The Coming Venture Capital Boom

No, I am not a Pollyanna.  I see the today’s carnage as much as everyone else.  This year is going to be tough. The destructive firestorm of leveraged, momentum investing has destroyed much of the forest.  But the forest will begin its renewal because Life Goes On, and with it ingenuity, entrepreneurship, and innovation. 

This firestorm is like the Year 2000 cataclysm, with a powerful difference.  Like 2000, there are questions about the ‘death of venture capital’ the ‘death of the consumer’ and the ‘death of the Web.’  It’s all bullshit. It's just a cycle.

Two phenomena emerged from that last great vc-techno contraction. First, the fire incinerated the weakest companies. It left standing, weakened, but inherently great restart and late-stage opportunities.  Yipes.com was a terrific example, founded in July 1999 as a IP data networking services provider. Left for dead twice with two recaps, the third time was the charm. After raising over $300M during the 1999-2005 period. Much of this capital was wiped out. Yipes gave great returns for the investors who saw the opportunity anew in 2005 (disclaimer: we led this round). Acquired for $300M cash in 2007 by Reliance Communications, Yipes was a great company, originally ahead of its time, and made us 5X in 32 months.  We will see dozens of these opportunities in the coming years, but it requires an investment discipline tethered to public market realities about who are likely buyers, why, and at what valuations.

The second phenomenon to emerge from 2000 was the re-invigoration of the Web. As with every wave of innovation, much of the activity became more imitative than innovative as this matured.  YouTube was but the first of hundreds of video aggregators.  MySpace was the first of thousands of social networks.  (If Andy Warhol were alive today, he’d probably be telling us that in the future we will all be our own social network.) The venture money that went into most of these imitations will soon be written off. 

Some substantial services were built from this post-2000 renaissance.  Few achieved both scale and profitability as an independent company.  (LinkedIn is one that may have achieved that goal. Facebook?) Nevertheless, there were many successful exits from the web revival, though paltry few in proportion to the amount of capital, media attention and entrepreneurial energy invested.

So why am I so sanguine about the prospects for venture capital as everyone seems to sound the alarm about Recession, the lack of capital, and the fear gripping the markets? It is simple:

1. Venture capital returns are predicated on scarcity of risk capital.  It has been all too abundant. That will change.
2. Many good businesses will be left on the beach as the rest are washed out to sea – the remaining VCs will invest in them and both the entrepreneurs and VCs will get rewarded as the survivors gain market share and become successes in the economic recover.
3. The economic recovery plan of the new Administration will be massive and favor investments in productivity-enhancing growth sectors like information technology and energy technology.

Investments in material sciences electronics will blossom to provide ever-cheaper sources of domestic clean energy, today’s temporarily cheap oil notwithstanding.  (As the world economy recovers, the new capitalists in China and India will buy more cars and build more factories, rapidly returning oil back where it was and beyond.)

Investments in broadband, wireless, and mobile multi-core devices and cloud computing architectures will continue to reduce the cost of providing high value services in healthcare, personal entertainment, and even traditional enterprises.  Cloud-based computing will allow enterprises to treat IT as a variable cost, increasing their willingness to adopt by maintaining flexibility without big upfront expenditures. 

As the fire continues to rage in financial markets, it is hard to imagine when Opportunity will reappear. But the truth is when everyone sees Opportunity; they are only seeing the reflection.  True Opportunity appears at the market bottom, not at the top.   It’s times like these that test what you believe in, and I believe in the Business Cycle, Human Creativity, and the stimulative effect of massive Government spending. 2009 and 2010 will be great times to invest to reap the benefits in 2012-2014, for those who can judge both business risk and liquidity risk, and have the courage of their convictions.

Comments

[Adam Lindemann]

Great Post. You had called the end in good time and I trust your read on the new beginning.

[Karen Rands]

Completely agree with your post. As an economist by training and entrepreneur advisor and angel investor facilitator by living, I know that great wealth is created in times like these because the strong will survive and there is plenty of money out there that seeks to multiply itself. There are always ebbs and flows in the capital markets where there are market corrections as the natural order of things. A couple of key things that are different in this market from the blood bath following the dot.com meteoric rise. 1. There was stupid money being thrown at the also-rands that no standard business logic would believe the company would succeed (more in my post on this topic on www.entrepreneurblogspace.com) and 2. The capital was played and dry powder was gone and it took years for the VCs to gain the trust to attract capital again. The VCs I talk to were already being conservative, still feeling the pain from those days, and they still have plenty of dry powder because they recently raised their funds, and are at the beginning of their investment cycle/fund, not the end. Don't want to belabor this here in comments, but you have inspired me. I'll look for you on twitter.... karen_rands

[Paul Kamp]

Interesting blog post that contrasts with the recent Forbes article about the coming collapse in the VC space.

There seems to be a fundamental disconnect in the industry. Most people would recommend that the job of the CEO is to be out pitching for funding all the time. The trouble with this approach is that then the CEO is not running the company. Further, VCs are looking to invest later and later in the cycle, i.e. after a company has already finished development and has landed some customers. Further, they like to make larger investments because it is easier for them to manage their portfolio. This moves them away from being a VC and more of a banker.

