How The Traditional Venture Capital Pipeline Is Changing

Venture capital (VC) has largely become synonymous with innovation and startup growth. 

The money, prestige, and advice provided by VC firms have helped many entrepreneurs build their businesses and generate billions in profits. And although the Covid-19 pandemic initially slowed down investing, the market bounced back to break records in the second half of 2020. 

VC firms poured a record-high $130B into US-based companies in 2020. Huge VC deals like SpaceX‘s $1.9B Series J round and multibillion-dollar IPOs from VC-backed companies like Airbnb, DoorDash, and Snowflake consistently make headlines. 

Source: PwC and CB Insights’ Q4 2020 MoneyTree report

But VC is far from being the only game in town.

Traditionally, companies looking to grow have aimed to attract VC dollars, then attract more VC dollars in additional funding rounds, then eventually exit into the public market through an initial public offering (IPO) — a payday for venture investors. But in recent years, other forms of fundraising have gained ground as attractive additions or even alternatives to this traditional route.

Today, venture capital has become less of a necessity for startups looking to scale up quickly, and IPOs are no longer the sole end goal. In this report, we highlight the wide range of fundraising and exit options available to companies today. From crowdfunding and angel investments to private stock exchanges and SPACs, we examine the pros and cons of various investment mechanisms available to today’s businesses.

Table of contents

Why venture capital?

• What is venture capital?
• Benefits of VC funding
• Drawbacks of VC funding

Fundraising options are expanding

• Crowdfunding
• Angel investments
• Rolling funds
• Private stock exchange
• Going public: SPACs & direct listings

More funding options benefit founders

Why venture capital? 

Venture capital has grown into a major investment force across various industries. Many VC-backed firms have gone on to spur the growth of entire new market categories — like Uber in ride-hailing, Airbnb in home-sharing, and SpaceX in space transportation. These and other examples illustrate how the history of venture capital is marked by relentless innovation.

What is venture capital? 

Venture capital (VC) is an investment vehicle for institutional investors and wealthy individuals. VC firms pool money from these investors, also called limited partners (LPs), to form venture funds. These funds then buy equity in startups across various investment stages, with the hope of cashing out some or all of their shares when an acquisition, initial public offering (IPO), merger, or other liquidity event occurs.

VC investing is a high-risk — but potentially high-reward — activity. Two in three VC-backed startups fail, but those that succeed can be hugely profitable. Facebook is one such example: In 2005, VC firm Accel Partners acquired a 10% equity stake in Facebook for $12.7M. When the social media behemoth went public in 2012, Accel made $9B off its investment. 

Notably, VC investors are long-term players. They spend years funding startups through several rounds, hoping to eventually achieve market-beating returns. Many of these investments fail, but good VC firms know and expect it will take a lot of losses to find the rare, huge successes. These bets will generate the majority of a firm’s returns and cover for all the inevitable losses. 

At the initial seed stage, venture funding helps startups build a minimum viable product (MVP). In the next stage, capital is used to explore new business channels, refine the product, and expand into adjacent markets. Later on, startups raise funds to scale growth, buy competitors, or prepare for going public. In the final stage of VC-backed funding, startups exit through one of the aforementioned liquidity events.

Different stages of startup funding. Source: University Lab Partners

The bigger the market these startups target, the better. So it comes as no surprise that VC investments are most active in the B2B software, B2C software, direct-to-consumer (D2C), and life sciences industries — sectors with huge addressable markets and low upfront costs. Companies like Google and Slack have risen to dominance thanks in part to venture financing.

Benefits of VC funding

There are many reasons why startups seek VC funding. For one thing, banks are unlikely to offer loans to early-stage companies that have hardly anything to pledge as collateral, while VC firms go beyond financial statements when gauging a startup’s value. Unlike banks, they look into products, founders, and market-size estimates to decide whether to fund a startup. If they invest, VC firms get to own equity, and the startup can scale without incurring debt.

Many VC firms have a wealth of experience in overseeing early-stage businesses. Their mentorship can be invaluable, particularly for first-time founders.

