Venturing into the unknown

Venture capital firms invested only $3bn in new companies in the US during the first quarter of 2009, the lowest investment level since 1997. This amount was down 47% from Q4 2008 and 61% from Q1 2008, according to the National Venture Capital Association (NVCA). With fundraising stymied, exit gates shut and distributions to limited partners virtually non-existent, the venture world is asking, "What's next?" According to Dick Kramlich, NEA co-founder and general partner "it will take a 'Netscape moment' to get out of this morass: An emerging company with a technology that is so arresting, that has been proven, and is in an early phase of growth. And, then, an underwriter who says, 'This will be a big company'". But, Kramlich and others also say while the future looks promising, there are a few clouds on the horizon.

Exit strategy shift

So, why is venture changing? Simply put, the industry faces a number of challenges that require different answers than those given in the past.

"I started in venture in 1973, when the business was still in the process of developing structurally," notes Len Baker, managing director of Sutter Hill Ventures. "It was adapted for a particular set of conditions in Silicon Valley: capital was plentiful, and it was fairly cheap to start companies. Technology was moving very fast, but, it was susceptible to venture financing. And then we had a big bull market beginning in 1983."

Baker argues that the amount of capital available simply could not be absorbed. Others are not quite as drastic, pointing out that since time immemorial, everyone has complained about "too much capital chasing too few deals", yet the industry continued to grow. Nevertheless Baker has a point when he maintains that "from the early 80s, you could argue that technology was permanently overvalued until 2007. Huge markets can absorb investment that is driven by the amount of capital available, but that is different from the investing opportunity".

Gary Bridge, managing director of Horsley Bridge Partners, elaborates: "What happened in 2000 was more of an 'internal to the venture capital industry' phenomenon. The people in our industry had too much money and as a result, they went on a huge spending binge fuelled by LPs flush with money to be put to work. In retrospect, professionals were investing in many ideas with no hope of real success. The internet sector was the first area to feel the pain from this binge. There were some good companies formed during this period, but they were overwhelmed by too many me-too companies that couldn't get revenue traction. Soon after that, the telecommunications bubble burst. This sector had only a handful of giant companies able to buy or integrate all of the products being developed by hundreds of new companies being formed to serve them. As the market retrenched, these giants cut spending meaningfully and the smaller companies went out of business very quickly".

The result is hardly surprising, with Baker revealing that "returns for the asset class - even the top quartile - have all been single digits. Even the best firms were bailed out by a single deal - Google."

NEA managing director Peter Barris agrees: "We never fully recovered from the 2001-2002 market crash. The single largest issue for the venture industry since the internet boom and bust is that we haven't returned a lot of capital. The macro distributions have been small. There are a lot of questions about the anaemic IPO industry. We were starting to come out of it, when the IPO door slammed shut in early 2008. Then it became sealed in the third quarter."

The result has been a strategic shift in how the industry sees itself. "Our exit strategy is sale to another company," says Greycroft Partners founder Alan Patricof. "We don't invest any longer with the idea of taking a company public. It helps to condition yourself to realistic exits. Our exits will be strategic: I can't say that others have accepted that. There just isn't a public market today."

Of course, the dearth of IPO exits could be a temporary function of today's economy, but it doesn't seem so. "The underwriters that took us public are gone. All the small market makers and research people are gone. We've had a fundamental change in the way our business is operating now. We're in a private market. We will sell our companies through M&A transactions," explains Patricof.

Doing better with less

The venture world doesn't borrow money, therefore funding is less impacted by what the banks are doing than by the financial health of their portfolio companies - and their LPs.

"Most venture guys are focused on their portfolio," notes Walden chairman Lip-Bu Tan. "In the series-A round, we used to mark it up 2-2.5x. It is not easy to get subsequent financing rounds as up rounds in this market. But, if you have a good company, you can close an up round series-B. We are now going through a phase, 'Doing better with less.' It's very important to be patient. A lot of industries will be consolidating. Adding value-add to portfolio companies is important. It's crucial to really focus on quality, hands-on management." Tan has taken his own advice. He was recently named CEO of Cadence Design Systems, where he can more closely focus on the company's contributions to fabless semiconductor companies.

At the same time, strategic investors with large cash reserves have grown in importance. "Corporates who invest from their balance sheets don't have the dynamics of the LP situation," says Intel Capital president Arvind Sodhani. "We are investing globally and supporting companies in their needs. Remember that most of the GPs in China and India raised their capital from US and European LPs. There are plenty of LPs who have made it known, 'Don't come to us for funding.' Those portfolio companies will come to us because we are able to finance. Everything in the economic environment suggests that it won't change much for the rest of the year."

Adapting to globalisation

H&Q Asia Pacific founder and chairman Dr Ta-Lin Hsu observes that "20 years ago, Silicon Valley dominated the technology venture world. There was no competition. Now with the spread of technology around the world, everything is globalised and technology has become a commodity". Barris agrees: "We believe that the practice of venture capital is becoming and will become a global practice. You have to play globally or have to be very specialised."

With globalisation having changed the dynamics of venture investing, questions have been raised about Silicon Valley's position as the primary technology hub - has the technology world moved on? Kramlich does not think so. "The Valley is still the wellspring of innovation: the sun and water are here; we have the educational systems and a very refined technology infrastructure." Dr Hsu concurs: "I have a selfish hope that because of infrastructure, good weather and good immigration policies, Silicon Valley is still a good cluster point. It can still be a good place to showcase the world."

