The rise of VC Megafunds

(last updated April 2019)

Over the years, there’s been a tremendous increase in the level of entrepreneurial activity, mainly due to the technological advancements and the increase in the number of people leaving their day to day job in search for a greater opportunity. But mainly, technology has been the main driver that is paving the way for this entrepreneurial growth as seen by the powerhouses such as Amazon, Google and Apple. This trend has also contributed extensively to the growth of the Venture Capital industry and the size of the deals across all rounds. This trend in higher deal sizes have led to the growth of Megafunds.

“Megafunds are an inflated version of a normal sized fund where there is an extremely large pool of money and it is driven by super-sized financing of rounds.”

There are a number of questions that can be raised from this current trend. Firstly, what exactly is causing Venture Capital firms to invest large amounts of capital into companies? Secondly, what are the repercussions on the VC industry as well as the entrepreneurial space since the growth of the Megafunds?

What’s causing this disruption?

Recently, there has been an emergence of Mega VC funds due to the pace and activity in the tech industry. In March 2018, Sequoia Capital was raising $12bn for it growth and venture fund in the US and China. It also set a minimum of $250 million check size for its limited partners to participate in its growth fund. This is all in the efforts to build their “War chests” to compete against the Goliath that is Softbank’s $100bn Megafund. With this trend in the growth of larger funds there are a couple of repercussions to both the VC industry as well as the entrepreneurial space.[1]Besides Sequoia, many other VCs are following suit with this trend in raising Megafunds. For example, Battery Ventures raised $1.25bn for their two new funds and General Catalyst is targeting its largest fund size ever at $1bn. One thing that is evident is that there is no shortages of capital available to back Venture companies across various stages. But the question that this raises is, is the capital invested evenly across all stages or only in a certain stage?[2]

Below is a dataset of invested capital across the earliest funding stage (seed) to a later funding stage (Series D):

Starting with the data from the Seed stage, we see that the amount of capital invested is increasing at a diminishing rate at 50% from 2009 to 2014 and then about 10% from 2014 to 2017. Similarly, the number of deals increases at a similar rate at 42% from 2014 to 2017 but it has a sharp decrease at a rate of 14% from 2014–2017. With Series A & B, we see similar to the seed stage, the capital invested increases sharply but the deals decreased only moderately. In Series C, the deals are down moderately but capital invested went up moderately. Lastly in the Series D, the deals are down moderately and the capital invested is also down slightly. What this data tells is that all rounds (with the exception of Series D) follow the same trend of an increase in capital invested and the decrease in the number of deals. This tells us that lesser companies are receiving funding due to deal sizes going up implied by the increase in capital being deployed. We also see that this trend is most evident in the earlier rounds. Also, we observe that in the Seed and Series A stage, the average deal size is being driven by the more recent years, which is concurrent to the growth of Megafunds in 2017.[3]

According to Patricia Nakache from Trinity Ventures, Megafunds are changing the fundamental structure of the industry rather drastically.

She mentions that over the past three years, there is this division between the “haves” and “have nots” with some companies struggling to raise money and some that are able to raise a significant amount of money. However, what the Megafunds have done is create another layer called the “super haves”; companies in this layer are usually in a different league than other companies which ultimately leads them to becoming untouchable. The change in mindset for Early stage VC companies becomes whether they think the company can become a “super have” instead of just a “have”. This change creates more barriers for entrepreneurs as VCs would have higher expectations for their returns. An example of a super have would be WeWork; They recently proved their superiority by acquiring Conductor, a content marketing platform which works with larger enterprise clients. To compare the difference between a “have” company and a “super have”, we can look at their rival, Industrious. They have a total Venture funding of around $142million while WeWork has a total Venture Funding of around $6.9billon. Thus, even if companies have strong venture backing, they are outmatched by the super haves who are backed by Megafunds.[4]

