What draws venture capital funds to futuristic tech?
One of the top reasons for the start-up buzz to reach a crescendo is the easy availability of risk capital. Venture capital (VC) firms have increased in number and size, and the business of funding new-age companies often looks like a seller’s market. Despite that, VCs are often criticized for being neither creative nor supportive of real innovation. To understand what’s really going on here, we need to appreciate some of the non-obvious elements of the way the VC industry works.
The money that investors, called limited partners (LPs), allocate to VC funds falls in the high-risk-high-return segment of their portfolio. To make a mark, a VC in a developed economy such as the US would be expected to make at least an 18% return, so that after accounting for the ‘hurdle rate’ and ‘carry’, the LPs make at least 12-14% return. ‘Hurdle rate’ is a small return on capital, such as 6-8% per annum in which the VC doesn’t partake a share, and ‘carry’ denotes the share of profit a VC retains after deduction of hurdle rate and the return on investment given to the LPs.
In a country such as India, that 18% return would look more like 36%, owing to currency rate devaluation and greater perceived risk. And this astronomical return has to be generated from a portfolio where most companies fare miserably. To make the numbers work, the few companies that really perform well in a VC’s portfolio are expected to grow valuation by 50-100x in 4-5 years, thereby demonstrating a three-digit annual growth rate!
That leads to the obvious question: what kind of a business can yield that kind of growth? One common answer is: new age businesses. Without getting into a discussion around the many kinds of new age businesses, suffice it to say that futuristic tech is a major pick. This includes businesses that are built around emerging domains such as digital transformation, artificial intelligence (AI), Internet of Things (IoT), cyber security, renewable energy, and Industry 4.0.
Fund life cycles play spoilsport
VC fund life tends to be approximately 10 years. The first couple of years are seen as investment years, followed by another couple of years of portfolio management. And in the last few, funds have to exit their portfolio companies and wind up. When you hear about VCs shying away from taking risky bets in futuristic tech, their fund life cycle is the usual culprit. Many emerging technologies require a very long time to bear commercial fruit. In India, AI has been a buzzword in tech circles since the early 90s.
Yet a quarter of a century later, we have still to see the emergence of large commercial success. Drone start-ups were the flavour of the 2011-12 period. But years later, we can’t find even one runaway success. And the same is true for most new tech segments: a notable hot potato segment is wearables. The darling of investors a couple of years ago, start-ups in the wearables space find few takers today.
For a short period, I was the CEO of the business incubator at Indian Institute of Technology (IIT) Bombay, and was fascinated by some of the outstanding research being conducted there. Yet, VCs supported a very tiny fraction of inventions at IIT Bombay, as the distance from invention to commercialization was longer than VC fund cycles could support. This is a flaw with the VC model, not with IIT Bombay.
VCs make huge sacrifices at the altar of exits
Most of the common complaints about how VCs look at new tech arise from the mistaken assumption that it is the VC’s job to “encourage innovation” or “support disruption”. Sloganeering and social media posturing by top VCs perpetuate this myth. And myth it is, as generating returns for LPs is the fiduciary duty of the VC—something they can be held legally liable for. Along the way, if innovation gets encouraged or disruption supported, then that is a happy accident.
The overriding need to focus on exits explains why VCs are blamed for supporting me-too businesses, as opposed to true tech innovation. Occasionally, getting carried away by cool technology, at the cost of focusing on generating portfolio returns, in my experience, is a common mistake made by novice VCs.
If you look at the source of VC exits, it is dominated by secondary sales to subsequent investors, as opposed to initial public offerings (IPOs) and acquisitions. This is especially true in a nascent VC industry such as the one in India. If a VC knows that there is a huge probability that they will eventually sell their tech start-up investment to another VC, is it any surprise that the preferences of the downstream VC will play a big role in the decision to invest in the first place? That explains the investment-by-fad phenomenon that VCs sometimes seem to demonstrate, and also the hot-potato abandonment of sectors such as wearables.
As a result of all of the above, VC investment in futuristic technology remains an exception. More popular are shorter-term plays that primarily involve channel shift from offline-to-online, improving user experience, and digitizing the analogue.
Despite this, VCs do seem to be spurring on as much innovation in futuristic tech as large corporations. The latter have far more money and domain expertise, but they also have a disincentive to change the status quo.
Ajeet Khurana is an angel investor and mentor.
VC funds tend to focus more on short-term plays, but they seem to be spurring on innovation in futuristic tech as much as large firms