In the last fifty years Silicon Valley venture capital financing of early stage companies has evolved from a cottage industry composed of a few investors enamored with technology, to a concentrated financial industry composed almost exclusively of sophisticated institutional investors. But, it is now becoming a disintermediated retail financial services business, thanks in large part to the power of the internet.
Fifty years ago, most Silicon Valley venture capital firms were small firms, populated by partners characterized by a love of technology, rather than proficiency at “sharp pencil” financial metrics. As the financial world became increasingly aware of their success, venture capital became a recognized “asset class,” a small portion of which should be in every fund manager’s portfolio allocation. Silicon Valley venture capital became a big business of large pools, financial professionals and analysts reporting to limited partners who were primarily fund managers applying sophisticated financial metrics. The creep of financial modeling into venture capital required that portfolio companies “fit the model” requiring a potential for a huge multiple of return on investment. The need for these returns, the increase in the nominal cost of all inputs into the growth of a portfolio company and applicable government regulations resulted in increasing concentration of capital in the industry. As venture capital became institutional, it demanded legal services from law firms that looked increasingly institutional. So, venture capital firms wound up with a relatively short list of approved Silicon Valley law firms. With the market power of their franchise, these “bell weather” Silicon Valley law firms grew dramatically, charged higher and higher fees, and generated more and more paperwork. In part this was a reasonable hedge, recognizing that the fees would seem small in the event of a favorable company exit, and recognizing that the full amount of the fees billed would likely never be paid in the absence of a successful exit. So the oligopolistic ecosystem grew, until recent years.
In the last decade, the Silicon Valley venture capital industry has been shrinking, particularly in connection with early stage investments. Returns have fallen off, so institutional investment has tapered. A new class of angel, and super angel, investors has arisen. Technological advances have, in many cases, significantly reduced the capital required to start a new enterprise. The internet has enabled the emergence of crowd funding, and the recent JOBS act mandates changes to federal securities laws to accommodate crowd funding and internet based fundraising efforts. The near exclusive venture capital club is being democratized for early stage financing.
These recent changes in financing opportunities have created new opportunities for early stage companies. As a consequence, their legal needs have changed, and the profile of their ideal law firm has changed. The days of signing up with the exorbitantly expensive Silicon Valley law firm on the VC approved short list as the only realistic hope of raising the required capital is coming to an end. The next wave is a law firm that correctly assess the point of diminishing marginal returns on legal services, and provides the optimal level of service relative to cost and risk. A large monolithic law firm tends to have trouble optimizing this equation due to the distraction created by the loud sucking sound of its high overhead. A nimble, flexible and cost efficient firm has an advantage at correctly assessing the point of diminishing returns, and optimizing its service offerings to maximize client value.