The biggest returns are made if the investment is made early where you can fund a quick win or failure and test a business model. With the advent of cloud computing the cost of these investments should be dramatically less than in years past. This would argue for making more investments of a small amount, i.e. $1M or so in a start up.

I suspect that you are right in your post. Watch for the shakeout to happen at the top instead of at the bottom though. To add to your direction a bit, I suspect that the top-tier investors that make lots of smaller investments and nurture them appropriately will be the one that will survive and ultimately thrive.

Also, watch for lots of self funded or angel funded companies in IT doing well and remaining private as the SaaS model of doing business picks up steam.

[Dave]

You nailed it - "True Opportunity appears at the market bottom, not at the top." GE, Microsoft, Disney, HP...what did they all have in common? They started during the deepest downturns in the last 125 years. This article "How brands thrived during the Great Depression" (http://www.imediaconnection.com/content/20821.asp) highlights those that didn't blink during the Depression and greatly benefited. Clearly, you need to have some dry powder to make it happen but those that do or can create their own dry powder will thrive. We're encouraging all of our portfolio/client companies to go through a Sales Readiness Audit we've crafted that goes over 25 areas critical to the end-to-end sales process and then fill the readiness gaps. The clear lesson from the dotcom bust was the companies that got funding and thrived were those able to demonstrate significant revenue traction.

[Jonathan Aberman]

I agree with your thoughts and am also optimistic, although I have a slightly different viewpoint on where the growth opportunities are going to come from. I'd encourage you to check out my blog posting at http://www.amplifierventures.com/tabid/93/articleType/ArticleView/articleId/730/Outlook-2009.aspx and see what you think. Thanks, Jonathan Aberman, Managing Director, Amplifier Ventures.

[Peter Cranstone]

Great blog! In summary if the VC's DON'T invest now they will cease to be in 2012-2014. All this talk of retrenching and having no capital is just talk. Anyone in this business knows where the real action is and that starts at the "bottom" not the "top" as you say in your article.

Cheers,

Peter

[fred wilson]

awesome post. i reblogged the last paragraph at fredwilson.vc

[Jeff]

I am afraid you are not looking at the fundamentals. It would have been easy to have been optimistic in
We have to set aside a lot of the "lessons" learned in the last 15 years. Life was too easy - even mistakes were bailed out. Your Yipes example is actually an illustration (but not the way you intended). Reliance Communications of India was just as much a bubble player as Worldcom was in 1999. It is just that the bubble got shifted in time in India. Reliance Com reached an unheard of market cap that is a goodly fraction of India's GDP - you saw some of that money in Yipes. More recently it has crashed down to earth - I hope you didn't take Reliance Com stock!

Prediction: 90% of the VCs are not going to make it. They know *nothing* other than the bubble. Most partners I meet are qualified only in the sense of I-sold-one-bubble-company-so-I-am-a-genius variety. Most associates are freshly minted MBAs from Harvard-Stanford-Wharton-... with *zero* real world experience. Very solid foundation for a boom ....

[Debunkr]

While I want to believe this opportunism, something tells me that we're seeing a fundamental difference with 2000. First, we're seeing multiple businesses reach their nadir on weak fundamentals: Financial Services (how many hedge funds, vc, pe's do we really need? riskless returns, really? credit cards are no longer worth their convenience), Automotive (the ASP of the automobile has been kept 50% - 66% too high based on insane credit standards), Media (wholesale disruption of the model which was a house of cards anyways), Tech (maturation of industry -- e.g. x86 HW margins).
Given this background, I think we're in for a much longer period of "reset" while we work out some of these fundamental industry misalignments. Add to this a backdrop where the U.S. is going to have to learn how to become a participant in and not a dominator of the global markets, and we have some time before we reignite the growth engines.

[Fred Grott]

Fundamentally, I disagree. The VC market was sick in that there was not enough innovative ideas that were monetiezable to go around for the influx in capital. inf act the last 3 years was the worst returns on investments in VC funds ever. Also what has changed recently with all these web apis, cloud computing, and etc is that the costs of completing a prototype with actual subscribed users has become significantly less.

Lets tkae an example the top VC had invested in a firm called Loopt. loopt has yet ot make a profit in any year of operation largely due to an old way of over paying for server infrastructure by revenue sharing with CDMA mobile operators to get access to their GPS/data services. In fact as long as you put Mobile Operators in the position of selling data plans rather than the free access to the appp that uses that data plan you never wil make a profit as an app and service company.

Someone comes along and through a tech implementation eliminates the need for server infrastructure in developing a mobile loopt clone. Why are not VCs investing? Because when VCs have an over abundance of capital to invest they tend to make poor choices base don the short what is hot as far as investment not as far as monetization. If the VC had ot bet the other way where the funds pouring into the the VC were lean instead of fat than we would see this different investment tack.

