Thanks for the cash, everyone else: How Sand Hill Road is becoming Downton Abbey
I can't get over the two big surprises from my interview with outgoing NVCA president Mark Heesen we posted this morning: That a quarter of all the money flowing into venture capital is coming from international markets and, yet, the industry has become more geographically constrained, not less.
Like the very British traditions at Downton Abbey staying afloat with tacky American money, our vaunted American innovation engine that the rest of the world envies so much is increasingly relying on cash from all of those envying countries to keep going.
These two trends should theoretically be at odds. But venture capital is an inherently human asset class that doesn't operate the way things should in a perfect world.
The fact that there is this gap speaks to three things: The first is that for all the cynicism that a VC's "value add" is just marketing, brand and expertise still matters greatly in this business. Just having cash to invest doesn't make you a real investor, and most of the expertise is here, so the world's money looking to invest in venture capital is disproportionately coming here, even as it's coming from farther-flung places. Put another way: It's a sign of how much everyone wants the Silicon Valley seal of approval.
The second is that ecosystems take multiple decades to form and matter greatly. It's simply not a coincidence that the biggest tech companies continually come out of the same place and have for the last few decades. It's not a coincidence that the long-time second biggest ecosystem -- Boston -- has continually declined in activity, that Austin produces almost no consumer Internet companies of note despite hosting a social media spring break every year, that Seattle is still relying on its two mammoth hits of the past -- Microsoft and Amazon -- rather than using the talent and capital they created to branch out and create more giants.
To wit: The sector that is the most dependent on being in the Valley is the consumer Internet. This is notable, because it's the group that everyone keeps reminding us needs the least cash to get going, thanks to dramatic strides in capital efficiency. And it's also notable because other ecosystems have been repeating this hopeful phrase every since I've covered this industry: The Internet has made it so you can be anywhere and start a company!
Other ecosystems, particularly those in the US, have to face facts: The rise of the consumer Internet has made that less the case, not more. The reason a place like New York -- a rare city bucking this trend -- is excelling is because it's dropped the amateurish "Silicon Alley" moniker, and with it, the idea that it can compete in areas where the Valley is strong. Instead, it's focusing on strengths like finance, fashion, brand, and media. (Ditto, to an extent, early positive signs in LA.) Indeed, the early roots of New York's success go back to the ad tech exits of the late 1990s. New York isn't only playing to its strengths, it's building on them, and playing to the Valley's weakness: monetization.
The third notable thing is what it says about emerging markets. It's undeniable that eventually there will just be far more opportunity for growth in these markets. In less than 40 years the US will be the only member of the G7 nations that is still one of the seven largest economies in the world -- and we will not be the largest. More than half of the world's population exists in these countries, and more than half of them are under the age of 25. The relative growth as these populations surge into the middle class is unlike anything modern economists have ever seen. That fact that China is merely a part of this phenomenon is a humbling reminder of how massive this trend is.
I could argue a case that eventually more innovation will come from the emerging world too. Many VCs in the Valley would disagree with me -- maybe even all of them. But I mean innovation in the true sense of the word -- not just another photosharing app or an Airbnb for boats. When you look at what the huge problems are in the world -- climate change, water shortage, intense and rapid urbanization, shortages in agriculture, dysfunctional education -- these are all bigger challenges in these places. I'd argue entrepreneurs in the US simply aren't close enough to the problem to treat it like a priority. Add to that the fact that many other countries are prioritizing their governments developing and funding core R&D, while the US does less of that. (A major concern for the next head of the NVCA, Heesen said in our earlier story.)
All too often "innovation" as it's funded here includes things that excite teenage girls more than things that solve real global problems. Unlike some pundits, I don't knock VCs for that -- their job is to make returns, not necessarily make the planet a better place. And most of the pundits who judge them for that aren't exactly out solving sustainability problems themselves.
This is not to say Valley VCs are turning a blind eye to emerging markets -- not at all. There has been a rapid change in the last decade, where VCs have gone from investing almost only domestically to most of the major ones having some play in at least India or China, and increasingly many are jumping on the Brazil bandwagon.
This makes the phenomenon Heesen describes even stranger. The bulk of the money is leaving these markets, coming to fund a greater portion of US firms, and then an increasingly sizable portion is going back out to emerging markets where the greater opportunity is.
While on one level, US VCs have worked themselves out of a job when it comes to funding early stage consumer IT; they're apparently a crucial middle man when it comes to international investing. It's still a minority of the cash coming in and going out, but the trend line is dramatic. Many firms in the Valley are becoming a financial clearing house for private equity investment, analogous to how New York functions for the public markets.
The question is whether this is sustainable. If these two trends remain the minority of money in and money out, and the big consumer brands and exits continue to be homegrown and funded in the Valley, it probably is. Brand matters. International investors want to get in the next Google or Facebook and want to back the firms backing them.
But at least the money going in trend will become more pronounced. Because of the changes in pension systems in this country, as Heesen explained in our earlier story, VCs are increasingly relying on wealth in other countries. So far, they are not relying on returns from other countries, but that could change. Not anytime soon, but in another decade, perhaps. One of the Valley's most established firms -- Sequoia Capital -- used to be known for getting in every major US Web deal. While its US franchise is still strong, it has been seeing increasing returns come from its funds in Israel, India, and China.
If a greater portion of the money going in and the money going out are tied to wealth creation in emerging markets, you have to wonder how that plays out for the Valley long term. At some point -- it would seem -- local firms closer to the market will pop up and should become more dominant.
That's what we've seen happen in Boston. Even after returns declined, a lot of the money was still going to the venture talent that was already established there. That is changing now. Sure, a top firm like Spark may still be based there. But the bulk of its investing is done elsewhere. If it hadn't been early to leverage its proximity and jump on the New York resurgence, it could have fared much worse. Meanwhile other East Coast firms like Greylock have rapidly moved their center of gravity to the West Coast to stay competitive. Others have just faded away in brand and importance.
For the reasons I stated above, I think the ecosystem of Silicon Valley will remain dominant for some time to come. But humility is not our strength here, and we'd do well to recognize that it's increasingly the world's money that's going into our companies -- not our own.