With Venture Capital broken, what is a start-up to do?

When reading the latest issue of Harvard Business Review, you may start to worry about the future of Venture Capital.In the last 10 years, if you put money into venture capital, you return was likely in the single digits, perhaps even negative. You would have been better off putting the money in a bank account.  From 1980 to 1997 however, quarterly returns were 22% per quarter. The article adds that this period of staggering returns, combined with the Internet boom which just got started, led to an oversupply of venture capital firms and money, and subsequently lead to too much stupid money chasing bad deals, and currently the IPO market has dried up, and M&A valuations have come down, thus creating less deals:

Source: Harvard Business Review

The solution, the article proposes, is for a shake out to happen, and that the “good” firms remaining take a more proactive approach in getting involved in their companies’ success.  This is certainly good advice, however, it could mean that VC’s may take on board even fewer deals, as each deals requires more personal attention, and with fewer deals and seemingly fewer VC’s, starting a company could be increasingly more difficult. 

Increasingly start-ups have to look to Angel investors for funding, as online networks makes organizing this easier, and also because companies can manage on less money. However, Angel money may often not be “smart” money, as traditionally they are perceived as not getting much involved in the companies they invest in. Thus, VC’s still hold the promise of being able to help founders on areas of weakness, and bring small companies into the doors of big firms to close the one deal that allows them to take off.

However, there are a number of other problems the VC industry needs to address, besides getting more involved in helping their businesses:

* VC’s need to start looking beyond +/- 10 numbers in the zip code of their home office.  Another Harvard study found that half of VC backed companies are located in either the Silicon Valley, New York or Boston, which is also where you have the highest concentration of VC firms.  When you now can hold video conferences over Skype for free, and cheap tools are available to any start-up for collaboration and managing their business, geographic proximity should not be a valid reason for wanting your investment company next door;

* Bet smaller and bet more. There should be no shame in building a business that generates $20-50m in revenue. You don’t have to beat eBay or Facebook (or get acquired by them) with your next big idea. This means VCs need to invest in more companies, and make smaller bets – while at the same time be more involved. Sounds counter intuitive, but is not if VCs start changing they way they operate;

* Develop an industry approach.  The incubator model, made popular in the dot com days, actually had legs but was executed wrong, as the focus was too much on purely providing capital and office infrastructure. Organizations like Plug and Play Tech Center are using elements from this, but in a more holistic setting, with less pressure to produce the returns. The idea is to help the startups by setting up an environment where they not only get access to capital, but also legal advice, business advice from advisors and other entrepreneurs, government funding and assitance and more. This is a model which VCs should actively get involved in, as the centers will do part of the job for you – allowing you to bet on more and bet smaller.

Luckily, not all is bleak for the industry as a whole. Yes, there are fewer IPO’s, but M&A activity is picking up. In the media sector, this charge is being lead by interactive marketing services:

This could mean that VC’s may see lighter times ahead, but a recent report from Pepperdine actually shows that while VCs are now looking at more business plans than compared to 6 months ago, and are finding a much higher level of quality business plans, there are actually less start-ups getting funded:

Comparison of VC Investments 1H 2010 vs 2H 2009

Source: Pepperdine Private Capital Markets report, summer 2010

It can also be noted that among the surveyed VC’s, 84% expect that demand for VC capital will increase in the next 12 months. But if VCs are getting more picky, and not much has changed fundamentally to address the issues I mention above, it could seem like Angels may be the answer.  Angels take a far broader investment perspective, and tend to look more on the deal than where your company is located, which is natural given that they are not bound by the VC method of doing business:

Angels investment range in miles

Source: Pepperdine Private Capital Markets report, summer 2010

And the old belief that Angels represent “dumb” money may not hold true, as a significant portion prefer to give advice to their portfolio:

Benefits provided to investee company

Source: Pepperdine Private Capital Markets report, summer 2010

So an increased activity in the Angel network, and better organization of such, may help part of the fund raising issues for start-ups.  However, funding and strategic advice is only one component, and unless these networks also start to develop a holistic industry approach to incubating start-ups, this group may also be faced with disappointment in their returns, and subsequently reduce their activity.