As mentioned above, the venture capital industry is completely intertwined with the technology industry in general and the startup industry in particular. The main characteristics of the venture capital industry and the changes it is undergoing are, first and foremost, a result of the corresponding characteristics and processes experienced by the technology industry. Even typical local variables, such as political instability, have only a minor effect on this industry.
The 1990s have been characterized by an exceptional window of opportunity in the communications and Internet fields and in the industries which support them. This opportunity came from new technological capabilities in these areas which advanced the world in quantum leaps. These possibilities, which were not previously utilized by industry giants, created a large vacuum which naturally drew in entrepreneurs and technologists who established many companies, some of which became new global giants over the years (such as Cisco and AOL).
At present, it is unclear whether the pace of technological advancement and its embracement by consumers will persist in a manner enabling an accelerated growth of the technology industry as was demonstrated in the past decade. As a result, these are significant changes that the financial backers of the technology industry are going through.
The Impact of the Crisis in the Capital Markets on the Industry
Figure 10-1 illustrates the tight relationship between public capital markets and the venture capital industry. This relationship can be used to describe the main impacts which a crisis in the capital markets would have on the venture capital industry.
Figure 10-1. The Relationship between Public Capital Markets and the Venture Capital Industry
The Impact of the VC-Market Cycle There is an intimate connection between the prices of publicly traded stocks and the amount of capital raised and invested by venture capital funds. Successful exits through the stock market by way of IPOs, secondary offerings, in which shareholders sell shares to the public, or by selling shares released from lock-up or, alternatively, acquisitions by public companies at high prices, provide investors with enhanced incentives to invest in venture capital funds. Since most of the funds raise substantial amounts of money when there are many successful exits in the market, additional investors invest more in the companies directly, and since the number of potential investments does not rise proportionately, then naturally the returns in the subsequent periods are lower. It is indeed projected that funds will not be repeating the returns they demonstrated in the years 1999 2000 (see the section on the return on venture capital funds) and, consequently, their ability to raise capital will decline. Less money will be invested in funds also because investors in funds prefer, in times of crisis, to invest in investments carrying a lower risk. That, in turn should improve the returns in the following years, assuming the market will return to a growth path.
Small and mid-sized funds with short investment records are hit the hardest. Well-established funds still manage to raise capital in bad times.
Support of this phenomenon may also be found in the behavior of some funds. Even funds which can raise a large amount of capital may decide not to pursue this course of action in times of crisis because they do not anticipate high returns for their investors. The Crosspoint fund, for instance, decided in 2001 to cancel a scheduled investment of $1 billion in a new fund it was planning to establish even though the fund had already received commitments from investors. The reason given by the fund was that the fund managers did not foresee in the near future sufficient likelihood of yielding the returns to which investors in the previous funds had become accustomed. Other leading funds, including Benchmark Capital and Kleiner Perkins, reduced the size of their new funds. The upside is that since in times of crisis less money is invested in funds and consequently in startups, the funds' returns typically rise in subsequent years. However, this time, it seems the U.S. market suffers from an economic recession, which may impact the prospects for such returns.
Numerically, after record-breaking quarters in the amount of capital raised by funds and companies, the growth rate of capital-raising and investments slowed from the third quarter of 2000. This did not prevent U.S. funds from raising approximately $90 billion in 2000 and investing over $100 billion. In 2001, the capital raised by U.S. venture capital funds declined to less than half of that, and the investments made by U.S. venture capital funds also declined to approximately $30 billion, as compared to approximately $100 billion in the previous year.
Directing fund investments to portfolio companies Another phenomenon which is noticeable in times of crisis is that venture capital funds invest more in their portfolio companies than in new companies. Thus, out of the total amount of capital invested in the United States in 2001, only about $10 billion was invested in new companies, and the remainder was invested in portfolio companies in more advanced financing stages. This phenomenon is to be expected, given that in times of crisis the chances of raising capital from the public on the stock exchange or from new investors are low. Since the companies' financing needs are not diminished, they rely on private investors and the previous investors are a natural choice. The combination of a reduced availability of outside capital with valuations lower than would have been projected based on past data, drives funds to invest more in their portfolio companies at this stage. If, in the past, funds used to rely on their portfolio firms new investors, they are now compelled to persevere in supporting their companies. This process leads to a reduction in the number of new companies in order to sustain the greater support of each portfolio company over time.
Providing added value services Leading funds now emphasize more the value added services (see the section on the added value of venture capital funds) they provide to their firms. The cost of expanding the service package should always be measured by its impact on the fund's return, either by persuading entrepreneurs to work with the fund or by its direct and indirect effects on portfolio companies' achieving their goals. We expect this trend will continue, although it might be in the form of services for reduced fees, rather than services offered for free to the portfolio firms.
Investment rounds based on lower values ("down-rounds") In many cases, the valuations used for new investments are lower than those used for previous investment rounds. Starting in fall 2000, the market value of public technology companies, and hence of companies in the private sector, considerably declined. For instance, in 2000 and 2001, many companies which raised capital at the height of the capital market's prosperity were forced to raise capital according to valuations which were at times dozens of percents lower than their previous value (down-round) despite the progress they had made during this time in developing their products.
In 2001, the average value of companies which had performed private placements in the United States with the involvement of venture capital funds was approximately $15 million. Although this figure represents a considerable rise compared to the average value in the years prior to 1998, it is significantly lower than in 1999 and 2000. This represents a sharp decline in the value of the companies in conformity with the sharp decline in the value of traded companies.
Emotional considerations have always played an important role in the valuation process, and in 2001 it appeared that investors had despaired of the technology market. However, there is also an optimistic aspect to this phenomenon, since companies are now once again being valued based more closely on the fundamental economic prospects in their business models, rather than based on "bubble-prices" of 1999 2000.
It is important to remember that, despite all the talk about a "new economy," the basic principles of company-valuation have remained the same, i.e., the company's value should reflect the present value of the cash flows it will generate for its owners. Such cash flows are composed of direct cash flows which the company will generate in the form of operating and financing profits, as well as additional cash flows which the company or its owners will gain, such as the projected cash flows from selling shares on the stock market while possibly utilizing any higher favorable valuation which may exist at that time. It is these principles which ultimately determine the value of a company and the "bubble-prices" observed in the market prior to the decline drive many investors and entrepreneurs to believe their companies could benefit from exits at price levels which proved to be unsustainable (for a further discussion of the valuation of companies, see Chapter 9).
Furthermore, in times of crisis, the importance of the size of the investment round is greater than ever. In prosperous times, companies can be selective and choose to have smaller investment rounds to avoid dilution, assuming that additional financing will be readily available in the future; in times of crisis, however, they are compelled to increase the investment rounds due to the great uncertainty clouding the availability of future financing. In other words, the considerations remain unchanged, but the weights attributed to the parameters at the time of valuation are different.
Closing down and mergers of startups In times of crisis on the capital market, an increasing number of startups are denied additional financing, since the typical exit IPO or the sale of the company appear less realistic. At such times, investors, and particularly venture capital funds, usually sift through their portfolios to separate the wheat from the chaff, a task that would not necessarily have been undertaken with the same intensity in other times. As a byproduct of the uncertainty in such times, many companies with excellent products and promising target markets are also closed down. