VCs, Sears, and the disappearing middle market
A few weeks ago, I was chatting with Satya Patel of Homebrew about trends in the venture capital industry.
For reasons you’ve probably heard before -- startups require less money, Angel List has opened the industry, etc. -- he predicted the VC industry would shift from resembling a standard distribution curve with a large middle segment to an inverse curve with an emphasis on the lower end. The industry would evolve into lots of early-stage firms competing with angels at the bottom, a thin mid-level, and some healthy big time players at the top.When I considered the ramifications of this trend, and how most middle-tier firms have been responding to it, it occurred to me we’ve already seen this play out in the larger economy as a whole, and that VCs can learn a few things from the businesses that have come out on top as middle markets have declined.
Some of you might remember when Sears was the quintessential department store and a dominant force in retailing. Shopping there was part of the fabric of American life. Today, it’s a shell of its former self. Purchased by Kmart in 2004 in a merger of two languishing companies, Sears has been selling off assets amidst losses for years. Once the store of choice for the middle class, it has seen its customers depart for Walmart and Target at the low end, and Barneys, Saks, and specialty shops at the high end -- much like Satya’s predictions about the future of venture capital, the middle market where Sears operated hollowed out.
While the root economic causes are different, VCs can learn a lot from the decline of Sears and the middle market. Success can be found at both ends of the new inverse distribution curve, but as Clayton Christensen taught us, when an industry is being disrupted, half measures of reaching out to the bottom or attempting to superficially rebrand as a prestige firm aren’t going to work for mid-tier funds any more than remodeling stores worked for Sears.
Currently, there’s a tendency to view the early stage arena as a bubble and a train wreck waiting to happen. While it’s true that hype has attracted a flood of neophyte investors, a large part of this critique comes from incumbent middle-tier players who think they can buck the changes coming to their industry. Again, this is the classic incumbent reaction. Entrenched players always dismiss the rising low end disruptors just as Sears dismissed Walmart. And we all know how that turned out.
Even with all of the noise and dumb money, investing in the low end can be very profitable. But contrary to the undisciplined approaches currently being applied at the angel and seed stage, it requires well considered methods and exceptional skill.
I know that sounds like I'm stating the obvious but there are a lot of people piling in with ill-conceived ideas. The difference between someone like John Frankel at ffVC, who has produced outsized double digit annual returns for 10 years, and someone throwing money at an Angel List syndicate is like the difference between running Walmart and selling at a flea market. Both play to the low end of the market but one is a precision operation that produces huge returns while the other is run like a hobby.
At the other end of the market are the big money prestige funds. Consider the signal value that comes from an a16z investment versus a lesser branded fund. Some of my investor friends have told me that some well known VCs and angels provide zero, and even negative, signal value. The benefits of taking money from a fund such as Sequoia or Accel should not be underestimated. Additionally, not many firms can make a $25 million seed investment like Benchmark. Mid-tier funds simply don’t have the deep pockets and can’t offer the intangible benefits of a high end player regardless of how much they talk about their positioning.
Obviously I haven’t covered the details of either strategy. The point of this post is to show that the VC industry is bifurcating in a similar manner as other markets with the middle being disrupted from the bottom, per Christensen’s theory, and the high end pursuing a business model based on prestige and service.
Both ends of the market can be successful but very specific strategies must be followed in each. Mid-tier funds that haven’t fully committed to a low end strategy and don’t have the prestige, power, or dollars to establish themselves as a high end firm will find it increasingly difficult to compete.
Much like Sears’ disappearing middle class customers, these firms are catering to a disappearing class of entrepreneur. Posturing and arguing against the viability of the disruptors won’t be enough to save them.