Venture Capital Thematic Investing: Risks and Pitfalls
"Successful investing is about managing risk, not avoiding it." - Benjamin Graham
Venture capital (VC) has long been characterized by a focus on trendy ideas and markets, often leading to inefficient capital allocation. Investors frequently ask VCs about their investment focus, pushing them to articulate smart-sounding theses like AI, cryptocurrency, SaaS, fintech, or digital health. Consequently, capital gets funneled into these limited buckets, creating overfunded, competitive landscapes for startups within these labels.
How Market Inefficiency Manifests
This market inefficiency manifests in several ways:
Overfunding of Trendy Sectors: Startups that fit into popular investment themes receive substantial funding at high valuations. As a result, multiple well-funded companies emerge, competing intensely for the same customers and market share. This leads to reduced margins and often unsustainable business practices as these companies fight to differentiate themselves.
Neglect of High-Potential Outliers: Innovative startups outside these predefined buckets often struggle to secure funding. Despite their high potential, these companies are overlooked because they don't fit the current investment narrative. This neglect can result in missed opportunities for significant returns as these outliers face less competition and can dominate their niche markets if they succeed.
Pressure on VCs to Conform: VCs feel pressured to develop and present investment theses that align with current trends to attract funding from Limited Partners (LPs). This conformity stifles creativity and risk-taking, essential components of discovering truly disruptive innovations.
The Risk of Following the Crowd
By conforming to these investment theses, VCs might have suboptimal returns. Any thesis that sounds appealing to LPs is likely already saturated with capital. Therefore, investments in these areas face stiff competition and diminishing returns as too many players vie for a limited market.
Historical Perspective
Historically, the most successful investments have often come from outside the conventional wisdom of the time. Companies that did not fit into any defined investment thesis could carve out significant market niches and achieve substantial success with little to no competition. Examples include early investments in tech giants like Amazon and Google, which did not fit the prevailing investment narratives at their inception.
The stories of Canva, Airbnb, WhatsApp, SpaceX, and Dropbox illustrate that persistence, innovation, and a willingness to take risks are crucial for startups. These companies faced significant funding challenges but ultimately transformed their industries, highlighting the potential rewards of supporting unconventional and innovative ideas.
Airbnb: Founded in 2008, Airbnb initially struggled to find investors who believed in renting air mattresses in people's living rooms. After several rejections, the founders persevered, eventually securing funding and growing the company into a global hospitality giant.
SpaceX: In its early years, Elon Musk's SpaceX encountered significant skepticism and funding challenges. Despite multiple failed launches and financial difficulties, SpaceX secured contracts with NASA and achieved remarkable success in the aerospace industry.
Canva: co-founded by Melanie Perkins and Cliff Obrecht in 2012, is a prime example of a startup that struggled initially to find funding but eventually revolutionized its industry. Melanie Perkins conceived the idea while teaching graphic design at university, where she noticed her students struggling with complicated and expensive design software like Photoshop. Determined to create a more accessible solution, Perkins and Obrecht launched Canva with a vision to democratize design for non-professional designers.
The journey wasn't easy. Before securing funding, Perkins faced over 100 rejections from investors. Her breakthrough came after meeting venture capitalist Bill Tai, who introduced her to key figures in Silicon Valley, including Lars Rasmussen, co-founder of Google Maps. This network helped her raise the capital to launch Canva.
Since its launch in 2013, Canva has grown exponentially. It offers an easy-to-use, drag-and-drop design tool that has garnered over 60 million active users and generated over 7 billion designs as of 2021. The platform's success is attributed to its accessibility, allowing anyone to create professional-quality designs easily. Today, Canva is valued at $40 billion, making it one of the most valuable startups globally.
Strategic Implications for Investors
For investors and VCs, this analysis suggests several strategic implications:
Broadening Investment Horizons: Investors should consider a broader range of opportunities instead of concentrating solely on trendy sectors. This includes being open to unconventional ideas and markets that do not fit into popular investment themes.
Encouraging Innovation: By providing capital to outlier startups, investors can foster innovation and potentially uncover the next major success story.
Risk Management: Diversifying investments across various sectors and themes can mitigate the risk of overexposure to any single saturated market.
The venture capital industry must recognize and address the inefficiencies created by thematic investing. By broadening their investment focus and supporting high-potential startups outside trendy themes, investors can achieve better returns and drive greater innovation.
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Disclaimer
Private companies carry inherent risks and may not be suitable for all investors. The information provided in this article is for informational purposes only and should not be construed as investment advice. Always conduct thorough research and seek professional financial guidance before making investment decisions.
