Do VC’s Back Startups?

17 min readFeb 5, 2019

Executive Summary

While innovation cluster theory puts great emphasis on access to capital for technology focused start-ups, conventional wisdom assumes that this implies venture capitalists (VC’s) play the key role in providing capital in any regional economic development plan that a country or region writes to create its leading innovation cluster(s). however:

VC’s focus the vast majority of their capital on established, emerging-growth companies that are already far beyond their formation and seed phases.
This tendency is being exacerbated as ever larger amounts of VC capital are going to pre-IPO and later investments.
Conversely, the majority of US start-ups that do receive organized funding in their initial phases, receive that funding from accredited angel investors — In each of the last 3 years angels exceeded $22 billion in funding (2014 $24.1 billion, 2013 $24.8 billion, 2012 $22.9 billion).
Over the last 3 years, an average of 35% of the angel capital has gone into the Seed or earlier stage of investment or $25.1 billion over the three years compared to just 3% of VC capital.
Recently incubators and accelerators have emerged to play an important role especially in the very first formation phases of a start-up’s life cycle however, they provide only modest funding.
While equity crowdfunding may offer an additional future source of start-up funding, to date it has focused on real estate and peer to peer lending with technology start-ups representing a minority of the modest equity capital committed in the US.

The implications for US Innovation and Entrepreneurial Policy should be:

Those writing regional economic plans in the US at the national, state or local levels need to be clear that their plans will not succeed without the creation of a large and vibrant angel community in their region.
Innovation cluster strategies must, consequently, include ways to accomplish competitive advantage in attracting angels to invest in the innovation cluster.
Conversely, less is needed with regard to VC focus — the VC’s invest after companies have been made VC investable by angel investors by which time the company can raise funding outside the geography of the cluster.
US lawmakers and regulators should put more emphasis on finding ways to incentivize and motivate citizens with the potential to be angel investors to become so.
More can be done in terms of encouraging today’s angels to invest more — for example, the small business capital gain exemption could be extended and a parallel small business capital loss program could be put in place.

In conclusion, in the US and around the world growth in the economy, jobs, and human well-being are being driven by innovation and the formation of start-ups focused on bringing these innovations to market. These start-ups are being backed by angel investors — not by VC’s or by other means; regional economic development plans focused on stimulating clusters of innovation need to directly reflect this fact. Within the US, federal, state and local governments can do more to stimulate growth if they reflect on this reality and build their plans accordingly.

Context

Since 1990 when Professor Michael Porter of Harvard University wrote “The Competitive Advantage of Nations” building upon the centuries older works of Alfred Marshall and Adam Smith, the notion that industry clusters can build relative competitive advantage for a country or a region has become a broadly accepted notion. In parallel, it has also become broadly accepted that clusters of innovation should be prioritized in most regional economic strategies. This is due to technology being viewed as the driver of innovation and advances in human well-being in most economies today, as well as the basis for new business formation, GDP growth and job creation (OECD 2011, 2012 and 2013).

As a result, leaders and policy makers in most countries today believe that stimulating the formation of local clusters of innovation, and encouraging the formation of technology focused start-ups is the key to moving their economies forward. As countries and regions around the world have focused on strategies to increase the strength of their clusters of innovation across areas ranging from information technology, to life sciences to clean technologies and beyond, they have focused on five principal pillars for their strategy. Typically, the resulting cluster of innovation strategy includes statements revolving around each of these five pillars such as:

Build a world leading innovation capacity through encouraging research and development in government owned and private research facilities, and by encouraging private sector R&D through grants, investments and incentives
Make available scientific breakthroughs to entrepreneurs through translational science initiatives, centers for technology licensing and commercialization and provide grants and non-dilutive funding for start-ups
Attract investment capital and stimulate the local VC community to act as sources of capital for startups seeking to commercialize on the scientific breakthroughs created by the innovation capacity of the cluster
Support the creation of a deep supporting ecosystem made up of professionals such as lawyers, IP attorneys, accountants, consultants and bankers with cluster relevant expertise as well as industry associations and non governmental organizations to support the entrepreneurs and the start-ups in the formative phases
Encourage larger companies to assist by asking them to support the innovation cluster as well as act as go to market partners and potential acquirers of VC backed companies

While government can make innovation capacity a reality through funding universities, professors and research programs, and entrepreneurs are usually willing to take scientific breakthroughs and turn them into new and innovative companies, many clusters are still born when capital is not forthcoming. The reaction is usually that Governments focus on working even harder to court and attract leading VC’s to support these clusters.

But Do VC’s Back Start-ups?

