SECOND INTERNATIONAL HARVARD CONFERENCE ON INTERNET & SOCIETY may 26-29, 1998
Venture Capital and the Internet
by Steve PapaFew industries are as celebrated or as misunderstood as Venture Capital (VC). It is celebrated because many experts credit the strong VC industry as the sole cause of the U.S.'s continued dominance in high-tech entrepreneurship. Yet it is often misunderstood because it is a small, relatively young industry that involves only a few thousand participants. Despite its roots that go back for centuries, VC has only recently emerged as a formal, structured industry. Furthermore, the VC aspects were not the focus of attention when the ventures were expeditions such as Queen Isabella's backing of Christopher Columbus, but the recent success of companies such as Yahoo and Netscape have made venture capital part of the everyday business vocabulary.
Venture capital is defined as "money made available for investment in innovative enterprises or research, especially in high technology, in which both the risk of loss and the potential for profit may be considerable. Also known as risk capital." (source: American Heritage Dictionary) Essentially, the venture money is used to build a business in the expectation that value of the resulting business will be much greater than the initial investment. The following four examples illustrate what can happen:
Lycos, the Internet search engine - In 1995, 80% of the ownership (equity) of Lycos was purchased for $2 million. Three years later that 80% is valued over $1 billion. Annualized return: over 800%
Cisco, the world's largest networking company - A $2 million initial investment in Cisco was worth over $6 billion just seven years later (even more today). Annualized return: over 300%
Firefly, an Internet software company - Founded in 1995 as a result of the MIT business plan competition, Firefly burned through $18 million and was sold to Microsoft for $40 million three years later. Annualized return: estimated to be between 5% and 30% (source: Red Herring, 4/98)
Go, the legendary Pen computing company - This company was founded in 1987 and eventually raised over $75 million. Eight year later the doors were shuttered and the book, Startup, written by the company founder, is perhaps the only remains of the company. Annualized return: a $75 million loss (or $150 million if, alternatively, the money had been invested in risk-less government bonds).
As illustrated above, the VC business is not for the faint hearted. In fact there are many, many more firms like Go than there are like Lycos or Cisco. The average return for all VCs is estimated to be in the low 20 percent range. Despite this, in the heady decade of the 80's, many venture firms were able to sustain annualized returns on their portfolios in the range of 30-50+%. Even over the long term there have been some outstanding successes. For example, Venrock, the venture capital arm of the Rockefeller trust, has achieved a 35.5% IRR since 1969 (source: Wall Street Journal, 3/16/98).
HISTORY OF VC
Even before the time of Queen Isabella, there were nobles sponsoring commercial ventures. But commercialism at the time was really exploration with the intent of exploiting natural resources. Columbus's expedition was a typical 'venture' project of the era in that the intent was to establish a new trade route while also conquering territory. With the emergence of democratic capitalistic society and the industrial revolution, the nature of venture projects and the projects themselves changed dramatically. In place of the monarchs were the successful industrialists such as John D. Rockefeller. In place of explorers were entrepreneurs such as George Eastman (Eastman Kodak) and Henry Ford.
As financial markets became increasingly sophisticated in the twentieth century, new forms of investment management began to emerge. Instead of wealthy industrialists managing their own investments, groups of investment managers would make the investments. Over time, the liquid public markets would be used to allow the average person to participate in venture investing. In 1946 the first venture firm emerged on the public stock exchange—ARD. While ARD was a success, it demonstrated that the volatility inherent in a venture fund was too much for the public markets.
In place of a publicly traded company, VC evolved into a form of investment management partnership. Wealthy investors and trusts (philanthropic trusts, pension funds, university endowments, etc.) contributed funds as limited partners. The general partners in the fund, or investment managers, made the investments. By the early 1970s the number of venture firms slowly grew to about 50. Today there are hundreds of firms, each specializing in specific industries and types of financing. Some of the more well-known firms include: Accel, Greylock, Highland, Hummer-Winblad, IVP, Kleiner-Perkins, Mohr-Davidow, Oak, Sequoia, Venrock, and many others. The industries are numerous and include biotechnology, semiconductors, telecommunications, software, retail, and health services among others. The type of financing ranges from seed stage (the funding of an entrepreneur with an idea) to later stage (a firm with a prototype product needing to fund continued development or a firm with a product but in need of cash for promotion).
In the past few years there has been a tremendous growth in the amount of money managed by venture capitalists. In 1997 alone, over $10 billion in capital was raised by VC funds. The abundance of venture money has introduced keen competition for deals and has dramatically transformed the business. In fact, many economists wonder if the historically high (anomalous if you prefer) returns are the result of an inefficient venture capital market—too little money for too many deals. The industry proponents argue that the new money is increasingly managed by inexperienced venture capitalists and their failures will shrink the available capital pool. They also argue that the successful, experienced venture capitalists will continue their success as the conventional wisdom is that not all venture capital money is equal. In particular, it is the VCs that know how to add value beyond providing money that will differentiate themselves as the winners.
