What’s Really Going on in the VC Industry? What Does it Mean for Startups?

Posted on Jul 16, 2010 | 96 comments


Lots of discussion these days about the changes in the VC industry.  Here’s my take:

1. The VC industry grew dramatically as a result of the Internet bubble - Before the Internet  bubble the people who invested in VC funds (called LPs or Limited Partners) put about $50 billion into the industry and by 2001 this had grown precipitously to around $250 billion.

2. But VC is an “illiquid asset” so funds didn’t disappear quickly - In 2000/01 the stock market quickly adjusted punishing investors in the NASDAQ and in individual public technology stocks.  Consumers pulled their money out of these risky investments, but when LPs make commitments to VC funds they make 10-year, legally binding commitments. So as of 2008 total LP commitments were still at nearly $250 billion.

3. The VC industry in shrinking –  Paul Kedrosky was early on the scene with this prescient prediction that the industry would shrink.  What accelerated this was the collapse of the public stock markets.  LP’s who invest in funds are typically university endowments, public & private pension funds, insurance companies, large corporations and very high net worth individuals called “family offices.”  To give you an indication of how bad, for example, university endowments are suffering check out this chart.   You’ll notice that Harvard lost 30% of the entire value of its portfolio.  If you’re interested to read a more detailed piece on how they think about this check out.

So the people who invest in VC funds have two problems.  One is the “denominator problem” which says that if an LP invests X% (the numerator) into “alternative investments” such as venture capital and if their total amount available to invest (the denominator) goes down by 30% then the amount they allocate to VC will by definition need to go down by 30% to stay the same percentage.

The second problem is more troubling.  The VC industry has performed terribly over the past 10 years.  Many firms didn’t even return LPs their original money let alone a profit.  So even within the “alternative class” our LPs are looking at other asset investment choices such as distressed buyout funds, private equity or hedge funds.

VC will shrink.  Oh yes it will.

4. This means that some funds will disappear – Returns are not even.  The top quartile funds have performed well. [side note: our last fund at GRP Partners is currently ranked as the 5th best performing fund of the year 2000.  Our current fund was raised in 2008/09.]  Many funds have not performed and will start to disappear.  This is finally happening because the boom of 1998-01 means that many funds are reaching the maturity of their 10-year funds [strangely, 10-year funds usually last about 13 years!].

The best and most consistent funds in Silicon Valley (e.g. Sequoia, Kleiner Perkins, Accel) can and will easily raise money.  But even great funds that are not in this historic and long-established funds will not find fund raising easy.  This is best told in this amazing and brutally honest piece by Alan Patricof where he talks about the recent difficult fund raising experience at Greycroft [they just raised a $130 million fund].

I was at dinner with a large LP and mentioned that I had heard the industry would shrink by 50%.  She laughed and said, “Our predictions are for a much larger drop.”  Gulp.

5. Funds that raise money will be smaller - There is not only less money going into the VC industry, those that raise funds are often raising significantly smaller funds.  Some funds like Battery Ventures have bucked the trend by raising $750 million.  Others will, too.  But my conversations in the private corridors on Sand Hill Road in Silicon Valley is that many fund sizes will be smaller going forward.

6. This is producing a game of musical chairs –  You know: the music is playing while 8 partners walk around a circle of chairs.  The fund size shrinks by half so half the chairs disappear.  The music stops.  Partners leave the industry.  Some partners don’t have to walk – they just sit down while the music is still playing and therefore other partners need to go.

But equally some partners joined firms in 2000 and have still never seen any upside in cash since their funds haven’t yet returned the initial capital [note: VC funds usually return all of the capital that they raised first and then share 20% of the profits above this hurdle].

I suspect both were at play in Rustic Canyon Partners that went from a $500 million fund to around a $200 million fund.  PE Hub reported that there were defections and the implication was that the fund was “fighting for its life.”  I don’t think this is accurate.  There are some very talented partners remaining at Rustic Canyon and I’m told some committed LPs.  But I also know that some of the partners who left were also very talented.  PEHub followed up their analysis with this.  Think about the math.  It was clearly a game of musical chairs in some cases and in others a case of talented people believing they could make more money in a different job.  After all, most people don’t understand that “venture capital is a get rich slowly” scheme.

7. It takes less to start a business these days – We all know that it takes less to start a technology company these days.  You don’t need to buy hardware – there’s Amazon AWS.  You don’t need to buy expensive software – there are free open source solutions for nearly everything.  You don’t have to hire as many sales people because much can be sold online.  So companies are running for the first 1-2 years on significantly less capital than they did 10 years ago.

