I have been trying to reconcile two
trends I'm seeing. First, large
companies are acquiring venture-backed startups to accelerate their innovation
efforts. Even as the R&D budgets and
associated efforts of large corporations are increasing,
they have not been keeping up with the accelerating pace of technology and
business model innovation. These
acquisitions fall in two categories.
First, acquisitions as a means of jump-starting corporate innovation
efforts and getting corporations into the “innovation flow.” Good examples of such venture-backed company
acquisitions include Avis’
acquisition of Zipcar, Walmart’s acquisition of Kosmix and of
Small Society, Wellpoint’s acquisition of Resolution Health, and Home Depot’s recent acquisition of Black Locus. These
acquisitions are less about the technology being acquired and more about the
innovations the startup employees will be able to create once they are part of
the acquiring company. Second,
acquisitions as a means of staying in the forefront of innovation. Companies in this category are acquire
frequently in order to enter a new sector or grow a sector they are already
working on. Good
examples include VMWare’s
acquisition of Nicira, and Facebook’s
acquisition of Instagram. Finally, a growing number of corporations from
American Express to P&G, from BMW to GE, and Walmart to Best Buy
establishing operations in innovation centers, such as the Silicon Valley, in
order to tap into the startup and innovation flow.
Second, while the number of
seed-stage companies is increasing dramatically because their founders see
opportunities for a quick exit based on the first observation, the number of
companies that can receive expansion rounds and make viable acquisition
candidates remains small. This is
because
Many of the seed-stage startups that number
in the thousands and are funded primarily by non-institutional investors, i.e., entrepreneurs themselves,
angels, super-angels, friends and families, are not
innovating, don’t have no product roadmap, hypotheses of viable business
models, or even ideas of how to acquire and retain customers.
The
number of management teams that can be backed by institutional VCs for scale,
give the “escape
velocity” and make it a viable candidate for an exit that provides high returns
to a venture investor has remained small. As
shown below, the number of companies that receive additional rounds of funding
by institutional investors has remained largely unchanged in the past 2-3
years.
The
number of institutional VCs who can fund and materially help these early stage
companies is getting smaller. Fewer of
these institutional venture firms are able to raise new pools of capital particularly
capital that can be used for earlier stage investments. The Limited Partners (LPs) that provide the
capital to the venture firms want to take on less risk with the capital they
provide and they want returns faster. The thinking is that investing in later
stage companies shortens the time to liquidity while reducing the risk of the
investment. Because of the overall
venture industry’s returns have been low over the past 10-12 years, the
allocations LPs are making to venture funds have decreased and are now about
25% of their peak in 2000. LPs want to
invest in only a few venture funds that they consider as having the right deal
flow of early stage companies that have higher probability for meaningful
exits. So we are moving from an industry
with a broad investor base to an industry of specialists (SaaS specialists,
biotech specialists, consumer internet specialists, etc.).
Therefore,
because the number of the desirable startup acquisition candidates will remain
small, large corporations will need to find ways to foster innovation from
within. Corporations must also become
better at selecting which companies to acquire.
In this way will be able to identify companies that can provide the
desired innovation in the short term but also have the teams that will stay
with the acquiring company thus providing long-term benefits. The capacity of institutional VCs to invest
in seed-stage startups will not increase.
In fact, it may continue to decrease further. Rather than creating as many seed-stage
startups with weak teams, dubious innovations and no long-term prospects,
entrepreneurs must seek to form strong teams that can innovate and build large
and enduring companies.
