Lakshmikanth Ananth, Class 12, and Chris Grisanti
Stuart was wondering whether he was ready for his venture firm’s upcoming offsite. He had materials prepared for the usual things the partnership covered—macro environment, deal flow, portfolio, Limited Partner (LP) meeting, and strategy—but somehow he had a gnawing feeling that he had to push the partnership beyond the usual this time. 2009 had a been a tough year, though his firm had finished strong with two new investments in the last quarter. The nuclear winter of 2002–2003 had been tough as well, but he and his partners had steered the firm through that experience to emerge smarter and stronger. Was this downturn any different?
Jim was in high spirits after a brainstorming session with his team. Everybody had their creative juices flowing and ideas for product improvement were gushing out. Jim was a serial entrepreneur. He had previously co-founded and sold three companies, and he had joined his current startup very early on as a CEO. He saw a talented team and a good idea, and over the last 12 months he had transformed the talent and idea into a really good product. As he was walking out of the meeting, one of the co-founders pulled him aside and asked him whether they should return the call from an acquirer who loved their product and team or push ahead with raising money in order to accelerate innovation and customer acquisition. His first instinct was to just put together a pitch deck and get the fundraising show on the road with venture capitalists who knew and trusted him. In a few weeks, he would have several term sheets to choose from. However, as he thought about it some more, he asked himself, “Are things really different this time?”
Modern venture capital traces its roots back to Georges Doriot who, in 1946, created the first fund that accepted capital from sources other than wealthy families, focused on private sector investments in innovation, and had the first home run with his $70,000 investment in Digital Equipment that led to a $350 million IPO. The last half century has seen the rise of venture capital to become synonymous with innovation and wealth creation. Since 1980, fast-growing entrepreneurial companies have accounted for the majority of new jobs created in information technology, life sciences, and now clean technology. Kauffman Fellows, a subset of venture capitalists, had by 2004 made $6 billion in venture capital investments, sparking growth in hundreds of new enterprises, $15 billion in annually recurring revenues and the creation of 48,000 jobs.1
Stuart, the venture capitalist, and Jim, the entrepreneur, are the most prominent protagonists in the venture capital industry. They operate under a set of assumptions that have not been revisited since the early 1990s. Dr. Jeffry Timmons in his seminal work on venture capital in the late 1980s foresaw both the coming wave of returns and the dangers of “me-too” investing strategies in the 1990s. In Dr. Timmons’ 1992 book Venture Capital at the Crossroads, Don Valentine of Sequoia Capital questioned the assumptions that venture capital operated under then, with his perspective that (a) there is too much capital chasing too few great ideas, (b) venture capital has not generated healthy returns in ten years, (c) the number of venture firms needs to shrink, and (d) entrepreneurs need to be patient and capital-efficient. However, what followed is best summarized by John Doerr’s famous quote: “The Internet is the greatest legal creation of wealth in the history of the planet.”
Venture is at the crossroads again. In the 2010 NVCA Predictions Survey, 90% of the 325 respondents suggested that the number of venture firms will shrink over the next five years; furthermore, over half of the respondents felt the industry will shrink by 16% to 30% over the same time period.2 Jason Green, a thought leader from the charter Kauffman class, summoned the spirit of Dr. Timmons in saying,
The demise of high rates of venture capital return in the 2000s coincided with a brand of venture investing that was long on financial engineering and deal making and short on value-added attributes that classic venture capital was built upon. Those that look in the rear view mirror to assess prospective returns are likely to miss out on the next great wave of innovation and entrepreneurship. Equally risky, though, is to plow forward as an investor defining success by the size of funds under management rather than the distinction of one’s strategy or the fanatical devotion to truly adding value to building great companies. Are we as an industry fated to learn the same lessons over and over again? I certainly hope not…
It is time to revisit the assumptions under which venture capital operates.