8. So super angel and seed funds are proliferating – As a result there has been an explosion in the number of amazing early-stage investors such as Softtech VC, Floodgate, Felicis Ventures, K9 Ventures, OATV, Lowercase Capital, Founder Collective, and many, many more.  There are also super angels that are so numerous I’d rather just link to the best list out there, which is VentureHacks’ AngelList.

9. And VC’s are doing earlier stage deals – And we all know that VCs are doing earlier stage deals.  The most notable is First Round Capital who built their entire fund and model around this type of investment and the notion that exit values in the future will be lower than they were 10 years ago.  They are also the most innovative new fund to enter the market in the past 10 years in my opinion.  There is also True Ventures that does early stage, seed investments.  And of course Foundry Group, Union Square and a whole host of other firms including my own.  I have written more in depth on this topic in the past.

10. This is producing a “boomlet” or a bubble in early-stage investing.  That’s OK. – This massive increase in seed & angel funding caused Paul Kedrosky to predict that there is a coming seed fund crash.  I don’t know whether there is a “crash” coming per se but I do believe that too much money is going into angel and seed companies too quickly.  I’m OK with this – it feels fairly benign.  But one problem it is causing is that early-stage deal prices are creeping up again higher than historic norms.  This smells like classic froth to me.  So IMHO it’s probably more of a mini “bubble” than an impending crash.

11. But it takes the same amount of money to scale a big business and this is where outsized returns are earned – If you want to build a big business you still need big bucks.  Fred Wilson wrote a great piece on this. He acknowledged the importance of the growing seed fund movement in creating a new wave of cost-effective innovation.  He then profiled his portfolio company FourSquare who started with a very small investment.  But now that it’s time for them to scale they need a lot more capital and therefore just raised $20 million from Andreessen Horowitz.  Think about it – while FourSquare has established itself as the clear market leader it is unquestionable that Facebook, Yelp, CityGrid and many more well capitalized companies will be gunning for them.  Staying “lean” is not an option.  If FourSquare wants to dominate it’s market it’s time to GO FAT.

12. Many angels and some seed funds will get burned – In good times it’s great to be an angel or seed investor.  You invest low amounts of capital and the company gets to IPO (96-99) or trade sale (05-08) without raising too much capital and certainly not on punishing terms.  But in bad economies many angels get burned. More money is needed, VCs are harder to come by and when they invest it can be on penalizing terms.  Often if you have deep pockets (or a proper fund) you can protect yourself by getting out your checkbook again.  But this only works if you have deep pockets.  And ironically the one time angels hate to get out their checkbooks is in a difficult market (in part because they’re also feeling it in their real estate investments, stock market portfolio, etc.).  So angel and seed stage investors’ returns will be dependent on good times continuing or on the ability of their portfolio companies to get financed.

13. So forming tight relationships with larger investors in the value chain is a critical skill for investors – The smart angels and seed fund investors know that one of the most important success criteria for an early stage investor is the ability to get the next round of the company financed.  Nobody understands this better than First Round Capital.  I have never seen a fund that spends so much time building relationships with every other VC (in addition to many entrepreneurs.)  Some seed angles and seed funds clearly get it.  Others spend less time on this activity.

I also think that seed funds with a very clear sense of purpose will do well.  One of my favorites is K9 Ventures.  Listening to Manu Kumar speak is like listening to a focused entrepreneur speak (and I can’t say this about all funds).  He has a set of clearly defined criteria in order to invest.  Price MUST be in a certain range.  Team must be purely technical.  Revenue must come from a primary source (as opposed to advertising or other third party sources).  Teams MUST be in the Bay Area.  And so on.  When you listen to his rules you get the sense that he really has a strong thesis for his investments and a belief in how he’ll make good returns.

14. This is especially true if we have a double dip economy – If the economy is in recovery then angels and seed funds are heros.  If we hit a double dip economy then the next phase of their investment cycle begins.  They’ll need to focus on getting portfolio companies funded.  Those that invested narrowly enough and/or have great relationships with VCs will do well.  Those that spread there bets widely or haven’t fostered VC relationships will have some triage work cut out for themselves.  ”Financing risk” is one of the biggest risks for seed stage investors.  This only becomes noticeable in down markets.

