Innovation in VC will come from outside of Silicon Valley

There has been an ongoing debate for the last 5 years on whether or not the VC (Venture Capital) model is broken, as reflected in the poor performance of this asset class during the last decade against comparable public stock indexes or their IRR (Internal Rate of Return).

A high concentration of the sector´s returns from very few elite Venture Capital firms and the disappearance of mediocre VCs unable to raise new funds, unmistakably signal that the rules of the game have fundamentally changed.

Some of these structural transformations in the Venture Capital industry are:

1. The initial costs of launching Internet-enabled startups have dropped 50 times in the last decade. What used to require one million dollars in seed capital just to begin testing the concept; now can be done with twenty thousand dollars. These highly “capital-efficient” startups combined with the enormous opportunities created by structural disruptions of large markets, represent today one of the most attractive areas of investment. This is clearly reflected in the amount of funds that this asset class has attracted in the last couple of years.
2. Information Technology is becoming a commodity. Low cost and universally-available modular software components allow a small group of developers to build sophisticated products over a weekend. By the same token, engineers are becoming commoditized as well.
3. New methodologies from Silicon Valley allow a scientific approach to market and product validation in a very short period of time, reducing considerably the prime risk in any startup: market acceptance.
4. The decline of these entry barriers has altered the startup ecosystem, where traditional angel investors are losing access to deal flow that is captured (or even generated) earlier by incubators, and the subsequent follow on investments are provided by institutional “super-angels” in lieu of VCs. The new players (incubators and “super angels”) are taking advantage of the more dynamic environment by substantiating higher returns on a broader base of startups funded (instead of the 3-4 deals per year typical of old-school VCs); and on potential early exits that capital-efficient startups allow (against the home runs that VC relied upon for generating the bulk of their IRR).
5. The changes described above have been initially evident for Internet-based startups, but as the inescapable Digital Revolution permeates the rest of the economy; they will affect practically all types of business endeavors. Eventually every new business project will be “Internet-enabled”, even if it is more clearly associated to manufacturing, retail, healthcare or finance. Some people still refer to Internet startups as “digital companies”. In the short terms there will only be “digital” and “digitalized” businesses. They will have in common one key driver: Distribution. This is where the Internet, Mobile and Social Networks have radically transformed the business landscape.
6. The intensity of this 21^st Century “Industrial Revolution” is overwhelming; this is not a new version of the dot-com bubble from the 90´s. This time the size of the wave is several hundred times greater than a decade ago and will cause an era of creative destruction where exceptional investment opportunities will begin to appear in large markets.

Disruptive innovation frequently comes from serving the “non-consumers”, which did not have access before to the existing product or service offering. It is very likely that genuine innovation in the Startup/VC industry will arise outside of Silicon Valley, from emerging markets with nascent ecosystems and limited resources, like Mexico.

Startup Factory, the first modern Internet incubator and early-stage seed fund in Mexico has been operating since 2010 in an embryonic ecosystem, which has forced it to adapt and discard conventional premises from Silicon Valley, as well as to create new models that ultimately reflect the current global investment realities. Relevant pieces of this learning are:

• Selecting the right market is the foremost step for any high-impact startup. This rarely can be done properly by immature founders; this is where Incubators and VC firms can bring a lot of value. Even famous Silicon Valley incubators like Y Combinator that operates in mature environments, recently requested founders to carry out projects originated by the incubator itself.
• The cost of experimentation to find a relevant problem within a market, identify the customer, the distribution channels and the preliminary solution, is much lower in emerging markets vs. Silicon Valley. Under these conditions it makes more sense to have a “testing laboratory” for projects without founders, and once the validation has occurred, bring in the founders with the right profile. This approach has also strong implications in the IRR of the early-stage VC fund, as a much higher equity position can be negotiated with the founder, as it has been demonstrated by successful incubators with internally-generated projects, such as Idealab in the U.S.
• Engineers as startup founders are oftentimes overrated. If the incubator has a strong inhouse staff of technical resources for all the different projects, a business founder (not necessarily an MBA) with a practical understanding of technology applications and industry experience, can oftentimes produce much better outcomes.
• The seed capital provided by incubators (around US$20 thousand) has to be automatically followed by a second post-seed round of US$150k to US$300k. If this does not happen in almost a continuum, the startup can easily die. This is the reason behind Y Combinator´s automatic US$150k convertible-debt facility to all their “startup graduates”, as a way to assure they will have a minimum runway to go on until the next, more likely, VC round. And this is one of the most critical funding gaps in emerging markets: spreading small bets in several projects is fun and sexy; waiting for the startup to generate significant sales and profits to put a couple of million dollars is comfortable for the VC; but injecting a few hundred thousand dollars into a company that still needs to demonstrate its feasibility is where few people want to take a chance. This phase needs to be highly compensated; it is the crucial leap of faith.
• Typically over 60% of the value of these capital-efficient startups should be captured by the investors at the seed and post-seed stages, following the premises described above. By the time a more traditional VC round (US$2-3 million dollars) would normally happen to capture 20-30% of the equity, it is possible that the startup would reach a valuation that would not make sense any longer for the VC or that would exceed the amounts that the fund covenants allow them to allocate (especially in emerging markets with small VC funds). This new generation of startups is growing very fast, reaching in a few years distribution levels (and the associated pre-money valuations) that other companies developed in decades. The time to capture the bulk of the value from this new generation of companies is at the early stage where the risk/reward factor is the optimal. This is the main reason we are experiencing a global rush into early stage investment.
• Operating in emerging markets forces you to think out of the box. One area that Startup Factory is actively exploring is erasing the artificial boundaries of digital and “bricks and mortar” businesses, experimenting with “digitalized” companies as explained above; that could include retrofitting existing companies acquired under a traditional private equity approach, and then repositioning their brands and assets with enhanced digital distribution channels.