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March 21, 2011 Venture Builder

Small is beautiful | Not every VC deal has to be the next Facebook

By Michael Gurau

In past Mainebiz articles, I’ve described the success rate for early-stage venture capital as equivalent to a baseball batting average — .333, for example. That is, for every nine companies a VC backs, only three generate meaningful returns. Often, only one of the three winners ends up being a home run or grand slam (10-50 times return), with the other two being “doubles or triples” (3-8 times return), to continue the baseball analogy.

Without the home run, the other “wins” are not typically sufficient to make up for the losses of the six other investments. Swinging for the fences, early-stage VCs look for opportunities with outsized potential for growth, that turn a company with less than $1 million in revenue at the time of investment into a company generating $100 million in revenue by year five; no small feat, particularly in a stagnant U.S. economy.

Surprisingly, a handful of high-profile VC stories belie the economy, harkening back to the bubble that began in the late ‘90s and crested at the end of that century. With its viral growth, accelerated by the success of the movie “The Social Network,” Facebook — a company backed both by wealthy individuals and VCs — is one such home run in the making. With more than 500 million users globally, the company reportedly turned down an offer to sell to Microsoft for $1 billion, but later sold a small piece (1.6%) to Microsoft at a valuation of $15 billion. Today, Facebook carries an estimated value of $65 billion (yes, that’s “b” as in billion).

Another notable meteoric growth story is Groupon, a company that has merged coupons for local businesses with social networks. The company negotiates offers with restaurants, spas and other “Main Street” businesses, creating an offer for a product or service that ranges from 50%-75% off full retail; to achieve the discount, recipients forward the offer to friends in their network, making the offer “viral.” Retailers take a hit on the offers with the hope that these low-revenue “trials” lead to follow-on business. This three-year old-company reportedly generated some $34 million in revenue (its split of the cash paid for the offer) in only its second year; by its third year (2010), the company reported revenue ranging from $500-$750 million and was projected to be the fastest company ever to reach $1 billion in sales. During 2010, the company turned down an acquisition offer by Google priced at $6 billion. Not bad for three years work.

While valuations of companies like these seem crazy and destined for a correction, the differences between the boom-bust of the late ‘90s and this environment are notable. First, some of the dot-com babies of the earlier era were realizing similarly large valuations but without the revenue that both Facebook and Groupon can show. Second, the earlier era was frothy not just for web markets but also for the general market. By contrast, Facebook and Groupon are showing growth when the surrounding market is still in recovery from the collapse that began in late 2008.

But what about the rest of the VC market without social network giants in their portfolio? A great many are still working out the challenges of their investments. As described in “Capital pains,” (Mainebiz, 12/13/2010), it’s a tough market for funds that aren’t seeing the growth these new media ventures have experienced.

As a result of the economy and its impact on VC, there’s a good deal of talk that “the venture capital model is broken.” That overused phrase is often coupled with another hackneyed expression: “Too much money chasing too few good deals.” Certainly, for those looking to piggyback on the social media trend, that’s probably true. It’s no more likely that new entrants will try to dislodge Facebook than a startup will look to create word, spreadsheet and presentation software to knock Microsoft off its perch.

Venture capital is not broken for those who can see, fund and manage high-potential opportunities. There are many problems to be solved in many high-growth arenas — advanced materials, biotechnology, software and clean technology, to name a few — that continue to show real promise for professional and private investors. And with so much attention focused on web and social media, these other areas show promise for outstanding value creation for professional investors in the four- to eight-year time horizon.

Not every deal has to be worth $65 billion to make the math work for VCs who may never be early investors in the next Twitter or Groupon. Smaller funds can realize home runs sufficient to continue supporting the kinds of growth companies that were the foundation of the industry in the ‘60s and ‘70s. As the teacher of noted British economist E.F. Schumacher once said in a different context, “Small is beautiful.”

 

Michael Gurau, managing general partner of Clear Venture Partners, a Maine-based early-stage venture capital fund, can be reached at mg@clearvcs.com. Read more Venture Builder here.

 

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