The traditional model of start-up funding has always held that investors in technology companies at inception include the entrepreneurs themselves, their friends and families, and angel investors who are willing to invest their own money into the new companies. Later, early and late-stage VC funds may become investors in these start-ups, but only do so once the company has matured to a point that it is considered investable by the VC.

However, in the main, people simplify this multi-part funding cycle into a simple premise — VC’s back start-ups. But this has been changing very rapidly and, as a result, the conventional wisdom is now misleading.

According to the most recent Dow Jones VentureSource report for the 4th quarter 2015, VC’s have effectively stopped seeding most start-ups in the US:

For the full year 2015 US VC’s invested $72 billion but only into 3,916 companies.
While US VC’s invested an enormous $17 billion in the 4th quarter, this capital was only distributed amongst 902 companies.
Of this $17 billion, the majority went to pre-IPO companies and not start-ups. For example, Uber alone raised a $2.1 billion round (with significant Chinese backing), and the median valuation of the later stage companies US VC’s backed was a staggering $957 million — a far cry from the valuation of any start-up.
While US VC’s also made investments in rounds closer to the start-up phase (the Series A and Series B rounds), these investments were made at median valuations of $12 million and $117 million for the A and B rounds respectively. Again, high valuation levels that indicate that these are no longer true start-ups but, rather, emerging growth companies.
This last quarter VC’s backed fewer companies than in any of the last 13 quarters but the dollars put to work were the fifth highest in that same period.

The PriceWaterhouse and NVCA MoneyTree report for 4th quarter 2015 shows similar data although they do not capture all of the expansion capital activities of their VC members such that their totals for VC activity are lower than those of Dow Jones VentureSource:

74 megadeals of more than $100 million each represented a very large portion of the US VC investment capital deployed in the 4th quarter.
10 deals alone took approximately $2.2 billion in funding, or 19% of the total of $11 billion that MoneyTree says was invested by VCs in the 4th quarter.
VC capital invested in Seed-stage companies totaled only $375 million across 52 deals in the same quarter (or an annualized rate of around $1.5 billion).
Just 3 percent of all venture investment dollars now go to Seed-stage companies and almost none in formation capital (the first money used to form a start-up).
The average Seed-stage deal in the 4th quarter had a valuation of $7.2 million, up from $4.1 million in the third quarter — also implying that VC Seed-stage deals are either closer to a typical Series A round, or that VC’s have become very generous in their valuations of start-ups.
While VC’s backed 1,400 companies in the 4th quarter that had not received VC backing before, almost all of those companies had raised capital from other sources in order to reach a VC round.

In short, today US VC’s are focusing their efforts and capital on emerging-growth companies and very few start-ups receive any funding from VC’s until they can justify valuations in the many millions of dollars. VC’s simply do not deploy material capital into the start-up phase of a company’s life cycle in the US (Formation and Seed-stage funding). Instead, US technology companies will need to have moved a long way beyond a business strategy — they will have established their company, formed their founding team, built their initial products, perhaps have begun to serve customers in the marketplace, and might even be generating substantial revenue — before a VC will consider them for an investment.

VC’s back very few start-ups

What Changed?

After the 2008 crisis US VC’s were confronted by a substantial shakeout and a flight of capital to leading firms. The best VCs got much larger while others, in the face of this flight of capital, ceased to invest and instead focused on their existing portfolios. Many VCs went out of business all together. As the National Venture Capital Association Yearbook points out:

The number of VC funds in the US is today only 1,206 down from 1,803 in 2004 while the number of firms managing those funds is down to 803 in 2015.
The number of active VC professionals today has decreased 36% to 5,680 from 8,964 in 2004.
Interestingly, while the number of professionals has declined, the money managed has increased. The average firm now manages $195 million and the largest fund raised was a whopping $6.3 billion.
In 2014 alone, the VCs raised an additional $29.9 billion which they need to invest.

This trend of fewer funds and fewer professionals managing ever larger sums of money gives rise to some simple consequences:

VC’s prefer to put larger amounts of money into each deal that they back — their average check size is going up very quickly and now stands at $18.8 million.
In addition, while the larger VC firms are backing more companies, they are doing so in later stages — instead of investing in start-ups at the formation and Seedstages, they are investing in those companies later in their life-cycles.
Many VC’s are putting the bulk of their money to work in well-established later-stage growth firms or as pre-IPO capital — essentially what used to be known as expansion capital investing.
Furthermore, many VC’s are also participating in “non venture related investments” including investing in debt, buyouts, recapitalizations, secondary purchases, IPOs, investments in public companies such as PIPES (private investments in public entities), investments for which the proceeds are primarily intended for acquisition such as roll-ups, change of ownership, and other forms of private equity that are not even captured in the statistics of the NVCA.

In short, and with a few exceptions, VC’s have become expansion capital investors, rather than start-up investors. And this is unlikely to change given the massive amount of capital that is today managed by US VC’s.

