In our latest piece on 2008 review / 2009 preview, we look at the world of Venture Capital (VC). Just when VCs thought they were seeing the light at the end of the tunnel, it turns out there’s an oncoming train that is getting louder, closer and set to derail VCs for good.
Today it’s widely known that plummeting real estate and equity prices are making it hard for investors to keep plowing money into VCs. We covered this in October 2008 to explain the impending panic that was to set with many VCs. It is our belief now that 2009 will highlight this sentiment as IPOs get shelved.
According to Paid Content, the few IPOs that VCs were hoping for are actually not going to happen:
Two of the rare digital media IPOs planned have done something not that rare these days: withdrawing their IPOs. NameMedia, the domain name media company headed by Kelly Conlin, previously CEO of Primedia and IDG, and Eyeblaster, the online rich ad format company, have both filed notices with SEC to withdraw their planned IPOs. Both cites the usual, “market conditions”.
NameMedia filed its S-1 in November last year, with an intent to raise about $172 million. The Waltham, MA-based company offers two main services, monetizing unused domains and facilitating domain name sales.
Meanwhile, Eyeblaster, the NYC and Israel based company, filed for a $115 million IPO in March this year.
Other digital media related companies that have withdrawn their IPOs recently include LocalMatters, Synacor, and Focus Media (which sold part of its company this week to Sina). When will CurrentTV, the only media related IPO pending that I know of, withdraw?
You tell me, but at this rate, my money is on “very soon”. The timing of a piece in Forbes magazine could not be better:
Three years ago Venture Capitalist Timothy Draper graced the cover of a financial-industry trade magazine wearing a wide grin and a Captain America costume. Draper, the tagline said, had joined the “League of Extraordinary VCs” for his smart investments in Chinese search service Baidu and free PC phone service Skype. Both picks earned Draper’s firm, Draper Fisher Jurvetson, and one of its affiliates millions in profits.
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Lots of DFJ’s investors, though, are still waiting for their payoff. Many of the big universities, foundations and rich individuals who parked money in the firm’s flagship funds have yet to see a dime of profit from Baidu or Skype. Those homerun investments were made from a DFJ affiliate called Eplanet Ventures, in which only some of DFJ’s investors participated. (DFJ declines to say how many.)
The investors in other big DFJ funds raised around the same time as Eplanet have come up empty. The return on the DFJ’s $640 million Fund VII, raised in 2000, is a sickly –2% as of Sept. 30 (and) has paid back only $115 million to its investors, even though the fund is entering the ninth year of its ten-year life and should be realizing more gains. Many investments have been marked down significantly. Investors would have been better off buying the S&P 500 index, which is down 0.4% annually in the same period.
The venture capital industry is staring at the most vicious shakeout in its history. Returns are pathetic for most funds, the public offering pipeline on which venture depends for its exit strategy is clamped shut.
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The median annual return for all venture funds raised in 2000, the peak of the dot-com craziness, is –1%, according to research firm Cambridge Associates.
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Where Draper won’t find much sympathy is with the pension funds, foundations and well-heeled investors who make up the base of venture firms’ investors.
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The venture firms earn between 2% and 2.5% of their capital under management and retain 20% to 30% of any profits.
(…)It has been 11 years since the venture industry has returned more cash than it has plowed into investments, according to the National Venture Capital Association. The industry is now managing $257 billion, up from $64 billion in 1997.
“There are way too many people in the business,” says Kenneth Goldman, the chief financial officer of VC-backed Internet security company Fortinet and an investor in other venture capital funds. A shakeout in the industry has been a long time coming but could finally be at hand.
Joshua Lerner, a professor at Harvard Business School, recently analyzed returns, net of fees, for 1,252 U.S. venture funds going back to 1976. The median return for top-quartile firms was 28%. That included the huge profits of the tech boom, which aren’t likely to recur. The median return for all venture funds was just under 5%, or worse than what Treasury bonds would have given you.
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Illiquid investments like venture-backed startups don’t look so hot. VCs “have been living off fumes for a long time now,” says one prominent Silicon Valley investor. “If you have any money, the last thing you’re going to do is put it into an asset class that hasn’t generated a return for ten years.”Research firm Private Equity Intelligence unearthed other dismal figures:
- Menlo Ventures’ 1999 fund had a –13% annual return as of the end of 2007
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- The data also show that Mayfield’s 2000 fund is off an annualized 7.4% over the same period.
- Sevin Rosen Funds in Dallas is in even worse shape: Its 1999 fund had lost an annualized 23.4% as of March 2007, and a fund raised one year later in 2000 was down at 17.6% per year as of the end of 2007. Partner John Jaggers says the 1999 fund had improved slightly, with a compound annual return of –17%.
Some investors are belatedly voting with their feet, shifting future allocations within their private equity portfolio out of venture capital or dumping existing stakes in venture portfolios entirely. In February the $129 billion California State Teachers’ Retirement System changed its allocation goal and now aims to invest only 0.5% of its total portfolio in venture capital, down from 1.3% previously.
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Is it possible that VC firms are in it for the annual fees as much as for the 20% to 30% carry? They raised $36 billion in 2007. At the standard management fee of 2%, that yields $720 million a year even if there are no gains.
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DFJ’s $375 million Fund VI from 1999 posted a 2% annual return as of September and has returned only $135 million to investors. They got cash from the successful initial offerings of companies like Athenahealth and EnerNOC, but overall those wins and other exits haven’t been enough to make investors whole, at least so far. DFJ has opened four main funds since 1999 (VI through IX), raising $2.1 billion. By the year 2007, when all those funds were running concurrently, DFJ could have grossed as much as $41 million a year in fee income for the firm and its ten managing partners, plus other investing staff. “It doesn’t cost $41 million a year to keep the lights on,” says Paul Kedrosky, a former venture capitalist who is now a senior fellow with the Ewing Marion Kauffman Foundation, which studies entrepreneurship.
