The Venture Capital Market

There's a wonderful blog conversation ongoing between Paul Kedrosky and Fred Wilson on the optimal number of venture capital firms. To summarize, both advocate for a reduction in amount of capital and number of VC firms participating in the market.

Check out Kedrosky's post from this week - Fred Wilson and the Venture Capital (Non-)Cartel and Wilson's - The Venture Diet is Working.

I look at it from a market standpoint, driven by supply and demand. But like a good economic analyst, I've got more than two hands...

1. Good firms will survive and poor ones will exit. The challenge though is the slow speed of entry and exit in the VC market. Firms can take years to raise capital from investors, then need time to evaluate eventual investments, then ride them through to exit. Unsuccessful firms that enter the market take years to display their incompetence, so the market is stuck in the intermediate term with an over supply of VC firms and capital. Overall, you'd think that's a good thing for entrepreneurs - more investment money chasing fewer projects. But, VCs are not a commodity product - each have their advantages and strengths that abet entrepreneurs in their drive to successful exit. This means that entrepreneurs need to examine their options more closely - more money and more favorable terms doesn't always mean the best deal.

2. Maybe the challenge is not an over-supply of VC firms, but a dearth of investment targets. Are we out of good ideas? I'd say no way this is the case. There are always plenty of good ideas in today's global marketplace, with that number rising exponentially as countries like India and China gain increased access to technology and build a economic infrastructure that supports the development of new technologies to replace the old.

3. Market inefficiency could be an explanation - there isn't enough communication between aspiring entrepreneurs and VCs. I don't think this is the case either - VCs get hundreds of business plans submitted every week and "investable"start-ups only going to develop in markets with access to communication nodes and infrastructure that provides clear awareness and access to the existing VC firms.

4. Or maybe it's that the venture capital model is no longer relevant for a majority of emerging companies. Back in December 2008, I wrote that venture capital is moving "up the ladder." As deal size requirements get bigger and bigger, that means that the exit opportunities must be bigger and bigger. There's limited room for the mega-exits, so that means that more and more start-ups are seeking smaller investment amounts funded by angel investors, leaving the formal venture capital firms with fewer investment opportunities. Bigger exit requirements also mean smaller rewards for company founders and early-stage team members that accept venture capital. That makes the whole idea of funding with VC less attractive. Altos Research is bootstrapped, profitable, and quickly growing (gasp!). Our company founders never wanted to use VC as a vehicle for precisely this reason (and others...).

Profile of Angel Investors

Received an emailed list of the :most cited articles from Institutional Investor Journals. One of them caught my eye - "A Profile of Angel Investors" - published in the Journal of Private Equity. Haven't downloaded or read the article yet, but passing along in case you should care to...

Venture Capital Panel Discussion: Fred Wilson & Jordan Levy

This morning's sessions at the InmanNews Real Estate Connect Conference in New York City included a panel discussion with Fred Wilson of Union Square Ventures and Jordan Levy of Softbank. Some interesting insights and perspectives regarding the state of venture capital and the general economy.

From Fred Wilson (who also authors the A VC blog):

• Spoke the prospects of building additional business applications on the Twitter API - labeling Twitter more as a platform than a service.
• Said that given the economies of scale, a viable internet business can be built on $20 million of revenue instead of the traditional $50-100 million models.
• The issue with the smaller revenue scale is finding venture capitalists to invest in these enteprises since it presents an exit problem for VCs. Assuming a 25% profit margin, a $20 mln business yields $5 mln in profits. If a VC owns 50% of the venture, that equates to an annual dividend of $2.5 mln which doesn't mesh with the 10x IRR models on which VCs operate.
• As a result, he discussed SecondMarket as a potential market location to buy and sell private shares of these start-ups to enable better liquidity of these smaller internet companies even though the company was initially developed for bankrupcy and vendor claims.

From Jordan Levy:

• Read some well-known statistics about the number of IPOs in the market (8 total in 2008 and none in the second half of 2008)
• Said that the VC industry as a whole has returned 0.2% over the last seven year period.
  