15. The reality is that right sizing the industry isn’t enough.  You need to right size each segment of the industry. – While many people publicly predict that the future of investing is about seed investing I think this is wrong.  There is a certain size market for seed funding that should exist.  Excess capital will drive up prices in that segment and drive down returns.  I think this segment has expanded due to structural changes discussed earlier but it still has a natural limit.  Then there is a certain size market for A round VCs, B round VCs and growth equity investors willing to put $50 million to work.

What you’ll see is a natural segmentation of the industry (which already exists) where each segment is right-sized and we’re all inter-related and our successes mutually dependent.  The earlier the stage, the cheaper the price, the smaller the check, the higher the risk and therefore the higher expected return.  So Chris Dixon is right that super angels and seed funds should perform better than VCs – they’re taking higher risks due to an early stage.  But many others won’t navigate these risks well and will underperform.    You don’t get the increased reward without the commensurate increase in risk.

I did a short explanation of this whole phenomenon in this video.  Start at minute 50.30 and run for just a few minutes.

16. Importantly, what does this all mean for startups? As I argue in the same video above – startups are better off by the “right sizing” of the VC industry.  When there is too much money in VC then too many companies get funded and raise too much money.  Try selling your product at a fair price when you have 4 competitors who’ve each raised $10 million in VC and who expect it will be easy to raise the next $10 million.  Over funding drives poor market behavior and makes it difficult for strong players to earn proper returns.  I’m not anti competition – to the contrary.  I just don’t like too much competition armed with large balance sheets funded on speculation and hoping purely for user numbers.

So in the future less of you will likely raise VC money.  You’ll have to find alternate ways of financing your dreams and that’s OK.  But those of you who do get funded will build stronger businesses, make better returns, hire better & more committed employees.  And of course you will produce our next wave of innovation.

  • http://avc.com fredwilson

    great post Mark. i agree with all of this.

    the one thing i don't know is how the other industry sectors in VC (cleantech, biotech, retail, etc) will be affected. i don't think the capital efficiency drivers that are at work in IT are as much of a factor in those sectors. and they make up a decent percentage of the overall VC pool.

    this techcrunch post [http://techcrunch.com/2010/07/15/venture-capital-investing-up-34-percent-to-6-5-billion-in-q2/] says that of the $6.5bn invested by VCs in Q2 2010, about half went to cleantech, biotech, and medical devices and equipment

  • http://david-noel.com David Noël

    What a great overview and recap. Thanks for all the work you've put into this post, Mark.

  • http://www.hypedsound.com jonathanjaeger

    Thorough post. I'm not going to lie, it's more entertaining to hear all this in a conversation on This Week in Venture Capital, but it's nice to have an easy to reference blog for the future as well.

  • chrissheehan

    Good post Mark on the state of the VC industry relative to IT/tech enabled businesses. I agree with your comments. Its going to be fascinating to see how this all plays out over the next 5 – 10 years

  • http://twitter.com/janthonymez J. Anthony Miguez

    Thanks for the great post. I am sharing it with all the angels I know. Miss the pretty graphic you drew on TWiVC segmenting the market :) As an LP in all of First Round's funds, I have seen the benefits of Howard and Josh's work at building a new model and agree with you that it is worthy of duplication.

  • http://reecepacheco.com reecepacheco

    as usual, super-thorough, Mark.

    great read on the industry – acknowledging the changes while stepping back to say “hold your horses, big VC's aren't dead in the water.”

  • Rob K

    Mark- Great post. I agree with almost all of it.

    I'm not sure the super angels will get burned. Their fund sizes allow them to make decent profits at median IT/Internet exits (around $60MM). It's the $200+ million find that needs the company to scale or needs 5+ wins.

  • http://twitter.com/vsagarv Vijaya Sagar

    Great post Mark. Just a few days back, a fairly respected Indian VC was telling my friend how difficult it is becoming to raise funds. And I've seen angels going conservative with cheques, as their real estate investments turned dull.

    Another thing that's going on: Amidst all this confusion, either to make up for old losses or to not miss out the party, VCs are putting money into companies whose technology/business they don't fully understand. This herd-investing will invariably lead to segment-specific bubbles.

  • http://www.kidmercuryblog.com kidmercury

    the angel –> VC –> acquired/IPO model is still built on the premise of selling out to a higher round, with the big money coming when you take your company to the casinos on wall st so that the public can lose all their money. the public markets are broken and correcting them requires significant structural/legislative reform. i also disagree with point #11, and think federated models will prove that idea to be invalid. i also think in regards to point #11 folks should think about what that guy coase said regarding why the firm exists in the first place, and when the firm ceases to be a cost-effective means of coordinating labor.

    key points that always get ignored in these discussions but are worth considering and cannot be ignored now matter how hard people try: impact of dollar crisis; impact of broken public markets. spend a lot of time dwelling on these issues, feeling bad about them, and you will come to very different and shocking conclusions. then express those conclusions, and as you get ignored and attacked for doing so, resort to condescending jokes as well as set up jokes — meaning making comments that will set up jokes for when the dollar crisis and the brokenness of public markets and the regulatory environment become more undeniable. this will be a positive investment, for humor, like love and truth, is a bull market that never ends.

