Uncharted Territory
There is a fundamental economic, and perhaps psychological evolution
taking place in the venture capital community.
by John F. Ince
Upside.com
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There is a fundamental economic, and perhaps psychological evolution taking place in the venture capital community. Some interpret this change as the classic sign of a maturing and stabilizing industry; others see it as the deadly demise of an industry that has already seen its heyday.
Either way, the VC industry is clearly in a period of hibernation. Whether this constitutes paralysis or is simply the exercise of good judgment in a down market remains open for debate, but this much is clear: The venture capital industry today is still processing—economically, intellectually, and psychologically—all that has happened since the burst of the dot-com bubble and the events of Sept. 11.
Ted Dintersmith, a partner at Charles River Ventures (CRV), says, “I may be wrong, but I see it so clearly. There is an awful lot of future bad news in our business. It’s already happening. In two years, you’re going to have the LPs [limited partners] saying, ‘What were we doing?’”
However, not everyone thinks the recent slowdown is an unhealthy development. Alan Austin, partner and COO of Accel Partners, says, “I think we’ve got a situation where it’s gotten very foggy on the freeway. Prudent drivers have slowed down. It doesn’t mean that VCs are in shock or having psychological problems; I don’t think it’s a good time to be going 60 miles per hour.”
Just how foggy is it out there? Graham Watson, Deloitte & Touche Corporate Finance’s managing partner in Northern California and Hawaii, says, “We’ve seen the slaughter. In third-quarter 2001, the amount invested was just under a quarter of what was invested in [third-quarter 2000].” That’s not to say the capital isn’t available. In fact, most analysts agree that there’s too much money in the VC business today.
In the course of one decade, venture capital went from a $3 billion business to a $100 billion business, resulting in an estimated $40 billion to $60 billion of investable capital, or so-called “dry powder,” still looking for a place to call home. Last year, Crosspoint Venture Partners raised eyebrows with its decision to cancel a billion-dollar fund; the company said that it didn’t think it could effectively invest that capital in the current market.
The origins of that surplus, as you might guess, can be credited to the infamous Internet bubble. From 1980 through 1995, the amount of money raised in aggregate for the industry was generally a mere $2 billion to $4 billion per year, with the exception of 1991, when it was approximately $1 billion. In the late ’90s, driven by robust IPO markets and venture groups posting good results, the LP community aggressively started moving larger portions of their portfolios into so-called “risk capital.”
In 1999, when the IPO markets went insane, LPs were suddenly getting more distributions and pouring the money straight back into venture firms. Mark Heesen, president of the National Venture Capital Association (NVCA), says, “In the year 2000, the VC industry broke every historical record, from the number of companies funded to the amount of money raised, [and from the amount of] money invested to the number of venture-backed IPOs and acquisitions.”
page 2: All Grown Up
The venture capital industry soon outgrew its roots as a boutique industry that operated in a relatively unstructured environment. Dominant and established franchise players, such as Kleiner Perkins Caufield & Byers (KPCB), Sequoia Capital, Mayfield, New Enterprise Associates (NEA), Accel Partners, Battery Ventures, Charles River Ventures, and numerous others, started operating with complex networks of strategic partnerships and a long waiting list of limited-partner investors. Since then, venture capital has become increasingly institutionalized, both in terms of the internal organization of VC firms and, more significantly, in terms of its importance in the larger private-placement marketplace and our national economic psyche.
Optimists argue that the technology sector of the GDP is also much larger, and the VCs’ abilities to do things right are more developed than they ever were. But CRV’s Dintersmith remains unconvinced by these arguments. “Those things are all true, and they’re a good argument for why, if our industry could digest $3 billion before, it can now digest $10 billion. But can we digest $100 [billion] or $60 billion and have it all provide good returns for the LPs? I don’t think so.”
Richard Frisbie, a founder and general partner at Battery Ventures, suggests the venture capital industry may, in fact, develop a bad case of indigestion that could result in the disappearance of many firms. “The NVCA only recognizes about 800 VCs, but I’m convinced there are twice that number out there, many of them operating under the radar screen. Most of those will be gone in a few years. Of the 800 who are recognized by the NVCA, probably 200–300 of those will be gone.”
