Venture capitalists doubling down on tech

TECH venture investments have come roaring back during the Covid-19 pandemic. After declining 13 per cent from 2018 through 2020 amid an overall venture funding pullback, the total value of global venture investments in technology in the first quarter of 2021 nearly doubled from the same period in 2020, more than twice the growth rate of other sectors.

That's according to Bain & Company analysis, using our Startup Investment Cruncher database, of all deals by independent venture capital (VC) firms and corporate venture capitalists (VCs). Tech startups accounted for nearly 70 per cent of total venture investments in the first quarter of this year.

The pandemic fuelled this growth by accelerating the shift towards later-stage deals that had been underway for several years. Investors have flocked towards surer bets to hedge risk and ride out the storm.

But we expect this preference for later-stage rounds to continue after the pandemic. The result is growing competition for late-stage deals, which is creating opportunities for larger-sized funds and blurring the lines between traditional venture capital and private equity.

Where are venture investors focusing their technology bets? The two segments generating the most interest right now are artificial intelligence (AI) and cloud technology, which together grew more than twice as fast as venture investments in all other sectors over the past decade and now make up more than a third of total tech venture investment value.

Venture investors' divergent approaches to investing in these two critical sectors symbolise the way they have evolved. In AI and machine learning (ML), most venture investors now prefer startups developing products customised to specific industries, according to our analysis.

This signals that investors and entrepreneurs have moved beyond the starry-eyed stage of pursuing a generalised AI algorithm to solve broad problems, and now they are taking a more stepwise innovation path with clearer payback opportunities.

The story is different in the cloud. Over the past decade, investors have increasingly placed bets on startups with a "horizontal" (or cross-industry) focus.

Enterprises across industries are adopting software-as-a-service (SaaS) tools to modernise operations and gain an edge, and they are pursuing a seamless, multicloud infrastructure layer to bring about the hybrid cloud future desired by CIOs.

Looking more closely at AI/ML, the vast majority of venture investments are concentrated in two countries: the United States and China. Given the dramatic decrease in foreign direct investment between these two nations in recent years, we may be witnessing the formation of two competing ecosystems around this strategically important technology. Several patterns have emerged in this race.

The two sectors receiving the most AI/ML venture funding - transportation and healthcare - are fragmented, each with more than a dozen well-funded contenders in the US and China.

In transportation, this results from long development cycles for autonomous driving, and different dynamics for robo-taxis and long-haul trucking create room for regional champions.

In healthcare, venture investors anticipate winners in segments ranging from drug discovery to AI-supported diagnostics and imaging.

The fact that social media platforms ByteDance and Kuaishou are the two biggest venture capital bets on Chinese AI/ML companies over the past decade is likely a by-product of the earlier ascendency of US social media companies. Investors look to precedents like Facebook and understand the network effects and outsized returns that can result from achieving massive scale.

HOW CORPORATE INVESTORS CAN WIN

What does all this mean for mature corporations attempting to use the venture-funded startup ecosystem to build their business?

There's no shortage of opportunities to invest, but increasing competition and rising deal prices increase the odds of missteps.

In addition, the many fragmented sectors makes it even more critical for investors to understand the diverse landscape of startups and technologies.

We have identified a few opportunities for corporate investors to differentiate themselves in this environment.

• Become a customer or partner. This is one area where corporate investors can gain an edge over traditional VC firms, which don't always have a clear use for their portfolio companies' products. By becoming a customer or partner of the startup first, the mature firm can lay the groundwork for a future investment by testing the earlier-stage company's technology and getting to know their team.
• Be clear about your parenting advantage. The best corporate VCs not only have a clear deal thesis that fits the business's overall growth strategy. The deal thesis should also entice startup founders by articulating the benefits of an investment from a corporate VC, such as access to the larger firm's go-to-market capabilities and technical talent. This can give corporate VCs a leg-up over pure financial investors.
• Build a targeted portfolio. Corporate VC leaders may want to believe they can make rifle-shot investments that dramatically outperform the industry standard, but this approach often backfires. Many larger corporate investors make the mistake of betting on a startup without thoroughly screening a healthy number of investment candidates. Effective venture capital firms typically screen at least 20 startups before making the first investment in a target field. With every new meeting, they go back and revise their investment thesis based on what they have learned. Then, they make multiple investments, selecting the companies that best fit their strategy.

There's no getting around the fact that venture investing can be difficult for large corporations because they don't have the same risk tolerance as independent VC firms.

Leading corporate VCs have found a way to comfortably act more like traditional VCs, but it may require modifications both to their organisational payment structure (to better attract and retain venture investor talent) and to the company's governance guard rails around tolerance for failed startup investments.

The stakes have never been higher for corporate VCs to get that balance right.

• The writers are partners of Bain & Company. Ravi Vijayaraghavan is head of Apac Technology & Cloud Services Practice, based in Singapore. Michael Schallehn is based in Silicon Valley and Chris Johnson, in San Francisco.