Is Venture Capital Turning Around And Can Startups Still Get Money?
December 2009 / January 2010
Volume 7 Number 6
The question on everybody's mind in the technology industry is when will the venture capital market recover from the recession. A year ago, doomsayers such as Sequoia Capital scared everyone into thinking that a multi-year recession had arrived and it was a horrible time to be launching a startup that needed a lot of cash.
But just a year later, many of the indicators are so positive that economists have declared that the recession has ended and the recovery is beginning. The same thing is true for the venture capital and startup industry. The leading indicators such as the GDP growth of 3.5 percent in the third quarter show that a recovery is in the works, but lagging indicators show that the recovery isn't strong, the VC ecosystem is still weak, jobs are scarce and there are still problems that could derail it all.
Despite the tough environment, the traditional VC sector is still functioning. Seed capital may be easier to come by than large later-stage rounds, but the pipeline for money has not completely dried up.
One of the best leading indicators of a recovery in the technology startup is the reemergence of deal making.
Dave McClure, a managing director at the Founders Fund and master of 500hats.com, is one of the best connected investors in Silicon Valley. He currently runs FF Angel, a seed-stage investment program for Founders Fund, and also manages the fbFund REV incubator program on behalf of Facebook, Accel Partners, and Founders Fund. He is an advisor for 30 startups and runs a couple of dinners each month for startup networking.
McClure said that the dealmaking among VCs started picking up in the summer. For a the first half of 2009, everything was dead, McClure said. Then investors started looking over deals in the summer. McClure said that deals that VCs wouldn't touch a few months earlier were drawing multiple offers. Now, VCs are contacting McClure nonstop because they all want to close a deal before the end of 2009.
Such swings in behavior are common at key pivot points in the technology economy. But it's hard to believe that just a year ago Sequoia Capital, one of the most storied VC firms in Silicon Valley and a funder of both Apple and Google, warned startups to slash costs because the good times were over with the onset of a severe recession.
Now, Greg McAdoo, a partner at Sequoia, said at a recent event the firm has been making more investments in the last 12 months than in the preceding two years. The company has made 20 early stage investments in the last year.
"That deck of slides was so misunderstood. The point there was to run your business cognizant of the times we're in," McAdoo said. "We had a lot of startups that fell into really bad habits—things you might have gotten away with in a nice economy, but that wouldn't fly in these times."
VCs have stuck to investments in capital-efficient companies, or those that can get off the ground with a small investment and a lean engineering team. Those small startups can prove out a concept and earn their next round of funding. They can also operate on a small amount of capital for a longer time. They can take their time developing a new product and then be ready to launch it when the recession clears. While VCs once valued the number of the users, now they look to see how soon revenues will come in.
One of the truisms of Silicon Valley is that recessions are a good time to start companies, said Andy Sheehan, managing director of Sutter Hill Ventures. Employees are cheaper to hire and there are plenty of them available. All other costs are also lower. Valuations aren't sky high, and so investors can get better deals for their money. If a company shows that it can monetize its products early, it is a lot easier to fund than companies that have no clear path to profitability.
All of that should prompt venture capitalists into action.That's the thinking, anyway. But venture investing hasn't come back. The National Venture Capital Association said that VC investments in the third quarter were $4.8 billion, up 17 percent from $4.1 billion the second quarter and an abysmal $3.3 billion in the first quarter.
But most of the money went into existing investments in the third quarter. A relatively small amount—just $633 million—went into new startups. That was a record low amount of money going into first-time fundings for startups. In that sense, the VC market is still in a bad state. Only 17 venture firms raised money for new funds in the third quarter of 2009; that is the lowest number in 15 years, according to the NVCA.
The figures for returns lag for a couple of quarters. The return on investment for VCs dropped 12.5 percent in the fourth quarter of 2008 and again by 2.9 percent in the first quarter of 2009. That figure is expected to be on the upswing now. A lot of companies are getting bought for $50 million. The problem is that investors may have pumped $100 million into these companies.
If you look at the problems of the VC community, some of it is more related to a glut of venture capital firms than the recession. Analysts have said for a long time that there are too many venture capitalists putting too much money into subpar startups. A long-awaited shakeout has begun to happen. If the shakeout proceeds, the poor-quality companies and VCs will get weeded out. That process is happening to some degree, and so it's only natural that fundings will dip for a time.
"There is activity out there, but it's not nearly what it was 18 months ago," said Peter Kidder, division risk manager at Silicon Valley Bank. "People in the industry are saying that the industry size will shrink by a third or a half. The fact is that too much money went into venture capital."
But all is not lost.
While venture capitalists may not make as much money or hit as many home runs as they used to, the economy will move forward without them. Morgan Stanley analyst Mary Meeker says that the broader trends all show that the tech economy is in a state of recovery. The stock markets are the leading indicators. The markets started picking up during the summer and are now well ahead of last year's levels. She noted that credit is loosening up, earnings estimates have started going up as a group, and information technology is the No. 1 capitalized group on Wall Street now (that means that tech stocks are valued the best as a sector).