• Relayed the regulatory burdens hindering the IPO market by using his own attempt at an IPO that cost $3.5 million and utimately led to the decision not to go public. This is a well-documented problem also described in Michael Malone's recent WSJ article.
• Said that there is still lots of venture and institutional money available for good ideas, but given the current economic state, competition for that money will continue increase.
• Felt that angel capital is less robust ("the angels are scared") which doesn't bode well for small scaling companies requiring start-up capital in the $50K - $3 mln range that falls below the VC channels.

Venture Capital Trends: By Stage, Round, & Industry

In March, I noted that venture capital is moving "up the ladder" - more money was flowing into latter stage investments, with only about 10% of VC deals going to start-up stage investment (as compared to 25% in 1995).

In August, I examined venture capital investments by financing round which revealed that Series E round financing is on the rise which augments this earlier observation. Extending the March data through the end of Q3 2008 shows no real change - venture capital continues to flow into later stage rounds.

(click on the chart to enlarge)

However, there is a case for the "stability" of the Early Stage round trends. In their Fall 2008 recent report - "The Entrepreneurs Report," Wilson, Sonsini, Goodrich, & Sonsati (WSGR) stated that "this stability is one of the key indicators of the continuing rate of innovation in the sector, and clearly a positive sign in the face of the ongoing economic turmoil impacting world markets." (More on this at the end of these trend charts.)

Extending this analysis with the latest data from PWCMoney Tree, I examined venture capital investments by industry since 1995 to see if there were any structural changes of the industries receiving funding. Here is a summary of the data. (Note: Percentages measured in terms of total dollars invested.)

1. Hardware/Telecommunications: This industry grouping shows a clear downward trend in hardware-related industries since 2001.

This isn't terribly surprising, as many of the operational functions are moving from heavy equipment to cloud computing solutions.

2. Biotech/Medical/Energy: This industry grouping shows a clear upward spike in Biotechnology early in the decade (though waning a bit lately), a lagged spike in Industrial/Energy (reflecting the demand influence of clean and renewable energy technology), and a consistent rise in Medical Devices (maybe because more people are getting older and we're generally less healthy?).

Again referring to the WSGR report - "Early-stage companies are particularly well positioned to successfully respond to the challenges posed by future climate legislation." Further, the National Venture Capital Association released the results of a recent survey conducted from November 24 - December 12, 2008 and includes the predictions of more than 400 venture capitalists from across the United States. In a summary of this survey prepared by VCExperts - "clean technology is viewed by the highest percentage of respondents as potentially growing in 2009 with 48 percent predicting increased investment and 20 percent predicting unchanged investment."

3. Software, Financial Services, and Media/Entertainment: I grouped these together because of the movement towards cloud computing and the ongoing convergence of media and software applications in places like Facebook. No major changes in this group which was a bit surprising. With the influx of angel capital in recent years and the lower start-up costs required for software-related companies, I expected venture capital investment dollars to have declined, which is indeed falling steadily in the Software industry.

Overall, the consensus for the 2009 venture capital industry isn't terribly positive. The aforementioned NVCA survey reveals that 92% of VCs expect a downturn in 2009. The Fall release of the University of San Francisco Venture Capital Confidence Index reflects these sentiments as well.

While a general economic slowdown is an easy scapegoat for the negative outlook, Michael Malone wrote an outstanding piece in the Wall Street Journal - "Washington is Killing Silicon Valley." Malone's opinion article clearly describes the elephant in the room when it comes to innovation and technology - heavy regulation places a long-term management cost when start-ups seek their IPOs. These projected costs outweigh the risk-adjusted benefits to new business ventures. Maybe there's a reason we're seeing the trends outlined above.

Venture Capital Trends - Q1, 2008

Found this article on VC Experts (a great source for articles and analysis on a myriad of venture capital topics) a couple weeks ago.

In short, Barry Kramer and Michael Patrick of Fenwich & West LLP analyze the venture funding terms for over 100 companies in the San Francisco Bay Area. For those number-crunchers, this is a great piece to read.

I'll spend some more time analyzing this weekend to infuse my own perspectives, but for now, here's a link to the article.