(…)When the VC industry was riding high on such successes as YouTube and Skype, it could afford to be picky about its investors. Nowadays the new money is harder to come by. Veteran firms such as Mobius Venture Capital and Worldview Technology Partners are bowing out. The Carlyle Group just announced it is closing its Silicon Valley office.
“The industry today is still structured for big exit deals, and it’s not getting them,” says Douvos. He calls recent VC returns “terrible” and says he has jettisoned some of his fund’s traditional venture partners who are raising big, later-stage and international funds, which he doesn’t think will do particularly well.
(…)If other big-name investors also start dumping venture investments to rebalance portfolios, “it’s going to be hard for people to raise big funds” in the future, says Scott C. Malpass, the chief investment officer for Notre Dame’s $7.1 billion endowment. Investors “are not going to be able to put a lot of new money to work.” Some in Silicon Valley say the number of venture firms, 741 at last count, could shrink by the hundreds before things pick up.
Some disillusionment with venture capital has already begun to set in. In 2006 the giant Calpers California public-employee pension fund started selling off $2.1 billion in private equity holdings, including VC investments. “We’ve seen distributions coming back to the [investors] basically drop off a cliff,” Calpers Private Equity Chief Leon Shahinian said at a November VC conference in San Francisco. “I think, in terms of fundraising for VC funds, it is going to be a challenging environment.”
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[B]ehind closed doors, association board members heard a dire warning from two tech investment bankers about the state of the new-issues market. “There’s not a market for anything today,” said Paul Deninger, one of those bankers, in an interview later. Deninger, vice chairman of Jefferies & Co., said initial offerings won’t bounce back without an easing of regulations on public companies and structural changes in the VC industry.
Read more.
The title of this post could be “you don’t know who’s swimming naked until the tide goes down,” well - the tide is going down… and a lot of VCs are turning out to be suckers, not worthy of… VC money. Why is the industry so broken? Well, let me count the ways:
It all starts with the draconian terms that VCs push onto entrepreneurs, that in fact rob them of real ownership and give them little incentive to stick through thick and thin.
VCs force entrepreneurs to take a short term approach with a cliche “we all go home or nobody goes home” mentality that they themselves don’t adhere to, as the Draper example atop outlines.
The VC model might have worked when high technology and the Web was really something new and niche, but these spaces are hardly new or unique, they are staples of the broader economy and the fickle and me-too behavior of VCs does not help, which sees them invest in the latest, hottest trend even if there is really little value to anyone outside of the Valley’s zip codes. Take the UGC trend that backfired, for example. VCs - who lack advertising and publishing experience - suddenly tried to pass off as new media experts and flopped in a big way. Hubris and arrogance does not begin to describe it. In fact, even in the downturn, VCs are quick to blame everything (the economy) and put their heads in the sand rather than look in the mirror or in the rear view to assess what they did wrong.
Most of my observations and conclusions are on the consumer Web space, naturally, but some of the conclusions apply across the board.VCs also talk a lot about long term, but their actions are actually driven by short term tendencies. For example, with oil flirting $150 per barrel, clean energy was the hottest new sector. But with oil falling below $50, I do wonder, will VCs maintain that appetite or will they lose their energy for… clean energy.
Of course, now that the good times are over and spending more money than you make is unwise, the nastier VCs are unable to hide their toxic ways as it’s every man for himself.
And if you sense any resentment or gloating, you are indeed correct. The two reasons why we’re still in business, without a doubt, were:
1) my refusal to accept those draconian and unfair investment terms and
2) the VCs hard-headed refusal to believe in content.
So yes, I am enjoying this storyline quite a bit and could not have scripted a better one.
My prediction for 2009 is simple:
- Don’t get me wrong, at some point all companies need additional funding, but ata) early stages, startups can and should turn to friends/family and banks (via operating credit lines and credit cards). Oddly enough, recevntly VCs’ behavior was more bank-like than risk-taking, anyway.
b) advanced, profitable/growth stages, then you can turn to VCs or Private Equity, because let’s face it, only then do you get a fair deal…
- VCs are the new record labels (better than what I used to call them): sure, without their money oftentimes bands would have never been able to record an album and become popular… but the Web has indeed changed things, and you don’t really need a label… or a VC. With those shackles removed, the end game for VCs is nigh.
- Had the economy not imploded, I would have seen angels squeezing VCs from the bottom and private equity crushing them from the top.
- But, with the economy melting away, most VCs will render themselves ever more irrelevant… and a few will even force startups to shut down so that they can use some of the leftover funds to repay ever-more-impatient investors.
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December 31st, 2008 at 11:48 am
[…] Thursday December 25 Wednesday December 31 2008 - Venture Capital […]
January 2nd, 2009 at 3:51 pm
[…] So basically, if you look into the rearview mirror, things look bleak. But looking ahead, things look rosy. They say it’s darkest just before dawn… so both sides are probably right… but I am not sure it’s darkest just yet. I expect a lot of VC-backed casualties in 2009. For more on this, read our 2009 year in preview. […]
January 3rd, 2009 at 1:11 am
>>”VCs are the new record labels…”
perfect analogy:
1) crappy at picking hits / poor judge of talent
2) take way too much equity in exchange for value-add
3) as a result of market changes, artists (entrepreneurs) need their cash less & less, going “indy” (angel / self-funded) more often
and except for a big branded few at top & small nimble at bottom, the broad majority are going to get creamed in the next few years.
January 3rd, 2009 at 2:17 am
Haha, totally agree with Dave, love the “VCs are the new record labels” quote.