VENTURE CAPITAL AND THE CREATION OF NEW INDUSTRIES
The process of creating a new company is often described as an art. In the words of Professor William Sahlman of the Harvard Business School, "Creating a company is like baking a loaf of bread." In this analogy, the components of a successful business are akin to the ingredients required to bake the bread. Depending on the venture there is a need for varying degrees of proprietary technology, business partnerships, financing, management talent, etc. While many entrepreneurs are aware of all of the ingredients required—many are not, and it is the venture capitalist's job to identify which ingredients are missing. Even if the entrepreneur is aware of what is necessary, the entrepreneur will often look to the VC for help in obtaining the particular ingredient. In the case of capital, a VC is an obvious provider. In the case of management talent, partnerships, and access to technology the VC may be less obvious but can also be extremely helpful. In fact, in the increasingly competitive world of venture capital, the VCs that can help find the ingredients beyond the capital are the ones that will attract the best deals and preserve the historical returns to their funds. Lastly, the other role of the VC is to assess whether the timing and placement of the firm is correct, thus allowing the combined ingredients to rise, like the load of bread, into a successful business.
VC TODAY
There are a number of contemporary trends in the VC business:
An abundance of capital: This results in greater competition for deals. VCs are often unable to perform the level of due diligence that they would like—if they take too long, someone else will provide funding instead. This competition is forcing VCs to strive to add as much value as possible beyond the money. Some funds have gone so far as to partner with software development consultancies to provide immediate technical talent along with their infusion of capital (the BRM Group is but one example).
Increasing complexity of technologies: The days of the 'generalist' venture capitalist are long gone. With increased competition and increased technological complexity, a VC must be an expert in the specific field to discern the intrinsic value in an idea, technology, or management team. Many firms now specialize in fields as narrow as data networking or genomics instead of just high-tech and biotech.
Change in exit strategy: Historically, most venture-backed companies intended to go to the public markets as a final liquidation event for the VC's investment. Upon a public offering, the VC would gradually sell their shares in the company and return the funds to their limited partners. In the past few years this has been changing as a number of large technology companies have been buying VC backed startups before they IPO. Some experts have likened this to big companies outsourcing their R&D departments. The net result of this is that many companies are being grown with the intent of being sold at an early stage. When this happens, the companies become much more product focused and have less regard for the longer term outlooks of their particular product, market, or the company infrastructure that is being built.
Premature IPO: The market euphoria created by Netscape's IPO in 1995 resulted in numerous firms heading for the public markets before they even had a stream of revenues. In the past, it was very difficult to sell an unprofitable company to the public markets but this belief has been permanently changed (at least for Internet and other high-growth potential companies). Traditionally, subsequent rounds of venture funding were used to get the startups to the point of profitability but the public markets are now being used instead.
Startup competition: Recently, as soon as one startup is funded in a particular area, nearly a dozen competing startups emerge within months. This competition forces early stage firms to seek publicity and partnerships much earlier than they have done in the past. Anne Winblad, a successful venture capitalist and partner at Hummer-Winblad, likens this to 'cheerleading'. In some cases, firms will have signed up customers, been featured in the press, and made distribution deals before the first line of code is written or the first prototype designed.
Other forms of venture funding: The success of so many venture backed companies in the 1980s and 1990s has created thousands of millionaires. These 'angels' are intimately familiar with the entrepreneurship process and help other entrepreneurs succeed by providing capital and other resources. In addition, many corporations are starting venture funds. For example, Intel backed over 100 companies last year and Lucent recently started a fund. While one of the goals for these funds is capital gain, the primary goal is to nurture entrepreneurs that are creating businesses that are complementary for the parent company. For example, the Lucent fund might invest in a telecommunications hardware company. Upon the success of the portfolio company, Lucent, the parent, would then acquire the company and assimilate its technology, customers, and employees.
CONCLUSION AND LOOKING TO THE FUTURE
The venture capital industry is, in broad terms, unique to the United States. The industry has been a substantial force in facilitating the vibrant US technology sector. Would there be a Netscape or Apple if the VC industry had not been present? We can't answer this for sure but we can ask another question—Are there similar companies formed in countries without a VC industry? The consensus seems to be that the degree of 'big-time' entrepreneurship in the US is much greater than in other countries. Now that the US market has become intensely competitive, will the US VC industry recreate the magic internationally? Economics would lead us to believe that the VC money would be directed towards the less efficient international markets where there is less VC competition. On the other hand, economic theory ignores the many other contextual factors that have made entrepreneurship and the creation of new technologies much easier in the US. The legal code, culture, and infrastructure available in the US may very well have as much to do with new venture creation as the VC industry. Nobody knows for sure, but the next decade should provide some valuable insights into these issues.
Reference Links
National Venture Capital Association
www.ipocentral.com - Resource for tracking firms going public
www.ipo-network.com - Resource for investing in newly listed companies
www.aeeg.org/resources.html - Entrepreneurial resources
www.killshot.com/vc.html - Information on venture capital
envista.com/vci/ - Venture capital institute
Venture Capital and Principal Investment Club at the Harvard Business School
Red Herring magazine - covers early stage high-tech investing
Upside magazine - covers technology entrepreneurship
www.findingmoney.com - References for raising venture capital
www.moneyhunt.com - Site dedicated to entrepreneurs raising capital
www.en-wave.com - Entrepreneurs resource page
www.en-wave.com/cgi-bin/en-wave/store - Extensive links on entrepreneurship
www.tannedfeet.com - Entrepreneurs help page