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Revising Expectations: The Future of Venture Capital and Entrepreneurship

William M. Reichert, Garage Technology Ventures


The world of venture capital and entrepreneurship has changed dramatically over the past decade. Not just in the obvious ways -- we've all exhausted ourselves talking about the foolishness of the Bubble, about the lessons we hope everyone (else) has learned, and about how we are all sensibly returning to "basics." But the fact is, no matter how the statisticians spin the numbers for us, we are not just returning to the early '90s; we are not simply going "back to basics," to a more disciplined, sensible venture world -- with lower valuations but greater patience.

The New World

Just as innovation and evolution have changed the public equity markets, so has the venture world changed and evolved. Investors and entrepreneurs who don't understand this change will find themselves left behind as the ecosystem of venture creation evolves beyond them.

Competition: Venture capital was built on the fact that the market for investments in early stage high technology companies has historically been quite opaque. Venture capitalists trade extensively on inside information -- in other words, they depend on finding out information that others do not know in order to get into the best deals and do the deals on favorable terms. Nothing wrong with this. These are private transactions, and VCs have to work hard to find good deals and get an inside track. But the process of venture creation has become less opaque than it used to be as the number of players, the number of conferences, the number of newsletters and the number of databases have expanded and linked, distributing information about startups and investors much more efficiently. For both venture investors and entrepreneurs, this makes the world a much more competitive place. This is good news for most, bad news for some. Increasingly, there are other entrepreneurs and investors who can equal or surpass any technological achievement or innovative solution you can come up with. Increasingly, customers (whether they are enterprises or consumers) have the ability to evaluate a broad range of alternative solutions from U.S. and international suppliers. No longer can a few venture capital firms claim to have a corner on "value added investing." No longer can Silicon Valley entrepreneurs presume to have an inherent advantage over entrepreneurs in Denver, Chicago or even Shanghai.

Market opportunities: The '90s represented an unprecedented era of infrastructure investment -- in networks, telecommunications and enterprise software. As a result, many new companies emerged and grew at amazingly rapid rates even after they became big. We are unlikely to see that kind of broad-based investment and growth any time in the next several years. The opportunity to ride a tsunami of market growth is gone. Instead, we are likely to see the next stirrings of investment come from specific solutions that help individual corporations differentiate themselves and become more competitive. We will see hundreds of excellent mid-sized companies emerge in this next wave of innovation, including many from outside the traditional venture capital hotspots of Silicon Valley and Route 128. But we will see very few new billion dollar companies created.

Returns: Just as we have to revise our expectations for recurring annual gains in the Nasdaq, investors and entrepreneurs need to revise their expectations for returns from new ventures. The increasing competitiveness of private equity, combined with the narrowing of market opportunities, mean that success will more often mean 3x and 5x returns, not 20x and 50x returns. We experienced a period where the minimum return assumption was a home run. Now we need to manage expectations to singles and doubles.

Valuations: The impact of all these factors has already transformed both entrepreneurship and investing. Valuations have plummeted and the distribution of ownership between entrepreneurs and investors has shifted dramatically toward the investors -- or more specifically, toward the most recent investors. Investors justify these valuations because exit valuations have dropped so significantly. They need these lower valuations to make the math work for their venture funds. We've grown weary of the gallows humor over who has proposed the most egregious cram down terms. But now the harsh reality coming from the venture community is "the zero pre-money term sheet." At some point, however, these harsh valuations drive quality entrepreneurs away from the venture capital marketplace, and they either find a way to raise capital from other sources, or they abandon their entrepreneurial inspirations altogether.

Talent: There is a bright spot in all of this, however. While the '90s bred a generation of unrealistic investors and entrepreneurs, as the dust settles, we will discover that this era recently past also caused us to build out an extraordinary infrastructure of intellectual property, engineering talent, management talent, support talent, technical standards, international networks, public policy frameworks and organizational practices that make the innovation and venture creation process more efficient going forward. The next generation of successful entrepreneurs and investors will find and exploit these resources, giving them an advantage that the '90s generation did not have.

In sum, the venture world today and going forward is not like the old world of the early '90s. The challenges are different, and the opportunities are different. For most, it won't be as much fun as it was in the '90s, but for those who understand the opportunities, it will be very profitable.

Challenges for the Future

The venture community is like an ecosystem, not like a balloon. When a balloon expands, and then contracts, it looks like it did before. When a balloon expands, and then bursts, there is nothing much left. But when an ecosystem expands and develops rapidly, and then has a crisis -- being starved of the nutrients of capital spending and venture investing -- it must adjust. It cannot simply shrink, but rather it must somehow withstand or absorb the withering away of its varied constituents. Some survive by retreating (carving back). Others survive by evolving (changing strategy). Still others simply do not survive.