If Not VC’s, Then Who Does Back Start-ups?

The US Small Business Administration office of advocacy defines a small business as having less than 500 employees. By this definition, there are more than 28 million small businesses in the US. Of these 28 million US small businesses, relatively few are technology focused. However, Professor Jeffrey Sohl at the University of New Hampshire tracks new business formation in the US that is backed by angel investors. According to his annual research, in 2014:

73,400 businesses (in contrast with the 3,916 backed by VCs in 2015) were backed by angel investors with $24.1 billion in funding.
In each of the last 3 years angels exceeded $22 billion in funding (2014 $24.1 billion, 2013 $24.8 billion, 2012 $22.9 billion).
Over the last 3 years, an average of 35% of the angel capital has gone into the Seed or earlier stage of investment or $25.1 billion over the three years.
316,600 angels were active in backing these businesses.
Most of these businesses were technology start-ups: 27% were in software, 16% in healthcare services, medical devices and equipment and 10% in IT services.
In addition, other sectors backed by angels such as retail (9%) and financial services (8%) also include many technology enabled businesses.

By the relative numbers it can be seen that angels are much more important for most companies in their start-up phase of life compared to VC’s who, for the most part, only invest in angel-backed companies once they have significant traction that justifies larger investment rounds. Professor Robert Wiltbank of Willamette University is the author of the annual Halo Report which analyses the investing activities of the US Angel Capital Association’s members. In 2014 he found:

The mean angel round was $725,000 in the 3rd quarter 2015 — a fraction of the VC mean investment of $18.8 million in the 4th quarter of the same year
The median valuation at the time of investment was just $4 million compared to the hundreds of millions reported by Dow Jones VentureSource for the US VC’s

When analyzed by round of investment, Angels are backing true start-ups in their formation as well as in their Seed and sometimes Series A rounds. Conversely, very few angels follow on invest into the subsequent rounds (Series B and beyond).

The angels of the US are seeding most US technology start-ups.

The Rise of Incubators and Accelerators

Due to the emergence of digital technologies, an increasing number of people have felt able to start entrepreneurial ventures — on the one hand the costs of doing so have greatly reduced, and on the other hand the twin forces of globalization and digitalization have expanded addressable markets to the point that start-ups are able to serve customers globally almost from the day they are founded. It has never been easier to launch a new technology enabled company.

However, with VCs investing later, and angel groups selective with the number of formation phase start-up firms led by first time founders that they choose to become involved with, there has been a gap in the funding environment for start-ups. First time founders need some capital, but much more importantly they need a great deal of education, mentorship and access to capabilities for their start-up. And they need a place to base themselves too.

While some angel groups provide these activities, the great demand across the US from first time founders has led to new models in which some combination of a place to base the company, an environment of support and mentorship, and perhaps a little funding allow for a higher likelihood of moving past the first six months of entrepreneurial formation activities.

Incubators and accelerators have become this alternative for many first-time CEOs. While somewhat simplified, the distinction between incubators and accelerators is that incubators generally have a non-competitive selection process, are non-profit, last 1 to 5 years, and focus on formation to Seed stage companies. Conversely, most accelerators have a highly competitive selection process, are generally centered around an investment business model, last 3–6 months and have intense mentorship programs on-site. There are many alternative models within this new and emerging field, however, some dimensions across which they vary include:

They may have a physical space or they may be virtual in nature.
Some focus on providing office space only while others focus on the acceleration activities.
Some charge a monthly or weekly fee for space — perhaps $600 for a desk with access to shared facilities but do not take equity. This is the “real estate incubator model as used at WeWork and RocketSpace.
Others take equity (Often in the 5 to 10% range) and may provide a small cash grant (Typically between $25,000 and $50,000). This is the “equity based accelerator model” as practiced by Y-combinator, TechStars and 500 start-ups for example.
Some may have follow-on funds that can invest in the Seed or even Series A rounds of those companies that they see getting the most traction — though most start-ups in incubators and accelerators do not move into these phases.
Additionally, some provide “access to innovation” services for corporate sponsors who want to “scout” the innovation ecosystem and perhaps discover companies for subsequent partnerships.

Angel Investors are an important component to this entrepreneurial ecosystem, and are actively involved as mentors and advisors for incubator and accelerator programs alike. In many cases, accelerator managers are also active angel investors who provide additional financing to some of the ventures, either directly or via a fund. In this way, incubators and accelerators work symbiotically with angels who are often actively involved in visiting the nascent start-ups and provide both financial and advisory support. All have active and invested interest in helping these start-ups flourish.

