The Future of Venture Capital Funding in High Tech

Like almost every aspect of the economy, venture capital financing of High Tech Hardware and Software startups were way down during the most recent recession.

There was pressure on virtually every segment of the economy, and the worldwide financial system was  in by far the greatest disarray of our lifetime. The preferred exit strategy for Venture Capitalists, the IPO, pretty much shut down for quite a while and really hasn’t come all the way back. Financial returns at Venture funds took a hit like everything else financial and VCs without impeccable track records were not in good position to attract new capital –given the current frantic flight to quality by investors. Things looked dire in the VC business and a painful shakeout began which has not yet fully run its course.   There have even suggestions by many people, including some prominent VCs, that the long running and revered Venture Capital financing business model is “broken”, and that it will eventually cease to exist as we now know it.

In fact, the VC business has struggled since the Dotcom bubble burst back in 2001. In a report summarizing the 2012 performance for VCs, the National Venture Capital Association says the aggregate VC industry finally returned to the black last year—“the first post-bubble year in which venture funds collectively distributed more cash to limited partners than they brought in,” said association president Mark Heesen. The recession only made things much worse and brought some industry issues to a head–as well as judgement day for a number of VC firms who have been like ghosts sitting on the sideline managing existing portfolios–but with no dry powder as they have been unable to raise new funds.

Things have slowly gotten better since the recession ended but aren’t back to any sense of “normal”. So what really is going to happen in the Venture Capital business in the long run?  Will a software or technology entrepreneur be able to fund their company via the VC route in a relatively “normal” sense  in the future? Or will it continue to be more than the usual struggle? Let’s take a look at some of the things that might happen.

SHORT TERM AND LONG TERM IMPLICATIONS
First of all, I don’t believe  the Venture Capital business is going away. There is a bit of pain left to go in many industries since things haven’t exactly come roaring back and the VC business will be no exception. So in the short term, all but the best performing VC funds will have a difficult time raising money, startup capital will remain tight, valuations will be lower and the whole experience of raising money will be even more painful than normal (and it’s always painful).  But make no mistake, there are software and tech companies closing funding rounds every day. There is still money out there in the short term for deserving business plans. And in the long run, the economy will rebound and things will go back to some new version of “normal”. I do believe that the Venture Capital business needs to make some adjustments, however–so it will probably be a “new normal”.

HOME RUNS VS. SOLID SINGLES AND DOUBLES
One of the staples of the Venture Capital financing business model has been finding “home runs”, meaning those companies that can grow large enough for an IPO. These are few and far between. VCs have always said they would gladly invest in 5 to 10 failures to find that one big hit. The IPO market is still very depressed by historical standards for the time being, which puts a lot of pressure on the basic premise of how to make money as a VC. I’ve always thought the “big hit” model was lunacy, and akin to throwing darts at a board–it’s so hard trying to pick out who the huge winners are going to be a startup stage. There’s a lot of luck involved in a company getting to an IPO, and even more luck involved in picking them out at birth.

This strategy seemed to work fine when the markets were consistently heading up and to the right, and quite a few companies could do an IPO and get a billion dollar market cap. But I’ve always thought the very basis of investing and company building is in finding those companies that can give you a return on your money, skillfully balancing risk and reward. Considering those companies that have truly developed a strategic advantage and a sound business plan, some of them may get very big, others not so much–depending upon the specifics of their target market and business. But VCs for years have been basing investment decisions in large part upon huge markets and the potential for the big hit. I think it led to some lazy investing and that part of the Venture Capital financing business model may need some adjustment.

In fact I’ve seen many “seed” and other non-traditional, smaller VC funds pop up to fill the void in the last few years that profess to be happy to invest in singles and doubles. Some of these look like a hybrid between an incubator and a VC fund. There are lots of variations out there and I think there is still a search for a winning formula. There aren’t enough of them yet, but I think this is a big step in the right direction.

VC COMPENSATION MODELS
As VC fund size and limited partner returns increased during this golden era of VC funds, so too did the compensation to the General Partners of the fund. When funds and returns were out-sized, limited partners swallowed hard or looked the other way. It’s analogous to a mutual fund with a hefty management fee–when the returns are great, it’s no problem. But in times like today, the small fees associated with an index fund look pretty good compared to that under-performing mutual fund with active, expensive management. Unfortunately, since 2001 VC returns have lagged even the returns of the stock market.