  • http://www.cognation.net deancollins

    I guess the bigger question is what additional value add can a “superior” vc deliver over another apart from just cash.
    Will we see internal improvement within the funds to bring about differentation between the various companies.

  • http://www.davidblerner.com davidblerner

    Up there as one of your great posts in my mind… thanks for laying it out.
    dave

  • http://twitter.com/NukeGold Nuke Goldstein

    There's something to be said about the type of people in various sectors. I'm a software engineer and entrepreneur, my wife is a microbiology scientist. I have been exposed to the two worlds and I can tell first hand that the type of folks in the hi-tech world are much more the material investors like and seek.

    The reason probably lies with the quick gratification of the field and the fact most of us literally started a venture in our basement with just a computer and coffee and a boatload of vision and motivation. Biotech, cleantech and others mostly start in the parallel universe of the academy where a different mentality exists, and time moves much slower.

  • http://alexjmathews.com Alex Mathews

    Fred, check out this article in the Boston Globe today, stating that the lion's share of New England VC investments in Q2 went to the life sciences sector http://bit.ly/aVJ12f

    Mark, great post, incredibly insightful as usual.

  • dshen

    I also think that angels are going to get burned because we don't have the resources of the super angels out there to diversify broadly. I wrote about this in a post recently [http://ds.ly/9zylbP] and am starting to sit on the sidelines a bit. There are way too many internet only startups out there and I can't tell who will win and who will not when a few competitors and near-competitors pop up for nearly every deal I see – how do I know that the one I pick will win? Even if they are backed by prominent investors, I don't think that is enough of a predictor to win – most people know I hate social proof [http://ds.ly/dxyrZ9].

    I also love your comment about how this is a really slow way to make money. In talking to many people who are trying to get into the VC business, they seem to think it's a fast way of making money. This applies to both people applying for jobs in traditional venture funds and also to new angel investors who think that the next Google is easy to find. All that competition out there, as you say, is making it harder and harder to produce a Google when the marketplace is splintered so thinly.

  • http://www.comradity.com K. Warman Kern

    I'm curious about what VC's think they have learned and what the implications are going forward.

    Clearly, as @fredwilson comments below, the dollars seem to be moving into biotech, green, medical, etc. where the correlation between proprietary technology and success is higher than the “consumer” media world.

    But what has the VC community learned about the “consumer” media world and how will they be evaluating investment opportunities in the future?

    I've been down the VC route and our “principles for success” (http://www.comradity.com/comradity/comradity-ma…) weren't on the VC radar screen.

    Would be interested in knowing what VC's believe these days.

    Katherine Warman Kern
    @comradity
    http://www.comradity.com

  • Togilvie

    This is a great post. One thing I've been struggling with (in your post and Fred Wilson's) is point 11.

    I agree that businesses will still need capital. But since that capital is being provided at a later stage, there is less risk and more bidders for the good companies. (i.e. Cost of capital declines)

    This sounds good for the VCs that are investing at this stage, but I'm not sure. Lower risk implies lower returns, which means that the “spread” between public market returns and VC returns will decline.

    We're simultaneously seeing a longer window for companies to exit (I've anecdotally heard 6-8 years versus 3-5, but don't have hard data.) I think this means LPs should be demanding a higher “spread” in return for their lack of liquidity.

    What does this mean for the category? I'm not sure, but I think that the times are changing for both ends of the “barbell” in early stage companies today.

  • David Lokshin

    If VC fundraising supply/demand lag is 10 years long, does that mean that the industry could be under-capitalized into 2020 (given the difficulty in raising funds now)? Or is this mitigated by the lower costs of starting a business?

  • philsugar

    Try selling your product at a fair price when you have 4 competitors who’ve each raised $10 million in VC and who expect it will be easy to raise the next $10 million.

    Amen Brother! Been there with three not four. Thank god the next $10m didn't come for any of them.

  • Yavonditte

    Nice article. I too agree with much of what you are saying. Not sure what the average founder/entrepreneur does with this information, but it's helpful for the community to understand what is happening.

