It’s Morning in Venture Capital

Posted on May 23, 2012 | 64 comments


This article originally ran on PEHub. If you prefer the super short version – I’ve summarized the post in the final section.

Many observers of the venture capital industry have questioned whether its best days are behind it.  They are frustrated by the past decade of subpar returns for the sector.  The most recent report to weigh in on the troubles of the industry was produced by the esteemed Kauffman Foundation.

There are obvious reasons the industry has had less-than-desirable returns, including: massive over-funding of the sector, huge increases in inexperienced venture capitalists that took a decade to peter out, and the massive correction in the value of the public stock markets that closed many exit opportunities for half a decade.

I can’t help feel a bit of rear-view mirror analysis in all of “VC model is broken” bears in our industry. I have been close to the tech & startup sectors for more than 20 years and I can’t think of a period in which I felt more optimistic about the innovation and value creation I see in front of us.

Looking ahead at the next decade I am excited by what I believe will be viewed as one of the best and most rational investment periods for venture capital due to seven discrete factors:

1. The number of startups being created has increased by an order of magnitude

Cloud computing and the open source movements have brought down the costs of starting a company by more than 90%.  If you want to understand the details of why this is, I covered it in detail in this post, Understanding Changes in the Software Industry.

This has led to the creation of incubators, accelerators and seed funds. From this we have seen a commensurate boom in the number of startup companies. When I was graduated from university in 1991 it was only the really committed who eschewed the corporate world for creating tech startup businesses.

When I came out of college LA Law was one of the most popular shows on TV and made being a lawyer sexy, so most of my peers made that career choice.

But in 2012 a visit to any major college in America will show you the massive increase in aspirations of our young talent to become the next Mark Zuckerberg and build a future Facebook. The movie, “The Social Network” might have had more of an impact on creating future entrepreneurs than any other event of the past 5 years. Thank you, Aaron Sorkin!

Contrary to some press reporting, the boom in startups, the creation of accelerators and seed funds as well as the deserved popularity of AngelList do not signal doom for our industry. They are, in fact, great news for traditional venture capitalists. The most successful of these businesses will still need venture capital to scale their businesses.

They need a combination of capital and experience to separate from the rest of the pack – the low cost of starting a business means it is even more vital to become the market leader more quickly. What the explosion in startups really means for our industry is a much bigger pipeline of potential deals if we VC’s can be patient.

Yes, it’s true that FOMO (fear of missing out) is driving some irrational behavior and valuations amongst uber competitive deals and well-financed VCs. I’ve written in detail about that in this post, “On Bubbles, And Why We’ll Be Just Fine.”

It doesn’t seem too irrational for seed or A deals, just a bit higher than the norm. And by the C round it seems like investors feel more confident in setting a fair market value. But in a race to be sure you don’t miss the next Pinterest, some people are paying huge premiums for “market risk” B rounds. Some will pay off, others will not.

For those patient enough to source great companies at reasonable prices and prepared to weather the next inevitable downturn, I believe firmly there will be economic rewards for discipline and patience.

2. The number of venture capital funds has shrunk by two-thirds

To really assess what opportunities the VC industry has over the next decade, one needs to first look at some of the root causes of poor returns in the past decade.

The Funding Problem

In 1998 there were around 850 VC funds and by 2000 there were 2,300.  Thomson Reuters data shows that around $10 billion of LP money went into VCs per year pre bubble. By 2000 the total LP commitments had mushroomed to more than $100 billion.

Everybody knows that most funds are 10-year funds (and that strangely 10-year fund really means 12-year funds). So it is unsurprising that an over-funding environment and the commensurate returns hangover would have lasted until about – well – 2012

Just why does over-funding dampen returns? For starters we saw a huge influx of inexperienced managers enter the VC industry proving clearly that being a VC is not a purely quantitative job.

