Is Venture Over-Sold? The Outlook for Venture Capital

This article first featured in Preqin’s Private Equity Spotlight – March 2012

The days of the dot-com boom are now a distant memory to venture capitalists and the industry has been forced to evolve in the face of reduced performance. David York, CEO and Managing Director of Top Tier Capital Partners, looks at the current state of the industry.

The years 2000 to 2009 were a rough decade for venture capital. After a tremendous run from 1985 to 2000 – during which the US venture-capital industry produced IRRs as much as 100% higher than major public-market indices – the sector fell on hard times. First the Internet bubble popped, then the telecom industry collapsed, and finally, like everyone else, the industry suffered through the global financial crisis. As a result returns plummeted; the Preqin median IRR for venture, which sat at 25.9% for the 1997 vintage, fell to (1.0%) by the 2000 vintage. Chastened VCs burrowed back into their Sand Hill Road offices like bears going into hibernation, waiting for the market to thaw.

That thaw has clearly come. Early-stage deal making has rebounded so much, in fact, that some pundits are warning of a second, unsustainable tech bubble, driven by hype over innovations like mobile apps and social networking. We agree there is some selective hype hanging over the market today. But we’re also heartened by several larger, macro trends that we think make this venture market different than the heady one that crashed 12 years ago – and a more positive place for investors.

Fig 1: Adopting technologies over time

The first trend relates to capital – specifically, the amount of capital being raised by venture capitalists right now. What’s positive is that investment is down compared to the bubble years. In 2011, US VCs raised an aggregate $16.6 billion from 69 funds. In 2000, the industry raised an astounding 249 funds worth $63.2 billion. This decline in fundraising is a good thing because historical data shows an inverse relationship between venture-capital performance and the amount of venture capital deployed as a percentage of US gross domestic product (GDP). And while VC investment has been slowly rising for the last three years, that capital is being deployed more selectively by fewer firms, since the tech- stock bust winnowed the field of VC players. What’s more, for early-stage investments, valuations are below where they were before the global financial crisis, as VCs set more realistic expectations for how fast companies can grow. Later-stage investments are at a decade high, but this is largely due to high company valuations in later rounds of financings in hot sectors such as consumer services.

The second positive trend bolstering venture capital today, in my view, is robust innovation. Venture capital historically has backed many of the US economy’s most game-changing companies, including Microsoft, Apple, Genentech, Netscape, Amgen, Cisco, and many others. Today we find ourselves on the cusp of several new, profoundly important trends in IT, healthcare and “clean” technology that could produce a new crop of similar corporate giants – and create substantial market value for investors around the globe.

In IT, many VC-backed companies are leveraging exciting new developments in “cloud” computing, mobile technology and social networking, for example, and making real money from those trends. (No redux here.) Facebook has over 700 million members and boasted revenue of $3.7 billion last year. It earned $1 billion in profits. Start-ups like Dropbox and are also racking up sales as they change the face of computer storage and content-sharing by allowing people to store ever-expanding reams of data on offsite Internet servers, instead of on their own PCs. On the mobile front, scores of start-ups are developing businesses for today’s increasingly complex smartphones, which are rapidly replacing PCs as the computing device of choice for most people around the globe, particularly in emerging markets. The number of mobile Internet users is expected to exceed desktop PC users by 2014; Apple recently sold 37 million iPhones in one quarter. Furthermore, the rapid adoption of technology is accelerating, as demonstrated by Figure 1.

In healthcare, astute VCs are backing companies capitalizing on the US government’s new support for healthcare-IT services, such as electronic medical records, and its focus on containing healthcare costs. There are also groundbreaking efforts underway in areas such as personalized medicine, molecular diagnostics and the development of drugs for rare, “orphan” diseases.

Finally, there is significant innovation today in clean, or green, technology, with many VC-backed companies finding new ways to help consumers and businesses conserve energy, track energy use and upgrade the aging electric grid. This is a pivot away from the first wave of green innovation, which focused heavily on more capital-intensive projects such as solar, biofuels and wind companies, and suffered its share of investment duds. More-promising, high-profile, cleantech companies backed by VCs today include Serious Energy, Silver Spring Networks and Sun Run.

VC-funded startups aren’t the only ones innovating. Since the tech bust, the venture industry has re-invented itself in many ways, becoming more global and stage-agnostic with its investing. This is yet another force that is lifting the industry’s prospects and differentiating it from the way it operated a decade ago.

Today, venture capitalists are doing more “seed- stage” deals as well as larger growth-stage investments, allowing them to better balance their portfolios and cash flows – sometimes by investing less money in risky companies – and thus enhance their returns. We’ve seen a marked increase in seed-stage investing, such as in deals worth less than $500,000, among the managers we back. In our 2007 vintage year fund of funds, for example, which includes funds launched from 2007 to 2010, fully 20% of the investments were made at the seed stage. That’s up from 12% in our 2002 vintage year fund of funds.

VCs are also going global today like never before. With projected economic growth rates in countries like China and India still two to three times higher than GDP growth in the US, VCs are exploring those markets for potential opportunities. High- profile VC firms including Accel Partners, Bessemer Venture Partners, Kleiner Perkins Caufield & Byers, Sequoia Capital and NEA have all opened offices or expanded operations overseas, often in multiple locations, taking advantage of the high growth potential of those markets. Again, this helps diversify venture firms’ risk profiles and gives them a better shot at above-average returns.

One of the biggest factors making me optimistic about venture today is the exit environment in the US. After a long freeze, large venture-backed companies are finally going public. (IPOs, as opposed to M&A exits, traditionally supply VCs with their highest returns.) Facebook’s IPO, which could value the company at between $75 billion and $100 billion, is anticipated this spring. Tech companies including Groupon, LinkedIn, Pandora, Jive Software and Yelp have successfully gone public recently, and a diversified list of companies including Splunk, Brightsource Energy, ExactTarget, Envivo,, LaShou (China), Palo Alto Networks, ServiceNow, Silver Spring Networks and TRIA Beauty could go public soon. Overall, in 2011, 52 US venture-backed companies went public in deals worth a total of $9.9 billion, up 41% in dollar value from 2010, according to the National Venture Capital Association. The aggregate value of venture-backed M&A deals last year was $23 billion, up 23% from the year before and the highest level since 2007.

Clearly, the venture industry is not performing at the same level it was in the late 1990s. But most people now acknowledge that period to be somewhat of an anomaly, driven by the initial explosion of Internet companies. Now, we’ve settled back into a more normal cycle of investment and exits – but one driven by many new exciting innovations.