🇺🇸 Make Venture Soft Again
In the nascent years of venture capital, software was the battleground of innovation. Pioneers like Microsoft, Oracle, and SAP laid down the foundation for what would become a multi-trillion-dollar industry. Fast forward to the last several years , and venture capitalists were enticed by the allure of other sectors, notably direct-to-consumer (DTC) companies. However, this article contends that for the venture asset class to perform well, it's time to go back to the roots and focus more on software investments.
The Software Advantage
Software startups, especially those that leverage network effects, have unique qualities that make them incredibly attractive for venture capital.
Scalability: Software companies are inherently scalable. Once a software product is built, it can be distributed to millions, if not billions, of users worldwide at near-zero marginal costs.
Network Effects: Startups like Facebook, LinkedIn, and Airbnb have demonstrated the potency of network effects. As more users join the network, the value of the platform increases for both old and new users, creating a virtuous cycle that's tough to break.
Recurring Revenue: Software companies, particularly SaaS (Software as a Service), have ushered in an era of predictable, recurring revenue streams. The subscription model not only assures regular income but also builds customer loyalty.
Gross Margin: Software has high gross margins. Once the initial development is done, the cost to produce an extra copy is nearly zero.
The DTC Misstep
Over the past few years, VC firms have been increasingly seduced by DTC startups. Companies like Casper, Harry’s, and Warby Parker, with their unique brand appeal and customer engagement, appeared as potential unicorns. Yet, many of these investments have failed to deliver the kind of returns VCs expect.
The primary reason for this is simple: these companies are fundamentally different from software businesses.
Firstly, DTC companies operate on slim margins. Unlike software, the cost of goods sold (COGS) for DTC businesses is high. Each product sold requires raw material, production, and often complex logistics. Coupled with high customer acquisition costs, these expenses significantly cut into potential profits.
Secondly, scalability is harder to achieve. Each unit of a product has to be manufactured, stored, and shipped. And as these businesses scale, complexity and costs often scale linearly, negating economies of scale that software companies enjoy.
Lastly, DTC companies face intense competition and require significant brand differentiation and marketing spend. Creating a unique brand in a crowded market requires not only a unique product but also significant outlay for marketing and customer acquisition.
Venture's Soft Comeback
Venture capital, as an asset class, is designed for high risk and high reward. It thrives on investing in startups that can grow quickly, achieve strong network effects, and provide outstanding returns. For the foreseeable future, software companies seem to be best suited for this model.
Venture capitalists are now rethinking their strategies, prioritizing businesses with proven scalability, high gross margins, and strong network effects — traits that are the hallmarks of successful software companies.
The venture capital landscape is cyclical, characterized by periods of fascination with different sectors and trends. However, as we look to the future and seek the next cohort of world-changing companies, the case to "Make Venture Soft Again" has never been stronger. It’s time to return to the roots, and those roots are firmly embedded in software.