Why Have Venture Capitalists Shifted To Seed Stage Investing?

On the heels of my last post on venture capital’s role in innovation, I decided to take a look at how active venture capitalists were in funding companies that are early in their innovation lifecycle. The proxy for this is the earliest stage at which venture capital can come in – seed capital or start-up investment. What I found was surprising. The chart below shows the percentage of new venture capital investment (in terms of dollar value) that went to seed /start-up stage companies each year over the last 15 years. This is the best way to look at this type of data - absolute figures tell you more about what the venture market is doing overall - to understand real deal trends you have to examine changes in proportions of investment over time.

What’s clearly surprising about this data is the recent spike in seed investment (relative to other stages) by venture capitalists. 32% of all new venture investment this year has gone to seed stage deals. What’s driving this?

I know for a fact that pure seed-stage venture funds have had trouble raising funds over the past few years (relative to balanced and later stage funds), which means that traditional venture funds are now leaning more towards seed stage deals. I can think of a few reasons why:

• Venture capital firms are being forced to engage in cheaper, earlier stage deals because syndicate partners are increasingly tougher to find for later stage deals.

• Venture capitalists are still worried about the future of the exit markets (the IPO market and M&A activity) and therefore are hesitant to engage in later stage deals. These are deals in which they would have to reserve adequate capital for if subsequent venture rounds are needed to sustain the companies. We've seen a lot of firms face reserve shortfalls over the past year as the exit markets have essentially been closed. Venture capitalists with the expectation that exit markets will remain tight would clearly be detered from making later stage investments and would perfer less capital intensive earlier stage deals.

• Perhaps venture capitalists are simply going back to their roots and finally taking more risk again. There’s probably the realization that outsized returns can only be attained by generating higher return multiples off of earlier stage deals. Some of this might be pressure from limited partners - low multiple later stage deals just are not attractive, particularly when you consider the fees and illiquidity that come with commitments to venture funds.

Regardless of the reason, this shift to earlier stage investing can only be a good thing for the venture industry. The firms that are truly good at building companies and working with entrepreneurs will stand out and perhaps help repair the image of the venture industry.

Data Source: NVCA PricewaterhouseCoopers/National Venture Capital Association.

PricewaterhouseCoopers/National Venture Capital Association. MoneyTree™ Report, Data: Thomson Reuters.

Venture's Role in Innovation

A big debate was spurred by Vivek Wadhwa last week when he lashed out at the venture community through a post on TechCruch.  Wadhwa contends venture capitalists do little, if anything, for innovation and even detract from innovation. His post comes on the heels of the National Venture Capital Association (NVCA)’s most recent “Venture Impact” report which highlights the importance and impact of venture-backed companies in the macro U.S. economy.  The report does make some outlandish claims, such as 12 million jobs, and 21% of GDP can be attributed to venture-backed companies. Clearly venture capitalists cannot realistically lay claim to those statistics. The report, meant to be a lobbying tool more than anything, includes any company that has received any type of venture funding at any point in its life under its definition of “venture-backed,” which is pretty misleading. Not to say that venture capital does not have a positive impact on the economy - it does - but it is definitely not responsible for the numbers the NVCA presents.

Wadhwa took things a bit further in his post though, and cites research (itself a bit questionable) that shows not only do the vast majority of successful entrepreneurs not need venture capital, but that those who do take it see their companies become less innovative. This leads Wadhwa to conclude that “gold digger” venture capitalists with MBAs have increasingly been simply funding “me-too” companies resulting in high failure rates and declining returns. Looking past the VC-bashing, his main argument really is that venture capital does not facilitate innovation and therefore does not play a meaningful role.