But on micro level, over-funding also creates performance problems for specific companies. In a rational funding environment you might see 3 or 4 great competitors slug it out over the market, each with enough funding to prove their performance until the next milestone where the market decides whether they deserve more funding. They compete on features, price and execution.

In an over-funding environment companies are encouraged to eschew revenues in a land grab to acquire eyeballs, clicks, page views or whatever other vanity metrics give VCs the false comfort that they’re sitting on a gold mine. Try charging customers for your product when you have 12 competitors giving the product away free finances by $20 million of VC.

The Exit Problem

And of course the funding problem coincided with the stock market correction that took away most exit options for years to come. IPO markets had burned an entire cycle of retail stock investors and many institutional investors to boot.

The numbers of potential buyers had decreased dramatically both because large companies were shedding jobs and because many past buyers simply lacked resources to make acquisitions. And in a market with too much capacity (too many startups) the leverage was completely in the hand of buyers at M&A activity finally picked up.

So of course returns from 2000-2010 were subpar on average for the industry.

Today’s Normalization

Fast forward to 2012 and none of these conditions hold.

While the number of startups has increased exponentially, the number of active venture capitalists has shrunk by more than 2/3rds in the past decade to less than 750 today and still shrinking. Put simply, more deals and fewer venture capitalists mean better access to deals, more stability for winners and great returns for the best in our industry.

Money flowing into our industry has also massively downsized.  LP contributions to VC firms shrunk from 2000 and by 2005-2008 had stabilized to around $30 billion per year.  By 2010-2011 this had shrunk by half again, averaging under $15 billion.

It’s also worth noting as data would suggest from this SVB venture funding report, lower costs to build tech & operate businesses implies the possibility of lower loss ratios in portfolios. It will take some time to prove out this hypothesis, but the data above suggests it may be the case.

So it’s hard to make a compelling argument that the performance on average in the past decade will prima facie have any predictive powers in determining the next ten. In fact, the market conditions would argue for quite the opposite, which is what makes rear-view-mirror analysis so blurred.

3. There are 20x more consumers online

In 1997, the year the Kauffman Report begins its analysis; there were 70 million users online globally. In 1998 it was 150 million, 1999 250 million and by 2000 it had crossed 350 million. Even at this staggering pace it still represented less than 6% of the world’s population.

By the end of 2011 the Internet population was estimated at 2.3 billion, with 275 million in North America alone (source: Internet World Stats) and an astounding global penetration of 33% of the world’s population. Considering how much world poverty exists this penetration rate is truly mind-boggling.

Put simply – doing business online is significantly more valuable than it has ever been. There is no sector of the economy that isn’t being transformed by the online community that is now voraciously consuming media, applications, communications and buying global products.

To ascribe past poor performance in our industry to the current market situation we face is myopic.

4. We’re online all the time and at high speed

It’s not just that more people are online, it’s that we’re online all the time.

Internet usage a decade ago was less than 1 hour per day and was restricted to narrowband communications. Today we’re online 3.1 hours per day on average, and that’s excluding the other 13 hours a day where we have our mobile devices, our connected TVs, our iPads and Kindles and soon our cars connected to the web.

The ability to interact, transact and disrupt is an order of magnitude greater at broadband speeds than at 56k dial-up modem speeds. Just how transformative is broadband? As of January 2012 consumers were watching 4 BILLION video views per day on YouTube. A decade ago the idea of even watching video online would have been laughable.

THAT is disruption. And as the recent VC fundings of Maker Studios, Machinima, Movie Clips, Big Frame and Fullscreen will attest – opportunities for massive growth in our sector are anything but moribund. The video industry will be disrupted just as books, newspapers and music before it.

And retail, financial services, hotels, the auto industry, taxis, flowers and every inefficient or protected industry out there is being altered by technology changes that change market dynamics and create opportunities for the innovative, the nimble and the risk takers.

5. Mobility really changes everything

It’s not just that we’re connected to the Internet at higher speeds and for longer; we’re actually always tethered to the web. In fact, the majority of Americans are now carrying computers in their front pockets.