Positive earnings reports from Apple and Intel are encouraging. Intel had the best improvement from the second quarter to the third quarter in terms of revenue growth in 30 years.
What's more, the exits for venture capital investments are improving again. There were twice as many initial public offerings this year compared to last year. Deal volume is twice what it was last year and dollar volume of the IPOs has quadrupled. And there are dozens of companies now in the pipeline. Electronic commerce hit bottom in the first quarter and has been recovering ever since. All of these things are part of the leading indicators of a tech recovery.
All of this evidence that points to a recovery is hollow if it doesn't lead to a recovery in jobs, which is the last thing to turn positive after a recovery begins. A year ago, the nation's unemployment was around 6 percent. Now it is stuck at around 10 percent.
And consumer confidence is rising but it is still below normal levels. Manufacturing is recovering, but factory usage is around 70 percent of full capacity. Foreclosures are still rising.Those are all lagging indicators. Once they're back to normal, the recovery will be a confirmed fact.
Bill Fraunhofer, managing director of Citi Technology West, said that another big indicator of a revival is when the IPO market shifts from lukewarm to hot. He doesn't foresee that happening until perhaps 2011.
In the meantime, where and how do you get money?
Now many folks are wondering if certain sectors will take off faster than others. The recovery may not help all industries equally.
In the third quarter, money flowed into the software, biotech and energy/industrial sectors as large investment rounds returned. The average first-time deal in the third quarter was $4.1 million compared to $5.1 million one quarter ago. Seed or early stage companies received the bulk of first-time investments, garnering 66 percent of the dollars and 68 percent of the deals, but that fell short of second quarter percentages when they accounted for 76 percent of the dollars and 73 percent of the deals.
The startups that are getting money are the ones headed by veteran entrepreneurs with trusted teams, said Sheehan. "Cold calls rarely get you anywhere, so you have to find a trusted introduction," he added.
Angel investors are a good alternative to VCs early on, but like all investors they were hit hard by the stock market declines. Angel rounds can be group investments and they typically range from $1.5 million to $2.5 million. But entrepreneurs have to remember that angels can rarely get a company through three or four rounds of capital. If a startup needs that much capital, it will have to go to VCs sooner or later.
Deals are taking longer to get done. Due diligence is more thorough. VCs observe for a longer time. So entrepreneurs have to figure out exactly how much runway their cash will give them. It's possible to get bridge loans to get past shortfalls, but that's not easily done. Banks and private equity companies are also shy when it comes to taking risks these days. But taking out a loan is not a bad idea if that money will get a startup past a milestone that could result in a much higher valuation, Kidder said.
Strategic corporate investors are another alternative for startup funding. Intel Capital chief Arvind Sodhani says that strategic investors may step forward even as other investors back out of taking risks. That's because the strategic investors want to move a technology forward. They don't necessarily want return on investment as their No. 1 goal. Startups can benefit from the brand and marketing muscle of the strategic investors, which can help a small company get credibility, Kidder said.
But strategic investors aren't helpful if they pigeonhole a startup as a captive of the strategic investor. If the startup can no longer be seen as a neutral vendor because of its ties to a strategic investor, it won't be able to attract outside capital any longer, said Jon Gavenman, a partner at Cooley Godward law firm.
What will confirm the recovery?
Mary Meeker said she was excited about the positive trends related to technology adoption. One of the fastest-growing sectors is the use of mobile data on devices such as the iPhone. Apple iPhone users account for 65 percent of data usage, but only 11 percent of the total mobile market share in the U.S.
"The iPhone is the fastest growing piece of hardware the world has ever seen," Meeker said.
Japan is years ahead of the U.S. in mobile data and Meeker believes it will serve as a model for what will come. She said that the U.S. has a long way to go to catch up with the patterns of mobile Internet usage in Japan. By 2013, the number of heavy web mobile users will triple to a billion users.
The shift to the mobile web is no less than a new computing cycle, such as the shift from mainframes to minicomputers, from minicomputers to PCs, from PCs to the web and laptops. Each time one of those shifts happens, the number of users increases tenfold. Indicators of this growth: Global positioning system (GPS) chip shipments are up 57 percent this year, while Wi-Fi chip sales are up 42 percent. On the content side, Facebook has seen huge growth in usage, as have social networks on mobile phones.
All of these trends toward mobile internet expansion will cause huge shifts in wealth creation, Meeker said. In each major computing shift, new winners emerge, and the incumbents fade away. These macro trends are obvious to VC investors. So they're busy putting money into mobile startups, from application vendors to platform companies. They may not be right about the future. But at least they're betting on something.
Dean Takahashi reports from Silicon Valley for Innovation.
Copyright © 2012 | Innovation America