The Death and Re-Birth of Venture Capital

Michael Butler is chairman and CEO of investment bank Cascadia Capital. He is writing a book titled Financing the Future and the Next Wave of 21st Century Innovation, and is serializing it here at peHUB. What follows is an excerpt from the fourth chapter.

A decade ago, every ambitious and analytical business-school student dreamed of becoming a rock-star venture capitalist like John Doerr or Jim Clark. And why not? The returns were robust, the headlines and magazine covers were positive, and the personal wealth just piled up.
There’s a very different kind of pile up today on Sand Hill Road, however. And it looks more like a car crash than a personal cash stash. Very few venture capitalists are crying poverty, but the VC industry is undergoing a wrenching and major restructuring that will cause unfamiliar pain and dislocation for a long time to come.

To put it bluntly, the venture capital model is broken and even the smartest VC’s aren’t sure how to fix it – or if it can be fixed at all.

While they’re looking for elusive answers, the venture business is being partitioned into two sub-segments – the winners, who represent 20 percent of the firms, and the also-rans, who account for the remaining 80 percent.

For the most part, the winners are big, established brand-names like Kleiner-Perkins, Sequoia and NEA, or geographic and/or industry specific funds like OVP and Technology Partners. In both cases, these winners are still generating attractive risk-adjusted returns on capital. And because of their strong and proven track records, these blue-chip firms will almost certainly continue to get the best access to the best deals and best entrepreneurs. This means, of course, that the best pension funds and endowments will keep investing in these elite funds, accentuating and perpetuating the emerging two-tier structure of the venture capital industry.

By almost any measure, the VC business is shrinking today in the wake of the unprecedented Internet market collapse of a few years ago. Between 2000 and 2007, for example, the amount of venture capital invested dropped from $105 billion a year to $29 billion; during the same time period, the number of annual deals fell from nearly 8,000 to just under 4,000. Perhaps more telling is the fact that the number of venture capital firms in the United States contracted by 49 percent between 2000 and 2006.

I believe there are five reasons why the contraction will continue for the foreseeable future in the venture capital industry.

First, the technology and telecommunications sectors, which have been responsible for so much VC growth over the past decade, are slowing down. There are still interesting situations in wireless software, and the SaaS model is intriguing, but for the most part innovation seems less compelling in IT right now. In addition, many of the opportunities that currently exist in new media and on the Internet require very little capital compared to software development and, thus, may lend themselves more to angel investing than venture capital.

Second, it’s unclear whether most venture capital firms can successfully diversify and migrate from information technology and telecommunications into new segments like clean technology, alternative energy or healthcare. It’s true that $3 billion of venture money was invested in clean technology last year, but generating meaningful returns in these still-emerging businesses requires specialized expertise, and many of the tech and telecom focused VC funds don’t seem to have that knowledge base readily available at this point in time.

Third, there is intensifying competition from European venture capital firms, which have sophisticated talent and experience in several of these new and growing sectors, including the clean technology space. Their experience and expertise, combined with the favorable exchange rate, puts U.S. VC’s in a bit of a box – and this probably won’t let up anytime soon. Right now, we’re involved in a number of deals that have come from solid and successful European VC’s.

Fourth, an increasing number of entrepreneurs are seriously questioning whether venture capital mentoring is all it’s been cracked up to be – particularly in light of the start-up carnage that was left in the wake of the Internet revolution earlier this decade. More and more fledgling companies associate a double negative with the venture capital experience: expensive money and ineffective counseling.

Fifth, angel investors are squeezing venture capitalists out of a number of small but potentially lucrative deals. This represents quite a turn of the wheel, because venture capitalists had the upper hand during the last cycle and frequently crammed down on the angels. There is definitely some bad financial blood here – and, quite simply, this is pay-back time. The angels’ increasing significance was demonstrated recently when CleverSet – a software company that recommends online products – relied on them for a good chunk of financing.

So, the once-vaunted VC model is broken – now what? How does it get mended? And how long will it take?

