The State of the Venture Capital Industry: A Needed Return to Rational Exuberance

By Todd T. Pietri

The venture capital industry needs to return to rational exuberance, but we are also of the opinion that as an industry we have a long way yet to go.  In fact, if the early stage venture industry doesn’t change the way it operates, returns for all of the stakeholders – limited partners, venture capitalists, and entrepreneurs – will fall well short of the impressive returns the industry has achieved historically, which have been 19% compounded for the last 20 years.  

That is putting the thesis of this speech rather delicately.  In more blunt terms, future venture returns will not crack double digits unless we stop investing $20 million into mediocre early stage companies.  Entrepreneurs also must change their spending habits and figure out how to build successful businesses with $5 million.  If we all make the necessary adjustments, we can produce outsized returns.  But if venture funds remain complacent and turn this industry into an asset gathering and fee-generating machine like the mutual fund industry, we will all regret the outcome.  

You might be surprised that I am concerned about the state of the industry.  If you look at the media, the stock market, and the press releases of the National Venture Capital Association (NVCA), you might come to the conclusion that the industry has not only turned the corner but is on a decided upswing and in some respects this is true.  After all, venture capitalists appear to have their confidence back.  

In 2004, VCs will invest approximately $20 billion, which will exceed the $18 billion invested in 2003.  Investors in venture funds also have a renewed appetite for the asset class.  Pension funds, endowments, foundations and other investors will invest close to $15 billion in venture capital funds in 2004, which is up from $10 billion in 2003.   Returns are improving as well.  Through the first three quarters of 2004, 247 venture backed companies were acquired.  More importantly, of those deals that disclosed returns, more than 30% of the acquisitions generated a 4x return or better for their investors, a significant improvement over 2003.  The IPO market for venture-backed companies, while still weaker than it was through the 1990’s, is showing promise too.  66 companies went public through the third quarter of 2004, including Google, which has doubled in price in 4 months and now has a staggering $50 billion market cap.  Lastly, the third quarter data shows that seed and early stage companies are attractive investment targets again, as 30% of all transactions were in favor of those riskier ventures. 

Given these statistics, you may wonder why I am so concerned about the ability of the venture industry to generate fantastic returns going forward.  But the key to my concern is buried in the adjusted NVCA annual numbers.  In 2003, the average amount invested per venture backed company was $9 million.  Based on discussions with John Taylor at the NVCA, and a study by a prominent venture capital firm, the average venture backed company now consumes over $20 million over its life.  The typical company raises $5 million in the first round and another $15 million in follow-on rounds.  

Looking back to the 1980’s and early 1990’s, however the data shows that venture capitalists used to invest a little more than $3 million per company on average and perhaps $5 million over the life of the company.  In other words, while many of the metrics in the venture capital industry are returning to more normal levels, the amount of money invested per company, even when you adjust for inflation, is today alarmingly high, or at least 3x what it used to be. 

Now I admit that if a company is thriving, the smartest thing to do may be to swing for a homerun and raise a ton of capital; for example, when a company is fortunate to enough to be in a large, growth market with tremendous demand for its products and services but where only a short window of time exists to capitalize on the opportunity.  

The problem of course is that very few entrepreneurs, and venture capitalists for that matter, want to admit that their company is not one of those fortunate few companies that merit a large capital infusion.  Like the children of Lake Woebegone, every child is “above average.”  Therefore too often, the preferred course of action is to pursue a “get-big-fast” strategy, even when valuation has hopelessly outpaced the underlying fundamentals of the company.   The hope is that somewhere down the road, the gods will be kind and it will all work out as hoped. 

There are several reasons why this line of thinking generates a lousy shareholder return.    First, financial common sense tends to evaporate when a large pile of money is in the bank.  The virtue of having very little money as a young company is that it focuses the mind, inspires resourcefulness, and promotes wise decision making.  Once the wire clears however, management can easily lose focus by pursuing new markets, new products and acquisitions before there is a rational business case.  Also, a management team that can successfully execute a business plan with 30 employees often gets overwhelmed by a premature expansion to 120 employees. 

