Milestone Group Quarterly: October 2008
Articles
By Invitation:
The Death and Re-Birth of Venture Capital by Michael Butler, Cascadia Capital
A decade ago, every ambitious business-school student dreamed of becoming a rock-star venture capitalist like John Doerr or Jim Clark. And why not? The returns were robust, the headlines and magazine covers were positve, and the personal wealth just piled up.
There's a very different kind of pile up today on Sand Hill Road, however. And it looks more like a car crash than a personal cash stash. Very few venture capitalists are crying poverty, but in the wake of the financial market mayhem and meltdown, the VC industry is undergoing a wrenching restructuring that will cause unfamiliar pain and dislocation for a long time.
To put it bluntly, the venture capital model is broken and even the smartest VC’s aren’t sure how to fix it.
While they’re looking for answers, the venture business is being partitioned into two sub-segments – the winners, who represent 20 percent of the firms, and the also-rans, who account for the remaining 80 percent.
By almost any measure, the VC business is shrinking today. This contraction was set in motion by the unprecedented Internet market collapse of a few years ago, and it is has gained momentum in recent months because of the unprecedented freeze up of the capital markets. Between 2000 and 2007, for example, the amount of venture capital invested dropped from $105 billion a year to $29 billion; during the same time period, the number of annual deals fell from nearly 8,000 to just under 4,000. Perhaps more telling is the fact that the number of venture capital firms in the United States contracted by 49 percent between 2000 and 2006.
I believe there are five reasons why the contraction will continue for the foreseeable future in the venture capital industry.
First, the technology and telecommunications sectors, which have been responsible for so much VC growth over the past decade, are slowing down. In addition, many of the opportunities that currently exist in new media and on the Internet require very little capital compared to software development and, thus, may lend themselves more to angel investing than venture capital.
Second, it’s unclear whether most venture capital firms can successfully diversify and migrate from information technology and telecommunications into new segments like clean technology, alternative energy or healthcare. It’s true that $3 billion of venture money was invested in clean technology last year, but generating meaningful returns in these still-emerging businesses requires specialized expertise, and many of the tech and telecom focused VC funds don’t seem to have that knowledge base readily available.
Third, there is intensifying competition from European venture capital firms, which have sophisticated talent and experience in several of these new and growing sectors, including the clean technology space. Their experience and expertise, combined with the still favorable exchange rate, puts U.S. VC’s in a box.
Fourth, an increasing number of entrepreneurs are seriously questioning whether venture capital mentoring is all it’s been cracked up to be – particularly in light of the start-up carnage left in the wake of the Internet revolution. More and more fledgling companies associate a double negative with the venture capital experience: expensive money and ineffective counseling.
Fifth, angel investors are squeezing venture capitalists out of a number of small but potentially lucrative deals. This represents quite a turn of the wheel, because venture capitalists had the upper hand during the last cycle and frequently crammed down on the angels.
So, the once-vaunted VC model is broken – now what? How does it get mended? And how long will it take?
Well, the truth is that it’s going to take some time for the venture capital community to fully adjust to its new reality – maybe even a full decade of transformation.
And during those 10 years, the VC’s who survive will likely have to become one of three types of funds:
- Regionally focused funds – By bringing local market insight, a network of local relationships and on-site mentoring, geographically focused funds can gain access to the highest quality deals and generate attractive returns.
- Specialized or industry focused funds – VC’s will have to be nimble over the next few years and go where the dynamic companies are – the alternative energy, clean technology and healthcare sectors.
- Fund Complexes – The funds that don’t downsize and/or specialize will likely need to become multi-asset class and global to be able to generate the required returns on their capital.
The VC community will end up looking like the commercial banking and investment banking industries - some very large and global players with broad product offerings, and a lot of smaller, focused boutique firms that are specialized. The large funds will be more than $1 billion and the small funds will be between $200 million and $250 million.
We haven't seen the worst fallout from the current financial cycle yet, but I'm confident venture capital will find a way to revive and renew itself. It always has -- and always will.
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Michael Butler is the co-founder and CEO of Cascadia Capital. His recent focus on sustainable technology has helped propel Cascadia into some of the most important transactions in this market.
Prior to co-founding Cascadia Capital, Butler served as a Managing Director at Lehman Brothers responsible for global equity sales and equity syndicate. He also served on the firm's Equity Commitment Committee, Equity Syndicate Committee and Private Equity Commitment Committee. Before joining Lehman Brothers, Butler was a Principal with Morgan Stanley & Company, where he was responsible for divisional global product and risk management and was a member of the division's Operating Committee. He has been involved in numerous equity financing transactions for both public and private companies.
Butler holds a B.A. in Political Science from the University of Washington and an M.B.A. in International Finance from the Wharton School of the University of Pennsylvania..
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