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.
