Survival of the fittest | Investors can reap rewards by sticking with the pros
The early-stage venture capital industry is undergoing a tectonic shift that began with an oversupply of funds coupled with an undersupply of experienced, tested fund managers. It has since erupted into something that many predict will be a dramatically reduced early-stage VC funding market.
As noted in my July 13 column, “Mind the Gap,” the economic environment has hampered those fund managers with companies that were raising money and/or seeking a robust market for realizing value (exits), which now face an unknown timeline for doing so. VCs whose companies needed capital from other funds now find that they must reserve capital for additional investments in existing companies, rather than new investments, thereby reducing available capital in the market for new companies with new ideas.
VCs who were hoping for liquidity, such as a sale or IPO, so that they could go out and raise new funds can’t do so. Even if they could, the institutional and individual investors who provide capital to funds are pulling back, suggesting a long dry spell ahead for early-stage companies hoping for outside funding.
But the recession is not the full story in the current phase of the early-stage venture capital market. For many years prior to the downturn, a common refrain was that there was “too much money chasing too few good deals.” In good years — most of the 1990s — when the VC industry was showing great growth and returns, many new funds formed — not all by experienced managers — bringing new capital to the welcoming market of entrepreneurs, who could play one investor off another to get the most capital at the best terms. Early-stage investors found themselves bidding against one another for the best opportunities (and funding many that ought not to have been) resulting in inflated valuations and less opportunity for outsized returns.
If managed by experienced and tested VCs, early-stage, high-risk investments should translate to commensurately high returns, certainly higher than investments at later stages of development, which presumably carry less risk. That’s quite the contrary to reality — the early-stage asset class has underperformed relative to later-stage investment. Does this mean early-stage investment is a bad bet?
Value of experience
Some of the most experienced firms continue to fund the most experienced teams with the best product-market opportunities. The rest of the investment market — often loaded with first-time fund managers — was left to figure out the venture capital business on the fly, backing less experienced teams and less robust businesses. So, these newbies lost a lot of money and, as a result, dragged down the returns for the early-stage asset class as a whole.
So, we have the perfect storm of negative events — oversupply of funds, managed by less experienced investors; poor liquidity for funds looking for exits, reducing the likelihood of new funds being raised; and all funds retrenching to tend to their portfolio, leaving less capital available for new investments.
The Kauffman Foundation recently suggested that the overall funding market needs to shrink significantly, shake out a lot of players and, presumably, leave only the strongest to survive. This view, which predates the recession, speaks to supply and demand — reduce the availability of capital and funds that are left will see better, more rationally priced opportunities. That’s probably a good thing in that it leaves the marketplace to the best-performing funds, but probably not a good thing for the countless entrepreneurs who will not find support. So, don’t plan on any help in the near term from the private sector.
The public sector is not in great shape either. Federal deficits and state budget shortfalls would seem to translate to less public sector involvement in innovation and capital markets. The Obama administration seems to understand the importance of innovation and small business in the economy. And with Karen Mills — an ex-venture capitalist and Mainer — at the head of the Small Business Administration, there’s reason to believe the government may once again play an important role in innovation and small company formation.
At least three recent bills are related to increasing the availability of seed and early-stage capital — in two cases, related to the New Markets Venture Capital program that I manage for Coastal Enterprises, and in one case related to availability of seed funding and/or tax credits for early-stage investment.
These initiatives are necessary but not sufficient. Institutional and individual investors would be well served to recognize that the next few years ought to be vintage ones for professionally managed funds with capital. So, if you capital-rich players are sitting on the sidelines, find your way to funds that know what they’re doing. You’re likely to look back in seven or eight years and be glad you did.
Michael Gurau, managing general partner of Clear Venture Partners in Portland, can be reached at mgclearvcs.com. Read more of Michael’s columns at www.mainebiz.biz.
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