The changing maths of venture capital

If you have been reading this blog over the past couple of weeks you might have picked up that I’m a big admirer of Steve Blank and his thinking about how to build startups.  Yesterday he wrote a blog post entitled Welcome to the Lost Decade (for Entrepreneurs, IPO’s and VC’s) which sets out the changes to the environment in which we are all working and explains how tough life is going to be for the startup ecosystem as a result.  As I said I’m a big fan of Blank, but I think he over states his case this time.  In the rest of this post I will pick out the salient points from Blank’s piece and then finish by saying why I think the situation isn’t as bad as he makes out.

Blank’s starting point is that the startups and their venture funds used to rely on the IPO markets to provide liquidity and latterly to fund the later stages of growth, but that the IPO market has been moribund for a decade.  As you can see from the two charts below the difference between the nineties and noughties is stark.

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It is true that the picture has improved this year as H1 2010 saw 2x the total number of IPOs in 2009, and from our perspective the public markets are working much better, Tesla (in which DFJ is an investor) got out OK a couple of weeks back and we have a handful of other companies that might float soon.  However, whilst the recent uptick in venture backed IPOs sweetens the picture a little we are still a long way short of the 150-200 IPOs per year of the early 1990s, let alone the activity levels during the bubble.  Moreover, the macro economic picture remains unexciting and it is hard to see much change from the current status quo over the next couple of years at least.

As a result VCs making investments now, and by extension the entrepreneurs who take their money, must plan for exit via M&A and as Blank points out that means lower exit values.

I don’t think that means we are in a ‘lost decade’ though.  It does mean that making money out of startups for both entrepreneurs and their investors needs to be done differently, and will often be more difficult, but it is still very doable.

Here are the reasons why I remain optimistic:

  • The fundamentals for startups get stronger all the time – the pace of innovation continues to increase exponentially and startups’ ability to move faster than large companies is becoming more and more of an advantage
  • In many sectors the capital requirements to start and grow a business are decreasing
  • New sources of liquidity for shareholders in startups are emerging to fill the gap the IPO market has left – e.g. DST
  • The economy and IPO market will come back eventually (not that you should plan for it today)

That said, this is absolutely not a time to be complacent, and I think Blank is right to assert that a startup will have to be stronger to survive now than was the case 10-20 years ago.  As he says, capital efficiency is much more important than it used to be, and raising capital takes longer and needs more creativity and forethought than it has for a while.  But these problems are surmountable.  And for the entrepreneurs that figure out how, the prize will be big – competition is weaker today than it has been for a long time and businesses that are founded today will hopefully be exiting into the next boom some 3-5-7 years hence.

For VC funds this means that the optimum size just got smaller – more capital efficient companies and lower exit values both point that way.  That means living off fat management fees is increasingly a thing of the past which I guess makes life tougher – but that is probably a good thing as it puts the focus 100% on delivering great returns and generating carry.

Finally – I owe a thanks to Mark Gibson of Advanced Marketing Concepts for pointing me to Blank’s post.

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  • John

    Good stuff Nic, as always.
    I would observe, if i may, that the two big changes for non-hardware start-ups are that firstly, the cost to a workable product have fallen (duh) but secondly that the costs to achieve scale have paradoxically increased. The effect of the web has to been to concentrate market power not weaken it. That means more working capital in the scaling end and less in the development end. This also affects exit timing. Investing earlier means holding longer, all other things being equal. And it affects investing frequency: the old adage for LPs was that even if you can time the market you cant time innovation so LPs would encourage a consistent investment frequency. But this makes less sense if the risk is not the effectiveness of the innovation but the receptiveness of the market. So periods of investment inactivity can make sense.
    Lastly, and there are two reasons for this, it changes the role of the corporate investor in my view. 10 years of pressure on earnings for public companies has reduced the capacity to innovate (with noble exceptions). And an effect of this has been an average tenure for CEOs for public companies being 3 years or less. This means that the incentive to fund innovative investments with a 5-7 year pay-off is small. But the investment horizon for investors like Sov Wealth funds and the big patient Family Offices is 15 – 50 years.
    This probably means an increasing role for corporate investors wanting to bulk up their capacity to innovate. GM announced a $100M fund, and Kaplan announced a programme – i think we will see more of this. Super-Angels can take companies through to A (maybe A sharp/B flat) but fee driven VC funds still don't like that stage – which makes for interesting opportunities for corporate investors who want to link their scale and reach to innovative start-up products. James Mawson is on to this – check out Global Corporate Venturing http://www.globalcorporateventuring.com. I think this will become essential reading for the start-up community, entrepreneurs and investors – especially if we see a resurgence of 'stealth' investments by corporates. The data we have on start-ups is once again partial and poor – researchers cant get enough information by just calling the investment managers at the VC Funds anymore. There too lies an opportunity I think.

  • Thanks John. I didn't put it in this post, but I agree, the cost to scale web companies is still significant and that is why there is still a role for venture funds in this sector.

    It will be interesting to see if corporate venturers will have the patience they need to build teams and hold investments for the length of time necessary.

  • Alan_Gleeson

    Hi Nic

    Mark Suster has a similar post on this today with very similar conclusions to yours

    http://www.bothsidesofthetable.com/2010/07/16/w

    Alan

  • Thanks Alan