As you might imagine from my post on inflection investing, the landscape between early commercialization and a universally known good investment has been top of mind.
VC has become increasingly "barbelled" in fund sizes and financing rounds. Early-stage and unicorn rounds continue to grow, but rounds in the middle have stayed relatively stagnant.
There are three truths around uncertainty and risk in venture capital that are important to understanding the potential opportunity of inflection rounds.
- For an investment to create an excess return, there must be excess uncertainty as viewed by the market. The inverse is not true. Not all uncertain investments are good investments.
- You can take market risk without taking the technical risk, but the inverse isn't true. If you accept technical uncertainty, you're by definition also accepting market uncertainty.
- Market uncertainty implies a lack of competition, if market uncertainty were solved more companies would be competing to win share. Again, not true of technical uncertainty. You can build a better mouse trap in an existing market.
Putting these three together helps explain why the best investments are made when venture firms take on market uncertainty.
When Apple was funded no one knew how many people would buy a personal computer; the ultimate size of the market was analytically unknowable. Intel, Google, Amazon, etc. all went into markets that they helped create. High market risk is associated with the best VC investments of all time.
The best investors from a returns lens have traditionally had a knack for understanding when market uncertainty has been solved before others do.
Recently, venture firms have started to seek startups that have already solved a large part of market uncertainty from their lens. They're leaving market uncertainty behind for market SIZE uncertainty and potential public market uncertainty.
They seek startups growing 100-200% YoY with 75% gross margins and $20M+ in ARR. These startups command a premium, but the return criteria shift from CoC to risk-adjusted IRR. So far, the market has stayed frothy enough to support this strategy.
But, creating excess return (alpha) means finding the returns where others don't - and by definition taking on some uncertainty that others won't. This is always true, but it becomes even more true when markets turn.
This leaves the middle for the taking. Firms with the ability to identify market leaders AND successfully solve market uncertainty have traditionally had significant advantage and will likely continue to do so moving forward.