Disruption is coming for venture capital

My first job in America, after I graduated from business school, was at Harvard Business School professor Clayton Christensen’s consulting firm. Christensen, who coined the theory of disruptive innovation, was one of the most influential business thinkers of our time. CEOs flocked to him for help spotting and preempting disruption of their businesses as well as the creation of their own disruptive innovation, so he built a consulting firm to help. I was a part of that team.

Learning from Christensen was one of the most formative experiences of my life. Our job was to spot, and sometimes to create, waves of disruptive innovation across a broad variety of businesses, a skill that I’ve exercised routinely as an operator, founder, and now VC.

Incidentally, of all the tired phrases in venture capital, “disruptive innovation” is the most misused and misunderstood. Many use it as a moniker for any big technological leapfrog, or for any big business disruption. In reality, disruptive innovation is a process, not an event. A process that is specific, predictable, and replicable.

In the mid-1990s, while studying industrial sectors like steel and disk drives, Christensen discovered that category leaders (or incumbents) are incentivized to focus on serving the “top of the market”—or their most profitable customers—with better products, more features, and more customized service. In doing so, they price out the “bottom of the market” (i.e. customers who would be satisfied with a much simpler product). When incumbents focus on serving the top of the market, they leave the door open to disruptors—scrappy category entrants—to capture the bottom of the market. Over time, these disruptors get better and better, move upmarket, and eventually displace the incumbents themselves. This process is what Christensen referred to as disruptive innovation.

Disruptive innovation is a phenomenon that doesn’t discriminate; it can happen to any incumbent in any industry. Christensen famously wrote a case study about the impending disruption of Harvard Business School itself, and taught it at his own super popular HBS class, much to the rumored chagrin of the Dean.

In the same spirit of observation of one’s own industry, and as an emerging fund manager at a time of record dollars in VC, it is my hypothesis that the venture capital industry itself is in the process of getting disrupted.

To spot impending disruptive innovation, look for four agents: the incumbents, the customers at the top of the market, the customers at the bottom of the market, and the disruptors entering with simpler, easier, cheaper, and more accessible products.

Mainstream VCs are today’s incumbents. Traditional VC firms have built their business model to find, lock and serve those they believe to be their most profitable customers: startups that match the pattern, those they believe will achieve the biggest outcomes. “Believe” is a key word here. There is a slow feedback loop in venture capital between investment and payoff, so VCs go by the past to determine who they think will be the most profitable investments in the future.

What does this business model look like? It looks extremely founder-friendly. Quick decision-making, huge rounds, founder-friendly terms, and minimal diligence so the company can get that money fast. Post-investment, it looks like in-house fundraising support, in-house recruiting, in-house PR, in-house executive development, in-house business development . . . I could go on. Think of all the perks that come with a round led by Andreessen Horowitz, or an investment from Y Combinator. The perks attached to an incumbent VC are truly amazing. But they’re only accessible to the “top of the market”—founders who match the VC’s historical pattern of most profitable investments.

As mainstream funds focus their time and dollars on serving these founders, they’re ignoring those they believe to be the “bottom of the market.” These are founders who don’t match the pattern, who are so used to hustling without help that they can do a lot with very little. All they ask for is a chance, a check, and a good word with other investors. Anything beyond that is a bonus.

You don’t need to look far to find the disruptors. Hundreds of emerging managers like myself are raising smaller funds and writing smaller checks to founders overlooked by mainstream VCs—operators and founders with sidecar vehicles or rolling funds, writing small checks to people in their networks—and tools like Republic’s equity crowdfunding and AngelList’s founder-led roll-up vehicles, which allow founders to take control of their own rounds and raise in smaller amounts.

All of these small funds and fundraising self-help tools don’t appear threatening to mainstream VCs, just like the scrappy, overlooked founders we see don’t appear profitable to them either. Neither party matches the pattern of what incumbents think is worth their while. This perception is how disruption starts. And this dismissiveness is why disruption happens.

I run a $10 million pre-seed fund that invests exclusively in women-founded companies. I know many of the most powerful VCs dismiss funds like mine. They think of us, condescendingly, as a “diversity thing” and as “impact-driven.” They’re missing the point.

I invest in the overlooked segments of the VC market. Working with Christensen taught me how this story unfolds. And I know which side he’d bet on.