October 22, 2011
Until 2001, information technology and communications investments (ITC)—the bread and butter of VC portfolios—outperformed the economy by 50% for almost 40 years, owing largely to immaturity of the sector. There were periods during this time when VC-backing conveyed a kind of celebrity status on its recipients. Venture capital infusion was viewed as a success in itself, and proof that a company was credible, scalable and promising. Although that belief is proven true about half of the time, the other half of the time, VC-backed companies fail. Even in the heady days of the tech boom, venture capital was really just a tool—a means to an end for funding innovation and growing business in a way not possible otherwise—the same as it is now. Despite this premise, the perception of VC money, and the VC industry have changed significantly since the 1990s. The reasons are as follows:
Reason 1: The bread and butter of the VC industry is much different in 2011
The maturity of the ITC sector means that VC money has a more difficult job than it did in years past—parts of the market are less scalable or covered by industry players that control the routes in for new companies. Although the decreasing white space in some ITC segments means that there are fewer traditional VC-worthy investment opportunities, the probability of a new company securing VC money remains tiny—less than one percent—and the chance is not likely to increase. Beyond that, the sources of money are shrinking. The number of VC funds is diminishing because the biggest, most reputable funds attract the best companies and yield the highest ROIs. A VC firm that performs poorly has trouble raising more capital, and a VC firm that can’t invest for want of capital closes.
For the smaller players, the VC business model functions best—if at all—when the investments are large. Venture funds want to invest in companies with the potential to grow quickly and return 35% or more compounded annually on the initial investment. Obviously, 1) a 35+ percentage return on a large investment is more than a 35+ percentage return on a small investment and 2) VC money comes with a commitment to help the company grow, to mentor it and sit on its board, and to secure the best ROI possible. The marginal return for these efforts decreases if the firm makes ten angel-sized investments instead of one traditional VC-sized investment.
Beyond that, ITC startups don’t necessarily need much money to succeed. Paul Graham, an entrepreneur turned super-investor and founder of YC attributes this to four factors. He writes, “Moore’s law has made hardware cheap; open source has made software free; the Web has made marketing and distribution free; and more powerful programming languages mean development teams can be smaller.”
Reason 2: Portfolio company exits are slower post-recession
In addition, the recession has lengthened the time between initial investment and exit considerably, causing a backlog of portfolio companies under private equity management. More specifically, at the very end of 2010, private equity firms owned 5,994 portfolio companies—the highest number on record—with a median hold time exceeding five years. When the hold time is long, performance that at least matches VC predictions is critical; there isn’t time or liquidity to compensate limited partners when an investment fails slowly, and there isn’t liquidity to make new investments until the logjam begins to move.
Nevertheless, rumors of the death of venture capital have been greatly exaggerated
Although it’s clear that venture capital as it existed for the past 40 years will be unnecessary for companies making incremental changes to existing, affordable technologies, there are two important reasons that venture capital will remain extremely important.
Reason 1: Quantum leaps will continue to require large, smart investments
The first reason VC remains important is that ITC still contains great, un-mined swaths of opportunity for truly innovative companies. For example, human interaction with computers is in its nascence and improvements are path-dependent on the evolution of interaction to date. Advances that are truly innovative are incredibly expensive, and bootstrapping—no matter how expertly effected—just won’t be enough.
The energy and biotechnology sectors face similar hurdles—time and human capital to truly innovate are rare and expensive. In other words there are specific opportunities where large, traditional VC investment is absolutely necessary.
Reason 2: VC prestige and big capital infusions yield returns from wading-sized talent pools
The second reason is that when a company takes a long time to become cash-flow positive, the prestige associated with VC money makes it possible for companies (especially those that are not consumer-facing) to attract and maintain staff with the knowledge and ability to do really hard things, like develop the predictive algorithms that precede machine learning.
For an example of how expensive machine learning can be, consider Watson—the computer system that surpassed the champion achievement level on Jeopardy in February 2011. Watson took twenty expert engineers three years to create. Assuming an annual salary of $100K for each member of the team, the labor costs alone would exceed $6M.
But expense is just one issue attendant to creating a Watson-like system—the more difficult problem is securing talent. The pool of extraordinary software engineers is extremely shallow, help is always wanted, and salaries are soaring. In other words, software engineers have many choices, and the prestige and attention that still follow working for a VC-backed company are factors superior talent considers when choosing among opportunities.
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