I’ve been thinking about Sam Lessin’s latest deck about the future of venture capital and its implications about the future of how technology is funded and built. Sam is General Partner at Slow Ventures and partner to Jessica Lessin, founder of tech industry publication The Information.

It’s certainly worth reading if you’re in the industry (although be aware that it’s a DocSend link that requires that you provide your email address to proceed). I don’t always agree with Sam — in particular, he recently wrote a piece about banning TikTok because of pro-Palestinian content that I vehemently disagree with. But there are some claims in this deck that, if true, will be seismic.

He first sets the stage for how VC has turned into a kind of assembly line over the last twenty years:

With clarity and manufactured consistency of what late-stage VCs had to 'roll off the line' to sell to the public market, it became possible for the whole ecosystem to reverse-engineer and standardize the metrics companies needed to be worth at different stages and 'peg' valuations to those stages for intermediate products.

This trend towards startup standardization, measurement, and 'legibility' at all stages allowed the VC factory run way more efficiently and dramatically scale up. It allowed different funds to specialize in different stages of startup production - doing just one step - and passing the goods along for markups.

This is a clear description of the venture capital funding ladder: from pre-seed to seed, then through early equity funding rounds, then to growth rounds, and out into acquisition and the public markets. As Lessin says, individual funds and ecosystems developed around each of these stages. It was like a factory line in a way, but also a bit like a Ponzi scheme: the way early stage investors made money was by later stage investors putting money in.

At each stage, Limited Partners — high net-worth individuals, pension funds, and so on — put a certain amount of their money into a venture capital fund with the expectation that they would see a return within a pre-determined timeframe (often ten years). VCs typically made a 2% management fee and then took 20% of the profit once the fund reached maturity.

The trouble was, most of the companies constructed this way didn’t succeed in the public markets. The model described above worked fairly well for the inward-facing market of investors, and sometimes created services that people used, but it didn’t actually create the value necessary to justify those valuations. This — together with a reformed market landscape in the wake of the pandemic — means that the formulae investors used to calculate valuations are meaningless. There’s no factory-ready set of calculations to use. Every company is different.

Every company was always different, and valuations could never be paint-by-number, but it’s become harder to maintain the appearance of set standards.

Lessin also points out that the factory model also allowed absolutely unscalable non-tech companies to get the tech treatment: direct to consumer products, electric scooters, networks of doctor’s offices, and so on were all VC-funded using the same metrics designed for software, despite not being software at all. These companies didn’t do well at all and trust was eroded.

There are lots of reasons why this happened, which Lessin doesn’t touch on: once limited partners have put money into a fund, the investor needs to deploy capital from that fund on investments within the timing of the fund. These investments have to come from somewhere, and it becomes harder and harder to find the right kind of software deals the more competition there is. In a 0% interest (“ZIRP”) environment that hosted an explosion of VC funds that were all competing for founders, investors often hustled hard to get any deals at all. There were simply more funds than viable software companies to support.

All this and a renewed government interest in enforcing anti-trust rules means that acquisitions (which were how many funds really made their money) have slowed. And because LPs didn’t get their money back from previous funds, they’re not re-investing in new ones. And potential founders aren’t leaving big tech companies, because layoffs and a more uncertain economic environment means they might not get their jobs back if their startups fail.

What Lessin does say — in, for me, the most interesting part of the deck — is that this dynamic is still going on, and is behind the current AI boom. He characterizes investor interest in AI as a somewhat desperate attempt to maintain the venture investing status quo:

But what of generative Al you say! Well, this is what you call wishful thinking... a clear example of a narrative generated out of desperation in the VC community vs. good sense. The Al startup opportunity is largely a mirage of thirsty investors trying to cling to an old way of doing things after similar spun up stories on Metaverse (and yes in its peak froth moment Crypto) didn't play out, and the last narrative around ‘on demand services' mostly crumbled.

It’s an extending / sustaining innovation, Lessin argues: one that allows incumbents (Microsoft, for example) to make higher profits rather than providing opportunities to new players in the marketplace. There are no moats: no way for startups to maintain a lead because there are no network effects and everything is open source. On top of this, the startups are so overpriced because of the concentration in investor activity that they would need to be phenomenally successful to provide a reasonable return. If any of these turn out to be the case, investors in AI startups will not see the returns they’re hoping for.

Remember, this doesn’t mean AI isn’t necessarily useful in itself: it’s simply an argument that it might not be a good fit for new startups or for venture capital investment. Whether a venture is suitable for VC funding is not a value judgment on it in overall. Nonetheless, it’s an enormous statement.

Instead of pursuing the “factory” model of startups that require lots of rounds of funding, Lessin suggests that small investors should put their money into more capital-efficient businesses: small business platforms, communities, and business-to-business platforms with low expenditures. In other words, communities that are built slowly and can be revenue-driven without having to grow to monopoly size. The world where investors can aggressively fund a tech company until its competitors are dead, regardless of its own profitability, is gone.

I see this as largely positive: this is a world where people are more aligned with the services they use, and where revenue rather than exploitation is central. It remains to be seen how accurate it will be for the market at large, but I consider it notable and exciting that investors like Lessin are coming around to thinking along these lines.