  • Jon Katzur

    Great post- very interesting! I have been a passive reader of the blog for about a year now, but I figured I'd ask a little more. Reading this and Fred Wilson's excellent piece on the USV blog leads me to the enquire- how do these changes affect the timeline of raising capital for a startup? In his blog Fred talks about successful startups needing 20 million to grow over 5 years- but this article and others show that for most startups the funding cannot be linear, or even the nice quadratic curve of that post. Funding is normally actually a step function, with varying intervals between steps. How should startups think about funding reconciling the seed mini bubble as well as the hurt on the VC industry with their needs to grow?

  • Dayna Grayson

    Great post, and I whole heartedly agree and am pleased with the changes afoot.

    Unfortunately, the lack of meaningful exits–IPOs (perhaps due to things like Sarbanes Oxley) and M&As is what is REALLY driving the changes. The decline in returns is a result of this. When the bubble burst, exits disappeared and there was musical chairs in figuring out what to do with capital invested.
    While there have been good years for a few IPOs and M&As, overall only the best of the best companies find exits.
    The IPO market needs to be fixed and a double dip economic recession won't help, of course.
    There hasn't been an overall, meaningful uptick small or large M&As and without those the Angels and VCs markets alike have to shrink.

    So while I agree with your strategy for Angels to concentrate on getting their companies funded going forward, unfortunately, it still only begins there.

    My take on what this really means for entreprenuers: find true -partners- who will fund your startups from the seed to exit and concentrate on building something big and game changing.
    Companies are bought, not sold.
    IPOs happen for category creators and big disruptive ideas.

  • http://bothsidesofthetable.com msuster

    Thanks. You're right and I didn't make this clear enough. On point 7 I said “we all know it takes less to build a technology company these days” which was my attempt to say this but I appreciate your clarification.

    For readers, had lunch yesterday with a VC who invests in chips, for example, and he said it is still a minimum of $50-$100m per company just to get to market.

  • http://bothsidesofthetable.com msuster

    I think also there are just simply less VCs who have deep enough knowledge to be able to invest in biotech, clean tech, etc. I bet this will be very different in 20 years from now.

  • http://bothsidesofthetable.com msuster

    Ha. Thanks. Funnily enough – I wrote it because I know that many people don't have the patience to sit through the show. That said, with no marketing we're already up to 25,000 viewers per show through ustream, youtube, web and itunes.

    But for anybody interested we do cover a lot of these topics in the show and if you watch the episode in the post prior to this one we get into it directly.

  • http://venturehacks.com nivi

    Thanks kindly for the link to AngelList Mark. We've got a new and improved list up here: http://angel.co

  • http://bothsidesofthetable.com msuster

    Ha. Yeah, that was a little real-time improvisation! re: my graph – funnily enough I was thinking about mocking it up on balsamiq to include in the post but it was already 2am. Sleep? Graph? Sleep? Graph? Sleep won.

    re: First Round – I don't know how they do it, frankly. Howard works harder than most people I know in the industry and I'm convinced Josh must have a doppelganger to speak to as many people as he does. I seriously have never met a single portfolio company of theirs who doesn't think the world of them.

  • http://bothsidesofthetable.com msuster

    Thanks, Reece. As usual when a trend happens I think most people overshoot the reality of what the change actually implies.

  • http://bothsidesofthetable.com msuster

    I'm pretty sure many will. It's very easy to assume away, “well if it doesn't scale we can still sell the thing for $20 million and make a reasonable return.” I've heard this many times. The reality is very different. Right now some early stage M&A transactions are happening again. But if we hit the double-dip they'll be gone in a New York minute. So will VC investments. We saw what happened in Sept '08. And when this happens angels will need to decide whether to double down to provide runways for companies. Many will not.

    I'm not singling out super angels. I'm just saying that as an asset class I think it will follow a predictable trend just as VC does.

  • http://bothsidesofthetable.com msuster

    In the US it doesn't seem like angels have gone conservative just yet. If the double-dip happens though – all best are off.

  • http://bothsidesofthetable.com msuster

    The angel – VC – public market problem is one that certainly existed in the past and is one of the reasons why the IPO market has been dead for so long. Sarbanes Oxley being another. We'll see where it all goes but many investors write checks on the assumption of M&A as the most likely exit these days.

    I think on 11 we'll have to agree to disagree.

  • http://bothsidesofthetable.com msuster

    You're right. For many firms I think VC = cash. But the ones that truly separate themselves you can see the value pretty clearly in terms of strategic insights, recruiting assistance, partnership introductions, help raising future rounds, etc.