I’ll answer the second question first by saying that, given the long lifecycle of VC funds, it’s going to take some time for the venture capital community to fully adjust to the new reality that has befallen it – maybe even a full decade of true transformation.

And during those 10 years, the VC’s who survive will likely have to become one of three types of funds:
•    Regionally focused funds – Funds that are sized appropriately and are focused on a geographic region can be very successful. By bringing local market insight, a network of local relationships and on-site mentoring, geographically focused funds can gain access to the highest quality deals and generate attractive returns. Madrona Venture Group, for example, has done a good job of sizing its fund to the opportunity at hand. Madrona has focused on the Pacific Northwest and has generated attractive returns for its investors.

•    Specialized or industry focused funds – VC’s will have to be nimble over the next few years and go where the dynamic companies are – the alternative energy, clean technology and healthcare sectors. These emerging segments are complex – and combine science and sociology; building a new Web browser, for instance, is not the same thing as saving the world from the impact of climate change. Technology Partners is a wonderful example of a fund that has changed its focus and emerged as a leader by focusing on life sciences and clean tech.

•    Fund Complexes – The funds that don’t downsize and/or specialize, the ones that remain large, will likely need to become multi-asset class and global to be able to generate the required returns on their capital. Funds such as Sequoia, Summit Partners and Ignition Partners are offering access to some or all of the following: seed, early-stage VC, late-stage VC, growth equity capital, PE, mezzanine debt and public equity capital. And they are making investments not only in the U.S. and Europe, but also in China, India and Israel.

The VC community will likely end up looking much like the commercial banking and investment banking industries – some very large and global players with broad product offerings, and a lot of smaller focused boutique firms that have specialization as their competitive differentiations. The large funds will be more than $1 billion, and the small funds will be between $200 million and $250 million. We’ve learned from the commercial banking and investment banking experience that large and small firms can be very successful, but firms that fall into the middle – that are neither large nor small – won’t be able to generate attractive returns on capital.

The VC world looks extremely dark right now – and we haven’t even seen the worst fallout from the current financial cycle yet. But venture capital will somehow find a way to revive and renew itself.

It always has.

Ever since ADR, the first U.S. venture capital firm, was formed by Georges Doriot in 1946, innovation has been efficiently energized and capitalized in this country. The stagflation of the late 1970’s severely challenged VC’s and the Internet Bubble almost wiped many of them out. Now the industry is a much diminished version of its turn-of-the-century self. Yet when I look ahead, I see the top-tier VC firms – the winning 20 percent – continuing to pick winning companies with winning ideas. That’s more than comforting and sure to stimulate the economic growth this country needs to keep pace in the relentless global marketplace.

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4 Comments

  • As a scientist/patent lawyer/investor I may have a unique perspective on the problems in the VC market. I believe that an underlying cause of the problems you have identified is a plugged R&D pipeline. A handful of VC funds that have access to the best early-stage execution teams are able to go to universities and successfully execute tech-transfer agreeements. But there are hundreds of research labs both within universities and in university-backed startups that are better suited to doing R&D and transferring it out to another group for commercialization. Since Bayh-Dole was passed in 1980, researchers have moved out of large corporations and into universities, but the flow of R&D out has not kept up with private benchmarks for technology licensing.

    What the VC industry needs to do is implement a division of labor between VCs who are best at identifying and mentoring inventors and R&D and VCs who are best at identifying and mentoring early-stage product development teams. As all too many know first hand, these are different teams, and we are forcing round pegs into square holes in all too many cases.

    The long-term health of the United States economy is at stake here. More and more Ph.D.s are heading back to their home countries as R&D funding dwindles because too few inventors are able to obtain pre-product funding for their work.

    A corollary is that a stronger patent system would help — a patent system which encouraged licensing and discouraged litigation, a patent system which gave inventors actual leverage in negotiations with larger entities, instead of leaving them at the mercy of greedy VCs or large corporations.

    Feather the nest for inventors and the IRR for the entire VC industry will improve, and with it will our GDP over the long-haul.

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