Despite the stratospheric increase in venture capital funding over the past year, early-stage funding of tech start-ups has actually decreased.
CB Insights’ State of Venture report for the third quarter of 2021 showed that global venture capital had reached nearly $100bn in the three months covered. Investment deals are frequently $100m-plus as investors chase later-stage deals in a bid to garner short-term gains by backing a unicorn. There are more than 900 unicorns in the world today, according to CB Insights.
However, all of this comes to the detriment of a shrinking pool of seed funding. CB Insights found that early-stage funding is actually declining and even posits that Silicon Valley – ground zero for risk-taking venture capital – is suffering a shortfall of Series A capital. In 2021 early-stage deals are at a seven-year low as a percentage of total Silicon Valley deals. Historically, Silicon Valley has been the incubator for the world’s innovative technology breakthroughs.
In the pursuit of short-term returns, current venture capital trends might well be blocking the future innovation pipeline.
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Give institutional investors a shot at early-stage investing
If venture capital doesn’t stay true to its original philosophy of unearthing early-stage innovation, alternative seed funding sources need to be identified. In September 2021, the Bank of England’s Productive Finance Working Group published a road map for increasing productive finance investment in the UK, which recognised that the UK's pension funds have not traditionally been able to invest in less liquid assets, with a particular focus on direct contribution pension schemes.
The report highlighted an important issue. Pension funds should be able to capture the value of early-stage tech investing. At present, the average worker only has exposure to public markets and is excluded from the real gains, which remain the exclusive domain of venture capitalists, private equity and industry insiders.
Take Canadian pension fund Omers, which has a venture arm investing in early-stage tech start-ups. Global managing partner Damien Steel says it is currently the only pension fund in the world investing in early-stage funding but hopes that others may follow. Omers' portfolio includes Hopper, DuckDuckGo and Wefox.
Pension funds by their very nature play a long game, so they should be ideally suited to venture investments that traditionally have a long feedback loop. However, it does require a different type of investing mindset. Unlike other asset classes, early-stage tech investing returns are driven by outliers. Any investment strategy targeting average returns will not produce sufficient returns to warrant the investment programme.
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The greatest barrier for institutional investors to invest directly into early-stage tech is a lack of willingness to attract and retain top talent who are experts in this specific space. This requires a different structure in the business; funds that are unable or unwilling to create these internal structures should instead invest indirectly through existing asset managers targeting existing venture capital opportunities.
Don't mess around with the life savings
What of the risk involved in investing hard-earned pensions? Steel says Omers has managed to limit risk by limiting exposure. For example, Omers' venture fund represents only a very small part of the fund's overall asset make-up, so the risk is small, but with venture-level returns, the potential reward is huge.
In addition, the operation becomes high risk if institutional investors aren’t willing to do what is required to attract the right team of experts. Early-stage technology investing requires highly experienced investors with a unique mix of operational and investing backgrounds. The market for this talent is fierce, but those asset managers willing to do what is required to attract this specialist talent will reap the highest returns.
If policymakers around the world provide financial regulation that allows pension funds to invest in early-stage technology, this alternate source of long-term funding will help maintain the innovation pipeline, and the short-term wins of late-stage funding in pursuit of unicorns will not threaten future innovation.
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