  • http://bothsidesofthetable.com msuster

    I always say “angel investing is a muggs game unless you have really deep pockets.” I don't believe in picking individual winners. Returns come from diversification and the ability to lean heavily on the 10% that work really well.

  • http://bothsidesofthetable.com msuster

    I'm not sure I can really speak for all VCs about what they've learned. Frankly, I'll bet as an industry we've learned some good lessons and some bad. On the “bad” side, we've seen how quickly some business have scaled in the past few years through social networks and I think too many VC assume away how difficult that actually is. It is reminiscent of the “chasing eyeballs” problem of the late 90's. On the “good” side I think many VCs realize that early stage businesses need to be more capital efficient these days.

    But if any VC's read this feel free to add on.

  • Rob K

    You might be right, but I'm looking at the math. Median venture exit is $60M (per the NY Times). Assume a fund owns 25% and makes $15M. 2 or 3 of those returns a super-angel fund but it takes 15+ to return a $200M fund. That's why VCs are increasingly swinging for the fences and even raising valuations to put more capital to work (per Chris Dixon).

  • http://bothsidesofthetable.com msuster

    Oh – for sure. I tried (unsuccessfully obviously!) to say that I though each segment of the market was going through its own changes and that each segment needs to exist but will be right sized.

    Later stage investors clearly still have the problem that IPO markets need to open in order to get returns. I think my bigger point in 11 that I *tried* to make was that so much of the Internet meme these days is that you don't need much capital to build business these days. That's true for small businesses but to build large companies you still need expansion capital. Just look at Atlassian taking $60 million from Accel after all these years of not doing so.

  • http://bothsidesofthetable.com msuster

    I don't really know but I don't suspect so. We still have an overhang of capital that will lest for a few more years. By then we'll see how fund raising shakes out. My guess is that we won't have a lack of VC money as an industry to invest but it may feel so since it will be compared to the amount available over the past 10 years rather than compared to the mid 90's.

  • http://bothsidesofthetable.com msuster

    Yes, I was there too. Painful.

  • http://bothsidesofthetable.com msuster

    Yeah, I wasn't trying to build something actionable – just reflective. Thanks.

  • http://bothsidesofthetable.com msuster

    Thanks, Jon.

    Unfortunately fund raising timelines are VERY dependent on current economic situations and they change on a dime. Right now, for example, there is a return to rapid funding and higher creep on prices. I think this is the GroupOn / Zynga effect coupled with the public market rebound. My guess is that things will tighten up really quickly when / if a double-dip recession occurs. If it doesn't expect easier funding for some time.

    I normally advise people along the saying “hope for the best, plan for the worst” so I encourage people to be sure that they don't “under” raise capital and don't delay their fund raising plans.

  • http://bothsidesofthetable.com msuster

    Well said. Thank you for the addition.

  • http://bothsidesofthetable.com msuster

    Cool. I've update the link in the original post. Love the improvements on the new site.

  • http://www.kidmercuryblog.com kidmercury

    if you guys took an honest look at the dollar crisis, as well as 9/11 being an inside job, stock market being rigged, and kookology in general, you would also see the bigger problem and how this extends to point #11. ask yourself why the US has had the most robust financial and M&A markets in the world, it is not because of some comical, hubris-ridden notion that this country is better than others. it is because of the dollar empire.

    another way of looking at it that is more solution-oriented is through the lens of hackers who attack facebook and other big centralized systems: fb had to raise 3/4 half billion to builds its empire, but a hacker with a laptop and some camping gear can bring it down. there is a book called brave new war which talks more about this issue, and sheds some light on federated models, distributed teams, etc and how that is the future.

    but the brave new war/coase argument is an academic argument based largely on subjective interpretations so i don't really blame you for disagreeing. what i do blame all of you guys for is your ignorance towards the the travesty that the public markets have become and the dollar crisis. as such i am leaving this comment so that in the future when what i am saying becomes obvious i will have something to link to when i make fun of you guys. to clarify the set up joke is not about academics or analysis, but rather about ignorance of the truth, which is why this allegedly unforeseeable crisis wasn't seen in the first place, and why it won't go away — in fact it will only get bigger — until the problem is dealt with honestly and directly.

    thanks at least for replying and not deleting my comment. unfortunately the same cannot be said for many of your more cowardly, immature, psychologically weak, objectively inferior peers. rest assured i am plotting even bigger jokes to be played upon them, as is the universe.

