01 Mar 2005
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Venture Capital’s Comeback

Since the tech meltdown in 2001, venture-capital partnerships have trimmed staff, scaled back the size of funds, and gotten back to the basics of investing. For the top firms, business is looking up.
Re: Jim Breyer (MBA 1987); Rob Chandra (MBA 1993); Tony Sun (MBA 1979); Clint Harris (MBA 1977); Brian Dovey (MBA 1967)
by Roger Thompson

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With roughly half of the nation’s venture-capital firms and scores of venture-backed companies among its clients, Silicon Valley Bank (SVB), headquartered in Santa Clara, California, wields enormous influence within the tightly knit venture community. So when the bank’s president and CEO, Ken Wilcox (MBA ’83), comes calling, it’s an important occasion — at least under normal circumstances.

Spring 2001 was anything but normal considering that the Nasdaq had been in a free fall for almost a year, wiping out billions in venture investments. Wilcox, invited to a partners meeting at a “relatively well-known” venture-capital firm, arrived to find only one partner in the office. Momentarily nonplussed, he quickly agreed to a round of golf at nearby Pebble Beach.

That unexpected outing speaks volumes about the state of venture capital in the midst of the worst “correction” in the industry’s nearly sixty-year history. “VCs venture capitalists didn’t have anything better to do than play golf,” remarks Wilcox, whose bank specializes in serving the financial needs of its venture-capital and start-up clients. “They weren’t sure what to do with their lives.”

Four years later, venture capital is, at least, out of the rough. “We see a set of improving fundamentals for investment opportunities,” says Jim Breyer (MBA ’87), a managing partner with Accel Partners in Palo Alto, California, and chairman of the National Venture Capital Association, representing some 450 venture-capital and private-equity firms. An improving economy helped boost total venture-capital investing last year by 10.7 percent to $20.9 billion, up from $18.9 billion in 2003, according to PricewaterhouseCoopers. From Boston to Silicon Valley, top firms are competing for deals again. And the initial public offering market — the favored exit for venture-capital investors — rallied last year to post 249 deals, more than triple the number of IPOs in 2003.

But the road ahead remains uncertain for many, especially those not in the top ranks in terms of size and investment track record, say industry veterans. For all but the leading firms, raising money remains difficult. And deciding where to invest has become more challenging as new types of opportunities arise at home and abroad. Before inking a deal these days, venture firms need a global perspective on competition, if not a global presence, especially in China and India. Meanwhile, industry insiders worry that post-Enron regulatory reforms will have unintended negative effects on venture-backed start-ups. (See sidebar, page 28.) Their concern extends beyond clients to the overall health of the U.S. economy.

While the venture-capital community itself is small, numbering several thousand professionals coast-to-coast, its impact on the economy is enormous. Venture-backed companies employed more than 10 million American workers and generated $1.8 trillion in revenue in 2003, concluded a study by Global Insight, a leading economic and forecasting firm. HBS professors Paul Gompers and Josh Lerner, in their 2001 book, The Money of Invention, calculate that “venture capitalists have created nearly one-third of the total market value of all public companies in the United States.”

Flight to Quality

Over its nearly sixty-year history, the venture-capital industry had experienced several boom-and-bust cycles, but nothing of the magnitude of the tech-fueled bubble. Annual venture investing soared from under $10 billion in the mid-1990s to over $100 billion in 2000, before plunging back to earth after the tech bubble burst. Since then, annual venture investing has hovered in the range of $15 billion to $20 billion.

“At the height of the boom, all venture-capital funds had LPs limited partners begging to get in,” notes Wilcox. “Today, the really good funds are back competing for the very best deals, and LPs are lining up to invest money in them. But the mediocre and poorer funds are having trouble raising money.” He estimates that dozens of firms, out of an estimated 700 nationwide, will fail as the dust from the tech wreck continues to settle.

Most firms that close go out with a whimper after unsuccessfully attempting to raise a new pool of investment capital. “There are firms that have been out trying to raise money for the last twelve months or so, and they still haven’t been able to close their funds,” says Breyer. “I think that 2005 and 2006 will be bellwether years in terms of firms closing.”

Cash-starved funds are victims of the post-meltdown “flight to quality,” explains Rob Chandra (MBA ’93), a general partner with Bessemer Venture Partners in Menlo Park, California. “Limited partners now want to be in the top-tier funds, leaving the top funds oversubscribed and the new, emerging funds having difficulty lining up capital.”

From the LPs’ point of view, there’s good reason to be selective. Only the top quarter of venture firms outperformed stock indexes between 1980 and 2002, according to industry research. Firms with median returns lagged indexes by several percentage points, and those in the bottom quarter actually lost money.

While demand for top firms remains strong, there’s a limit to how much money can be put to work. Following the tech plunge, new deals dried up, forcing venture firms to return billions in uninvested capital. Even so, venture firms have an estimated $64 billion in capital “overhang” that has not been invested, according to VentureOne, a unit of Dow Jones Newswires. Today, leading firms are raising new funds of $250 million to $500 million, half the size of those raised during the tech frenzy, when billion-dollar funds were commonplace. Some industry veterans contend that there are still too many venture dollars chasing too few quality deals.

“The amount of capital flowing into our business is unsustainable,” says Anthony Sun (MBA ’79), a managing general partner at Venrock Associates in Menlo Park. “We can’t deploy $20 billion in quality investments. And we can’t generate $20 billion in exit values, either through IPOs or acquisitions. So the industry still is not in equilibrium.”

