What did investors learn from the Perfect Storm?
Discussions About Surviving the Perfect Storm
Returns have retreated from the record levels we saw during the Perfect Storm. As with the public markets, private equity returns also suffered a downfall in 2001 as measured by one-year returns. At the end of December 2001, each of the private equity sectors discussed above showed negative one-year returns ranging from a -3.5 percent to -33 percent. And for the first time since 1994, venture capital investment activity in 2001 actually declined from the previous year, dropping 62 percent from $106 billion in 2000 to $41 billion in 2001.
This was the largest recorded percentage and dollar decline. On a more positive note, the 2001 total was the third highest year and was almost twenty times the amount that was invested in 1991 and almost twice the 1998 total. Viewed another way, if we removed the years 1999 and 2000, 2001 would be a record year with the most ever invested by the venture industry.
The breakneck pace of entrepreneurial capitalism from 1998 to early 2001 was an aberration and is not worth using as a benchmark. Mark Heesen from the NVCA basically erases the data of year 2000 from everything he reads and sees, viewing it as an anomaly. Robert M. Metcalfe, the inventor of the Ethernet, the local-area-network technology in 1973 (LAN technology) and founder of 3Com, and now a partner at Polaris Ventures in Waltham, Massachusetts, simply says, “Just forget those years happened.”
In 2001, ventures in the expansion stage received 57 percent of this financing, early stage got 23 percent, later stage got 18 percent, and startup/seed stage ventures received only 2 percent. We found that as the total number of ventures receiving financing fell 40 percent from 6,366 in 2000 to 3,788, the number of first-round investments as a percentage of overall investments declined too from 27 percent in 2000 to 18 percent in 2001, as 1,172 ventures received financing for the first time from a venture capitalist. The total first-round activity in 2001 amounted to $7.4 billion, averaging $6.3 million per deal. For comparison, in 2000 venture capitalists invested a total of $29 billion into 3,333 first rounds, or an average investment of $8.7 million each.
As a point of reference, looking over the years 1990–2001 venture capitalists invested $280 billion in 29,182 ventures. Further analysis shows that $132 billion, or 47 percent, went to ventures in their expansion round, $68 billion, or 24 percent, went to early stage ventures, $58 billion, or 20 percent, went to ventures in their later stage, and $23 billion, or just over 8 percent, went for ventures in the buyout stage. Specifically looking at first-round investments between 1990 and 2001, venture capitalists invested $93 billion in 13,867 ventures.
This activity represents 33 percent of the total dollars invested and 48 percent of the total number of investment rounds for the period. Our analysis shows that the average amount invested in the first round increased dramatically from $2.7 million in 1990, to the peak of the decade at $8.7 million in 2000, and settled at $6.3 million at the closing of 2001.
Corpulent VCs, GPs, and LPs in Not So Heady Times
Unlike the ventures they support, venture capitalists learned that their industry just cannot scale. Venture capital under management increased tenfold between the late 1980s and 2001, from $25 billion to $250 billion, while the number of people making investment decisions at venture firms rose a little more than twofold, from 3,580 to 8,891. An increase in the fee income helped some venture firms expand operations, but the number of partners and staff did not increase nearly as quickly as did dollars under management. In fact, dollars under management per principal during the same period increased from $7 million to $28 million, which is four times the workload for the VCs. But as the limited partners saw it, much of the increased fee income went directly to the venture capitalists themselves.
Since the amount of capital raised by venture capitalists outpaced the amount of capital they put to use in investments in recent years, there is the issue of what some in the industry call “overhang,” “dry powder,” or simply uninvested capital. As much as 80 percent of the investments made by VCs since the Perfect Storm has been tied up supporting the portfolio ventures and not investing in new businesses. At the end of 2001, private equity industry experts first estimated that venture funds had more than $100 billion of dry powder, and buyout funds had more than $120 billion, for a total of $220 to $240 billion.
By mid-year 2002, Jesse Reyes of Venture Economics concluded that about a total of $150 billion was available for all types of private equity investments. In early 2003, John Taylor from the NVCA stated that some $80 to $85 billion in venture capital was still available for investment.21 According to R. Glenn Hubbard, former chairman of the White House Council of Economic Advisors, this “capital overhang” will still take a while for the industry to actually digest.
The Investors’ Dilemma
This leads us into the discussion of what Vinod Khosla described as “the Investors’ Dilemma.” The situation today is much like 1987, when the VC industry had negative returns. According to Khosla, there are good years, great years, and sometimes really bad years; we just got out of a couple of really bad years. He says we should still expect more losers than winners, and many will lose everything. But more will be won than lost and the value of winners in the future will exceed the cumulative market cap of the leaders today. He advises entrepreneurs that now is a great time to start a new venture. And as for his advice to venture capitalists, “This is a reckoning, but this is no time to retreat.”
In fact, the venture capital industry is now returning to the discipline that made up their business prior to the Perfect Storm. Jos Henkens, a partner at Advanced Technology Ventures in Palo Alto, said that “2001 was a wake-up year. This was the year when people said, `Hey maybe those rules set down by more experienced folks before 1996 weren’t that crazy after all.’” For example, we are witnessing the re-introduction of patience in investment decision making. As Thomas Jefferson wrote in a letter to George Washington in 1792, “Delay is preferable to error.” And the timeline for success is back to normal: seven to ten years for a venture to complete the entrepreneurial life cycle to a liquidity event.
Innovation Did Not Go Out with the Perfect Storm
So all the necessary ingredients for entrepreneurial capitalism are still in place. With an unlimited ability to scale for global markets, we still have the culture that supports entrepreneurship, risk, restarts, and even failure. There is plenty of capital available and a perfected mechanism for putting it into play and exiting efficiently. The cost of building a venture is lower as talent and professional services are readily available. The number of competitors is significantly reduced and the established players in markets stop innovating and stop their R&D in economic downturns, leaving opportunities for new business ventures.
According to Leo Spiegel, a general partner at Mission Ventures in San Diego, the VCs’ mindset must be based on investing through cycles in order to be successful. Tim Draper of Draper Fisher Jurvetson concurs, “We know that, and we know that historically, many of the best returns come from deals made while the rest of the industry is sleeping.” And it is highly unlikely that 2001 will mark the year that innovation and entrepreneurial capitalism ceased to exist. We close section chapter with a quote from Sunil Dhaliwal at Battery Ventures, a Wellesley, Massachusetts, venture capital firm with $1.8 billion under management. He says, “If you believe early stage funding can’t be found, that’s tantamount to saying there’s no more innovation left to be funded.”