  • Togilvie

    You made the point perfectly and I completely agree. I think it's actually *possible* to build big companies on much less capital, but far from *optimal*. Craigslist is probably the prime example here.

    I've simply been wrestling with a few friends around whether a more liquid class of VC is possible/desirable and diverted your thread a bit.

  • Beth

    The biotech and medical device market has some significant key differences:

    1. Financing: First, the National Institute of Health (NIH) funds over 80% of all scientific research in the U.S. The National Science Foundation, Dept of Defense, Dept of Energy, Dept of Education provide a nice chuck, and industry (pharma, device manufacturers) and private foundations the remainder for what essentially might be akin to “big seed” 400-500K to up to 5 million for series A, and then grant recipients can apply for “non-competitive” or “competitive” renewals depending upon the species of a grant. I have seen grants with non-competitive or competitive renewals last 20-30 years with 30+ million in funding. So, this looks like Series B and C. (In fact, the non-competitive renewals for meeting “research milestones” start to look like the tranches that the tech sector seemed to disfavor–at least in articles I've read; researchers love non-competitive renewals for meeting research milestones). Second, private foundations like Kauffman, James S. McDonnell, Gates, family donors, and universities themselves offer seed funding from 5K to roughly 300K–no ownership or options vest for the private foundations, the strings are to publish your research results and thank the foundation/university/donor for funding it. Third, new faculty frequently secure “bridge funding” from the university to cover their salary and research until they secure their first externally funded grant (NIH, NSF, DOD, etc.). Fourth, endowed faculty have a species of bridge funding as part of being an endowed chair to see them through funding gaps. (On the cost side, building wet labs and conducting other kinds of scientific research has higher start-up costs that two guys coding in an apt with Ramen noodles, and is subject to many federal regulations which are costly and cumbersome). The role of VC is typically through licensing agreements at a later stage although some VC directly funds early stage biotech. I imagine it is strange to think about fed financing essentially supplanting the role VC has in IT, but this is the dynamic and so the VC role is a little different. Politically and policy-wise, the federal government is making a big push to translate more scientific discoveries into commercialized products that improve health, environment, defense, energy, education, etc. The growth of life science, biotech and clean tech VC funds may really be the market reacting to the fed trying to drive commercialization from discoveries/inventions at the university to the marketplace.

    2. Geographic Distribution: Geographic distribution tracks the highest funded recipients of federal grant research dollars, not Silicon Valley and Boston per se (although the dots are close in regards to Stanford, Harvard, Yale, UPenn, etc.). Strangely, St. Louis has 80% of the SBIR money in the country and ranks third in receipt of NIH funding.

    3. Academe's relationship to VC-Industry: First, the Bayh-Dole Act ensures and simultaneously limits the potential returns to an inventor and the institution. The inventor receives some small percentage of the total royalty if the technology is successfully licensed. (The University generally receives 1/3 of the total royalties in a license agreement, the inventor may receive up to a third of the university's third…the university usually keeps a third, and the inventor's dept. usually gets a third–although this can vary depending upon the institution). So, the incentive to the inventor for financial gain is substantially reduced as compared to the traditional VC IT sector. Second, University's can be rather dysfunctional and hoard or “shelf” IP for many reasons, or just have trouble being effective in commercializing technology through establishing industry partnerships. Third, inventors–whether they be in the medical school or engineering school, mathematics, physics, etc.–generally are not gaining the core competency skill set to be entrepreneurs (some programs are trying to fix that). Fourth, the culture at a university can make being an inventor who pursues patenting, licensing, commercialization of a discovery feel like he or she wears the scarlet letter “C” for conflicted. The profits and culture of industry sometimes don't mix well with purity of thought, academic rigor, and high-mindedness of university life. This cultural dynamic, along with the lack of entrepreneurial skills, makes some academics shy away from pursuing development of their inventions into actual products, That said, some incredibly gifted surgeons/physician-scientists with entrepreneurial drive are leading change.

    NIH has limited or stagnated growth of its budget in recent years. How all this impacts biotech VC will be interesting to watch. Can biotech learn any lessons from the financing or deal structures of IT sector VC or vice versa. Any thoughts?

    Beth

  • http://angelnetworker.blogspot.com/ Thealzel Lee

    Very good insights. To your point #12, the VANTEC angels share the same concerns about the sustainability of our levels of investing in angel and seed rounds in our local startups. [Details here http://bit.ly/a9AETx. I agree with you that in the end, imaginative entrepreneurs will find alternative ways to fund their dreams – and these are the entrepreneurs that are worth backing.