With a Megafund such as Softbank Vision fund, they would expect to have much higher return relative to the amount they are investing. The two problems this creates are that companies will tend to be more overvalued and that a lot of companies are unable to get funding. This is caused by VC firms looking over early stage companies(Series B, C, D etc) and focusing on later stage companies for higher returns. Data from Crunchbase says that later stage companies are seeing most of the deals now with 64% of all VC money heading towards late stage companies, while the early stage funding have fallen to its lowest in the past five years. As shown from the graphs above, even with the increase in capital invested, we see fewer deals due to VC firms looking for the next super have to come through.[5] This change in landscape can be seen in the graph below:

We see that it used to be that VCs would lead the Series A round even before any traction so as to provide the company with funding to begin its operations and get over certain obstacles(as mentioned earlier). Now, Megafund investors expect companies to already have these things in place before even going into a Series A funding. What this means is besides the lack of capital, founders are also lacking the guidance and support needed from these VCs during the hardest period of their company’s life cycle stage. VC firms have so much experience in dealing with the challenge that these entrepreneurs are facing at this stage which is why on top of capital, their mentorship is crucial to these founders. For the valuation, since the main driver for the increase in number of deals is by the increase in deal size, it becomes the multiple that drives up the price of the company rather than its EBITDA.

What’s in store for these VC Megafunds?

Looking at the future trends, we can continue to see continual change in the landscape of the VC industry due to Megafunds continuing to focus on later stage companies and as well as VC firms growing their funds larger and larger. We can also expect an increase in Seed funds that will capture the remaining market that current VC are overlooking. In regards to the entrepreneurs, they would have to be aware and cautious of accepting funding from Megafunds while still in their early stage due to the lack of guidance that will receive. The trend of Megafund is certainly changing the venture capital and entrepreneur landscape. In particular, for the VC industry there are certain implications and takeaways :

• Given the Megafunds continuous focus on later stage companies, we can expect an increase in seed funds that will capture the remaining market that bigger VCs are overlooking
• Investing such a large amount of money means that the ventures will have a high valuation. Founders have a significant pressure on their shoulder to live up to those expectations and increase the company value even more. In a way VCs are favoring an environment where founders are more focused on the short term gains, rather than the long term. Entrepreneurs have very little room for error, as it might destroy value and lead to a down round in the next financing round.

While for the startup world, Megafunds bring on different considerations:

• Given the uncertainties associated with an early stage venture, a founder should seek smart money, rather than passive capital. Investors that provide smart money are not only providing capital, they are also providing guidance, expertise and business introductions.
• Given the high invested capital that a Megafund gives, entrepreneurs need to be wary of sky-high valuations. If the venture doesn’t live up to the high expectations, it can significantly suffer in the market.
• This also means that if the venture doesn’t perform as expected, entrepreneurs will have a much harder time to find an interested investor and raise money

[1] “This Venture Capitalist Says SoftBank Is Creating a Subset of ‘Untouchable’ Companies.” Fortune, Fortune, fortune.com/2018/03/07/patricia-nakache-trinity-ventures/.

[2] Wilhelm, Alex. “Why Some New Mega-Funds May Make Sense.” Crunchbase News, Crunchbase News, 19 July 2018, news.crunchbase.com/news/why-some-new-mega-funds-may-make-sense/.

[3] Ian Hathaway. “What’s Driving the Increase in Average Venture Capital Deal Sizes?” Ian Hathaway, Ian Hathaway, 15 Feb. 2018, www.ianhathaway.org/blog/2018/2/14/whats-driving-the-increase-in-average-venture-capital-deal-sizes

[4] “This Venture Capitalist Says SoftBank Is Creating a Subset of ‘Untouchable’ Companies.” Fortune, Fortune, fortune.com/2018/03/07/patricia-nakache-trinity-ventures/.

[5] Voices, Valley. “Venture Capital Is Losing Sight Of Its Most Important Investments: Seed-Stage Entrepreneurs.” Forbes, Forbes Magazine, 20 Nov. 2018, www.forbes.com/sites/valleyvoices/2018/11/16/mega-funds-create-seed-gap/#213dd7467892.