There has been discussion over the last few years that the VC fund Annual Management Fees which have typically been in the 2-3% range will be reduced, or maybe even go away entirely. Whether this has actually been happening at some funds, I’m not sure. I’ve always thought that the 20% carry standard will probably hold.  LPs won’t mind the carry if they are realizing good returns. What does this mean for the software/tech entrepreneur? It may not mean much, on the surface. But I do think it requires VCs to do more homework on their potential investments, possibly giving an edge to those entrepreneurs will less dramatic, smaller business plans but better risk profiles.

THE OXYMORON OF “LATE STAGE VENTURE CAPITAL”
I’ve always thought that the idea of “late stage” venture capital financing was kind of silly. However, the Venture Capital business has been moving this direction for quite a while. Part of the reason is that as many VC funds have gotten so big that it’s hard to deploy all of the money with “real” startup investing. And also it’s a less risky way to get to that big IPO payoff. But imo these late stage funds have gotten pretty similar to Private Equity firms except their time horizon may be shorter. So maybe these investors should really just be re-classified–in many ways they don’t look anything like their early stage brethren. At this stage, there are usually many other potential sources of capital. I believe that this late stage segment of the venture capital business is one that is the least important economically and may shrink over the long term.

CAPITAL-EFFICIENT BUSINESSES VS. KISSING FROGS TO FIND THE “BIG ONE”
I hope that the long run Venture Capital financing business will trend back to true startup investing and will reduce it’s reliance on the long home run as its basic method of making money. This is where they really add value to the “business-creation value chain”. What I expect to see–and there has been much discussion about–is a renewed search for businesses which are “capital efficient”. This means companies that will turn an invested dollar into a high multiple of that investment, in terms of revenue, profits and valuation. You might say this has always been true. But the key difference, I believe, is that that venture funds will be smaller and as a result will feel less pressure to fund high risk, high ceiling businesses where huge amounts of capital need to be deployed. As I stated earlier, VCs with very large funds have previously felt that the economics of their business demanded this approach. With smaller funds one can hope that capital efficient businesses in smaller markets–with lower ceilings but higher floors– will no longer be ignored. Solid singles and doubles may come into vogue!

IS MONEY REALLY “SMART’? OPERATIONAL EXPERTISE VS. FINANCIAL GUYS
I’ve always felt that the idea of “smart money” has always been a fallacy, or least one that was greatly overblown in the Venture Capital financing business. I know that there are A LOT of people that will disagree with me on this point. A lot of startup advisers will tell you that it’s imperative to raise money from investors who will provide much more than cash. In many cases,  I think it’s a bunch of malarkey. No doubt that there are many experienced, skilled and very well-connected VCs that can provide a strategic advantage to entrepreneurs who are fortunate enough to attract them as investors. But with money being a commodity, this is mostly about a VC firm trying to differentiate and provide a value-add.

Fundamentally, the need for capital and the need for advice/business assistance aren’t tied at the hip. Both are often needed, but they don’t need to come from the same place–they are important, but separate ingredients to the successful startup recipe. If you can get both in one package, that’s great. But too many VCs present themselves as experts in areas where they’ve really just been investors. Again, some of them are experts–but many are not.  Frankly, entrepreneurs need to be careful of utilizing faulty advice, regardless of whether it comes from someone who has put money in their company or not. Having money in a pocket should not be confused with operational knowledge or expertise.

WILL VENTURE CAPITAL FINANCING FADE AWAY?
As I stated earlier the answer is “no”. But I do think that the bubble excesses and strains of the recession have highlighted some weaknesses in the Venture Capital financing model. There will be adjustments to it–just like there will be adjustments in many other businesses as a result of our economic duress. I’ve offered some thoughts to get the conversation going–please feel free to disagree or otherwise add to the discussion. What’s your view of where the VC business is heading?  I’d welcome everyone to post a comment with your take on this always interesting topic.

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