Venture 2.0 - Preamble

This the first in a series of posts on the idea of "Venture Capital 2.0."  I thought it was appropriate to first set the stage of Venture Capital 1.0 as the point of contrast.  This first post is obvious stuff to those of us who have been in the business for a while, but less so for the casual observer.

Venture Capital 1.0 - The Cycle
The venture capital business has always been a ‘hits’ business.  One of my first blog posts (about a year ago) was on the "long tail of venture capital." The average venture investment generates a negative rate of return, but the outliers like Google, Microsoft, Cisco, and Apple have given information technology (IT) venture capital its superior rate of return.  The IT venture capital industry has always been cyclical.  For forty years the cycle has repeated.  Outsized rates of return attract capital, increasing valuations, and depressing returns.  The depressed rates of return created capital scarcity, laying the foundation for lower valuations, better rates of return and a repeat of the cycle.  Public markets have played an important role in the process, providing both the public appetite for new issues, as well as currency for acquisitions of venture-backed companies by public technology companies.

The IT venture capital industry today finds itself in a form of ‘stagflation.’ The absence of interest by the public market has made liquidity difficult to achieve, making the 2000-2005 period a particularly depressing one for those who are incented by capital gains.  At the same time, the interest in U.S. venture fund investment by non-U.S. firms is at an all time high, inflating the size of funds and increasing competition.  Venture capital fees remain at a premium to most other asset classes, but not the returns.

Venture Capital 1.0 - Key Success Factors
Success in IT venture capital investing has been a form of capital and information arbitrage for much of the period up to the late 1990s.  The scarcity of risk capital and the scarcity of insight about evolution of technologies and technology markets made it possible for astute venture capital firms to transform access to capital and superior technological insight into superior returns.  For example, as Moore’s Law was driving the electronics industry to the mantra of smaller, cheaper, faster, Sequoia Capital built a franchise reputation in semiconductor venture investments, based on the experience of its two founders, Don Valentine and Pierre Lamond, both early veterans of National Semiconductor.  A more recent example is ComVentures’ growth and success in the late 1990s.  Seeing the triple effect of telecommunications deregulation, global Internet growth, and ever-changing technologies and standards, the principals at ComVentures capitalized on their market and technological knowledge to raise several early successful funds.

Success begat success in the venture business.  Since venture investments have had payoff characteristics like options, i.e. limited downside and infinite upside, the key to the business has been "deal flow."  Deal flow is about seeing as much of the total distribution of deals, to generate a larger set of 'long tail outcome' candidates.  Success made IT venture capital business a first-order Markov process, where the probability of the getting the next hit was enhanced by having a previous hit, precisely because of the desire of all entrepreneurs to affiliate with "known winners."  The two masters of this phenomenon have been Kleiner, Perkins, Caulfield & Byers and Sequoia Capital.  Both parlayed early successes into institutional franchises. Other firms, many as old or older, have been less effective at sustaining the self-reinforcing dynamic of brand and success.  The sequential evolution of the IT "food chain" from semiconductor (Intel, National) to systems (Apple, Sun, Dell) to software (Microsoft, Oracle) to services (Yahoo, Google) has been the underlying order.

As the U.S. venture capital industry posted record rates of return in the late 1990s, the industry attracted record levels of committed capital that remains in place today.  Despite the abysmal performance of the industry from 2000 to 2005, many firms have been able to attract investors and avoid the re-equilibration and shakeout that has been predicted for the past five years.  It seems that limited partners have become inured to the venture capital cycle, expecting a repeat of the historic boom/bust experiences of old, and to average their rates of return over the next few cycles. 

A belief in forward-averaging the returns assumes that history will repeat.  The thesis of these essays is that the venture cycle has fundamentally changed for Information Technology and that formulae that worked over the past 20-30 years no longer broadly apply. 

• Globalization is both a risk and an opportunity with venture branding.
• Capital is no longer scarce, nor is access to venture capitalists.
• Information technology is no longer rarified and, in many cases, it is inexpensive.
• Global 2000 Enterprises, once the 'go to' customer for any fledgling IT startups, no longer have the risk profile they once had for IT innovation.

As I said, these observations are not new, nor are they particularly insightful.  And some firms are already responding.  The move to Cleantech is a move to exit IT (or diversify) to find alternative industries.  The move to build Indian and Chinese outposts are brand extensions.   

Presumably the Limited Partners who invest in venture funds have more incentive than anyone to develop an investment thesis about Venture Capital 2.0.  The next post will concentrate on the barriers to doing this effectively.

Comments

[Eway Zhan]

Peter,

I like a key observation from your post: veture firms transform their knowledge on evolution of technology and technology market and their access of risk capital into capital profit.

My question is, on what scale, or to what extent, a firm's ability to identify the right entrepreneur team affects its success? How does a firm's ability to pick the right team from the set of 'long tail outcome' candidates contribute to its success?

-Eway

[steve]

Please don't neglect to discuss "Venture Capitalist 2.0" -- the change in the type of individual who is a venture capital partner now versus in the past.

IMHO, just as the onrush of MBAs into startiups heralded the peak of Bubble 1.0, the fact that VC's are no longer specialists is itself a major change (and a troubling one for the asset class.)

Specifically, VC partners almost always used to be emigres from the fields into which, becoming VCs, they then looked at for investment. Former geeks, funding newbie geeks, in endeavors they could comfortably geek-speak about.

But now, attracted by the Bubble 1.0 halo and media attention, and empowered by the tsunami of capital flowing in (from LPs whose asset allocations havent changed despite that their pools of capital swelled big time in the last 10 years,) VC firms are equally likely to have partners with little if any prior experience actually working with technology at all, let alone the technologies they are investing in.

Regardless, looking forward to your next posts.

[Scott Rafer]

As a startup CEO, I tend to prioritize on the early sales, and I don't quite agree with this:
* Global 2000 Enterprises, once the 'go to' customer for any fledgling IT startups, no longer have the risk profile they once had for IT innovation.

Per Geoffrey Moore, we'd always go to the desperate departments in the big co's to find the first customers because that was the most economic customer acquisition available to us. I don't think that their appetites have change much. I think it's simply the case that broadband has made other, smaller customers far cheaper to find and serve. The intensely limited resources at a young company are going to find the most efficient path to critical mass and the Global 2000 are simply no longer on that path.

[Adam Messinger]

Many of the readers of this blog have undoubtedly already read John Battelle's related post, but I recommend it to those who have not.

[Nic Brisbourne]

Things are slightly different here in Europe where the VC industry is much younger. I comment in detail at http://www.theequitykicker.com/2006/08/30/evolution-of-vc-model-europe/. Please forgive the summary.