Startups also benefit by getting access to a VC firm’s network, resources, and expertise. Andreessen Horowitz (a16z), for instance, provides startups in its network with a range of accounting and marketing services. GV, the VC arm of Alphabet, helps startups with product design and marketing.

Drawbacks of VC funding 

Some of the challenges in working with VC firms are caused by entrepreneurs giving out a lot of equity in exchange for money. Investors become partial owners of the company and are entitled to a percentage share of the price of the IPO, acquisition, or other liquidity event. The more equity investors receive, the less left for employees and management. If the startup ends up as a huge success, founders might have to give away much more money than they would have if they had taken a bank loan.

Taking on VC investment could also mean losing some control over the company. Investors typically sit as board members. They may want to influence certain business decisions, like when to launch products or how to achieve the exit.

And VC firms want huge returns. Companies may be pushed to achieve high month-over-month growth, burning cash to win customers. This pressure can negatively impact some companies. Moreover, not everyone is willing to chase breakneck growth.

For example, Arkadium, a US-based gaming startup, grew organically to 150 employees. In 2013, the company raised $5M in VC funding, lured by the prospect of easy money. But frictions arose as founders Jessica Rovello and Kenny Rosenblatt were unwilling to keep raising money and growing relentlessly with the goal of going public. Unable to come to terms with its VC backers, the company used its profits to buy out the investors and become independent once again in 2018. 

Another persistent problem in the VC ecosystem is the lack of diversity in investors. Around 90% of decision-makers at US-based VC firms are men — and this heavily weighted representation can lead to skewed results in terms of which entrepreneurs get funded. In 2019, VC firms invested $3.3B in all-female founding teams — merely 2.8% of the capital that went to US startups that year.

A RateMyInvestor report found that most VC dollars go to startups run by white men, while other studies have found that Black entrepreneurs start their businesses with a third of the capital provided to white entrepreneurs.

All this in mind, it comes as no surprise that some startups opt not to take venture capital. And they might not need to either, as the range of alternative funding options grows. 

Fundraising options are expanding

As VC funding has grown, so too have other fundraising avenues. Today, companies can choose from an array of different types of fundraising and exit options — including crowdfunding, rolling funds, and direct listings — that present attractive additions or even alternatives to the traditional VC funding route. Now more than ever, entrepreneurs can choose the options that best fit their needs, plans, and growth stages.

Below, we highlight some of these fundraising options and their implications for today’s entrepreneurs.

Crowdfunding (typically early-stage)

Crowdfunding is the act of raising money from many individuals to fund a project or company. This process involves smaller amounts of money and is typically conducted on popular crowdfunding platforms, such as Kickstarter or Indiegogo.

These and many other niche- or region-specific platforms have existed for some time, but the category has seen recent growth: Funds raised through crowdfunding grew nearly 34% year-over-year (YoY) in 2020, and crowdfunding-backed projects are predicted to top 12M campaigns annually by 2023, according to Statista.

In recent years, legislative changes have made crowdfunding an increasingly viable alternative to seed VC rounds — which tend to require larger amounts of equity relative to later stages. In 2016, the Securities and Exchange Commission (SEC) allowed startups to crowdfund up to $1.07M in one year from retail investors by issuing securities. This funding limit was increased to $5M in November 2020. With the average VC seed round sitting at around $2M, entrepreneurs can now use crowdfunding platforms to raise enough money to start their business.

Since 2012, companies have raised a combined $1.8B through crowdfunding. One of these is Oculus, now a subsidiary of Facebook, which launched on Kickstarter in 2012. The VR company was seeking $250K but ended up raising $2.4M, before being purchased by the social media giant two years later for $2B.

Crowdfunding can go hand-in-hand with traditional VC funding, particularly at the later stages, when companies may decide that the support network or additional capital provided by VC firms is vital for continued growth. For example, Glowforge, a 3D laser printer manufacturer, ran a $28M Kickstarter campaign in 2015, setting a record for monthly funding on the platform. At the same time, it has raised multiple funding rounds from VC investors True Ventures and Foundry Group since 2015, which have gone toward supporting its product development and delivery plans.

