The new risk capital reality: What’s happened to VC?

This is the second article in a continuing series that examines the state of the ecosystem necessary to successfully bring technology to market. Based on dozens of interviews with entrepreneurs, venture capitalists, angel investors, business leaders, academics, tech-transfer experts and policy makers, this series looks at what is working and what can be improved in the go-to-market ecosystem in the United States, Canada and Britain. We invite your feedback.In a recent interview with the New York Times, Sean Parker, the entrepreneur behind Napster and Facebook and himself a venture capital investor, provided a rather gloomy assessment of the VC industry and the future of U.S. innovation in general.“The risk-reward doesn’t work out in favor of putting money into venture capital anymore,” he said.And yes, again, to confirm, Parker is himself a VC investor. He went on to say that the contraction of the U.S. VC market means that “innovation could gradually grind to a halt or at least become less effective,” a trend that could serve to erode the ambition and vision of entrepreneurs.“Ten years ago, venture capitalists would ask the question: Do you want to build a company and flip it or do you want to build a company and IPO it? It’s a trick question. The correct answer was always, ‘I want to build an incredibly valuable stand-alone business and maybe we get bought, maybe we go public but we’re going to build an incredibly valuable company,’” Parker said. “Now it’s actually not clear that that’s the right answer. There’s a lot of venture firms that are clearly interested in building something and selling it either to Facebook, Google, Microsoft.”Perhaps this is a perspective born purely of a Canadian experience, but, with respect to Parker, we contend that there has never been a shortage of entrepreneurs, or investors, on either side of the border who have been interested in building up something only to the point where it attracts a rich buyout offer.But whether the intent is to build an independent and globally competitive company, or just a tempting acquisition target, the challenge remains to find the necessary risk capital.It is a challenge that has become far more acute in recent years. From Europe to Silicon Valley, there has been a market contraction that makes for a leaner and meaner VC industry with fewer players and fewer dollars to go around. One need look no further than the last annual reports from national VC associations on both sides of the Atlantic to get a bearing on this:“For full year 2009, venture capital fundraising totaled $15.2 billion from 120 funds, a 47-percent decline by dollars committed and slowest year for fundraising since 2003. By numbers of funds, fundraising activity in 2009 will mark the slowest annual period since 1993.” – U.S. National Venture Capital Association (NVCA), January 2010“Venture capital investment in the UK fell to £296m in 2009, a drop from the £359m invested in 2008 and significant decline from 2007, which saw £434m invested. The number of companies financed fell from 455 in 2008, to 388 in 2009.” – British Private Equity and Venture Capital Association (BVCA), May 2010“Deal activity in the Canadian venture capital market continued to slow in 2009, to reach its lowest level since the mid 1990s. Down by 27 percent, a total of $1 billion was invested across the country, a decrease from the $1.4 billion invested in 2008.” – Canada’s Venture Capital and Private Equity Association (CVCA), February 2010VCs are finding it more difficult to raise new funds and have become somewhat risk adverse, favoring follow-on investments in later-stage portfolio companies that have achieved greater validation in the marketplace, at the expense of earlier stage startups.“Of all the predictions put forth this year, a collective lack of enthusiasm for seed and early-stage investing is the most concerning,” Heesen said. “The weak exit market combined with proposed (U.S.) tax policy which would discourage long-term investment puts tremendous pressure on our industry to move towards later stage investing.”This trend is not unique to the U.S. market. In an interview for this series, BVCA project manager Scott Sage noted the same aversion to early-stage investment has gripped VCs across both Europe and the U.K. In Canada, where the VC industry as a whole is less mature and less deeply rooted than in the U.S., the economic downturn that began in 2008 was yet another blow for an industry that had yet to make any substantial recovery from the dot-com bust.“The nation-wide statistics demonstrate the lack of capital in the venture capital industry,” Greg Smith, president of the CVCA, said in the organization’s recap of 2009. “The availability of VC dollars has been eroding for years. We are failing to capitalize on the potential of our entrepreneurs and small growth companies.”According to the NVCA’s industry forecast for 2010, the asset class will continue to shrink in size over the next five years. Deal flow in the U.S. will continue due to the sheer size of the market, but there will be fewer deals and for lesser amounts.This is the new reality. The dot-com boom died a long time ago.A deeper discussion of how and why the VC market has arrived at its current state is not our primary concern here. (Though we of course welcome comments on the subject and an interesting article on this appeared in a July 2009 issue of the New York Times). What concerns us is what startups must do to adapt. How are they to survive and thrive in the new reality?We will explore these points in more detail in the weeks to come. In our next installment, we will explore what, and who, is filling the VC void for early-stage companies and how they can reduce their reliance on external sources of funding.

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