The term innovation is being thrown around more and more, but when was the last time you experienced the launch of a product that felt truly revolutionary? Technology is stagnating and we believe the venture capital industry is to blame.

In the 50s a group of people now known as the “Traitorous Eight” embarked on a journey that would become the starting point for Silicon Valley and the tech industry. The Traitorous Eight earned their name when they left Shockley Semiconductors to start Fairchild Semiconductor, where they invented the silicon-based integrated circuit. 

Fairchild was an environment so rich in innovative spirit that it kept on spawning startups — a family of companies that became known as Fairchildren. Eugene Kleiner, a member of the Traitorous Eight, eventually went on to found Kleiner Perkins, one of the first and today most prestigious venture capital firms. And so the two key components of the booming tech industry had come in place: startups as its innovating force and venture capital companies as its funders.

Since these early days, venture capital funds have enabled and in many ways created the tech industry — a phenomenon that has fueled the immense societal transition from analogue to digital. The venture capital industry in itself has also flourished thanks to technological breakthroughs accomplished by its early members. 

But even with this strong history of symbiotic relationship, today, truly disruptive technologies are rarely funded, which has led to a diminished supply of building blocks for future innovation. Technology is stagnating and with time the venture capital industry will suffer.

How did we end up here?

While venture capital funds tend to have a holistic view of the state-of-the-art and where things are heading, two institutional factors prohibit them from making truly disruptive technological bets.

• Size: The venture capital funds have grown bigger and the only way to manage a big fund in a sustainable fashion is by taking bigger bets. These bigger bets tend not to be placed on new-thinking small companies operating in unchartered territories with high technological uncertainty, but rather on companies where the market risk is dominant, a risk that is usually mitigated by tossing more money at the problem. Hence, a race for technology has been replaced with a race for market. A good example of this is the scooter mobility space where tech differentiation is minimal. And as time goes, profit will be competed away, which will further reduce the ability of these companies to build value in product or technology.
• Mandate: Another reason is the path dependency of venture capital fund created by the institutional pressure from their investors (known as Limited Partners, or LPs). Venture capital companies grow and evolve by raising new funds. With each new fundraising, LPs thoroughly review the team and past fund performance. It follows that if a GP has a good track record within a specific tech vertical, it will be very hard to raise a fund with the mandate to invest in another vertical. This way of allocating money becomes a strong driving force towards the mainstream. Over the years, tech has taken a turn towards software, digitalisation and consumer products — a path that will reach stagnation without fuel from new R&D-centric tech verticals. As technological disruption tends to happen in young startups, one could think that disruption of the path dependency of the venture capital industry would happen in new, smaller, venture capital funds. Sadly, here too LPs are restricting renewal. A common criterion for new fund managers, on top of the one about proven experience within the vertical they want to invest, requires them to put “skin in the game”. This is a barrier which creates exclusivity for successful tech entrepreneurs and venture capital industry veterans. Thus, also new funds will have a hard time breaking out of the mainstream — they instead become deal flow machines for the venture capital titans.

The white heat of innovation

But what about the popular opinion that technological progress is now happening faster than ever? And what about the tech advocates who are saying that tech singularity is near?

We believe that this view is, essentially, the result of well-executed marketing. Incremental technology improvements are spun as disruptive. Fundamental tech breakthroughs from decades ago are sold as new. We see it with artificial intelligence, we see it with blockchain and we see it in with the electrification of the automotive industry. Don’t get us wrong: incremental improvements aren’t bad. They’re essential to unwrap the full potential of tech innovation. But the long-term effects of neglecting the building blocks are dire.

Change must start at the top of the value chain; from the LPs. They need to become more willing and able to understand technological advancement; they need to accept the risk associated with technological uncertainty; they need to lower their barriers for new GPs and diversify their investments; they need to allow for longer holding periods; and most importantly, they need to encourage venture capitalists to do the same. Unfortunately, this understanding is rare and role models are needed. To this end, we believe that European LPs can learn a lot from US university endowment funds that at their core have a respect for innovation and want the venture capital funds they back to be the same.

Because after all, “the science of today is the technology of tomorrow” and the funds that embrace science to guide them to what future technology will bring are also more likely to find sustainable competitive advantages, advantages built on true uniqueness.

Alex Basu and Per Anell work for Industrifonden, a venture capital investor based in Stockholm, Sweden, with a Life Science and Technology portfolio that stretches across the Nordics.