The argument that venture capital does not facilitate innovation is really not much of an argument at all; aside from the rare cases when VCs start their own companies, entrepreneurs are clearly the innovators - no VC would argue with that. So then the next question is around the role venture capital plays. VCs are not simply “middlemen” as Wadhwa states. It would be ignorant to group VCs into one bucket - some are better than others, but almost all VCs play a role in their portfolio companies’ management and strategy. Wadhwa points to research that shows a company’s innovation decreases after it receives venture capital. This is actually a product of maturation. Most companies far enough along to receive venture capital funding would see a decline in innovation regardless of whether or not they received that venture funding.  Venture investment is meant more to take an innovation to the next level, raising its impact and growing its reach, not to prompt innovation.

The role venture capital plays varies by industry as well. In the more visible internet sector, there is limited need for venture capital investment, particularly because the cost associated with starting and scaling web startups has become so low. Venture capitalists won’t always admit it, but it’s a space most do not understand well, and because of its high visibility they catch the more flack for failures. Other sectors such as biotech and cleantech need venture investment to scale. Innovation can be halted if not for investment by venture capitalist. Wadhwa does not account for this at all.

Looking at the big picture, there’s not necessarily causality between venture investment and innovation, rather the two go hand in hand. Innovation can only have limited impact without scaling which is often made possible by venture investment. At the macro level, as the US is faced with increase competition from abroad from countries like India and China, innovation will be paramount in our global competitiveness. The only way the US can continue to compete and maintain its current standard of living is by creating new jobs through innovation. Entrepreneurs will be at the forefront and VCs will continue to be there to back them. The innovation ecosystem is fragile and the last thing it needs is people like Wadhwa causing an unnecessary break in trust.

As an aside, Wadhwa in his piece also mentions that “VCs are looking for bailout money and tax-breaks.” I’m not sure what the basis for this claim is. Surely anecdotal evidence is not what bears the proof. There’s not a single VC I know of that would want to touch bailout money, given the caveats it would come with. Nor are VCs aggressively looking for tax breaks. The only major activity on that front is resistance against a change in capital gains tax, which is reasonable. The one exception where tax breaks have been asked for by VCs is in the cleantech industry where government subsidies have led to increased investment by not only venture capitalists, but by a wide range of investors. And finally, I’ve written about this earlier, but venture capitalists are sitting on approximately $120 billion of “dry powder,” not a figure that indicates the VC community is looking for handouts.

The Venture Capital Industry in 2009: Over/Under

With this week marking the start of the NFL season, and the calendar marching toward the fourth quarter, there’s no better time to do a bit of speculation around how this year may end up for the venture industry. Especially when you can have it take the form of the over/under wagers commonly associated with the sport (which are only made for fun of course). Half the fun was in deciding what the over/under should be the rest is in the takes. Here we go:

Category: Venture capital index return for 2009 (one year/end-to-end)

Over/Under: 6.5%

The Take: UNDER

This was a tough line to formulate without the second quarter venture capital index return which is not yet available. The Cambridge Associates US Venture Capital Index return for the first quarter was at -2.9% and the preliminary second quarter end-to-end return currently stands at 0.16%. With the NASDAQ up well over 10% in the third quarter so far, it’s fair to say the venture index will track further upward in Q3 and probably Q4. The venture index has been less volatile than the public markets despite FAS 157 mark-to-market rules, but the trend down the line should still be upward. There should be some bump in valuations before the year is out, but since exit activity will remain weak, the index should have a tough time breaking 6% for the year.

Category: Venture capital fundraising totals for 2009

Over/Under: Funds: 125, Dollar Amount: $12 Billion

The Take: UNDER – both number of funds and dollar amount

At the end of the second quarter, 70 venture capital funds had raised a total of $6.3 billion. Fundraising activity declined significantly in the second quarter, when only $1.7 billion was raised by 25 funds. As we find ourselves amidst the toughest fundraising environment in some time, limited partners have shown no signs of increasing their rate/level of commitment in the near future. Allocations within private equity for most institutional investors have either remained unchanged or dropped for venture, while increasing for more opportunistic strategies. Well established firms and proven general partners should be able to raise funds, but newer firms and those with less than stellar track records will have trouble.