The opportunity to transact at the point of purchase increases the sheer number of revenue opportunities. This world of local meets retail meets digital advertising portends to technology disruption and with it VC opportunities.

This never existed a decade ago. Heck, this opportunity didn’t exist three years ago.

According to Google data 30% of all restaurant searches now come via mobile devices. Our societal behavior is now to look up things we want to book or purchase at the point & time of need.

The desktop web introduced banner ads that offered “brand advertising” opportunities akin to television.  Mobile devices deliver “bottom of funnel” sales opportunities that deliver real & immediate economic results.

Search for a restaurant, book a table, eat in 30 minutes. Search for movies times, book your tickets, see a show. Bottom of the sales funnel.

The mobile world brings enormous business opportunities and changes to business models that were unthinkable when VCs made investments ten years ago that produced the last decade of results.

And the future?

Nearly 25% of US users access the web primarily through only mobile devices and these are our youth and thus our future. It is estimated that more than 30% of all YouTube videos are now being consumed on mobile devices and I’ve seen actual data that shows in some youth genres mobile video consumption now exceeds 50% of video views.

When you look at the developing world this is the majority of users (due to lack of landline infrastructure) and it portends future opportunities in payments, entertainment, application development and services.

This doesn’t seem like the end of VC to me, it feels more like the 2nd inning.

6. Everybody is now payment ready

Often overlooked in the importance of what has changed during the past decade is that we’re all payment ready now. We’re all one-click away from buying, watching, renting or ordering just about anything.

When you order an Amazon Kindle it comes pre-configured with your user name already configured into the device so that you can click a single button and buy shit. And buy people are doing en masse. It’s not a tablet – it’s an order entry device!

A decade ago most of the country was fearful of entering their credit cards or using mobile banking. Today all of our banking and payment information is accessible online and we are one-click from buying from Amazon, iTunes, the AppStore and PayPal.

Businesses are also one-click from advertising through Google and now Facebook. Web businesses can now grow revenue before they can even afford sales people.

This trend is often overlooked yet the results or palpable. When businesses really work – they explode financially at a pace that we haven’t seen in history and with limited investments to prove out this case.

If you think back to just the past couple of years we’ve seen enormous growth on limited capital in businesses like Words With Friends and OMGPop (both now Zynga) as well as Angry Birds.

This has spawned growth in related VC-backed businesses like Burstly, TapJoy and Flurry who help enable real-time transactions in mobile apps.

The whole ecosystem grows rapidly because the distance between, “I like this application” and “give me an upgrade” is one click with none of the traditional abandonment that comes with having to pull out your credit card.

Consider this: 5 years ago VCs were debating whether US consumers would ever adopt “virtual goods” in the way that Asian consumers did and thus saw the popular rise of QQ (TenCent) in China (which did $5 billion in revenue in the past 12 months).

Virtual goods are in fact booming on a global basis and in many instances deliver a much higher ARPU than advertising revenue. 2012 virtual good revenue is expected to top $12 billion this year. [thank you to Kidlandia for the chart]

And here’s the thing – 55% of the entire market of purchasers are 15 years old or younger. There is no stronger evidence of the power of one-click purchasing (as these people clearly don’t have credit cards).

Imagine how these consumers look in 10 years time. Will they really even understand cash? Unimaginable to you? Just remember that 10 years ago you had no: YouTube, Facebook, iPhone or iPad. In fact, you were cool because you had a Palm Pilot while your friends still used a Filofax (yes, you know I’m on to you).

7. We’re all socially linked

And finally it can’t be ignored that we’re not only payment ready, but we’re socially connected. Look at the rapid adoption of Groupon, LivingSocial or Instagram as proof of how rapidly businesses can grow through viral means.

It’s not just that businesses can monetize more easily, when people like products or services they are diffused more rapidly through the population than has ever been the case.

Nowhere was this more evident than the rise of Zynga, one of the fastest growing companies in history. But this is also spreading through non-game types of businesses.