But there is also an equally vexing structural problem with over-funded companies, which presents a stark new reality venture capitalists must contemplate going forward:  the venture capital market is in the process of reverting to its historical mean in terms of exit values.  When median IPO valuations for venture backed company’s crested above $300 million in 1999, it didn’t matter if a company raised an extra $15 million or $25 million of capital; 5x to 10x returns were still very achievable and the payoff came so soon that all interested parties were euphoric. 

However if median venture-backed IPO valuations return to their historical norm, which I believe they will, of between $70 million and $110 million (total value), as they were from 1994 through 1997, then companies that raise more than $15 million of venture money are going to have a very hard time generating 5x to 10x returns for their investors.  The problem is compounded by the fact that it is going to be harder and take much longer to get public in the first place.  Sarbanes Oxley alone has raised the bar significantly to get public, because you have to be big enough to pay for all of the fees, systems and people to keep your nose clean.

The historical merger and acquisition market paints an even worse picture.  From 1994 to 1998, average venture-backed valuations for M&A transactions ranged between $45 million and $70 million.  The outlier years were 1999 and 2000, at $156 million and $221 million respectively.  Given that 90% of exits for venture-backed companies are M&A events, not IPOs, every extra $5 million of unnecessary capital that goes into a company can make or break an attractive return. 

After considering such thorny logic, we find it strange that there are so many large venture capital funds.  Large VC funds are in a tough position.  They need to put $10 million or more into each deal.  If they syndicate, which promotes good risk management, their portfolio companies will have a minimum of $20 million of venture money, and usually much more goes in.  We just don’t feel there will be sufficient liquidity to satisfy all of these over-funded deals. 

A relevant question is, how do you build a great company with less than $5 million over the life of the business?  There are a few key strategies worth reviewing.  My favorite is to convince a customer to pay for your development.  You give the customer a lower price but he helps you design it for the real world and you keep the rights going forward.  Another way to fund R&D is to sell consulting services.  Take your expertise, sell it for hard dollars, and use the excess to pay your developers.  VCs will be impressed that your expertise has value in the market place.  Here is another key tip.  Sell your product as soon as feasible…a perfect product is the enemy of early sales.  An entrepreneur I know who created a successful business on $400,000, told me after he sold his company, which put about $5 million in his pocket, that he wished he hadn’t wasted so much time and money adding “nice to have” features to his product.  He says that he wished he had taken that money and hired sales people because the only thing his acquirer cared about was his revenue and customers.  Also, outsource your software development if you know how to manage an outsourcing relationship.  Lastly create a culture of cheap, or even a cult of cheap. 

Remember, dilution is often the enemy.  I think some entrepreneurs are starting to get the picture.  I recently met an entrepreneur who had founded a company during the bubble years.  He raised about $60 million.  The company was moderately successful but his ownership is very small and he is buried under a mountain of preferences.  He recently founded a new company.  He has raised about $500,000 in angel money and has built up his company up to $1.5 million in sales.  He now wants to raise $2 million.  After his presentation, which was pretty good, my partner asked him what keeps him up at night.  This is a classic question.  Some entrepreneurs answer it honestly which is commendable and helps us do our due diligence.  Other entrepreneurs get cute and give an answer that is really a positive like, “I really hope the team can continue to work 90 hours per week.”  But this entrepreneur said, “The biggest question I struggle with is whether or not I should raise $2 million.  It is going to cost me a big percentage of my ownership and I may be able to build a big enough company without it.”  Here is an entrepreneur who gets it.  He is doing everything in his power to get by on as little outside capital as possible.

At Milestone, we have chosen to focus on capital efficient businesses and entrepreneurs who know how to stretch a dollar.  We believe the market for small transactions, transactions between $1 million and $4 million, is the least competitive and thus the most attractively priced segment of the venture capital market, as there are very few firms that will consider such small investments.  In the context of our strategy, we invest in companies that have the option to build growing, profitable enterprises and generate 5x to 10x returns from exits under $100 million in value with one or two modest rounds of investment.

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