Category: Venture capital deal-making totals for 2009

Over/Under: Deals: 2,750, Dollar Amount: $15.5 Billion

The Take: OVER – both number of deals and dollar amount

At the end of the second quarter, venture capitalists had invested in 1,215 deals totaling $6.9 billion. Investment activity was quite consistent between the first and second quarters. There’s the sense that investment activity has dropped a bit in the third quarter but that deal sizes seem to be larger, perhaps reflective of a shift to investment in the healthcare and cleantech sectors. Look for venture capitalists to continue to invest in innovative new companies, particularly as they should still have the upper hand on deal terms and valuations. Follow-on investments in later-stage companies will continue as well since the exit market will not open up significantly at least till next year.

Category: Total number of venture-backed IPOs in 2009

Over/Under: 9

The Take: PUSH

 At the end of the second quarter there were just 5 venture-backed IPOs for the year, I’m counting just the LogMeIn and Cumberland Pharmaceuticals IPOs since, and projecting just two more. You have to have faith that two more venture-backed companies can hold an IPO in the next four months buoyed by the solid performance of those that have managed to go public so far this year. The good news is that 2010 looks to be a much better year.

Category: Total number of venture-backed M&A exits in 2009

Over/Under: 230

The Take: OVER

Through the end of the second quarter there were 121 M&A deals in which venture-backed companies were acquired. At the start of September we were at around 165. While the third quarter will probably end in line with first and second quarter totals, I’m expecting the fourth quarter to be relatively more active. The over/under is adjusted for this expectation, but I’m still taking the over. Strategic buyers, particularly those with abundant cash reserves will probably look to take advantage of depressed valuations while they last. 2010 could see a rise in valuations, especially if the IPO market opens up a bit more. It’s still worth it to note though that even if we manage to reach 300, the year will go into the books with the lowest venture-backed M&A tally since 2003.

Note: NVCA data was used for all the statistics in this post

Is Mobile Venture Capital Investment Really Dying?

It seems as though there has been some consensus building around the idea that venture capital investment into the otherwise booming mobile sector has been trending downward. The latest comes from PEHub last week – apparently only just over $2 billion was invested in 204 mobile companies last year, down from $2.5 billion invested in 237 companies in 2007 and $3.3 billion invested in 252 mobile companies in 2006. The data is admittedly imperfect and seems to primarily include mobile infrastructure and mobile-exclusive companies. Given that context, I can’t really question the data, but I do question anecdotal evidence pointing towards less venture investment into the mobile space in general and less attention given to the mobile space by venture capitalists, as the PEHub piece suggests (I'm speaking on a relative basis to other sectors – we know overall venture investment is down).

The reality is that the mobile market is gigantic, growing rapidly and undergoing a major transformation – a perfect storm of driving forces for venture capital investment. Interestingly, it’s the transformation that is skewing mobile investment data and perception. As smartphone adoption continues to grow and the mobile experience continues to evolve- mobile devices are more and more becoming an extension of the internet. At the same time, venture-backed internet companies (and really all internet businesses in general) have increasingly been adapting content/services to be delivered through multiple channels, including mobile (other examples include the use of desktop applications, widgets, social media sites, etc.). Investment going into extending channels of distribution for internet and tech start-ups to mobile users - including developing and maintaining downloadable apps and mobile sites- doesn't get pulled into any mobile venture capital investment tally, giving the perception that venture capitalists are perhaps bearish on the mobile sector. Furthermore, as the web browsing experience on mobile devices continues to improve and the line between apps, mobile sites and regular sites blurs, looking purely at investment data/figures on mobile investment will not tell you the real story.

