Research: How Cloud Computing Changed Venture Capital

How has technology changed which deals venture capitalists (VCs) fund and how they fund them?

Venture capitalists essentially invest in startup ‘experiments’, and subsequently provide more funding to the experiments that work, so that they can run more experiments. This leads to many failures (roughly 55% of startups) and a few successes (6% return > 5x the total amount invested). So an innovation that changes the cost of experiments changes the landscape for venture funding.

In recent research, we examined a particular innovation that had a broad impact on some types of startups but little to no effect on others. The introduction of cloud computing services in the mid 2000s allowed Internet and web-based startups to avoid large initial capital expenditures and instead “rent” hardware space and other services in small increments, scaling up as demand grew. Cloud computing made the early ‘experiments’ for these firms significantly cheaper.

We combined data from VentureSource, VentureEconomics, Correlation Ventures, CapitalIQ, LinkedIn, Crunchbase, firm websites, and LexisNexis to examine the funding of startups in the period around the introduction of Amazon Web Services (AWS) in both affected and unaffected sectors. (Thank you to Correlation Ventures for helping us with this study. Both Rhodes-Kropf and Ewens are advisors to and have a financial interest in Correlation Ventures.)

Startups founded in sectors that benefited from the introduction of AWS raised much less capital in their first round of VC financing after AWS. On average, initial funding fell 20% relative to unaffected sectors. Interestingly, this fall in costs only changed the initial capital required for the startup – total capital raised by firms in affected sectors that survived three or more years was unchanged. Thus, the effect of cloud services significantly impacted the initial costs of trying an idea, but not the costs of scaling a successful business.

This fall in the cost of starting businesses dramatically impacted the way in which VCs manage their portfolios. Some VCs shifted toward an approach colloquially referred to as “spray and pray” — VCs ‘sprayed’ money in more directions, and ‘prayed’ rather than governed. In sectors impacted by the technological shock of cloud computing, VCs tended to respond by providing less funding and limited governance to an increased number of startups. These VCs were also more likely to abandon their investments after the first round of funding. In fact, the number of initial investments made per year per VC in affected sectors nearly doubled from the pre-cloud to the post-cloud period relative to unaffected sectors, without a commensurate increase in follow-on investments. In addition, VCs making initial investments in affected sectors were less likely to take a board seat following the technological shock.

These effects arose both because some firms changed the way they invest and because of entry by new VC firms. Even the most active firms investing both before and after the shift tended to invest smaller amounts in a larger number of deals in sectors affected by cloud computing, relative to unaffected sectors.

This falling cost of experimentation allowed a set of entrepreneurs who would not have been financed in the past to receive early-stage financing — leading to greater democratization of entry into high-tech entrepreneurship. In affected sectors, VCs increased their investments in startups run by younger, less experienced founding teams. These firms were subsequently more likely to fail. But among those who earned a second round of funding – a indication of initial success – they had nearly 20% higher increases in value across rounds than equivalent startups in untreated sectors, and ultimate exits generated greater returns. In other words, these companies were more likely to fail, on average, but the ones that succeeded did so more dramatically.

An interesting implication of our results is that VCs seem to have provided less guidance during the earliest part of a startup’s lifecycle — when that guidance is arguably most needed. Moreover, younger and less experienced founders likely need the most mentorship and governance. Yet the VCs’ desire to make a larger number of smaller investment, implies that earlier startups with younger founders only get financed with limited mentorship and governance. This finding helps to explain the rise of new financial intermediaries such as accelerators (which have emerged in the last decade) that provide scalable, lower cost forms of mentorship to inexperienced founding teams. These are a natural response to the gap in value add created by the evolution of VCs’ investment behavior in early rounds to a more passive “spray and pray” investment approach.

Our work shows how a technology shock actually alters the funding landscape, shifting which future ideas get funded and how. A new innovation may open up a whole new range of opportunities, but also necessitate new ways of funding them. In the case of the innovation of cloud services, some venture investors moved toward a “spray and pray” investment style placing investments into more long-shot bets. Thus, our findings suggest that an initial technological innovation increases the pace of future innovation by allowing even greater experimentation.

This continues today. Innovation is decreasing the cost of experiments in areas as diverse as biotech, hardware, and agriculture, resulting in the need for new sources of small amounts of capital such as angel investors. Simultaneously, the falling cost of experimentation explains the anecdotal view that some VCs are waiting longer to invest and expecting startups to have accomplished more. In a market with many more small experiments, some investors will choose to wait to see the outcome before investing more. Innovation that affects the costs of experiments creates a financing market with many smaller investors in less well-funded startups and larger investors who are naturally investing after startup’s achieve commercial traction.