Part of the move away have already happen in that you have seen those left with moderate VC funds, apple, Goolge, and etc creating market growth funds for iPhone and Android app start ups. in Green energy a similar move might be McDonalds setting up a VC growth fund for Bioedisel startups. so we have some moves toward companies with strong market positions stating VC funds. This trend will continue.

Your post ignores most of the basic fundamental trends that have been occuring the past 18 months. the upcoming Venture boom will not be with normal VCs but with companies that have a strong market position setting up growth funds to fund startups in thsoe markets that compliment their objective of growth that market.

[Joe Duck]

Peter I enjoyed reading this until I came back down to earth. There will be some great opportunities with the challenges but unless we see more stability and less uncertaintly in the global biz climate I can't be this optimistic about high potential returns. We'll have more Govt money in the equation than at any time in history and one has to wonder how Govt sponsored businesses may turn out as their success comes from pleasing bureaucrats (who are often very antagonistic to private wealth) more than shareholders.

But hey, thanks for a dose of hope for 2009 even though I'll be happy with anything over 0% for this year. Last year the insane bag lady who recommended stuffing cash in a matress outperformed many seasoned investment pros by ... wait for it .... over 100% (ie 0 gain vs 50% loss)

[Roger Toennis]

http://www.paulgraham.com/divergence.html

A disruptive alternative vision from Paul Graham.

Roger

[Kevin Burton]

Hell yeah :)

I've been building my company for the last few years to be able to withstand any crisis like this...

I have no doubt we'll still be alive and kicking in 2010....

2010 should be a good year. In 2009 there will be a lot of new innovation happening with early startups followed by some profitability in 2010....

... and if you're going to tuck your tail between your legs and run home to mommy just because the sea is a little rough maybe you shouldn't be an entrepreneur in the first place.

[Thomas Leavitt]

If you've got capital, and patience, then definitely, there's no better time to start a new venture than in the midst of an downturn - you'll be able to pick up distressed assets at bargain prices, have tremendous negotiating leverage with vendors, and you'll have your choice of high quality candidates for employment. A lot of folks in Silicon Valley found this to be the case, post-crash.

If you anticipate a long incubation period before bringing a product to market, you're even better off, because the depressed market in general becomes irrelevant, except in that it may make alpha and beta testers more open to using your product. Even if you bring a product to market in the midst of a downturn, you're much more likely to have the time and space to do so in a conservative fashion... and when the economy recovers, you'll be in a position to take advantage and ride the upswing.

Of course, boom or bust aside, the fundamentals of starting and operating a business remain the same: have a product that people value, provide better service than the competition, and keep driving improvements and innovation.

[Chris Douvos]

Peter,
A good post. Indeed, there is much to be optimistic about; VCs are in the business of optionality and Nassim Taleb once said that the greatest thing about the American economy is its ability to seize optionality (while at the same time not pursuing worthless options too far).
On the other hand, I fear that the "venture capital business" as a whole will continue to struggle. The scale of institutional VC is just so out of whack that the arithmetic doesn't work for the average investor (http://www.lp2dot0.com/blog/2008/05/justify-my-love.html).
Of course, we have to separate the business of investing from the business of innovation and I'm positive that there will be some great businesses built over the coming few years.
The challenge will be (will remain?) one of selection. You're right to point out some of the good deals that were available after the bust (like Yipes,) but average fund-level (or even top quartile) returns over that period are likely to be modest at best (although, in fairness, it's still way too early to tell). Why this dichotomy? Becasue there were too many dollars forcing too many people to make too many investments in too many companies. For each Yipes, there were dozens of junk companies. The same will be true this time, although I suspect that some LPs will finally throw in the towel and the business will finally shrink (which will be a good thing - to your point about capital becoming scarce again.)

[a_vc]

I am optimistic about early stage companies as always. I believe there will be successful companies that are formed during this year and next providing outsized return in 2010-2012. Absolutely.

However I don't see a resurgence or a boom in VC - there is a need to differentiate successful companies from firms. As you said "Venture capital returns are predicated on scarcity of risk capital". Too many firms that have raised capital from 2002-2008 that should never had in the first place, entirely due to the bureaucratic PE/VC allocation metrics that large pension fund and endowments have and not much more. That will take another 7-9 years to shake out - bubble funds have still not disappeared and are propping up 2000 era startups.

There is still too much capital. Indications of this abound in recent sectors including web 2.0 and cleantech. Many social media and ad web 2.0 companies. Many solar companies that have been funded (with very few exit opportunities). Many energy efficiency companies aiming to do the same thing - great technologies with laudable ambitions and potential environmental benefits, however they will eat away each others margin. LED companies are another example.

Collers predicts a market of $150B in secondary VC transactions - which implies that these most if not all of these funds in particular will continue to make/support investments!

The LPs themselves need to clean house and enforce discipline on VC investing and allocation, however I don't know if this will happen anytime soon due to the significant amount of LP capital available.

[Christine]

Finally someone who makes sense. Were all the Cassandras born after the last bust, or are they just trying to sell their services to those who were? How many times do we have to remember how to spell "cyclical"?