New Strategies for VCs
October / November 06
Volume 4 Number 5
Venture capital returns aren't what they used to be. And that is starting to have an impact on the funding dance between startups and their financiers. The days of the big venture capital returns have faded. The five-year return for venture companies is -4.4 percent, according to Thomson Financial and the National Venture Capital Association. Initial public offerings are down, even though new money going into startups is still abundant. Legislation such as Sarbanes-Oxley has made it more expensive and difficult to run a public company.
And Wall Street isn't valuing promising new companies the way it once did.
These days, a good IPO will often return about $300 million to the investors, nowhere near the $1 billion returns in the technology bubble days. That means there will be many more exits through mergers and acquisitions, where the exit reward is more like $100 million. Only 19 venture-backed companies went public in the second quarter of 2006, according to Thomson Financial and the NVCA. In the same quarter, 86 venture-backed companies were acquired.
In this new environment, venture capitalists have had to change their strategies. Those who invest in venture capital funds expect to encounter more risk, but in exchange they have traditionally expected a 10-fold return. When the exit return is only $300 million, that means that venture capitalists can only pour about $30 million into a company during its lifetime in order to have a chance at the 10X return.
"To have a chance at a good return, the venture capitalists should invest in companies that take less money," said George Hoyem, managing director of Blueprint Ventures, a VC that invests in early stage and seed companies in South San Francisco.
This is not to say that the big returns are entirely out of reach. Big home runs still happen. It just means that the average results aren't as good. Sanjay Subhedar, a partner at Storm Ventures, said, "If you take away the bubble returns as an anomaly, there is no reason to think that venture capital returns will not be similar to historical returns. The 30 to 40 percent annual returns were unsustainable. The subsequent correction has also been overly dramatic. That means that capital efficiency is really important."
The change in environment is bad for some sectors in technology. For instance, the costs for making custom chips have risen with the difficulty of making one-time manufacturing prototypes. It often takes $50 million to bring a new chip to market, Hoyem said. But quite often the exit return for a chip company is no better than a return for a low-cost company that makes podcasts.
This means that certain sectors are hot. Software services companies often require no more than $25 million investments. Social-networking companies require even less to get off the ground. But then the VC has to be careful about getting into a sector that is overfunded. After all, who needs yet another MySpace clone, when the leader in that space already has a head start on getting more than 100 million users?
"For a software company, the exit return is about $150 million and for a systems company it is about $250 million," Subhedar said. "That means you can't put more than $15 million into a software company or $25 million in a systems company."
Life isn't easy for venture capitalists, even though there is a lot of money available. In the second quarter of 2006, venture capitalists invested the highest dollar amount into the most deals since the first quarter of 2002, according to the MoneyTree Report by PricewaterhouseCoopers and the National Venture Capital Association. Venture investing grew to $6.3 billion in 856 deals, a 2 percent increase in dollar value from the prior quarter and a 5 percent increase in deals. In the second quarter, 50 venture funds raised $11.2 billion, the highest level since the first quarter of 2001. The problem, as stated, is that there is a lot of money going into companies, but exit returns are weak.
While venture firms may want to try to hold the capital investment down, other investors who don't require a 10X return, such as unregulated hedge funds, are still investing in a lot of startups. Hedge funds don't mind if they can get a 20 percent annual return on an investment. That is keeping valuations higher than the VCs want. If the VCs stay out of an investment because the valuation is too high, they may be stuck on the sidelines. The venture funds can't live with lower returns because so many of their bets go sour. Hedge funds try only to beat the market and don't make ten bets with the expectation that only one will pay off.
"We see another pumping of the bubble," said Tim Chang, a partner at Gabriel Venture Partners. "Yes, we know that. What are the implications of that? Is it time to back a truck up to the bank and load up on money? If you do that, then you have to get a $1 billion exit. That's a white-knuckle ride."
But there are strategies available to the VCs to deal with this difficult funding environment. VCs are encouraging startups to keep costs low by outsourcing engineering work to India or China. Ambric, a networking chip company, started in Portland, Ore., where costs are lower for attracting engineers in comparison to Silicon Valley.
"One strategy is to look at companies that don't require as much capital," said Amos Barzilay, a venture consultant at Walden Capital. "If you are disciplined and mindful of valuations, you can make money."
