Derek Zanutto
It was 2013, and I’d been camping out in Uber’s San Francisco offices for weeks. Our team wanted to invest in the company on behalf of my private equity firm, but was utterly daunted by its “eye-popping” $1 billion valuation.
Back then, unicorns were a rarity and that was a far steeper price tag than we felt comfortable offering to a company in an as yet unproven market with no cash flow to speak of. After spending an additional two weeks in their offices conducting diligence sessions, the price tag rose even higher — to $3 billion. Despite our valuation concerns, we ended up making the investment. At the time, I never would have imagined that not only were we participating in the vanguard of a new industry — namely, ridesharing — but also, surprisingly, a transformation of the venture ecosystem.
Fast-forward a few years, and growth funds, defined as investments into companies that have achieved product-market fit and are primed to scale with further capital, have become significant forces in the tech ecosystem. They’ve invested in every major tech company that has gone public — Zoom, Slack, Uber and CrowdStrike, to name a few — as well as almost every single billion-dollar plus technology firm on its way to IPO. Given the current scale — growth funds poured $360 billion into startups in 2019 — it can be hard to comprehend that these funds were nascent only a decade ago.
Despite being relatively new to market, this investment category has quickly become one of the most active. It has also become one of the most confusing, as lines have blurred among early-stage VCs, private equity firms, hedge funds and dedicated growth-stage firms, all offering an abundance of capital and similar sounding value-add to high-growth startups. Based on my experience as a former private-equity-investor-turned-growth-stage VC, here’s a quick history on this young but massive industry, thoughts on where it’s going next, and suggestions for founders and startup executives seeking to understand the important but little understood nuances that will help them determine the right partner.
Reflecting back on any 10-year period in the capital markets can lead you to believe you’ve found new, unique, secular shifts in the way markets function. Zoom out 50 years and you’ll often find capital markets have a tendency to repeat themselves. Today, for example, later-stage funds, including those that primarily trade public stocks, are building teams to scout seed and Series A investments. Early-stage funds have assembled later-stage growth funds to double down on early-stage winners. While today lines are blurring across investment stages and funds, the reality is that private markets have seen similar trends before.
As an example, between the 1960s and 1980s, VCs moved later and ultimately invested nearly 90% of their capital in leveraged buyouts and late-stage financings before ultimately refocusing on early-stage bets in the 1990s at the dawn of the internet. As well-established funds cycled back and forth between early- and late-stage investing, “growth” emerged as a distinct asset class to target investments sitting in between early- and late-stage financings (roughly Series B to pre-IPO rounds).
This current growth cycle began in 2009 when Facebook accepted a $200 million check at a $10 billion valuation from DST. At the time, Facebook’s valuation shocked many investors, but then it went public in 2012 at a $100-billion-dollar valuation and is of course worth over $700 billion today.
But Facebook was only the start. There was also Uber and Airbnb. When I helped spearhead an investment in Airbnb in 2014, I was completely distraught over the “massive” $10 billion valuation. Of course, these big bets paid off — so much so that the entire growth category reoriented itself toward hypergrowth, capital-consumptive business models. The momentum clearly continues today.
Deciphering each firm type’s version of value-add
Companies now have a broad array of funds from which to choose when evaluating private market financings. Here are the four broad categories of funds most active in growth investing and the use cases in which they can provide the most value to their investments:
Dedicated growth firms
Funds like CapitalG came into their own in the 2010s and were built to support Series B to pre-IPO companies. These firms were created specifically to support high-velocity startups with the capital and resources to scale. Because many of these growth firms were built over the past decade, they typically have a relatively small number of funds under their purview and retain low partner-to-investment ratios, enabling each partner to focus on each company’s success.
Since companies in the growth phase tend to encounter familiar growing pains (e.g., maturing sales and customer success functions, building out new product lines and R&D centers of excellence), growth funds tend to invest heavily in in-house stage-specific marketing and sales; people and talent; and product and engineering resources in order to improve their portfolio companies’ odds of success.
Growth funds tend to be of most value when companies can benefit from highly personalized advice and programs to help them scale their go-to-market organizations and explore new product partnerships.
Early-stage VCs with growth funds
Many well-known early-stage investment firms that have built up reputations over decades have decided to raise new growth-stage funds to complement their existing early-stage franchises. Each VC firm runs its growth fund differently — some with the same team that invests in seed and Series A deals, and some with entirely separate teams that try to back the best companies from the early-stage funds.
Given their first-hand experiences as entrepreneurs and operators and their related personal networks, early-stage investors tend to be most helpful when CEOs need help finding new talent to fill CXO positions in their organizations.
Traditional growth and private equity
Just as many VCs have added growth funds to complement their core business, many private equity firms have launched growth-stage funds to expand their aperture beyond mature company leveraged buyouts. My previous employers were among the private equity funds that built out growth practices to complement their larger LBO franchises. Private equity firms often take majority ownership stakes, giving them control of the business.
Private equity buyouts have become viable exit options — even for early-stage startups
Private equity funds tend to be of most value when companies are in need of a more hands-on operational approach and debt capital markets expertise. Since private equity firms tend to take majority stakes, investments can also provide significant early liquidity events for founders and executives.
Public market investors with growth funds
Public market firms, including mutual funds and hedge funds, have in recent years dramatically increased their focus on pre-IPO financings. Many of these firms manage enormous funds dedicated to trading public stocks, with adjacent pools of capital reserved for early- and growth-stage financings that can feed the public trading desks’ relatively large ownership stakes in private companies just before an IPO (thereby allowing the firm to benefit in the day one IPO trading “pop”).
Since these firms will buy shares in companies before, during and after an IPO, public market investors tend to be most helpful when CEOs need advice on how best to position their companies for public market investors in an IPO.
In the short term, the number of growth funds will continue to increase, but within a few years we’ll see a reduction as weaker performers consolidate and close. Current exuberance is driving prices higher, which in turn is pushing returns lower than they were a decade ago. Only the strongest funds will continue to stay afloat. This is reminiscent of the 1960s-80s when many VCs moved later and new competitors entered the early-stage market, only to get flushed out as returns dampened.
Meanwhile, the strongest firms will grow stronger than ever due to the Flywheel Effect: Better investments will drive more knowledge and experience, which will lead to better advice for the next company, which in turn leads to access to the best investments. Just as certain early-stage VC firms have built incredible internal systems that help propel their continued success, we’ll see the same emergence of a new growth-stage top tier.
But for startups, none of this really matters. For them, there’s only one truly important question to ponder: who they want by their side through the journey.
*Special thanks to Pia Mishra for contributing to this article.
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