It seems that every other day there’s a new story that surfaces regarding the venture capital model. The argument can range from the completely pessimistic point: “Venture capital is dead,” to an optimistic look, “Venture capital isn’t dead, entrepreneurs just aren’t performing.” Usually the optimistic view is hammered with data and angry individuals declaring this view absurd. Really, no one knows what’s going to happen. However, there are some stealth and early stage models soon to be released that will forever change the venture capital model as we know it. One in particular, is launching a model quite similar to the wiki fund, an idea I wrote about months ago.
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The most level-headed perspectives have actually come from venture capitalists. Fred Wilson, for example, has communicated the disenchantment held by his limited partners to the world.
In the end, venture capitalists are finally understanding that there’s not only a problem, but that it’s not just the economy to blame for it. Basically, we’re at the foot of the mountain named, “Change.”
Never waste a good crisis. A number of VCs compare today’s environment to tech’s nuclear winter in 2000. But in the last such “winter,” digital media and the Chinese market emerged and entrepreneurs seized upon tough times to start their businesses. Today, we are on the cusp of the next wave of disruptive technologies with next-generation Internet platforms driven by SNS and online games. The cleantech sector provides upside for renewable energy, efficiency and natural resource management, and VC-backed technologies including water disinfection, solar panels, gridscale storage or solid state discs can play a key role. Lastly, a rising middle class in developing countries will fuel excitement and adoption of transformative technologies. Now is one of the best
periods in the VC industry to invest.
– Dixon Doll, co-founder and general partner, DCM Partners
This change is something that we are capable of implementing immediately. At the foundation of this change will sit technology; and this will occur whether from a web 2.0 perspective (people at the center of technology), or a software perspective (simulation and quantitative analysis). The competitive pressures to bring the changes about all are in place. The only thing that will force the change will be results; that is, venture capital as an asset class must underwhelm limited partners to the point where they ditch the asset class completely. This is happening now.
Already, venture capitalists are shifting the focus of their investment strategy to later-stage companies and existing portfolio companies (Graph 1). This can be attributed to many factors, not the least of which is overcapitalization. While the venture capital industry was arguably already overcapitalized, the economic downturn has drastically restricted exits, further increasing overcapitalization. This and investor pressure has led to venture capitalists focusing on later-stage deals to realize quicker and more reliable returns over a shorter time span. Additionally, it is much more cost-effective for venture capitalists to focus on fewer, larger deals instead of numerous smaller deals. The statistics speak for themselves- even though 53% of venture capitalists in America think “it is currently a ‘terrific’ time to invest in promising entrepreneurial companies” (42% think it’s a “fair” time to, and 4% think “awful”), there is a dramatic shift of focus away from early-stage companies (graph 1).
The average $25 billion injection in capital in the venture capital asset class is fading. The willingness, in the late 1990s, to finance risky ventures is finally coming to an end; the funds that were known as the “dot-com” era funds will be releasing their return performance over the course of this next year.
The Basics of Venture Capital
The articles popping up lately presuppose that the reader understands the structure of venture capital. Except for the incubators that have surfaced recently like Y-Combinator, almost all VC funds are organized as limited partnerships. Currently, there are well over 1,000 funds in existence in the US, and a smaller number of others internationally. Of course, some of the U.S. headquartered funds invest internationally. Most funds have a life of 10 years. Over the course of these 10 years, the fund undergoes various cycles: (i) generating dealflow, (ii) investing, (iii) mentoring/monitoring, (iv) board level oversight, (v) harvesting (which means reaping the rewards of the capital invested).
From a legal perspective, the fund’s manager is a separate entity-it’s a venture capital organization that simply manages venture funds that it creates for itself. The members of the managing organization (venture capitalists) manage the fund as it enters different stages in the life-cycle. If the venture capitalist is a senior partner, he or she is simultaneously focused on raising an additional fund -it’s how they stay in business. It’s a very basic principle of diversification–the more funds you have the more stability you have. It’s fair to say that many VC’s focus on how they can raise the next fund, rather than focus on squeezing the most out of their current fund.
This year and next should be an attractive time to make new venture investments. The pace of technological change continues to accelerate and there is no shortage of great entrepreneurial ideas. Yet many of the sources for funding away from institutional venture capital have shrunk dramatically. Angel investors, corporate investors and hedge funds have all cut back or disappeared. Entrepreneurs are realistic about what kinds of venture deals can be done in this environment. So we feel there is now a great opportunity for venture capital firms to back great teams building leading technology companies.
– Sandy Miller, general partner, Institutional Venture Partners (IVP)
A Look at The Internet Bubble and How It Changed Venture Capitalists’ Philosophy
Put simply, the internet bubble was all about ideas, not about the people behind the ideas. Everyone had an idea for an internet company. You simply take an idea from the real world, and apply it to the online world. Obviously, with the “newness” of the internet, VC’s couldn’t invest in teams with a profound amount of experience in the realm. Nothing mattered except the idea. It had to be big enough to pump up, inject false hope and hopefully ride the cash-loss wave until you dished it out to the public via IPO. The best VC’s were those who could make an idea look glamorous and complete the IPO before people discovered there was no business model.