  • http://www.jasonwolfe.co.uk/ Jason Wolfe

    I believe this is the key, and one of the reasons Angel-level investments are more “useful” (and hopefully therefore more likely to succeed). You give $100k to a naive start-up and $10k to a street-smart one, and I know which one I'd personally bet on being able to make it to the finishing line.

    I'll toss in the growing feeling that some (not all) businesses with huge potential value can bootstrap (at least in part) their way through growth, meaning they don't need to create equity debt.

  • http://www.jasonwolfe.co.uk/ Jason Wolfe

    Might disagree with this one (maybe only a bit). I sort of see Angel investing becoming slightly more niche (you hinted at this in the main post). Angels that know their sector/opportunity space really well should be able to perform better (domain experience I believe you've historically called it).

    Diversification is fine if you can find the volume of opportunities to do this with, but it's a bit like the difference between a machine gun and a sniper rifle.

  • http://how2startup.com/ Roy Rodenstein

    Great summary, one comment- as a (new-ish) angel investor, I am MUCH MORE bullish in hard economic times like now. Why?

    Because startups are (relatively) much more insulated from the macro economy than almost any other asset class. Especially very early stage startups which is where I am focusing, along with most of us at HackerAngels.

    Agree/disagree?

  • http://profiles.yahoo.com/u/WWZLWIPW4AOJGDA5LX66XEPQMM none

    If I could add a couple of things…

    1. I think one of the biggest problems was also cash flow. I think what happened was that LPs were making commitments to VC funds. VC funds would begin spinning off cash in 3-5 years. As the investing period in the funds were coming up (4-5 years), LPs were looking at the cash that the VCs were spinnig off and re-upping their commitments assuming the cash flows from prior funds would continue to come in. When in the last few years the VC industry took in more cash than they were spitting out in exits, I suspect that put a lot of LPs in a not so good bind. Add in all the other illiquid investments LPs were making such as PE/LBO, real estate, timber, etc, etc, a bunch of endowments got into a lot of trouble with servicing those past commitments and actually having enough cash in the bank.

    2. I also think that the industry tried to institutionalize back in 2000-2002. They raised bigger funds. They brought in new, younger partners. The VCs tried to scale up their business. Guess what. VC is about relationships and personalities (and to some degree too skill and knowledge!). Some of those things you can try to impart, but some of it is hard to. Throw in some of your other observations about startups needing less money, etc. and the VC industry found itself too big with too much money and not enough ways to deploy the cash.

    3. To your point about getting rich slowly. I think the single biggest reason (besides the slow down in the exit cycle of course) is the death of deal-by-deal carry. VCs used to be paid their 20% carry when they exited a deal and true-up the difference (also known as a clawback) towards the end of the life of the fund. So,VCs got paid carry while the funds were running. I've heard enough stories about how VCs in 1999 and early 2000 took a company IPO, the partners too their carry in stock, but never sold that stock. At the end of the life of the fund, clawbacks came and partners never sold the stock – while the stock had since tanked. The other partners who had sold their stock and now are having to put up cash to support their stupid partner that held on aren't happy and the LPs are even less happy that they have to worry that the clawback mechanisms aren't working quite as well as they should. Lawsuits are flying, etc, etc.

    4. I think 50% drop is kind. Think of it this way. We're looking at venerable firms like Venrock taking funds down by almost 1/2. We know a ton of funds are going out of business. Unless there are a ton of funds actually increasing size, which I think there are only a couple that I've seen (as in less than 5). Mathematically, that means 50% is being generous.

    Anonymously Posting

  • http://bothsidesofthetable.com msuster

    I like investing in hard times because investment prices are reasonable, founders are more passionate about what they're doing and necessity is the mother of all invention.

    That said, some words of caution for angels. Most startups struggle with initial revenue growth. Some fund this through advertising. The ad business contracts quickly in bad times. It's doing well but if things get worse it will contract again. Others build subscriptions – this relies on consumer spending. I think consumer spending will dry up. So … I think that the best companies will still need to rely on future financing rounds to have enough runway to build something really novel. Sure, some companies achieve this without the capital. But it's hard.

    The other thing nobody talks about is … people love to live the startup life for a few years when they're young. But if the company doesn't grow revenue or raise substantial capital it starts to get really old after 4-5 years of earning sub-par salaries so you start to see a flight of these hugely optimistic entrepreneurs as realism sets in.

    good luck. And let me know if super interesting stuff sprouts up!