Stuart’s assumptions are like those of many other venture capitalists. While he frets that there is too much capital, too many venture firms, and too many companies, he thinks that the venture capitalist down the street is in more trouble than he is. He is comforted by his assumption that the same set of LPs will continue to invest in venture partnerships. He sees the environment for exits easing up, providing much-needed liquidity. The weakest venture firms will be weeded out, he surmises, but for the most part, things will return to the normal state. Still, he wonders sometimes whether he should push his partners to examine these assumptions more critically. What if one or more of the things they took for granted did not hold?
Jim’s assumptions are similar to those of entrepreneurs who grew up in or around the Internet boom. Always think big—go big. Raise more money than you think you need so that you are better financed than the next three competitors in the space. Always keep your eye on the prize—a big exit—and do not sell early. First stop IPO, second stop plenty of corporate acquirers hungry to pay significant valuations. Venture is not going away, and there is always another firm around the corner willing to fund the next round. Jim noticed that some things were different this cycle, but he wasn’t willing to spend too much time examining his assumptions. What if some of the ground rules had changed?
In this article, we place the current state of venture capital in a larger context and look to the future through Stuart’s and Jim’s eyes. First, we take a holistic view of the venture ecosystem through an examination of the cycle of money into and out of the venture capital industry. Second, we look at venture activity and performance over a long timeframe: we start with the 1980s when data on venture activity first started being collected methodically3 and segment our analysis over decades. Finally, we apply the principle of market forces to place actions and actors in context and consider the future of venture capital through that lens.
The Virtuous Cycle of Venture
While players like Stuart and Jim are the stars of the venture capital world, they are part of a larger ecosystem encompassing LPs, venture firms, entrepreneurs, corporate acquirers and public markets, and finally wealth-creation feeding back into LPs (Figure 1). We can begin to understand this ecosystem through three simple determinants. First, what is the ongoing appetite of LPs to invest in venture capital? Second, what are the funds that can be raised and deployed by venture firms and other direct investors given capital as well as opportunity availability? Last, how effectively can that risk capital be used to create companies, drive innovation, provide returns, and be distributed to LPs? These determinants are the basis for the cycle of capital flows.
Figure 1. The Virtuous Cycle of Venture.
When every element in this cycle is optimally sized and performing, a virtuous cycle generates positive returns for every participant, and more capital is returned back into the ecosystem. The virtuous cycle is also influenced by the macroeconomic climate and innovation cycles (the most prominent being the dot-com boom). This virtuous cycle of venture has fueled the enormous growth of the venture industry over the last half-century.
To measure venture capital and develop a view on its future, we apply a quantitative lens to the determinants of the virtuous cycle, using data collected over the past 30 years.
Considering the activity across the venture cycle, in Figures 2 and 3 we see that the pool of capital available to venture capital has grown significantly over the past 30 years. $40 billion in total capital was deployed by the venture industry between 1980 and 1989, whereas this level of capital is invested in just an average year in the industry today. The number of companies receiving venture capital and number of investors participating has also increased over 500% between the 1980s and 2000s. This growth has been fueled by strong returns, the general growth in investable capital globally, and higher allocations of investment pools to venture capital by LPs like pensions, endowments and insurers. The most prominent examples were the endowments of major universities who invested as much as 30% of their capital into venture investments. These LPs have been motivated to invest in venture capital as means to capture strong, risk-adjusted returns as well as diversification benefits versus other investment vehicles.
Figure 2. Total Money in Venture Ecosystem (Billions).
Figure 3. Average Number of Companies and Investors Active Annually.
The up-and-to-the-right trends of the virtuous cycle across decades—capital committed by LPs, capital invested by GPs, number of active investors and companies funded—help us understand Stuart’s and Jim’s assumptions about their worlds. To them, the current downturn is just a blip when viewed across what is arguably a secular growth trend across decades.
However, all is not as rosy at it seems. While capital committed and invested has continued growing, exits have stalled. Proceeds from exits in the last decade have dipped to $354 billion, almost half the $650 billion level in the 1990s, while capital invested has almost doubled from $338 billion to $597 billion. This is a “double whammy” that both Stuart and Jim should be concerned about. Without exits, the cycle of venture breaks down.
