News & Analysis

VC Investment in Software Continues to Grow, Hardware Gets Left Behind

With smartphones and tablets now ubiquitous in the United States and around the world, it’s no surprise that venture capital investments in the software and applications that make these devices so enjoyable have greatly increased over the last few years.

Since 2004, when software accounted for roughly 63% of all VC investments in IT, the sector has seen explosive growth in both the number and size of its aggregate VC financings. In 2004, software collected 672 venture rounds worth $3.8 billion. By 2013, those numbers had essentially tripled, with 1,930 software deals closing last year for a combined $11.9 billion.

But what about VC financings in hardware, semiconductors and communications & networking—the core of what makes technology hum and what allows software to run in the first place?

Turns out VCs have spurned the hardware sector in recent years, instead opting to fund startups in the cheaper software space. After collecting 399 VC financings worth $5.4 billion in 2004, non-software IT managed to generate a comparatively paltry 230 rounds worth $2.8 billion in 2013. This year is on pace for even fewer VC financings than 2013. This development has prompted some venture capitalists to ask: “What happened to the future?” It was even featured on the cover of the November/December 2012 issue of the MIT Technology Review, the cover of which showed famed astronaut Buzz Aldrin, exclaiming: “You promised me Mars colonies. Instead, I got Facebook.”

Explaining Venture’s Reluctance to Fund the Future

There are many reasons for this development. As mentioned previously, software startups producing apps or social networking sites for mobile phones and the web are generally less-complicated and cheaper to get off the ground, and much easier (and quicker) to sell to potential acquirers down the road.

Meanwhile, in order to create faster, better or entirely new hardware, you need inventors, engineers, scientists and a whole lot of capital—more than what most VCs are willing to dish out for something that may be more likely to fail or struggle to get to a level where big companies would be willing to acquire.

A related explanation may be that VC funds simply do better in categories where “the innovation cycle is short, such as media and software,” rather than in more high-tech industries such as hardware IT and biotechnology, because the time frame to exit for these types of companies tends to run longer than the typical lifecycle of a VC fund.

Consumers have also played a part, by putting form, speed and ease of use ahead of capability, power and fresh technological features in their everyday devices. This has, in turn, put the design and manufacturing of a majority of the widely used devices today, into the hands of a small group of mega-companies, such as Apple, Samsung and… well, that’s about it. Those two companies command a combined 46.6% of the smartphone market (no other handset maker hits 5%) and 55% of the tablet market, according to Gartner, a market-research firm. In turn, they have only developed incremental upgrades to their devices every year, and then sell them at a premium.

Many would say, “yeah, so what?” After all, this is not exactly big news. The Silicon Valley culture of quickly creating a startup and selling it off in two or three years, then doing it all over again, isn’t exactly conducive to creating the next Intel, Microsoft or Cisco, all of which were VC-backed at some point.

VC Then, and Now

The reality is that venture capital used to fund the future. Former Founders Fund partner Bruce Gibney provided clarity in his “What Happened to the Future?” piece, noting that VCs funded the emergent semiconductor industry (Intel, for example) in the 1960s, gave critical capital to the first computer makers in the 1970s and 1980s, and helped generate immense returns with investments in biotech companies in the ’80s and ’90s.

“VCs backed all these enterprises, in the hope of profiting from a wildly more advanced future,” Gibney wrote. “And in exchange for that hope of profit, VC took genuine risks on technological development.”

But things changed in the 1990s, when venture portfolios began to incorporate more companies that “solved incremental problems or even fake problems. … Along the way, VC has ceased to be the funder of the future, and instead has become a funder of features, widgets, irrelevances.”

It’s not clear at this point what could get VCs to invest more in the future, particularly since the proliferation of seed financings has made it easier for startups to receive initial funding and easier for VCs to make low-risk bets on relatively non-inventive companies. To be sure, there have been VC-backed high-tech startups in recent years to see some major accomplishments. Think Tesla Motors, which went public and has achieved critical and mass success, and Oculus VR, the virtual reality headset-maker that was recently acquired by Facebook for $2 billion.

But by and large, venture capital has ignored the future, and what price the industry—and the general public—will pay down the road, nobody knows.

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