Nevertheless doubts remain. GSR managing director Sonny Wu argues that Silicon Valley is no longer the epicentre of global technology. "The Valley is different now than it was 10-15 years ago. A lot of innovation has become more dispersed. The Valley is becoming more and more virtual. The negative way is to say it's becoming more and more marginalised. If you can do everything in Israel or China, why do it here?"

Moreover, while there are many there are many venture markets in the world, such as India, Israel and Singapore, China dominates. "China is taking direct aim at the US capital markets. If you look at relative markets, the US markets have lost a lot of leadership. China has an opportunity to make strides in the capital markets," explains Kramlich.

In her 2008 book, Silicon Dragon, journalist Rebecca Fannin made a similar argument. It's not that the Valley has disappeared; it's just that the rest of the world has caught up. Smart and ambitious entrepreneurs are now everywhere, and they can do it cheaper elsewhere. "One hypothesis is that there's no manufacturing in the Valley. Everything related to stem cell is not there. Everything related to TV is not happening there. Will manufacturing come back to the US? I would argue that the easiest way to rebuild the economy is to rebuild at $8 an hour and not at $29 an hour," believes Wu.

However, simply transplanting the Silicon Valley model into another country hasn't been successful, according to Baker. "It has failed in Europe. I think that China and India will adopt their own structures. Analogue models in Shanghai and Beijing will not work out. Those doing more indigenous types of businesses will succeed. The dilemma for venture capital firms: how do you go global? It's very hard to have the branch plant model, where you have firms around the world," he elaborates.

Fewer, smaller firms

Although globalisation is making an impact on venture investing, the dearth of distributions remains a primary concern. "I don't think we'll see positive industry returns for another five years. That means we won't have had positive returns for 14 years. Investors have already become sceptical about the return parameters of this industry and that scepticism will become even more pronounced," states Bridge. "A minority of the venture capital firms will be able to earn positive returns, some earning very acceptable returns. Where will the majority of the companies formed in the last nine years go? They will either cease to exist, be acquired cheaply or become the "living dead". A minority of them will probably do okay, but they won't carry enough weight to provide the industry as a whole with positive returns," he elaborates.

As a result one can expect many funds to disappear and the remaining ones to be smaller in size. "I envision a world going forward with more, smaller funds that can make good money, not in absolute returns, but the IRRs may be better. Holding periods may be shorter and grand slams will be rare, but we can see ourselves doing doubles and triples," says Patricof. "Even though the multiple will be greater, the absolute number of dollars from any one fund will be less than we have seen in the past. For example, if a $150m fund goes up 4x, the profit is $450m. If a $500m fund doubles, it produces a profit of $500m. At the same time, I believe there will be smaller, more frequent realisations in shorter time periods. So the IRR's will do better," he concludes.

With holding periods contracting, remuneration among venture players could follow suit. "The biggest thing is the time horizon. Fund structures are overlapping and this forces a fairly short investment cycle. In the margin, carry goes down. If you're in a fund that doubles your money, on the margin you're working for a 10% carry. That doesn't incentivise people when you're entering a period when the rational thing to do is build companies over a longer period of time," explains Baker.

Bridge further acknowledges that the changes will affect the industry's professionals. "The old guard GPs are transitioning out and many of the continuing professionals have never tasted success. Even a GP with 10 years of experience may not have had real success yet. That is discouraging. One wonders if they will be prepared to stay in the industry and mentor their younger professionals."

A new investment profile

As the industry is facing tough challenges in the new environment, there is a clear need for venture players to identify a new emerging investment niche. However that is easier said than done. "Nobody knows what the next big thing will be. There are some cleantech and greentech businesses that will be big companies. Solar is an overplayed area. In the internet space, I'd say 'no' to Web 2.0. It's hard to see much in what's been invested in the past 2-3 years," comments Bridge.

Moreover with cleantech/greentech and alternative energy areas heating up, there's another problem for venture as the industry is not designed for these types of investments. "The nature of investment opportunities in cleantech doesn't fit the venture model. They tend to be capital intensive, require long term financing and depend upon government subsidies or government rule setting. So, the question is, can you imagine the best type of institution to make these investments?" explains Baker.

Dr Hsu speaks humorously but makes a serious point. "US venture capitalists are becoming more like Chinese style venture capitalists. If you are a VC and you go to China, you don't talk about your technology. You talk about the free land and the tax rate they will give you. You need to meet the mayors or governors. If you don't know the government's position on the subject you're discussing, you're in trouble. For clean energy and climate control in the US, you need to know about government policy. That has fundamentally changed venture capital."

According to Ted Schlein, a managing partner at Kleiner Perkins, 45% of his firm's investments are in the greentech area. "We have 40-45 different greentech investments: new types of fuels, new energy generating efficiencies. There's a very good alternative energy environment. The policy in Washington is supportive. The culture and climate are on." Others are more cautious. One general partner feels that, "John Doerr has gone wild on alternative energy. But, does he have his politics mixed up with his investing?" Nonetheless, Doerr is a pretty savvy investor, so maybe he's on to something and Kleiner Perkins is currently raising several annex funds to support investments in previously-closed funds.

All in all, it is a very tough environment but the world will continue to grow and innovate. Areas such as alternative energy, mobile platforms and life sciences will see great innovations ahead. But the big question is: What role will today's venture funds play in that growth? According to Kramlich "one of the misconceptions is that venture is a lifestyle business. It's not. It's a very intense and difficult industry." With the challenges facing its leaders and the need to adapt to a fundamentally changed universe, it will only become more so.

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