As mobile becomes another distribution channel for internet content, what you are going to see is mobile-specific services, such as advertising or payments become less relevant. Existing companies will eventually become consolidated into larger advertising or payment networks. This will either happen through the acquisition of mobile-only companies by larger service providers or expansion of mobile-only companies into other areas. For example, let’s say you are a mobile ad company such as admob. As the traditional internet experience starts to meld with the mobile experience, advertisers will be looking for cross-channel ad distribution, and you will be forced to cease being a mobile-only company and have to either expand your offerings or be acquired (meaning you will not longer be considered a “mobile company”). These same principles will probably apply to television and game consoles as the lines between them and the traditional computer and internet experience begin to meld.

So yes, investment into traditional mobile-only companies is declining, but it’s a natural progression. In no way is the mobile space being ignored or underappreciated by venture capitalists. The use of mobile as a channel of distribution and a source of growth will continue, but as the mobile experience evolves, fewer and fewer investments will fall strictly under the category of “mobile.” In fact, its existence as a category for venture investment may cease to exist all together, whether it’s 10, 20 or 30 years from now.

One final note – From meeting with a lot of VCs you find that those with international presence (particularly in Asia) are actually investing more heavily in mobile-specific services such as games right now. In the US, operators get in the way of the distribution channel too much. Although they are starting to work with developers a little bit more as they search for new revenue during the recession, operators in Asia and Europe are much more open and have allowed for much more innovation to take place, resulting in more venture investment into the mobile sector in those regions.

Venture Capital Overhang: $118 Billion

This past week, the Alliance of Merger and Acquisition Advisors and research firm Pitchbook Data released a report which indicates private equity firms in the U.S. are sitting on $400 billion in overhang – the difference between fundraising commitments and invested capital. The figure is essentially the “dry powder” or uninvested capital private equity firms have at their disposal. The data was covered in a number of places over the past week, but VentureBeat writer Anthony Ha pointed out that the data does not include venture capital... so I decided to do some of my own research. Below is the chart I came up with for venture capital, using the same methodology the Pitchbook Data report uses (data from PwC, Thompson Reuters and the NVCA):

Source: PwC, NVCA, Thompson Reuters

Over the past decade, venture capital firms in the U.S. have amassed $118 billion in overhang. Of course the data is not perfect; you’d have to account for management fees, recycling of capital, etc. But it does tell us that venture capitalists are sitting on plenty of uninvested capital. Only in 2003 did the ammount of venture investment come close to equaling the amount of capital raised, and the average overhang per year is $10 billion.

The $118 billion figure isn’t too surprising. It’s pretty well known in the venture industry that lack of capital is not a major issue, in fact there might be too much capital chasing too few good deals. Also this year we’ve seen venture capitalists pull back sharply on investment amid economic uncertainly, deciding that focusing their attention on better managing and growing existing investments was a better use of time. We’re also seeing deal sizes come down as the cost of starting technology companies continues to drop. These factors explain the $118 billion and perhaps it’s being reflected in the recent slowdown in fundraising.

Growing With the Real-Time Web

More and more, the way information is shared on the web is shifting to real-time. The “real-time web” is emerging (Read Write Web covers this quite well). The easiest examples to point to are the ones getting the most attention (Twitter, Facebook, FriendFeed, etc.) but the trend runs much deeper. Using Twitter as an example though; what makes its service truly valuable is the ability to aggregate, search and monitor trends within the real-time updates. If you want the latest news (and by latest I mean not just up to the minute, but up the second) on most anything imaginable, there is now instant (or at least faster) access to it, making the information much more valuable. This ability to instantly access the latest information is changing the way we experience, consume and share information. Twitter is not only place where this is happening as Read Write Web points out. Indications of the move toward the real-time web can be seen everywhere: Facebook has implemented real-time updates; the New York Times recently launched Times Wire which provides a stream of news (pictures too) that is updated every minute; Google a couple of weeks ago declared that real-time search, while still an unsolved challenge for them, will be very important; Google is also launching an application that incorporates real-time information from the web, with its just announced online communication tool Wave; through enterprise collaboration tools, companies are starting to realize the value of instant information; new recommendation engines (competing with Amazon’s or potentially Microsoft’s new Bing) are using real-time user behavior to help make purchasing decisions, the list goes on.