Evidence Fab: Just 18 months ago they started selling products and through a unique offering and a flawlessly executed social model they are reportedly on par to cross $100 million in sales in 2012.

That type of growth on limited VC dollars was unthinkable a decade ago.

Morning in VC

These seven factors are leading to better and more sustainable opportunities in venture capital than have been present at any time in our investment histories.

We have lower costs to create companies – leading to more early stage innovation. We have a more normalized venture market with less capital and fewer firms. We have consumers who are online at higher speeds and for more of their days. People are connected all the time and when they’re mobile. Each of these pocket computers is payment ready & social linked.

Given these seven factors – it’s hard to look in the rear view mirror and imagine you can see the future.

I believe it’s truly morning in the technology sector. And I remain convinced this bodes well for our venture capital industry.

Top image courtesy of Fotolia.com

  • http://LeanStartPad.com/ Jeff ‘SKI’ Kinsey

    As you should. I would also look for alternatives at most any and every price point that is truly segmented. What we call dumping for fun and profit.

  • Drew Freyman

    Mark, you have done a good job describing the VC investing climate.  It is true that there are loads of opportunities to make money.  Even FOMOs represent an opportunity to someone–someone who knows when to get in and when to get out.  It is cheaper and easier to start companies.  The market for technology products includes more consumers than ever before.
    I believe that those that bemoan the demise of VC would agree with you.  Their critique is not one based on diminishing investing opportunities.  They would agree that VC is working wonderfully for individual investors and companies.

    They believe VC is no longer working for society as a whole.  Although it may produce stellar opportunities and results for certain individuals and firms, VC may no longer be allocating resources to ideas that provide the greatest utility to the greatest number.  They worry that in a generation when “easy money” can be made off web applications like Facebook, technologies that require intense capital investment and long runways for success may be passed over by VC to the detriment of society.  Facebook is great entertainment but Cisco has done more for society.  Would a company like Cisco get funded today?  A health app for iPhone with an awesome backend on AWS is cheap to develop, quick to deploy, and may have great revenue potential but it is not another Genetech.  

    I think those bemoaning the demise of VC do not feel there are fewer chances invest and make great returns.  They fear whether all of the activity–the froth and all–is as efficiently allocating capital as VC did during previous generations.

  • http://innovocracy.org/ MartinEdic

    I think there’s another major change in the deal flow process. I’m involved in a crowdfunding site that works with universities (innovocracy.org) and even in our very early stage our first two funded projects (we support commercialization of products coming out of higher ed, not research) have attracted seed capital beyond the 5-10k raised via donors. This very crowded and somewhat dubious sector (after the JOBS Act) is turning out to be a great way to surface investing opportunities and I think all the data you provide supports this. The ability to build a proof of concept and prototypes on a small budget is great news for angels, seed and VC investors because due diligence at the initiation stage is tough. That’s why we’re seeing the growth of the accelerator movement, IMHO. Its a form of very early due diligence to get through that process or ours.
    It looks to me like it is also supplementing the the three Fs (friends, family and fools)!
    Great comprehensive post- I really appreciate your willingness to dive deep.

  • http://innovocracy.org/ MartinEdic

    I’d be curious to hear your take on B or Benefits Corporations one of these days. So far only six states have them including CA and NY. We’re electing that form and no one seems to really understand the implications…

  • http://is.linkedin.com/in/balakamallakharan Bala

    BIG FAT LIKE! awesome analysis and yes every GP should feed on this… I love it when people pick on each one of these topics and debate on it. I believe putting all this together everyone can be optimistic about the future if you are making something out of this but the basic principles remain the same, it is going to be an exciting decade or two to say the least where a transformation is happening. The principles of being an entrepreneur or part of a startup team does not change… one still needs to get the Product to Market fit right, Create a repeatable business model, compete and build fantastic teams that are driven by Autonomy, Purpose and Mastery. The macro environment matters but the basic principles are timeless. There has been no better time than now to do this. Thank you for sharing this Mark.

