Consider a easy truth: skilled investing requires an understanding of values. If you possibly can’t understand the value of an asset and the way it changes over time, you will not invest in it.
At one point, this understanding was a “moat” for enterprise capital firms. Those who could see value where others couldn’t were in a position to make decisions that resulted in excessive returns. Consider investors who saw the potential online markets in 1997, space industry in 2002Or cryptocurrencies in 2012.
There has been such an incredible growth in software investment over the last decade that it has completely distorted the way enterprise capital works and understands the world. Everything is now looked at through the lens of ARR multiples and SaaS growth rates. Many of today’s enterprise capitalists have not been around long enough to recollect a different environment.
This has led the entire asset class to massively scale and move away from fundamentally progressive ideas like the semiconductor revolution that created Silicon Valley.
The SaaS “boom loop.”
If your income as a VC is based primarily on management fees, Your encouragement is to acquire and mobilize capital as quickly as possible and to maximise the funds obtained and income from fees. In the past, this was limited by corporations that might only commit a certain quantity of cash to practical use. Acquisition took time and scaling took effort.
SaaS shattered this ceiling by introducing a model where capital could fuel growth through internet advertising for platforms that were essentially infinitely scalable. The extra money you set in, the faster the company will develop, the higher the investment will look and the easier it’ll be to acquire one other fund. This created a “benefit loop” for VCs that enabled the development of the mega funds we know today.
Enthusiasm for this incredible growth and the wealth it created began to vary practices. Perhaps the worst example of this is how raw ARR multiples have turn into the default pricing method as SaaS solutions have turn into effectively commoditized. The priority was to shut deals quickly, to not optimize the price, so discipline took a backseat. This would fundamentally change the way VCs understood value.
Unintended consequences
Not only did public markets not care about this era of investing (post-IPO investors care more about EBITDA or money flow than ARR), but in addition they made life much tougher for deep tech startups. Consider these two points:
- The VC’s goal is to make investments that triple or quadruple their value inside two to three years.
- VC investors understand value growth primarily through the prism of the ARR multiple.
So what does a company that spends years just doing research and development or building a product appear to be in this environment? They are unable to reveal revenue progress, so they do not obviously add value in the short term. This makes them unattractive to enterprise investors, regardless that they have a tendency to have much stronger and more durable competitive moats and marginalization, resulting in a smoother exit path.
All of this is a clear reflection of how enterprise capital has moved from “patient capital” creating lasting value to a short-term investor mentality characterised by increasing volatility.
Fixing any of those aspects would help put VCs back on track, but changing the underlying incentive to charge management fees would require a huge, fundamental change. Restoring VC financial discipline and adopting a more sophisticated approach to valuation could also be a more accessible short-term solution.