So what does this all mean and where are the opportunities for venture capital? The real-time web is here to stay, but it may require people coming to terms with the fact that there is simply too much information to consume. Kind of like how with television there’s always something on, the same will be true (or is already true in some cases) with the new live web – you’ll be able to “tune-in” to a site and catch what’s “on” in terms of content and information. At the same time you will be able to subscribe to, search for, or record, information that’s important to you. There’s still plenty of room for growth around these concepts as the conflux and growth of valuable real-time data is still new. Venture capital can play a role here. Here are a few areas where I think new companies might crop up and have potential to be backed by venture capitalists.

• Of course there will be companies that further develop technology and infrastructure around the real-time web – this includes companies that build tools and software to aggregate real-time data.
• There will be plenty of companies that will be able to use the increasing amount of real-time flow of information and package and present it in useful ways – there are limitless possibilities here.
• Companies that can find a way to rapidly verify the integrity of real-time data, particularly news, will find themselves in demand.
• Advertising and generating revenue around real-time data will be vital – companies that build ads using real-time data will be important, and even more important might be companies that can figure out micropayments (allowing consumers of real-time content to efficiently and effortlessly pay for content they consume – there’s definitely a huge hole here that PayPal does not come close to filling, neither does Google Checkout).
• Finally I think video presents a huge opportunity – 99% of all video is still watched over a television, and while bandwidth is often a limiting factor, video is undoubtedly going to become part of the new real-time web as the line between television and internet video starts to blur.

A Look At the Cleantech Investment Drop

Not only has cleantech investment by venture capitalists dropped off a cliff recently, but the average deal size has fallen significantly too – from $14.5 million in Q4 of 2008 to just $4.7 million at the end of the first quarter of 2009 (PwC/NVCA MoneyTree). Clearly VCs have figured out that deals that eventually need to scale to utility size are trouble. Still, I’ve heard many people point to the lack of project financing or debt (credit crunch) as to why things have stalled. In fact, venture-backed algae company GreenFuel Technoloogies shut down this week. The reason? They claim they were a victim of the credit crunch. But should VCs really have been reliant on project finance in cleantech investments in the first place?

Take a look at the chart below. I’ve graphed the average venture cleantech deal size over time, which I mentioned has fallen by almost $10 million, mainly because there were no major $100 million+ rounds. But what really shows how disproportionally cleantech was reliant on large scale financing is how much investment fell as a percentage of all venture investment.

It helps to put the data in this context because it shows that other sectors, while still experiencing declines in dollar amounts, were not affected nearly as much by the lack of large deals. And by other sectors, I’m talking mainly about technology deals, which have always been mainstays of venture investment. By and large, they are less capital intensive and, really, it’s where venture’s expertise lies. This level is where I think cleantech venture investment belongs.

The current average deals sizes (around $5 million) in cleantech are much more reasonable and the capital going in is still adequate enough support innovation. A recent New York Times article covers the shift in this direction. Liquidity-wise, hybrid tech/cleantech deals have much more promise too. Of potential acquisition targets, they seem like they are the most attractive since they can still produce great return multiples in reasonable amounts of time. Scaling is faster and cheaper - all VCs know this. So instead of trying to hit “grand slams” with large, utility scale projects it may be better to leave those to the utilities and GE’s of the world. VC’s should not be chasing stimulus money, or be in denial about the capital intensity of most renewable energy investments. To me, there’s nothing wrong or concerning about the decline in cleantech venture investment if it represents a shift back to venture’s roots.

A point on the data I used: I realize there are a number of sources I could have used (MoneyTree, The Cleantech Group, VentureSource, Greentech Media, etc.). And they all report different figures due to differing methodologies. The key is not to get caught up in the differences there – they all show the same trend which is the most important thing, particularly when looking at industry data on private equity, which always inconsistent among the different sources.