First time CEO’s need to be clear on what they are looking for before they begin to pitch to incubators and accelerators given this wide diversity of offerings. And they should be very careful about sharing equity unless they are sure they can not source similar support from their initial friends, family and angel investors — often for free. However, for many first time CEO’s this is a valuable new source of support in the early stages of life.

There is very little quantitative data regarding the funding of start-ups by incubators and accelerators. Based on a new study conducted by the Brookings Institution Metropolitan Policy Program:

Accelerators have experienced rapid growth in recent years in the US, increasing more than tenfold from just 16 programs in 2008 to 170 programs in 2014.
The 172 accelerators tracked by the study supported 5,259 companies over ten years, or an average of 525 companies a year (compared to 73,500 backed by angels).
The accelerators themselves provided $2.6 billion over ten years to the companies or an average of $260 million per year (compared to $24.1 billion provided by the angels in 2014).
While the annual capital made available has been growing as some accelerators such as Y-Combinator and 500 start-ups raise follow on funds, it is still believed to be less than $500 million a year in aggregate (excluding the capital provided by angels and VC’s to companies graduating from the programs).

So while incubators and accelerators play an important role in the ecosystem, and some, such as Y-Combinator and 500 Startups have become viable sources of capital, for the most part the start-ups receive their capital in the Seed round from the angel investors who engage with the companies emerging from the incubators and accelerators.

What About Equity Crowdfunding?

Over the last few years the US has worked towards making it easier for the broader population to invest in small businesses — to democratize start-up investing beyond organized VC funds and accredited angel investors. This has seen the passing of the “Jumpstart our Business Startups Act” or JOBS Act. First signed into law by President Obama in 2012, the act continues to be made into law as the SEC reviews and releases additional components of regulation. The JOBS Act as originally passed would, among other things, allow for:

An increase in the number of shareholders a company may have before being required to register its common stock with the SEC and become a publicly reporting company
Provide an exemption from the need to register public offerings with the SEC that would allow the use of internet funding portals including “equity crowdfunding platforms” (with certain limits on how much an investor can invest through these portals)
Create a new definition of “emerging growth companies” as those with less than $1 billion in revenues
Relieve these companies from some regulatory and disclosure requirements when they go public
Lift the ban on “general solicitation” and advertising of specific kinds of private placements

The JOBS Act has stimulated the formation of a very large number of “equity crowdfunding” platforms and businesses. While the potential may be significant in terms of providing additional avenues for start-ups to receive funding, the current progress is modest. Crowdnetic, which tracks the major crowdfunding platforms in the US, reports that from September 23, 2013 through September 23, 2015 (two years):

There had been 6.063 distinct offerings of which 1,596 were successful in raising commitments of $870 million for an average of $545,122 per successful issuer
California alone accounted for 472 of the successful offerings raising $270 million
The top three sectors benefiting were Real Estate Development, Real Estate Investment, and Oil and Gas Production and Pipelines — technology start-ups are not the leading recipients of equity crowdfunding at this time
The two real estate sectors accounted for $208.3 million of the $870 million (23.9%) in total commitments made through equity crowdfunding platforms tracked by Crowdnetic

So, while crowdfunding shows promise in terms of being a viable approach to backing start-ups, in practice the $870 million raised to date has seen a majority invested outside technology start-ups. Furthermore, that $870 million pales in comparison to the more than $74 billion the VC’s invest primarily in later-stage rounds and the $24 billion that the angels invest primarily in formation through Series A rounds.

The angels, for now, continue to be the principal backers of US technology start-ups

Implications for US Innovation and Entrepreneurialism Policy

So, to summarize, while innovation cluster theory puts great emphasis on access to capital for technology focused startups, conventional wisdom assumes that this implies Venture Capitalists (VC’s) play the key role in providing capital in any regional economic development plan that a country or region writes to create its leading innovation cluster(s). However:

VC’s focus the vast majority of their capital on established, emerging-growth companies that are already far beyond their formation and seed phases.
This tendency is being exacerbated as ever larger amounts of VC capital are going to pre-IPO and later investments.
Conversely, the majority of US start-ups that do receive organized funding in their initial phases, receive that funding from accredited angel investors.
In each of the last 3 years angels exceeded $22 billion in funding (2014 $24.1 billion, 2013 $24.8 billion, 2012 $22.9 billion).
Over the last 3 years, an average of 35% of the angel capital has gone into the Seed or earlier stage of investment or $25.1 billion over the three years compared to just 3% of VC capital.
Recently incubators and accelerators have emerged to play an important role especially in the very first formation phases of a start-up’s life cycle however, they provide only modest funding.
While equity crowdfunding may offer an additional future source of start-up funding, to date it has focused on real estate and peer to peer lending with technology start-ups representing a minority of the modest equity capital committed in the US.