Returns have trended down for the last decade. The rolling 10-year IRR for the venture capital industry as a whole as been trending below 10% (Figures 4 and 5), much lower than the 20%+ IRR that is typically demanded from venture investments. U.S. venture returns over a 10-year horizon dropped from 26.2% in Q2 2009 to 14.3% in Q3 2009 as venture returns for the first half of 19994—when the exit market was especially active and profitable—were no longer included in the calculation.
Figure 4. Venture Fund Performance: Rolling 10-Year IRR.
Figure 5. Venture Activity Normalized to 1981 Levels.
However, while the pace of exits has slowed significantly, venture firms have continued to deploy capital—commitments to venture funds and investments in venture-backed companies have continued unabated despite the decrease in returns. When venture activity is normalized to 1981 levels (Figure 5), we see that capital deployment on an average during the 2000s was 44x the levels of 1981 while exits were only 6.7x. This asymmetry is unsustainable.
Stuart should indeed evaluate his assumption about continued LP appetite for venture. He knows that in 2009, 125 venture funds in the U.S. collected $13.6 billion, down from 203 funds that raised $28.7 billion in 2008 and down from 217 funds that raised $40.8 billion in 2007.5 He initially thought of this near-term trend as a response to the economic downturn. Seen in the light of longer-term fund performance and activity levels, he should expect that LP commitment will continue to trend down to match exit levels.
Stuart and Jim should also take a hard look at their assumption regarding the longevity of venture firms. Approximately 2,800 venture investors are now active (meaning they have raised money in the last eight years) in a typical year worldwide; in the United States, there were 794 active venture capital firms at the end of 2009, down from a peak of 1,023 in 2005.6 So, Stuart and Jim should expect a continued shakeout in the number of active firms. Stuart should be a bit more selective about future co-investors: A top firm in a different geography could be a better co-investor than the firm next door. Jim should also weigh longevity when deciding which firm to accept funding from. One might also expect individual longevity in venture to be less certain as even healthy firms have been deciding to shrink fund size.
Among the factors affecting the virtuous cycle of venture, the most significant is the relative paucity and evolving profile of exits—the time from series A investment to IPO has been increasing steadily over the past decade, with the average now standing at 8+ years, as seen in Figures 6 and 7. Investors have been demanding increasing maturity for companies offered on the public market, and the resulting lengthening of time to public offering has depressed IRRs. The mix of IPOs to M&A exits has also changed noticeably—from almost a 1:1 ratio in the 1990s to 1:7 in the 2000s. While this is a reasonable shift as end-markets mature, multiples generated by M&A exits have dropped from 7x to 2.7x, thereby compressing returns. In addition, the backlog of venture-backed companies waiting for exits has increased steadily in the 2000s. Roughly 900 of the 2,800 companies funded every year are new entrants while only about 400 companies exit.7 Even if the current pace of exits doubled, several years would be needed to work through the existing backlog of 5,000 companies waiting for exits at the end of 2009.
Figure 6. Exit Activity by Decade: Average Number of IPOs and M&As.
Figure 7. Exit Metrics.
Stuart has been operating under certain assumptions regarding the size and nature of funding needed to move from earlier stages through exit: With larger fund sizes and the appetite to go big, venture capitalists like Stuart have swung the pendulum in the direction of more capital in every round. The capital a firm invests in the average venture round has crept up to $7.8M in the 2000s from $4M in the 1990s.8 The timing and size of capital does two things in this new paradigm of long germination periods for companies and high likelihood of M&A. First, larger rounds that are more front-end loaded tend to depress IRR for investors. Second, larger rounds require more concentrated venture portfolios, greater syndication between funds, and/or larger funds in order to provide the necessary capital. These implications are unattractive. Given the long-term exit trends, Stuart would do well to go back to the basics of calibrated capital infusions into companies based on success milestones and tangible reduction of risk factors.