Deloitte & Touche’s Watson agrees that a shakeout is ahead: “With the limited-partner market being increasingly selective about where they will deploy their capital, coupled with the overhang of capital and poor valuations, there is only one endgame, which is contraction of the market size.”
A New Generation of VCs
There has been some talk recently that the current downturn will result in a whole new generation of younger VC firms that will start to replace established franchise firms. Names that come up in such discussions include Foundation Capital, which emerged (along with Benchmark Capital) from the ashes of Merrill, Pickard, Anderson & Eyre in 1995; Redpoint Ventures, which came out of Institutional Venture Partners (IVP); Polaris Venture Partners, which came out of Burr Egan Deleage & Co.; Great Hill Partners, which came out of M/C Partners; and Versant Ventures, the health care–focused spinoff from IVP, Crosspoint Venture Partners, and Brentwood Venture Capital.
Does this foreshadow a shift in the industry’s power structure? Mark Saul, a partner with Foundation Capital, believes so: “We passed on EToys and people thought we were nuts. Because we stuck close to our knitting and imposed a discipline on our investing, we were able to close a new fund of $600 million in May 2001.” But it should be pointed out that many other, more established, firms were equally successful, if not more so, in raising capital during this same period. Within the last 18 months, Matrix Partners closed a $1.2 billion fund. Charles River Ventures also raised $1.2 billion, and NEA raised $2.3 billion.
Most VCs working for established firms are skeptical of the notion that these new firms represent much of a threat and suggest that, instead, they simply reflect a normal churn in the industry. Battery Ventures’ Frisbie says, “This is a natural process. It’s nothing new. Every year, several new firms start up with experienced partners coming out of well-known predecessor firms. So then the question becomes, Are these new firms better-positioned than the established firms? Absolutely not.”
It may be stretching the point to suggest that the VC power structure is about to be radically altered. Accel’s Austin says, “The proposition that the day is about to be seized by the novices is absurd. It overlooks the values of wisdom, experience, historical perspective, and the franchise value that all apply to this kind of investing.”
page 3: So, Who Will Survive?
Which firms will be able to emerge from the current downturn in the strongest position? The firm’s size, its experience, and the quality of its team are all important, but the critical driver of success in venture capital has always been the internal rate of return (IRR) that the VCs report to their limited partners. Floyd Kvamme, partner emeritus at Kleiner Perkins Caufield & Byers, says, “It’s not necessarily the large firms that will continue to thrive. The critical factor is IRR. There will be large firms that will have difficulty raising funds if their returns are poor. For example, if a firm has done well, or at least above average, for four straight funds, the LPs may tolerate a poor fifth-fund showing. But if the next fund also has poor returns, the venture firm will have trouble raising a following fund. In other words, two consecutive poorly performing funds are a real problem.”
Another important factor is the degree of diversification of limited partners. NEA Co-Founder and General Partner C. Richard Kramlich says, “If the VCs’ limited partners are people with adequate resources to meet all of the funding calls, and if the VCs are diversified—that is, they don’t have a great dependency on just a few limited partners, nor are [they] too limited in terms of companies or sectors—then I think the size of the firm itself isn’t of great consequence. I know a few firms that could be classified as large, but they have relatively few funding sources and are sector-focused. Their situation is very precarious.”
The firms that will be in the greatest jeopardy are the newer, smaller funds that have yet to develop specific domain expertise or post decent IRRs. It is unlikely that there will be banner headlines announcing the closing of any individual VC firm, and the process will take a while to work its way through the system. “There are two levels of ‘gone’ for a venture firm. On one level, the name doesn’t exist anymore and the phone is disconnected. Very few firms will be gone in that sense,” says CRV’s Dintersmith. “It takes a long time for venture funds to fade out of existence. When you raise a fund, you have a five-year time horizon. The last thing the LPs want is a whole bunch of illiquid positions. So everybody’s incentive is to keep the fund alive for 10 years or more. But over the next five years, we’ll find a lot of funds gone in the sense that they won’t be able to write a check for new investments.”
Finding Their Footing
The industry won’t get healthy again until several critical factors come back into balance. One of those factors is salary level. Adam Grosser, a general partner with Foundation Capital, points out, “Top code-writing developers are still getting paid $120K–$140K, and salaries are one of the major cost drivers and consumers of cash in a young company. If salaries don’t come down, companies will be significantly more expensive to build than they were in 1995. Unfortunately, the exit valuations for companies formed today are nowhere near what a 1995-vintage company could command as it matured in 1998 or 1999.”
