Mid-Decade Musings


Lean venture capital returns are in their seventh year but, barring force majeure-type events, we should enjoy more positive results starting in 2007. Why? Because we’ve largely cleared the bubble wreckage, the second wave of the Internet is upon us and new disruptive technologies are emerging to create new industries.  

During the bubble, the VC financial model in was giddily re-engineered to work with billion dollar exits. The public markets became late-stage venture financing vehicles which allowed public offerings of many companies that had no business going public, when measured against traditional, more rational metrics. When the party ended, we faced an overabundance of funded companies that required either painful recapitalizations or fire sale liquidations. We suffered a Depression-like loss in jobs, with Silicon Valley employment plummeting by over 20 percent.

Enterprises which support entrepreneurial activity right-sized for the new reality: Investment banks shut their Silicon Valley offices; Law firms shed corporate lawyers by the hundreds or went out of business and; VC firms quietly shed partners or decided against raising the next fund. Surviving or new venture-backed companies have struggled in a low or no-growth environment where potential customers are still wary of doing business with startups and keep tight controls on their purse strings. Potentially-acquisitive public companies have favored buy-backs of their own stock, instead of growing their businesses with new technologies by buying venture-backed startups. Sarbanes Oxley has significantly increased the cost and regulatory burden of being a public company and raised the bar for going public. The wave of initial public offerings of the late Nineties combined with several slow growth years and the higher IPO hurdle created by wary public markets and the cost of SOX has created a dearth of bankable private companies strong enough to go public. Just as we had started to put all of this behind us, the option back-dating scandals came along, casting a pall over the whole technology sector and further threatening to further erode the cherished institution of the stock option, which fuels the human capital side of the equation. Clearing out the detritus from the tech wreck hasn’t been fun.

Happily our business is cyclical. While we were cleaning up the mess, the second Internet wave has been building quietly. Like many previous disruptive technologies, the first Internet wave was characterized by a mania of enthusiastic over-investment followed by a manic-depressive crash. Like prior disruptive technologies, the second wave is proving larger than the first. At the millennium, there were about 400 million desktop PCs around the world providing Internet users access to mostly text data. By the end of this decade, there will be billions of cheap, Internet-enabled mobile devices delivering every imaginable kind of media, to anyone, anywhere and at any time. This staggering growth in Internet users and the universe of available content and services triggers unimaginable consequences and opportunities for new businesses.

Unfortunately, here in Silicon Valley, recovering from the first-wave hangover has obscured this second wave and the opportunities it presents. Recovering from the tech wreck has been hard and protracted labor. The second wave doesn’t have the irrational euphoria of the first one. After shedding thousand of jobs, employment growth has been slow. We’ve added lots of jobs, but most of them are offshore in places like China, India and Eastern Europe. Commercial real estate vacancy rates have subsided but there are still tens of millions of square feet of empty office and R&D space in Silicon Valley.

While the first wave hit us directly at Netscape headquarters in 1995, the second wave is a more global phenomenon hitting hard in places like India and China where hundreds of millions of people are joining the Internet community. Given what we have had to recover from, it is no surprise that we are somewhat numb to the enormity and power of this second wave.

The pace of entrepreneurial activity and innovation seems to remain constant no matter where the ecosystem may be in its cycle. Intrepid entrepreneurs figure out how to fund their ideas no matter what the market is doing or where we are in the cycle. With venture capital firms preoccupied with cleaning up their portfolios and tending to their troubled companies, professional seed and early stage investing slowed to a trickle. Fortunately, during the last six years, entrepreneurs have continued to start companies despite the relative paucity of early risk capital from the venture capital community and have found creative and frugal ways to finance these ventures. Bridge financings from friends and family have often stretched into two or three year affairs with several extensions. Creative partnerships with established companies, government grants, provision of consulting services to fund operations, and self funding have been commonplace. It is difficult for an entrepreneur with only a business plan and good idea to get funded because investors want reduced risk or no-risk deals. What would have Series B stage investments in the ’96-’00 period have become Series A deals with experienced management teams, products and customers. The good news is that the entrepreneurial teams that can navigate through this tougher funding environment and survive until their first round of venture capital funding tend to create stronger, more viable businesses.

From the perspective of term sheets and preferred stock financing documents, investor sentiment shifted last year from fear of making another lousy investment to fear of missing the next Skype. When we look back at this decade in a few years, the tipping point in the fear/greed cycle may well have been the fall of 2005 when eBay acquired Skype and Google concluded its secondary offering. This may have signaled the start of the next cycle of positive returns, just as Netscape’s IPO in 1995 triggered the resulting technology gold rush. The first stirrings of this up cycle feel more sober and grounded than the last one, although private company valuations are increasing as are the instances of competing term sheets. 
 
New industries and opportunities like clean technology and nanotechnology may combine with the second wave of the Internet, continued advances in the life sciences and the completion of the processing of the tech wreck to create a good three to five year run. The high price of oil has fostered opportunities in alternative energy and related fields where there had been little incentive for innovation for decades. One might argue that there is a rash of irrational exuberance in the clean technology sector which has allowed some questionable companies to go public and has caused high pre-money valuations of private companies. As there was with the Internet, there will probably be a first wave of over-investment in clean technology followed by a crash of sorts. Real businesses like SunPower and Renewable Energy Corporation will, however, continue to emerge from this sector.

Recently, the California legislature signaled that the second wave of clean technology may be larger than first. Just as it took decades for the hazards of smoking to become apparent, the hazards of our greenhouse gas producing economic system, which is slowing cooking us and the planet, are becoming more evident. We may be creating the tragedy of the commons on a global scale by altering the shared atmosphere with heat trapping greenhouse gasses. The California Global Warming Solutions Act of 2006, which is the first piece of legislation in the United States to put a cap on global warming pollution from stationary sources, may position California and its venture capital industry to become the global market leader in clean technologies. This bill may be a harbinger of a massive shift in technology as we to transition to a sustainable society that ceases to slowly destroy the planet with its effluvia. The second wave of clean technology may well be characterized by businesses that create clean and sustainable solutions. The venture capital business will be the vanguard of this revolution.  

Finally, the inventory of bankable technology companies has slowly rebuilt the IPO pipeline. Over the next few years, IPOs of venture-backed companies should increase as more companies have had time to grow their businesses to significant size. In addition, public companies should curtail buying back their own shares to support or bolster stock prices and buy more technology companies as their own technologies become stale. As the number of exits increases, venture capital investors should see positive returns again — and may even start making more early-stage investments.