Jim should reconsider the possible value of selling early. The ideal exit point is when there is a significant local maximum and significant risk in getting to the next peak even with capital, talent, and market opportunity. In the late 1990s when entrepreneurs like Jim had their first taste of success, there were several active acquirers in every sector, IPOs were a credible alternative, and in many cases exits happened earlier in a company’s life when a lot of capital had not yet been raised. With an acquirer knocking at the door, Jim should seriously evaluate if the company is at a local maximum, even if it is early in its evolution. The opportunity cost of making the wrong decision is very high with 5,000 companies clamoring for exits.
These measurements of venture suggest that the virtuous cycle of venture is out of sync. Should venture capitalists and entrepreneurs be worried? Yes. At the same time, this is not the end of venture capital as we know it. Market forces will likely come into play to take the excesses out of the venture cycle. With 10-year fund lifecycles and 4-8 years for an investment to really play out, we should expect that corrective action will occur over a few years. In this section, we have conceptualized how we expect market forces to act through the lens of supply and demand economics.
In Figure 8, the supply curve (S) represents the capital that investors will be willing to put forward given a level of long-term returns. The demand curve (D) represents the number and availability of viable investments and/or funds that can provide investment returns. These curves move to the left or right, depending on the macro-economic environment, expectations of future returns, and the motives of investors. Our hypothesis is that the late 1990s provided a short-lived expansion of available, attractive investments (D1), which then returned to long-term equilibrium (D). However, longer venture investment cycles maintained excess paid-in capital (Point 2). The venture system, including number of funds and capital deployed, should return to equilibrium (Point 1) over additional cycles.
Figure 8. Venture Capital Market Forces.
The only potential complication to this hypothesis would be the entrance of higher numbers of non-financially motivated investors (sovereign wealth, corporate innovation funds) that could shift venture return criteria (S1), resulting in a permanently lower return equilibrium (Point 3). We now consider data points supporting this hypothesis.
On the supply side, although a perfect curve cannot be gleaned for the venture ecosystem, one can examine the rate at which companies are funded relative to exits. As the venture industry continued to grow through the 1980s and 1990s, the ratio of funding to exit has been around 12:1 (Figure 9). However, the supply of funding relative to exits increased by over 50% of baseline levels in the 2000s to 19:1. As discussed above and shown in Figure 9, the pace of exits has remained relatively flat and the money multiple on exits has decreased by 50% (Figure 10). These data points support a shift in the supply curve.
Figure 9. Ratio of Companies Funded to Exits: Average Annual Levels.
Figure 10. Total Value to Paid-In Capital: Vintage Year Samples.
On the demand side, we can use a sample of vintage-year performances of venture funds as a proxy for the number of attractive investments available (Figure 10), reflecting a curve that can shift due to one of two factors. First, the gradual increase in the global economy and the cumulative effects of innovation on society cause the demand curve to shift to the right gradually over time. In 1970, the ability to find attractive venture investments was likely lower than in 2000 on a purely numerical basis. Second, near-term paradigm shifts in technology or the economy cause the curve to temporarily shift to the right. The Internet era caused a shift of D to D1, as reflected in the return profile of 1994 vintage funds. When “the party ended,” the demand curve over-corrected to a point where there were very few 2004 vintage funds that were good investment vehicles.
What does this mean for the future? We expect that supply of capital will over-correct in the short term. The average year in the 2000s has generated $35 billion in proceeds from exits.9 LPs have recalibrated the supply of capital to venture by committing only $13.6 billion in 2009, with 2.5-3.0X money multiple expectations. As the exit market recovers with global economics, we could see supply inch up to the $20 billion level. On an inflation-adjusted basis, we project that this level will represent the new equilibrium supply and demand in the venture ecosystem.