This way of generating success has slowly died out. Limited partners are waiting to get out, and VC’s are trying to simultaneously figure out how to actually invest in the space. The future of new venture financing is going to be nothing like the recent past. The pressures that venture capitalists experience are now trickling down to entrepreneurs; however, the effect it’s had has not been detrimental to the entrepreneurship sector because, well, entrepreneurs are resilient. Additionally, the cost of starting a tech company can be funded either through (i) open-source technologies, (ii) grants, or (iii) universities.
Some say we’re on the brink of seeing venture capital transition from an art to a science. However, this really isn’t the answer at all. If it did transition down that path, we’d just be counting down until the next Long-Term Capital Management fiasco. The transition venture capital needs to go through is one in which: (i) value-based investing is given emphasis, and (ii) people are at the center of the next revolution.
This is an easy prediction to make. Anyone can predict change in any sector; however, the nature of that change is what will be most interesting. Touching briefly on the art and science argument again, the major point is that venture capital in the 90′s was an art: where one individual valued assets based on subjective matters of personal taste. Many say the science component will come into play with increased insight into valuations; however, this never has been, or never will be, the answer.
The core problem with the late ‘90′s model was the singular decision-making that sat at its foundation: one investor making a decision on behalf of millions of dollars in limited partner money. The world has grown, and technology now easily allows many individuals to collaborate and build information. Already, microlending is quickly becoming a mainstream source of financing. According to the research firm Celent, the nascent peer-2-peer lending market has grown from $0.6 billion in 2006 to a projected $5.8 billion in 2010. If everyone had the opportunity to invest in startups as they now do with loans, a similar explosion of market growth would take place- there is approximately $50 billion in annual US seed-stage and early-stage financing requirements, of which VCs have provided a rough $5 billion annually for the last 7 years. A plural nature will be the future of venture capital.
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The Last Capital Transformation
In 1952, for the first-time ever, a theory of valuing very risky financial assets was introduced. The capital markets were never the same. Portfolio theory, as it came to be called, was unleashed by Harry Markowitz in a revolutionary article. And yes, it was very academic. After this, many practices and theories erupted that took theory and science within the financial realm to the next level. The problem was, they lost focus on what makes a sound investment as the fundamental aspect was lost in the hype: value investing.
At the center of portfolio theory sits the concept of diversification. Diversification is the process of investing small amounts in many risky assets rather than investing a large amount of capital in a few. However, it also lowers the rate of return that investors seek for investing in risky assets.
With portfolio investing as a tool for managing risk, professional asset managers compete aggressively for a few basis points of enhanced yield. A basis point is one one-hundredth of a percent–one penny per year on an investment of $100. Asset managers’ pursuits of basis points are responsible for:
* Growth of the small-cap public equity market
* Securitization of mortgage portfolios and a variety of debt instruments
* And growth of the international equity capital markets
In every case where portfolio investing has transformed a portion of the capital market, it has driven rates of return down. The same is true of the venture capital sector.
The Concept of Capital Commitments
A commitment is a promise by a limited partner to provide capital when called upon to do so by the fund’s general partner. Many think that venture capitalists have money in the bank account, ready to cut the check. This isn’t the case. They simply have the power to call up a large institution like Calpers requesting a million dollars. The reason it’s set up this way is partly due to safety and partly due to debt/leverage. The reason why venture capitalists don’t solicit us to invest in their fund is because it would simply take too long-additionally, the everyday investor wouldn’t be able to commit one lump sum of $150 million. Really, it’s about laziness. It’s easier to go to convince one huge pot of money, compared to many micro-pots of money. Still, you’re probably invested in a venture capital fund, without even knowing it. Your pension fund may be investing your money for you. You’re an indirect venture capitalist.
This structure did not become “the way” of structuring venture capital until 1979. Before then, SBIC’s (Small Business Investment Companies) dominated the field through subsidized loans to cash-generating small businesses.
In 1979, a change in U.S. federal law enabled institutional asset managers like pension funds and endowments to invest in illiquid assets, including VC funds. These entities that invest in VC funds are investors who easily can tolerate illiquidity. They can hold investments for several years waiting for an appropriate opportunity to sell. Such investors do not need much inducement to encourage them to invest in VC. This 1979 regulatory change is the same one that enabled fund managers to invest in small firms, securitized debt, and international equities.
With regard to illiquid assets, because of portfolio investing, even a slight differential in expected returns, compared to returns on liquid assets, is sufficient to attract capital. Portfolio investing, in fact, argues for some investment in VC even with no differential return or a slight negative. Nonetheless, returns to VC investing have been attractive.
The long-run average return (based on the last 20 years) for investing in VC has been 20.3%. If we were to weight the performance by total funds invested, the percentage return would be much larger. These returns are dramatically higher than returns investors seek for investing in liquid assets (stocks and bonds). Long run, the (postwar) average return on stocks (the S&P 500) is 14.7%. VC returns have been almost 1.5 times as high.
The Bottom Line:
Venture capital is undergoing a transformation. While this certainly is not unique, and is finally recognized, we will see new, innovative models arise. Stay tuned.
Would you like to test the cutting edge, new model for venture capital? A stealth venture is now accepting test users. You can sign up below:
[Notice: Only 100 Spots Available. Sign up now!]
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