Barzilay said that even if chips are expensive to bring to market, VCs can still invest in chip-related companies that aren't capital intensive. For instance, some companies develop designs that are licensed for use in chips made by other chip makers. These silicon intellectual property companies don't require as much investment. But they can still pay big returns, as evidenced by silicon IP companies such as Rambus. On top of that, VCs can also invest in companies that design software tools for making chips. These so-called electronic design automation, or EDA, companies have a rich history of bringing tools to market at low costs. Then big companies such as Cadence Design Systems will acquire the startups.
Hoyem said that it also makes sense to look for technologies that have been incubated in big companies or government research institutions. For instance, Blueprint helped Intel spin off a corporate IT software division dubbed LANDesk.
Intel had funded LANDesk for a number of years and decided for strategic reasons to spin it out in 2002. Hoyem said the spinoff was an ideal venture to participate in as a VC because the company's technology was proven. Intel had already invested about $100 million into it, and so all that LANDesk needed was the last push to get into the market. Blueprint and Intel put $17 million into LANDesk and the company eventually sold to Avocent for $417 million. The deal returned about $60 million to $75 million to Intel, which otherwise might have shut down and written off the LANDesk division. Microsoft and Hewlett-Packard, also anxious to get a better return on research and development, have also made moves to spin off divisions in partnership with venture capitalists. Blueprint also spun out Covad Communications from Intel as well, a move that generated a 100-fold return. NEC recently spun off a division that makes video surveillance technology.
"We find there are lots of these kinds of opportunities," Hoyem said.
The sectors where government institutions are likely to enjoy success in spinning out companies to venture partners include homeland security and clean technology. Both sectors are red hot in terms of funding now and there is no structural problem, as in semiconductors, that makes these sectors difficult for VCs to fund.
The changes for the VCs have a cascading effect on everyone else. If life is tough for VC firms, it isn't that easy for entrepreneurs. But entrepreneurs can pursue strategies to adapt to the new environment as well.
SiBEAM, a chip company in Sunnyvale, Calif., that is making next-generation wireless technology, raised $21 million in a series B round recently from marquee VCs such as U.S. Venture Partners and New Enterprise Associates. CEO John LeMoncheck said that his company was able to show that its products would be applicable across a wide range of markets. That means the company won't be forced to sell out early to just a small number of bidders, he said.
"It's true it's hard to get a 10X return," LeMonchek said. "But in our case, the investors were an easy sell. We were led by a current investor because our story hung together."
For angel investors, the crunch has come as well. Angels are more likely to get "crushed," or have their ownership diluted, if they don't invest in subsequent rounds in a company. Silicom Ventures, a Silicon Valley angel investors group, started a new fund where its angels can invest alongside VCs in subsequent rounds so they don't get crushed.
"We invest at a lower valuation than we used to," says Gadi Behar, managing director. "When the exit valuations are lower, we have to invest at the lower valuation in order to have our own good returns."
Despite all of these tactical maneuvers, most venture capitalists still have faith in their ability to pick winners in the fields that they know. Staying focused on an area of expertise is bound to be rewarding, says Rob Herb, a partner at BA Ventures.
"It starts with being focused on the market," he said. "You must choose to focus on areas that represent large markets, offer the opportunity for rapid growth and provide the opportunity for a startup to participate. That typically drives you toward consumer markets as opposed to infrastructure markets. You can also look for markets going through a technology transition that allows a startup to gain a foothold in the transition and position itself to be self-sustaining."
Adds Gordon Hoffman, a managing director at Northwest Technology Ventures, "You have to be more selective. I come from the chip world. It's what I know. So I invest in the companies that the experts all want to join."
Keith Gillard, head of the North American investments for BASF Venture Capital, says that it pays to get involved in companies in early stages. The MoneyTree survey said that VCs are offering smaller rounds to more companies, leading to a dip in post-investment valuations for early stage companies. He says that VCs should be more active in supporting a company. That means taking a board seat and often going out to actively search for the startup's first customers at an early stage.
I always try to generate leads for the companies we fund," he said. "That's how you improve the odds of getting a better return."
Subhedar says it is OK to invest in areas such as chips for consumer electronics devices. But you have to be aware, he said, "That the environment is like a winner-take-all game. You will see 50 companies get started, and two will survive. That's the reality. You want to be the category leader. If there are a bunch of search companies, you want to be Yahoo! or Google."
Dean Takahashi is a reporter for the San Jose Mercury News and the author of The Xbox 360 Uncloaked.
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