But the fundamental issue for the VC industry is the fact that the end users of products and services, especially larger corporate customers, just aren’t buying these days. And when they do, they gravitate toward established firms rather than startups, because they want to be sure that their suppliers will be around in a few years. Frisbie of Battery Ventures says, “The root cause of the problems we see in venture capital today is that the marketplace for technology is decreasing. The overall market is shrinking. The market for telecom equipment was down 25 [percent] or 30 percent this year [2001], and it will be down next year. Software spending was flat to down this year and probably will be flat to down next year. The economy is in a recession. The technology sector is in a depression.”
But there have been some recent signs of hope in technology buying. More importantly, most observers believe that it’s simply a matter of time for the technology market to come back, because technology investments are key drivers of cost savings, efficiencies, and productivity increases. Deloitte & Touche’s Watson says, “Although spending is being managed very tightly in all corporations, companies can’t keep that particular tap turned off indefinitely. In a truly global economy, it’s vital to be positioned in the forefront of an increasingly large marketplace, and the success of corporations depends, to a large degree, on investments in IT.”
Most analysts expect that the shortage of end-market demand will continue for a short while longer, and this will drive further consolidation of portfolio companies within the VC-backed community. But Watson points out, “When corporate IT budgets open up again, the pent-up demand for efficiencies will bode well for those companies that have aligned themselves properly, funded themselves properly, built market share, and consolidated. Ultimately, they will succeed.”
The next year is a critical time for quality companies to shape themselves in anticipation of a rebound in the corporate marketplace. This may be a good reason for VCs to start spreading around some of that dry power. NEA’s Kramlich agrees: “As long as your expectations aren’t out of line, and your time frame is reasonable, I think this is the best time in the last 20 years to be an active player in this business.”
What’s Ahead?
Today, the reckless investing style that characterized the venture capital industry in the late ’90s is dead. The industry is rapidly evolving into something akin to more mature industries like investment banking and even legal services. The longer-lasting impacts of this shakeout will take several years to manifest themselves, because of the lag time that characterizes the VCs’ reporting of portfolio IRRs to their limited partners. Kramlich points out, “It’s a somewhat ironic situation that many LPs are now over-allocating funds to VCs because they make their allocations relative to their alternatives, largely public markets, which show their losses instantaneously. We had a 50 percent drop in the Nasdaq, but the venture pool has not declined commensurately. The better funds will post modest gains, perhaps between 5 [percent] and 15 percent, so the end result is, even with losses in the venture business, for a few years, their funds will be over-allocated in venture capital.”
Are we about to witness the demise of the VC industry? No. Reports of the imminent demise of the venture capital industry are off base. Battery Ventures’ Frisbie suggests one possible scenario: “There are probably going to be several big-name firms who just decide that the business is too tough, and they’re not going to be able to make enough money to warrant the incredible amount of work that’s involved in being a good venture capitalist. If the LP-capital spigot does get turned off, we will surely see a flight to quality firms. LPs will continue to invest, but only with VC firms that have proven their ability to make money in different cycles in the industry.”
Images have been tarnished, but it remains to be seen how this will translate into difficulties in raising future funds. However, this much is clear: The venture capital industry that existed two years ago is a vestige of the past and is likely never to be seen again within our lifetimes. Accel’s Austin puts things in historical perspective: “Today, we’re simply getting back to fundamentals. Yes, we had a great party. But when people start saying that the fundamental laws of economics no longer apply, it’s time to ring the bell signaling the top of the cycle. Ironically, we may now be entering a period of exaggerated fears about the future.”
Deloitte & Touche’s Watson says, “One of the things that has historically distinguished Silicon Valley and made it the envy of the world has been its forgiving attitude toward failure. That can be a positive attribute, because it encourages risk taking and innovation.” Perhaps part of the maturing process at work in the VC industry today is that it is becoming more risk-adverse, and yet it is also able to respond positively to failure.
For now, many of the top names in venture capital are facing the choice of spending most of their time and money trying to keep problem investments alive or letting their investments go.
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