Big funds: Funds with over $400 or $500 million to invest (roughly the top 60 funds) face serious challenges as the ecosystem changes around them. They are not exactly the dinosaurs of the ecosystem, but they are the sabre-toothed tigers - a species that was no longer viable, but was able to evolve. Large funds have to evolve to survive. Most startups cannot efficiently absorb $5 to $10 million of funding from one investor, which is the minimum most big funds would like to invest, much less $20 to $30 million. As a result, the big funds have a choice: Either give up early stage funding, or restructure. Most of the big funds are hoping to do the latter, but have effectively done the former. Big funds can't afford to invest in seed stage companies, unless they are confident that they are investing in companies that will be billion dollar exits. But it is harder and harder to talk your partners into that story these days - that two guys in a garage will be the next HP or Microsoft or Dell. Venture capitalists have been doing the math recently (and so have their limited partners), and as one general partner from a big fund has said privately, "There's just no model that can justify a billion dollar fund." In the salad days of multibillion dollar exits, a venture fund could multiply a billion dollar fund a few times with just a few home runs. But if a home run means a $250 million exit in the world of revised expectations, and if a fund typically has a 25 percent stake at the time of exit, a billion dollar venture fund has to have 15 to 20 home runs just to return their investors capital with a zero ROI. That, unfortunately, is the New Math for big venture funds. Faced with this dilemma, many large funds are holding back on investing in early stage companies, hoping for a return of better multiples. But increasingly we are seeing that their limited partners are less sanguine about the model and are demanding that big funds cut back their size.

Corporate investors: Hundreds of large, established corporations realized during the last decade that, in order to compete, they had to get access to new technologies created by new companies. In many cases, Cisco being just one highly visible example, corporations decided that venture capital could be viewed as a form of outsourced R&D. As a result, hundreds of corporate venture groups were established, which in turn poured billions of dollars into the venture financing pool. Many of these corporations discovered (or in some cases rediscovered) that early-stage investing is very different than applied R&D - they just didn't have the same control over the process. When liquidity events are generating wonderful contributions to your bottom line, as they did in the late '90s, management could overlook the problem, but when write-offs in corporate venture portfolios started to force companies to take significant hits on their quarterly financials, management reevaluated its investment policies, and most corporate investors backed off dramatically.

Angel investors: One of the big stories of the late '90s venture boom was the emergence of angel investors as a powerful economic force rivaling, and probably surpassing, the institutional venture capital community in early stage investing. Although no one could really pin down the numbers, angel investment became the primary source of startup capital as successful entrepreneurs began aggressively reinvesting their winnings, followed by successful high tech executives, and then successful lawyers and successful realtors, dentists and day traders. With the market collapse, the funding food chain broke, and angels could no longer count on their investments getting institutional capital. Angels assumed that many, and probably most, of their investments would not play out, but they also assumed that one or two would be home runs, and that would more than make up for the failures. Unfortunately for many angels it has not worked out this way, and as they watch their war chests shrink, they have abandoned the venture game.

Boutique funds: With practically no one left, this leaves the boutique venture funds to fund startup companies. These are firms with $5 million to $100 million in capital, many of which emerged during the boom. Most have some angle of specialization -- the expertise of their general partners, or a regional focus, or a sector focus. But most were originally designed to live off the Big Fund food chain. The presumption was that these small funds would either co-invest with the big funds, or they would be the precursor investors for a select group of larger funds. As a result, their investment criteria were pretty much the same as the big funds -- startups that were targeting huge markets with plans to grow really big. And if they required a lot of capital, that was fine -- the big funds were eager to put a lot of capital to work. But when the food chain broke, the boutiques were left holding the bag. When their portfolio companies need more capital, the big funds are no longer there to plow the money in, because the math didn't work -- Series C investing behind angels and small funds just doesn't offer the returns the big funds need with the IPO market closed and projected exit valuations shrinking. So in the few cases where the big funds can be coaxed in, it isn't just the entrepreneurs who get crammed down; the early stage investors are also being crushed. The game isn't very much fun anymore.

Resetting Expectations

In this new world, what should entrepreneurs and investors do? Is this a temporary hiccup in the inexorable upward path of innovation and new venture creation? Or is there something more fundamental going on that could mean a long-term downturn in entrepreneurship and venture capital?

To begin with, all of the players in the venture community need to reset their expectations and pursue a sustainable path in the new venture ecosystem. Without this reset, however, the current paralysis will continue unnecessarily, and innovation and growth will be hurt.

On the investor side: Limited partners and general partners, as well as angels and corporate investors, will have to accept lower rates of return for their portfolios. There will be some home runs -- new companies that reach billion dollar exit valuations and return 20x or even 50x multiples to their investors. But those will be very few and far between, and an investment strategy in today's environment cannot be predicated on finding scores of companies with that potential. Instead, savvy investors will understand that most successful companies are successful at the $20 to $50 million level of sales, over a four to six year period, meaning perhaps $50 million to $100 million exit valuations. Realistic business plans and capital investments have to be tailored to that level.

In this world, the big funds will either have to play the role of mezzanine investors for those smaller companies that break out, or they will have to compete for the relatively few really big potential wins. The smaller funds, if they can reset their models and wean themselves from the big fund food chain, will become the primary engines of growth in the evolving venture community.

