seems to be repeating the history of well-known extractive sectors such as the oil and gas industry or the diamond industry. In both of these cases, large corporations in the middle of the chain long remained focused on buying the stuff, transporting it, refining it and then marketing it to end customers. They were dominant players such as the infamous Standard Oil for petroleum or the legendary De Beers, whose shadow still looms large over the diamond industry.
At the time, these organisations didn’t really bother to integrate the difficult and risky business of extracting the raw materials from the earth. Because the probability of failure was so high and designing an industrial approach was so difficult, these extractive activities were best left to free agents: adventurous oil drillers in 19th-century America, or lone prospectors of rare minerals such as gold and diamonds (also known as garimpeiros in Brazil).
It was only later that vertical integration happened. In the petroleum industry, John D Rockefeller decided his beloved Standard Oil had reached a plateau in refining and transporting oil and he started to purchase the right to exploit vast oil fields across America. This triggered a radical upgrade and effectively transformed the whole sector into a proper industry. The days of lonesome risk-takers such as the legendary Erwin Drake, who drilled the very first oil well in the US in 1859, ended. And today searching for and extracting oil is a high-technology, capital and data-intensive, industrialised activity.
What will become of scouts?
Could the same happen to early-stage investing in tech startups? There are many signs that suggest it is happening. One is the proliferation of new approaches by established VC firms to address the pre-seed market — including scout networks. The other is the increasing amount of data that investors and others are using to map out the market and spot the best opportunities — exactly like advanced geoscience now helps oil companies discover new fields and assess their potential and value.
A third factor that suggests vertical integration is happening is how much more sophisticated venture capital is becoming. There’s a burst of newcomers, such as large investment banks (Goldman Sachs), established private equity firms (Silver Lake), radical innovators with indexing approaches (Tiger Global) and large legacy VC firms now diversifying under the form of hedge funds, permanent capital and lending.
If this is the new permanent state of VC, it will mean more money deployed, at a faster pace, across larger portfolios, with more data to back up investment decisions, and much more technology to conduct the whole business. In other words: a sector that will be more industrial than artisanal, and in which vertical integration up the value chain is bound to happen sooner rather than later.
What will become of scouts, then? Soon enough, the Standard Oils and De Beers of VC could decide that they’ve had enough of relying on oil drillers and garimpeiros up the value chain, and that they should do the whole thing by themselves, hiring employees (the geoscientists of VC) and incentivising them to discover and compete for the best pre-seed deals.
In this context, the proliferation of scout networks appears to be nothing less than a transitional phase, a prefiguration of a new industrial approach to early-stage deals. Scouts are still on the outside, but since they invest with VC firms’ money rather than their own, they don’t take as many risks as the free agents who once operated at the top of the chain. At some point, shouldn’t these garimpeiros of sorts be brought on the inside, thus completing the integration of pre-seed investment into the maturing VC industrial complex?
Nicolas Colin is cofounder of VC firm The Family. He writes a regular column for Sifted.