Unlike VC investments, crowdfunding means founders don’t necessarily have to give up ownership control. Startups can opt for donation-, debt-, or rewards-based crowdfunding, with the last type being the most well-known. Investors are offered incentives, such as a significant discount for products or services the company is building, in return for their money.

The benefits of crowdfunding extend beyond financial ones. With crowdfunding, companies can better accomplish the following:

• Gauge interest: Having investors — who are also potential customers — fund the company is a sign that a business idea is worth pursuing. Success in crowdfunding may prove to be vital for securing subsequent funding rounds.
• Build brand: Early backers are often great startup evangelists. They’re passionate about ideas and are likely to spread the message about a crowdfunding campaign they’re a part of.
• Execute ideas: Instead of pitching multiple VC firms and negotiating with many stakeholders, a crowdfunding campaign reaches millions of people via a single pitch. Entrepreneurs can quickly collect money and execute their startup ideas.
• Mitigate risk: Even if a crowdfunding campaign fails, founders won’t end up in debt and will have full ownership control. They can then more easily pivot to new ideas.

All this aside, crowdfunding is not without risk for entrepreneurs: roughly two-thirds of Kickstarter projects fail to meet their funding target.

Other risks involved in crowdfunding include:

• Reputational damage: An unsuccessful crowdfunding campaign may signal to other investors that a company is not worth investing in or doing business with. It can be hard to get rid of this negative perception.
• Lost customers: If a company fails to live up to the initial promises it gave to early backers, it risks financial and legal troubles. The company also risks turning loyal fans into critics just when it needs them the most.
• All-or-nothing funding: Some platforms, such as Kickstarter, require projects to get fully funded. Failure to meet a funding goal means that money is returned to backers. Without meeting that funding goal, all their prelaunch efforts could be in vain.

Angel investments (typically early-stage)

Like crowdfunding, angel investments typically take place early on in a startup’s funding trajectory, although they too can go hand-in-hand with traditional VC rounds.

Angel investors are high-net-worth individuals who invest in small startups and entrepreneurs, usually in exchange for part ownership. These investors are typically accredited and have over $1M in assets or an annual income of $200K+. Because angel investors usually use their own money when investing, their checks tend to be smaller than those of VC firms that pool money from multiple LPs.

While angel investing has been around for some time, like crowdfunding, this route has seen growth in recent years. In 2020, angel investors poured $2.7B in equity funding into nearly 1,500 deals. This is a slight decline compared to a peak of $2.9B in 2019, but nearly twice the funding levels seen in 2016. Furthermore, the average angel deal size continues to grow year-over-year.

It used to be the case that angel investors were primarily family or friends of the founder. But startups can now tap into a wider network of wealthy individuals, often from the startup world themselves, who are willing to bet on risky ventures. 

One leading figure in the angel investment community is Naval Ravikant, the co-founder of AngelList, a platform that brings together angel investors, startups, and job-seekers. Ravikant has invested in over 160 companies and has seen more than 50 exits.

Other notable examples of angel investors include Marc Benioff, founder of Salesforce, who has invested in a range of startups including Thrive Global, Zuora, Compass, and Gigster. He has made over 130 investments and achieved 30+ exits. Meanwhile, Marissa Mayer, former Yahoo CEO, has funded nearly 30 startups with 5 exits. Mayer’s investments include Cleo, Triplebyte, The Wonder, and Alma Campus.

Angel investors Naval Ravikant, Marc Benioff, and Marissa Mayer.

Popular celebrities have also been known for their angel investments. Ashton Kutcher, Nas, Troy Carter, and others make an ever-growing list of celebrity startup investors.

Some companies backed by celebrities benefit from being able to get their names out there more easily. Meat alternative company Impossible Foods, for instance, has been backed by a number of celebrities, some of whom — like Katy Perry — have taken to Instagram to promote the company.