Other Factors to Consider
Financial investors are the traditional constituents of LPs and GPs, and they set the required rate of return for their dollars; consequently, the structure of the typical institutional venture fund has been designed to serve the purely financially motivated LPs and GPs. But over the last few years, we have seen several non-traditional constituents such as governments, universities, family offices, sovereign wealth funds, and corporations stepping in and funding early (and sometimes all) stages of innovation. These constituents often have motives that reach beyond pure financial returns. For example, government innovation funds often have motives of job- and industry-creation that supersede profit motives, as seen in the numerous investments in wind farms, green manufacturing, and automotive industry retooling. Corporate funds often invest in order to gain exposure to specific industries, as well as information on innovation trends in adjacent markets. These actors could push the supply curve beyond what is justified by pure financial metrics. More importantly, these new constituents could introduce new models and structures that better serve their own objectives.
On the demand front, we don’t yet see a paradigm shift that will allow for above-average numbers of exits. M&A continues to dominate as the exit vehicle for venture investments. The number of IPOs may increase as equity markets return to health, but LPs and GPs will continue to think of M&A as the likely exit and calibrate their return expectations accordingly.
Fund size and commitment period are not included in our analysis due to lack of data; nonetheless, some suggestions can be made. Fund size is still a matter of conjecture. However, there is reason to test the standing assumption in the industry that the horizon for a venture capital fund is typically 10 years: With longer times to exit, it is unclear whether 10 years is adequate for the full cycle of investment and harvest.
Navigating the road ahead may be difficult for both Stuart and Jim. Stuart and his partners would benefit from recalibrating their assumptions to “the new normal.” This may include a painful contraction for venture in its current form, going from $40 billion to $30 billion or even $20 billion in annual investment levels. Over the next few years, Stuart should expect attrition in the number of venture firms and reduction in the size of venture funds. Stuart may also see new models emerge in venture that better serve the objectives of corporations, universities, family offices, and governments who are increasing the funding of innovation. Simultaneously, for Jim and his fellow entrepreneurs, the bar will be higher for raising venture capital and exit opportunities may be even tougher, in some cases to the detriment of innovation.
Short-term corrections notwithstanding, both Stuart and Jim should remain excited about the future of venture capital. They are both intrinsically driven by the thrill of creating the next “big thing”; by reassessing their assumptions and adjusting their decision-making appropriately, they can stay competitive and successful, opening the door to participating in the innovation and entrepreneurship engine that will inevitably create the next Apple, Cisco, Genentech, or Google.
Lak works in the Corporate Development group at Cisco Systems, where he is responsible for strategy, investments and acquisitions. Lak brings a decade of investing and operating experience to his work. Prior to joining Cisco, Lak was an active venture capital investor in Silicon Valley, where he participated in investments in companies such as Cortina Systems, Digital Chocolate, IMVU, Jasper Wireless, Open-Silicon, and Snapvine (acquired by WhitePages.com). Earlier Lak was with the private equity firm 3i, where he specialized in investments in India; he formulated 3i’s venture strategy in that area. Lak holds an MBA from INSEAD in France , an MS from Kansas State University, and a BE from Guindy Engineering College, India, where he was a Gold Medalist.
Chris works in the Corporate Strategy group at Cisco Systems. Prior to joining Cisco, Chris spent seven years as a portfolio manager and analyst at Franklin Templeton Investments covering the small cap market and tech/media/telecom sectors. In addition to his strategy and technology experience, Chris also founded several small businesses in the retail and consumer services industry. Chris earned an MBA in 2006 from the J.L. Kellogg School of Management at Northwestern University and holds a BS in Business Administration from the University of California, Berkeley.
1 Data from the Society of Kauffman Fellows based on a 2004 survey. New data is being collected in 2010 and early returns show that the impact of Fellows is trending toward tripling in every impact dimension.
2 National Venture Capital Association, “Venture View: 2010 Venture Capital Predictions Survey Results.”
3 Both Thomson Reuters and Dow Jones have historical data on venture capital dating back to 1980 but did not methodically collect data on venture before that period. Thomson Reuters data were retrieved from VentureXpert data service. Dow Jones data were retrieved from VentureSource data service.
5 Dow Jones.
6 Thomson Reuters.
7 Estimates based on Thomson Reuters.
8 Thomson Reuters.
9 Estimates based on Thomson Reuters.