  • http://twitter.com/simonjhughes Simon J Hughes

    Thanks Mark for this excellent summation of the landscape. Brilliant read.

  • Rob K

    Mark- Good post. I’m struck by how different your perspective is from Jo Tango, founder at Kepha partners and former GP at Highland, who argues that the flock of MBAs to start-ups must be indicating a market peak. I think there is some truth to that.

    My comments are here http://robkornblum.wordpress.com/

    I think you and Jo should debate it.

    I think the bigger factors that will hamper venture returns are the rise of angels capable of funding companies, coupled with the dramatic rise in valuations.

  • http://www.victusspiritus.com/ Mark Essel

    Amazon (kindle app) decided no purchases via the apple platform (mobile web only) was the right move.

    Without numbers it’s tough to optimize. If your subscription plan is app only, you’ll have to split the revenue. If it’s mobile web and web only you can keep 100% of the revenue but lose the native app base.

    How do you determine pricing your offering? If margins are tight you can charge a greater premium as long as the value of the service demands that premium.

  • http://essayswriter.org/ essay writing service

    Keep up the good job in posting very good topics.

  • http://www.servicecentral.com.au/ Service

    Great post Mark!

    I love how you left the best points until last. As I’m reading it I was wondering what about the growth of mobile, and the number of people connected, and BOOM! you mention those huge points right at the end.

    Now all we need to do is convince the big Pension Funds (and Australian Superannuation Funds) that its time to start investing in Startups big time!

  • http://www.servicecentral.com.au/ Service

    Peter can you give some examples of VC’s funding “safety first”?

  • http://www.3pmobile.com/ Peter Cranstone

    Looks for ‘large B, C & D’ rounds. It means that they’re parking their money (remember they always have the liquidation preference to get them out of trouble).

    Also look for investments into companies above a $500m valuation. For a VC to make money on these deals (X factor returns) they exit has to be in the billions. Only a very few players in the world can afford billions – and unless you have stunning traction and exploding revenues (which almost all of them don’t) then the money is just being parked for ‘safety’.

  • crowdsourcing is the future

    Seems everyone is drinking the kool-aid. The points made, while true, don’t address why VC is broken: it’s your selection and vetting process. And, if you are correct in how you connect these dots, it’s only going to get worse for startups (fewer VC’s = buyers market = more competition = further alienation of the startup.

    VC is dead in the sense that they don’t fund risky ‘early stage and seed’ startups (oh, unless they know the guy or he’s exited a company before [giving heed to the false assumption that last year's superbowl winners will be this year's]).

    VC’s are nothing more than banks anymore, and you even touch on it with your comment that “those companies will need capital to scale.” It would be much easier on startups if the VC world just came out and said it: They want to be the bank for a low risk, high growth business. There’s nothing wrong with that, but please don’t waste my time letting me pitch to you when you’re really not interested.

    Angels are currently filling in the gap between prototype-ready and breakeven. But I like the denial that 10-12 years of bad returns isn’t an indication that it isn’t working. I’d like to know what startup could sell their investor on that load of bull. You are all just afraid to lose you status and ego of being the gods of business. I say “ha ha ha” on you. While you’re smart and have experience, VC’s have utterly failed to encapsulate what makes a good startup, a good business, and how to find the next big thing. Jack Dorsey is the only one that has hit 2 grand slams. All the other ‘experienced’ horses you bet on return minimal gains, and that is because someone was dumb enough to buy their stupid idea for a profit. But you have failed systemize ‘big hit producers’ and just won’t accept that innovation comes from all over the country, from all ethnicities, from all walks of life and age groups and level of experience. You have failed to look at PEOPLE and their earnings/building capacity. You take the easy way out and try to check off the box that “they’re done it before, they’ll be our savior!”. Too bad.

  • crowdfunding is the future

    My comment was deleted?