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The Funding Gap for Middle Market Tech

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Until recent years, tech has been considered a high risk, high return zone best left to specialists. The earlier part of a tech company’s life cycle was restricted to venture capitalists and well-off individuals. Private equity activity was restricted to the later stages of companies, and buy-side participants tended to be either tech-focused funds and former tech executives.

Tech entrepreneurs have historically perceived two funding paths. They can bootstrap (maybe with a small friends-and-family round) or raise traditional venture capital in a series of rounds. Most aspiring entrepreneurs dream of the latter and it’s easy to see why. The media (and our culture) hypes up VC fundraising rounds. Investors are put on a pedestal as king/queen-makers. Our university and accelerator entrepreneurship programs steer founders to raise VC. Even debt options for younger tech companies have historically been predicated on raising that VC round.

 

But there has been a problem with how venture capital works. As David Spreng, a former Midas-list VC and now CEO of lender Runway Growth, recently said to me:

“When I was in venture, we would see a thousand deals a year. Only a hundred of those were a fit for venture capital, but many of the others had the potential to be really good businesses.”

The typical VC fund has one or two investments out of a portfolio of 20 that make the entire fund. It’s super-high beta. These power-law economics have made VC a perfect option for capital-intensive, moonshot startups, but the tech sector is much bigger and broader than that now.

Most businesses aren’t a fit for VC, but that doesn’t make them bad investments. Some businesses fail to raise deserved capital, and others raise from VC when they really should not have done so. Let’s call them the middle market of tech — companies that have the potential and desire to be more than “lifestyle” businesses, but which are unlikely to be “unicorns” with billion-dollar valuations.

The power law dynamics of venture funds drive businesses to chase unicorn-status. Potentially good businesses drive themselves out of business stretching too far, too fast. Boards turn down good exit options to go long, because a smaller return won’t solve their economics. Founders and employees dilute themselves to tiny ownership stakes, bury themselves under huge preferences, and then fail to achieve the kind of stratospheric exit needed to walk away with anything for all their hard work.

There is way too much wasteful “go big or go bust” behavior, but there are no easy villains here. There are plenty of VCs who try to be patient and flexible with their portfolios, but ultimately VC funds, especially the larger ones, have certain realities when it comes to their economics. These realities are simply not aligned with the middle market of tech.

However, VC power laws are not immutable.

The nature of tech companies has changed, particularly as software has impacted more and more industries. First, advances in software frameworks, dev-ops tools, open source technologies, and cloud infrastructure have made it far more capital efficient to start and grow your average technology company. Second, advances in entrepreneurial business thinking, led by Steve Blank and Eric Ries’ lean startup model, have helped entrepreneurs de-risk their ideas in far more capital efficient ways. Lastly, the tech world has long figured out how to shift from one-time license purchases to recurring revenue models, making their financials less lumpy and more predictable.

Capital abhors a money-making vacuum

The realization that there are stable revenues in tech has led to a rapid expansion in private equity and family office interest in areas that previously were avoided.

For example, Joe Liemandt, formerly of Trilogy Software and now the primary capital behind ESW, was one of the first to spot the economic potential inherent in stale enterprise software businesses. These once-hot companies were past their prime but had a long tail of cash flows due to captive customers loathe to change systems. When Joe started snatching these businesses up, he had little competition and could buy them very inexpensively. Since then, a number of PE firms have jumped into that game.

Constellation Software was also one of the first to realize the recurring revenue nature of small, highly-niche vertical SaaS businesses. They’ve rolled up these independent businesses into a $2 billion company. Several years ago, private equity firms wouldn’t compete for these assets because individually each company’s market was too small, but now PE is pushing down into these markets as well.

Things are also changing on the debt side. For example, David Spreng first co-founded revenue-financing company Decathlon to help fill the gap he observed, and now he has created Runway Growth. Runway Growth might historically have been considered venture debt, but they no longer require a venture capital backer to invest.

We’ve seen the expansion of PE interest in tech first-hand at Axial (the leading online marketplace for middle market M&A and investing):

In 2011, only 35% of our buy-side was interested in tech, as compared to 81% interested in industrials. In 2018, over 75% of our buy-side is interested in tech.

All the above activity is still focused on later-stage companies, not the early stage. You might argue that angels and so-called “micro VC” funds are filling this gap, but a lot of these investors are still aiming to back companies that steer into the VC path.

Closing the Gap

I talk to countless entrepreneurs and startup educators who see the same hole in the market. There simply aren’t enough entrepreneur-friendly funding options for tech companies with meaningful, but not unicorn, potential. If we know that capital spreads to seek new opportunities, then can we expect a revolution in early-stage tech financing?

The beginnings of it are happening. Most of the innovators are experienced VCs (Aligned Partners and Indie.vc) or entrepreneurs-turned-investors (Active Capital) who see the flaws in the current system and want to try a different approach. Lighter Capital is an example on the debt side, with their revenue-based financing for early stage companies. I also expect family offices to play an important role in filling this gap. They are increasingly investing directly into companies and have more flexibility without LP pressures. Kiplin Capital is an example of a family office already steering directly into this strategy of “lower individual returns but higher hit rates.”

A fair amount of the initial activity appears to be focused around enterprise (B2B) SaaS startups, because these companies can build stable revenue streams in a capital efficient manner, but this opportunity is much bigger. Every industry is becoming the tech industry.

There are a few challenges holding us back. First, many people don’t see this problem, and much of the industry’s incentive structure makes people not want to see it. However, it’s like The Matrix — once the veil is lifted, it’s hard to unsee it.

 

Another challenge is on the LP side. Institutional LP’s are understandably reluctant to try something new. Their need to put large check sizes to work also gets in the way. This leads to larger VC funds, which in turn leads right back to the problematic power-law economics discussed above.

Next, there is a dearth of people who know how to evaluate earlier-stage tech companies for the right kinds of risk. There are many people who know how to evaluate a mature tech company. There are many who can evaluate a startup for moon shot potential. But it takes a different skill set to understand, evaluate, and even teach de-risking techniques and early-stage operating efficiency. This talent and experience gap might be the biggest challenge for family offices or PE firms that want to take advantage of this market opportunity.

However, a certain amount of responsibility lies with entrepreneurs as well. It takes discipline to run a capital efficient business. It takes self-awareness and maturity to resist the hype and mythology that surrounds the unicorn path, and know when it’s not right for your business. A new mindset is also needed to run the experiments needed to de-risk a fledgling business. “Lean startup” concepts have been around for a decade, but most entrepreneurs still really struggle to put them into practice.

While the current model serves a few companies amazingly well, the market hasn’t caught up to a growing opportunity. Ultimately, I’m confident that this gap will be filled and entrepreneurs will be the better for it.  If you have a perspective on this problem, I’d love to hear from you at giff.constable@axial.net or @giffco.

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