Back to Basics

With the venture-capital turnaround that took root in 2004, venture firms returned to the fundamentals of dealmaking, with primary focus on the entrepreneur’s ability to build a good company, says Clint Harris (MBA ’77), a cofounder and managing partner of Grove Street Advisors in Wellesley, Massachusetts. During the bubble, the most valued skill was the presumed ability to predict what hot concept could go public fast. Now the pendulum has swung back to valuing entrepreneurial skills first and foremost.

There’s also a renewed appreciation for the amount of time and personal attention it takes to grow a successful company, observes Deborah A. Farrington (MBA ’76), the founder and cochairman of StarVest Partners in New York City. “We are back to the reality that it takes seven to eight years to build a company prior to going public, rather than two or three years, which was the expectation during the boom.” IPOs for “concept” companies also are dead, Farrington adds. Investors now want a company to be well on its way to $100 million in annual revenue before it goes public.

Inside venture firms, Bessemer’s Chandra sees a shift from specialization to generalization. “During the bubble, there were great rewards for VCs who focused on a very specific investment category, such as online pet food. You could invest in five or six companies in the same area and do quite well with all of them,” he explains.

Now, across the entire industry, there’s a shift toward the generalist as venture firms explore new areas of opportunity, such as nanotechnology, fuel cells, solar power, clean technology, and even entertainment. “Each partner is stretched to look at more areas and to constantly examine new opportunities,” notes Chandra. “It’s not enough anymore to focus on one area if you are going to produce top-tier investment returns.”

Exporting VC Dollars

Nor is it enough to focus exclusively on the United States. “When I got into this business in 1979, deals were done in Boston and Silicon Valley and hardly anywhere else,” recalls Felda Hardymon, a professor of management practice at HBS and a partner at Bessemer Venture Partners. “Back then, when you started a business in your garage on Boston’s Route 128, your competition was down the road or in Silicon Valley. Today your competition is just as likely to be in Shanghai or Bangalore. Venture capital now requires a global strategy. And the export of U.S. venture investment dollars is going to be a big, important change in the business over the years ahead.”

Hardymon points to Silicon Valley Bank’s recent investment scouting trips to China, India, and Israel as a sign of things to come. The bank organized the trips for senior partners from two dozen top-tier VC firms, who visited with government officials and entrepreneurs in each country. Hardymon ranks the trips as “among the biggest recent events in the VC world.”

SVB’s Wilcox says the trips helped make a point. “Technology today is global in nature, and to remain relevant to our customers, we must have a global perspective and a global presence.” The bank opened offices in London and Bangalore last fall and plans to open one in Shanghai this year.

Relevance also drives venture-capital firms to explore business opportunities abroad. Many of their portfolio companies now find their best customers in China and India, where U.S. technology products are in high demand. More importantly, the free flow of ideas and capital have created entrepreneurial hot spots around the globe, challenging venture firms to follow or risk being blindsided. “If we are going to invest in an entrepreneurial opportunity, we have to be sure there aren’t competitors in some other part of the world — whether China, India, or Israel — and have enough insight into each market to know that we are investing in something that is truly unique,” says Chandra, who traveled to China and India with the SVB delegation.

By investing in companies abroad, Wilcox acknowledges that U.S. venture-capital firms are helping to export U.S. jobs. “But I don’t think there is any way around it,” he adds. “Start-ups in India and China will have access to capital anyway, and it might as well be our capital so that we can get a return on it. Potentially, we can even garner some strategic advantage from the relationships.”

When evaluating offshore deals, cost saving isn’t the primary motivating factor, explains Breyer of Accel Partners. “One of the characteristics of international investing that gets lost, especially in discussions of Asia, is that centers of excellence exist all over the world. For VCs, foreign investing is much more fundamentally about the intellectual capital that is being developed all over China and India than about shaving costs.”

Developing a global perspective doesn’t necessarily mean having a global presence. Farrington’s StarVest Partners, for example, focuses on emerging enterprise software, a niche without significant foreign competitors. Nonetheless, the firm tracks foreign software developments to stay current with market developments.

Some firms spot great ideas abroad and bring them to the United States to launch. That approach works for Domain Associates in Princeton, New Jersey, which invests exclusively in life sciences companies. “We try to license ideas and bring them to the United States to start the business because there is a lot more infrastructure here that you don’t find abroad,” explains Domain general partner Brian Dovey (MBA ’67). “Also, you have very little ability for liquidity, namely IPOs and acquisitions, in Europe or Asia.”

Anthony Sun says that after careful consideration, Venrock Associates decided not to open an office and do direct investing in Asia. “It wouldn’t be a strategic fit for us,” he explains. “The opportunities that are developing in India and China are markedly different than the opportunities we look for in the United States. China and India bring strengths in the service industry and commodities. But they are not places to find leading-edge opportunities in technologies.” However, Venrock foresaw the globalization of venture opportunities several years ago and sponsored a new, independent venture partnership called Granite Global Ventures to invest abroad. The firm has offices in Silicon Valley, Singapore, and Shanghai.

Accel Partners is one firm that already has successfully established a presence abroad, having opened a London office in 2001. Currently, it is evaluating whether to open an office in China. “We will make direct investments in China, and we are in the process of testing a number of hypotheses around how best to build opportunities there,” says Breyer.

Looking ahead, HBS professor Josh Lerner predicts that a small number of global firms soon will dominate the venture-capital industry, while niche firms will thrive by specializing in specific regions or industries. Says Lerner: “The firms in the middle that try to do all things for all people will have a difficult time surviving.”

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