“The key to making great investments is to assume that the past is wrong, and to do something that’s not part of the past, to do something entirely differently” – Don Valentine, Sequoia Capital
Are you following the herd?
Ask any VC investor today: chances are they will tell you they invest in Enterprise B2B SaaS Startups.
Why? Because it makes sense, right?
The business model makes sense: high margins and recurrent revenue. The track record makes sense: there have been plenty of exits happening all over the world. The market opportunity seems to make sense too, with Covid-19 forcing corporate staff to depend increasingly on online tools.
Most importantly, today everyone understands SaaS businesses. We live, after all, in a business world run on Slack, Zoom and CRMs. Besides, if you are an investor and wait for the business to start selling subscriptions and generate $1m+ in annual revenues, you don’t even need to understand the tech behind it that much. At the end of the day, there are customers and an “addictive” recurring business: a business that’s already creating strong cash flow, with no need to ship physical products to keep selling to any given customer.
With all these factors coming together, it seems almost a no-brainer that most investors out there should focus on investing in such businesses.
It’s not just the “traditional” VC funds either. These days Corporations and Family Offices of High-Net-Worth individuals are also increasingly investing directly in startup businesses, and guess what? Most of them only want to focus on B2B Enterprise Software-as-a-Service companies with an established clientele (aka Series A+ startups).
Have all these investors found a way to have a “low-risk / high-reward” investment plan?
Maybe not.
As a recently published Tech Crunch article says, perhaps the era of “easy money” made by investing in Enterprise SaaS could be over.
The author, Danny Crichton, correctly points out that the larger returns we are seeing today for SaaS portfolios are unlikely to repeat themselves. At least not to the scale and frequency seen so far.
The big threat in the short term is simply price: SaaS investing has gotten a lot more expensive. It may be hard to remember, but just a decade ago the business model of “Software as a Service” was revolutionary. Much in the way that it took years for cloud infrastructure to take hold in corporate IT departments, the idea that one didn’t license software but paid by user or by usage over time was almost heretical.
For investors willing to make the leap into the space, prices were (relatively) cheap. Investor attention a decade ago was mostly focused around consumer web and mobile, driven by Facebook’s and Twitter’s IPOs. Whilst every investor was chasing deals like Snap(chat), the “contrarian” investors targeting enterprise SaaS (or even more exotic spaces like, gulp, Fintech) got great deals on what would later become the decade’s biggest unicorns.
As Warren Buffet would say, they were being greedy on deals that most where fearful about. Back then, investing in Enterprise SaaS B2Bs was the exception to the rule, not the subtitle to 90% of LinkedIn investor profiles.
According to Crichton, there are other reasons why investing in this market segment may not be the “free lunch” it looks like at first. Ultimately, though, the point of this article is not to dissect the pros and cons of focusing on Enterprise SaaS B2Bs for an investor in the 2020. What I would like you to consider, instead, is whether investing in what “everyone agrees” to be the ‘trend’ is the actually best way to drive returns in venture capital.
Trends, Hypes, and VC returns
By running the largest tech community in the UK (Silicon Roundabout), I have seen other trends come and go, with new markets go from obscurity to mainstream. There is hype. Investors flock.
But just as the “promised land” looks only a few steps away, the mirage then disappears.
I mentioned Fintech before: today that’s another investment focus everyone (especially here in the UK) seems to be having.
Problem is: today’s unicorns did not start out last year. Investors and consumers alike when they think Fintech, they probably think “challenger bank” or “payment platform”. Well, good luck finding one today and muscle in against big names VCs at Series A.
This was not always the case. At a Silicon Roundabout meetup, for example, we hosted an obscure tech startup back in 2016 that got 100s crowd-investors to fill in their round A. That startup is still around and is called Monzo. You might have heard of them as one of the UK tech unicorns these days. By then, another big name in Fintech, Transferwise, had only managed to raise a few million in Series B because very few investors would want to look into Fintech.
Today, though, the year is 2020. 5-6 years in venture capital is a loooong time.
You probably don’t need to be a tech investment genius to know that making money from the deals everyone chases is probably not a smart decision.
When I was working as a software engineer, for example, I invested some money in real estate. Even there, you can only “beat the market” if you find properties to develop in an up-and-coming area… But only before the papers or the TV call it so!
Going back to tech and startups, we witnessed many an example of great disruptors presenting at Silicon Roundabout over the last decade, which happened to be largely ignored because it was not “trendy” to invest in their innovative market opportunities at that time. Then hype would pick up and everybody would be chasing and fighting over the same type of deals.
Remember Blockchain?
The “blockchain hype” in 2017 was a great example of this phenomenon because it was pretty rapid and spectacular in its trajectory from geeky movement to hyper-inflated speculation and then back to something very few VC investors would touch.
We witnessed first hand in our startup community how only technical people would even experiment with blockchain before 2015. Even mining bitcoin was something obscure. I remember mining some in 2013 as a young deveveloper, after accidentally bumping into the whole thing by reading too much reddit and geeky forums after 9pm (please don’t ask what happened to my private keys though ?). In Silicon Roundabout some other devs took it seriously enough to build new tech with the underlying concept, but the average investor barely knew the whole thing even existed.
Then came 2017 and even banana-republic startups with no tech whatsoever managed to raise several million between ICOs and highly valued VC and Angel rounds.
Today I’ve seen perfectly good and serious startups being turned away by investors because they “use blockchain”.
The whole AR / VR movement more or less went through the same cycle over a much longer period of time.
If we look at what this cycle of hype-er-attention provokes in the VC market, what we then observe is that: the strongest the investment trend, the higher the competition for the best deals. Also, since many investors follow other investors in co-investment deals and VCs have normally a limited time to deploy capital, the higher the chance of picking a sub-par deal or a deal which is overfunded when the actual market is not ready to adopt it.
The Art of Picking the Right Market Opportunities (at the right time)
As the late Don Valentine would say: “I like opportunities that are addressing markets so big that even the management team can’t get in its way.”
To quote Warren Buffet once again, the opposite is also true: “When an industry with a reputation for difficult economics meets a manager with a reputation for excellence, it is usually the industry that keeps its reputation intact.”
What Don Valentine was saying is that even a subpar management team can win in a market that is really big that is exploited early. And, of course, a first rate management team in that same situation will do even better.
In venture capital, therefore, it seems that picking the right market when the hype has not already spoiled the party is what would help a fund managers reap the best results.
Do we have any data to back this up?
The short answer is “Yes”.
According to Nada et al., 2020, historical data suggests that differences in where, when, and at which stages venture capital firms invest account for much of the overall persistence in performance across VC firms. In other words, those investors who manage to show consistent high returns over time, seem to achieve this mostly by picking the right investment focus.
May be this the explanation for the strong returns often showed by emergent VC investors with an innovative approach and no “past success” bias to defend?
It is definitely something worth considering. Especially since the COVID-19 pandemia caused an accelerated disruption across industries and entirely new technology applications around machine intelligence and quantum computing are seeding the development of entirely new markets.
What we can say for sure, by looking at past cycles, is that if most investors and VC news only seem to be focusing on something… Perhaps you should consider if that’s the “future” of technology, or rather its recent “past”.