I think we're at the start of a major shift in the way technology startups are funded.
Current Trends
The two major factors that will drive the change are:
1) Less demand for venture capital
There are a few reasons for this. First, open-source technology, cloud computing, and online distribution have made it cheaper than ever to build a product and get customers.
Second, the availability of alternative sources of financing such as accelerators, angel investors, and now crowdfunding.
Lastly, companies are being "acqui-hired" after raising little or no capital and before needing substantial venture capital.
2) Venture capital fund returns are down
I think there are a few reasons for this. First, there's a lot of money chasing the same deals. A lot of VC firms have very similar investment criteria. This has led to a spike in valuations.
Second, rampant acqui-hiring of startups before they grow enough to generate the fund an acceptable return.
Lastly, inefficient capital allocation. Traditionally, VC firms have focused on making a few investments that each have the potential of achieving billion dollar outcomes. However, as Dave McClure of 500 Startup said, that's "really f**cking hard!"
What will venture capital become?
I don't think these trends are sustainable. Here's what I think will happen:
Operations
Investors will focus on helping with operations including business development/partnerships, sales, marketing, development, and recruiting rather than just financing, advice and introductions.
"For many early-stage companies still working on their product or developing customers, most of their challenges do not require large amounts of capital nearly as much as they require expertise -- particularly in engineering, design, and marketing." - Dave McClure
VCs will start taking a hands-on approach with their portfolio companies -- not just providing advice, but actually executing. That means there will be change in the types of employees at a VC firm. Rather than financiers and MBAs, they'll be operators that will make sales calls, code, and market. This will both attract the best companies and help the investments achieve superior returns.
VC firms will also be even more active in recruiting. They will actually have teams on college campuses recruiting top students before Goldman Sachs and Google can snag them.
Capital Allocation
There are at least two firms taking a different approach to capital allocation:
Dave McClure and 500 startups are looking to:
"place hundreds of bets on startups, hoping he can hit dozens of singles (like Ichiro) rather than a few home runs (like Barry Bonds). He expects about 20 to 25 percent of the 500 startups' portfolio will produce a positive outcome, with roughly 5 percent of the companies returning 20x or better, with the firm shooting for $100 million outcomes rather than $1 billion outcomes."
In contrast, K2 Media Labs
"healthily funding just a handful of fledgling companies at once. Instead of throwing a ton of new ideas against the wall and seeing which ones stick, K2 funnels its resources into the few startups it believes in, nurturing them until they blossom into mature companies with Ivy League IPOs."
If K2 does well they could just grow their staff and invest in more companies, and I think that could be really effective, because risk would be dispersed, like 500 startups, and they could still nurture.
I think we'll also see firms start investing in some under-funded areas (industry-wise and cash flow profile-wise) where valuations aren't so high.
If I were to start a venture capital firm
If I were to start a venture capital firm, it would be more of a guild then an investment company. Portfolio companies would receive an education through mentorship and formal classes and programs. I would create a community through hosting events and social media in order to source the best deals and talent. I would help companies by providing more than just financing by having in-house operators (solving one of the most difficult parts of starting a company) who would have the option of joining a portfolio company full-time. Like a "Lead Developer in Residence" or "Floating Product Manager." And I would look for opportunities that don't fit into the common VC investment criteria with a capital allocation similar to 500 startups'.