On the entrepreneur side: Most successful companies (by this more modest standard of success) will not be financed at the early stage by big funds or corporate investors. The key to early stage financing more frequently will be finding the right boutique funds to provide the early stage capital -- those funds that are willing and able to build companies without depending on later stage capital from big funds.

In this environment, entrepreneurs need to embrace a concept that has been lost for a generation: Capital Efficiency. We lived through a surrealistic era when capital was cheap and plentiful, and so the focus was on speed, growth, and critical mass. Now capital is dear, and entrepreneurs need to design companies that can reach critical mass on much less capital. This is not simply a return to traditional notions of frugality. It means understanding how to architect all aspects of the business plan to leverage partnerships, pricing models, industry standards, and the infrastructure developed over the past decade.

A related challenge for entrepreneurs will be deciding whether to pursue a horizontal or vertical market strategy. Horizontal generally means addressing a bigger, broader market. But the reality is that a lot of horizontal success stories are really an aggregation of vertical successes. (Hewlett Packard started as a niche play.) Any given customer is not really interested in a company's ability to solve all problems for all markets. The customer wants to know two things: Can this company really solve my problem? And will this company be around to support that solution? Unfortunately, investors tend to get more excited about horizontal models because they appear to address a bigger market, and so for clever companies with vertical solutions the answer to the second question appears to be, "No." As a result, enterprise customers are shying away from fragile early stage companies. If, however, a new breed of venture investors learns how to fund and support these companies, we will see more vertical market solutions emerging and thriving.

Exits: One of the keys to resetting expectations is the emergence of an efficient M&A market at the low end. Over the past decade, the venture industry grew dissatisfied with M&A as an exit strategy. "IPO or Bust!" was the prerequisite game-plan for any CEO that wanted venture backing. Venture capitalists made it clear, "We don't want to invest in a company whose aspiration is to be sold for $50 million." For a $500 million fund, that pedal-to-the-metal attitude makes sense. But there are many brilliant, non-trivial innovations that can offer marvelous returns for a smaller fund at the $50 million level, if both the entrepreneur and the investor can accept that outcome.

None of this is intended to imply that there is no future for big funds. There will still be plenty of startup companies that fall into the category of "potential home runs," and there will be even more entrepreneurs that think they fall into that category. The associates at the big funds will be plenty busy sifting though all the possible suspects. And the big winners in the IPO game -- once the game resumes -- are likely to pass through the portfolios of the big funds as their capital needs expand. But the most fertile soil for entrepreneurs and investors is down on the forest floor.

Opportunities

The era of innovation, entrepreneurship and venture capital is not over. Far from it. But the venture industry can no longer see the grand sweep of innovation the way we thought we could in the era of the next Big Thing. What we learned from previous down cycles is that the biggest opportunities are not obvious, because if they were obvious, someone else would have already done them. And if everyone thinks an opportunity is big, then the resulting overinvestment tends to generate low returns. Entrepreneurs are damned if they do, and damned if they don't. If they come up with something truly unique and innovative, their market opportunity is deemed too small. If they chase the prevailing hot sector, investors worry over the space being "too crowded." So where are the opportunities for entrepreneurs and investors today?

There are an enormous number of problems that need to be solved, and those solutions can generate excellent returns to those who produce them and to those who fund them. On top of this, the endless flood of innovation from universities and corporate labs, and even from garages, will create new product and market opportunities that we've not even dreamed of.

Some examples: The way applications work over the Web is terrible. Our computing experience has regressed to slow, cumbersome, screen-based forms. Someone needs to fix the Web's problems - speed, user interface, application integration, security. Or maybe we can toss out the Web altogether and create a whole new method of ubiquitous connectivity. And don't get me started on enterprise applications -- the way enterprise applications don't work is a scandal. The way cell phones don't work is another scandal. The idea that I should communicate with my thumbs on an itsy bitsy device is a joke. The fact that the police department can't communicate with the fire department is a tragedy. Why is videoconferencing so hard? Why does my computer still freeze up? Why can't I watch "West Wing" when I want to? (I can't even record it because there's currently no NBC affiliate broadcast that reaches my neighborhood near the heart of Silicon Valley.) And this does not even touch on the opportunities for innovation in the life sciences, materials sciences, and energy technology.

Certainly some of these problems are more important, and bigger opportunities, than others. But the point is, we have plenty of work to do, which means there are plenty of opportunities for entrepreneurs and investors. The growth and trauma experienced by the venture community over the past decade has created tremendous exhilaration and pain. The opportunity now is to take advantage of this experience, reset our expectations as entrepreneurs and investors, and push forward with innovation.


About the Author: Bill Reichert is President and Managing Director of Garage Technology Ventures, which he helped launch in 1998. Prior to Garage he was involved as a co-founder or senior executive in several venture-backed high technology startups. He has also held positions at McKinsey & Company and Brown Brothers Harriman & Co. Bill earned his B.A. from Harvard and his M.B.A. from Stanford.

If you have any questions or comments on this article, please feel free to share them with Bill at reichert@garage.com