 

Source: Instagram

New startups are cropping up to make the angel investing process easier. OurCrowd, for instance, is an online platform that brings startup opportunities to its investor members. Investors then choose deals to invest in and can easily build a diverse portfolio of startups. The platform requires members to commit a minimum of $10K per deal, which is much lower than typical VC deals. OurCrowd also helps already funded startups by providing industry experts as mentors.

Like crowdfunding, angel investments can augment later funding from VC firms — and possibly give companies that might have otherwise been passed over the lift they need to grow.

Rolling funds

Rolling funds are similar to traditional VC funds, with a few key differences. Rolling fund managers raise money continuously and, unlike traditional funds, don’t have to raise all of their capital upfront. This makes rolling funds more flexible: they can invest as soon as they receive even a fraction of the planned capital. VC firms, meanwhile, might have to spend months or years to convince LPs to invest in funds, and then are typically given a timeline of 8-12 years to invest in companies and achieve exits. 

Rolling funds are open to accredited investors, and LPs can increase, stop, or decrease their commitment on a quarterly basis (rather than being forced to lock up their cash for a decade).

Source: AngelList

Rolling funds also benefit investors by being easier to run compared with venture funds. For instance, AngelList shoulders a large part of the legal paperwork for rolling funds launched on its investment platform. Fund managers then have more time to search for startups to invest in.

With many of the barriers to investment removed, it comes as no surprise that rolling funds are taking off. Popular entrepreneurs and tech executives are particularly eager to raise capital and support new startups. In July 2020, a group of entrepreneurs led by former Facebook exec Dave Morin started Offline Ventures. This rolling fund aims to raise $50M in its first year and will require a minimum quarterly commitment of $25K from investors.

Another example comes from Sahil Lavingia, CEO of online selling platform Gumroad, who raised $5M to start his own rolling fund. Lavingia aims to invest in startups across various sectors, including B2B, commerce, SaaS, and developer tools. The minimum subscription amount in the fund is around $31K quarterly. 

“[VC firms] say they like disruption. But we’ll see how much they like disruption when they’re the ones getting disrupted.” — Sahil Lavingia, Gumroad CEO and founder of Sahil Lavingia Rolling Fund

Rolling funds benefit entrepreneurs by increasing the competition for deals. Startups may then have more leverage to secure better deal terms with outside investors. And because they raise money continuously, rolling funds are not incentivized to pressure startups into selling to achieve returns in a specific timeframe. 

But rolling funds remain modest in size. Startups in later stages may still need VC firms to provide huge sums of money to rapidly scale business. And despite the rising popularity of rolling funds, they’re still a nascent investment mechanism. It remains to be seen how well they will perform.

Private stock exchange (typically secondary market or later-stage investments)

A private stock exchange enables shareholders of a private company to sell their stock. Mature startups may use this option to reward founders, employees, and early investors instead of raising mid- or late-stage VC rounds or looking to exit.

Pre-IPO shares are in particularly high demand. Employees who own these shares can list them for sale on a private stock exchange if they need cash and don’t want to wait for IPO. For example, a company can organize and approve a one-off auction open to these employees and then specify how many shares they can sell. The auction is also an opportunity for individuals outside of VC firms to invest in private businesses. And with employees cashing out their stocks and no longer pressing for an IPO, the company can decide to delay an IPO or funding round. 

Some startups are aiming to make it easier to value and sell stock options for employees. EquityZen’s platform, for instance, allows shareholders of pre-IPO businesses to sell their equity to accredited investors. This pre-IPO equity marketplace has over 200K shareholders and investors. EquityZen provides its users with company price history and valuation, among other data points.

Carta, an equity management startup, has also developed a private stock exchange platform, CartaX. The platform will start listing businesses in Q1’21. Discussing the reasons behind this initiative, the head of business at CartaX, Andres Trujillo, and the general manager of Carta’s valuation business, Chad Willbur, wrote,

“As more and more capital is piling into the most attractive companies later and later into their lifecycle, the typical catalysts for going public are diminishing. This means that for early employees and investors, the time to exit is extending and as a result, pre-exit liquidity is increasingly important.”

A private stock exchange allows startups to have more flexibility when it comes to rewarding key stakeholders, and allows founders to take companies public only when they believe it is the best moment to do so. But with employees and early investors selling their stock options, founders and CEOs will have to welcome new partial owners of their companies. These partial owners may want to have a say in how the business is run and won’t necessarily back the current business strategy.  

Going public: SPACs & direct listings (exit stage)

After years of raising funds, developing their products, and expanding their client base, companies — and the investors backing them — may find going public to be an attractive next step. Today, companies are not limited only to the traditional IPO process to do so, with SPACs and direct listings offering potentially faster and simpler routes to the public market.

A special purpose acquisition company (SPAC) is a public shell corporation set up to raise money through an IPO, then merge with a private company, and take it public. SPACs are typically launched by a group of investors, called sponsors, who pool money from other investors. Sponsors look for the target company to acquire only when they collect enough money.

SPACs offer a number of advantages to startups that want to go public. Unlike a traditional IPO, the SPAC route offers more certainty because companies can negotiate a purchase price instead of leaving it to market forces. Speed is another factor. The merging of a SPAC and the target company takes 3-4 months — significantly less time than a typical IPO, which can take anywhere from 24-36 months. And some SPACs offer experienced leadership and expert teams that can help companies navigate a post-IPO landscape.

In 2020, SPACs raised over $80B in the US IPO market — outpacing traditional IPOs — across 200+ deals. Total SPAC proceeds also enjoyed year-over-year growth of over 500%.

And 2021 could be another record-setting year: In December 2020, there were 210 SPACs in the process of seeking acquisitions, all with 18-24 months maximum to find and buy the target company.

SPACs can also provide high returns to sponsors and investors. Some of the best-performing SPACs in 2020 included the following:

SPACs with the highest returns in 2020. Source: FactSet via Investopedia

The rise of SPACs, however, poses a challenge to venture capital. High-growth companies can get liquidity without relying on VC firms. Chris Douvos, founder of venture fund Ahoy Capital, explains that venture investors could miss out on funding mid- and late-stage private rounds if more startups go public earlier than before using SPACs.

“Generally speaking, venture capitalists are extremely mediocre public-market investors. They’re much better mentors and long-term partners in companies that have much more measured cadence that startups do while they’re private.” — Chris Douvos, founder of Ahoy Capital

Some VC firms, such as FirstMark Capital, Ribbit Capital, and Lux Capital, have also become SPAC sponsors — enabling them to support startups from private funding stages through a public exit — although this isn’t the norm yet.

A direct public offering (DPO) is another way for startups to go public. Companies that launch a DPO self-underwrite their securities and avoid intermediaries, such as investment banks or underwriters — saving costs along the way. Startups independently decide on the settlement date, the price, the offering period, the minimum investment per investor, and other terms.

Slack opted for a direct listing. Source: Personal Capital

In the past few years, several high-profile companies debuted on the stock market using a direct listing:

• Spotify: The streaming service went public in April 2018.
• Slack: The workplace messaging app had its stock market debut in June 2019.
• Palantir: The big data analytics company listed via DPO in September 2020.
• Asana: The workplace management platform directly listed in September 2020.

One of the drawbacks of a direct listing is price volatility. The share price isn’t negotiated previously, and the stock can thus trade across a wide range of prices. But companies with stable finances and decent prospects are well-positioned to overcome initial price volatility.

More funding options benefit founders

The investment landscape is getting more competitive. Today, entrepreneurs can — and do — choose from a wider number of funding options and opt for those that fit their business philosophy. Hypergrowth is no longer the only acceptable path forward. Startups now have a better chance of finding investors that support sustainable growth.

More entrants into the startup investment business means more competition for deals. Founders will be in a better position to negotiate terms when raising capital. They can ease exit pressure and avoid selling companies prematurely.

Growing fundraising vehicles that augment or replace venture capital are thus a major transformative force. How this expansion plays out long-term is anyone’s guess. But giving entrepreneurs access to ever more options for financing and strategic support means they’ll find it easier to bring their creative vision to life and keep the wheel of innovation spinning.

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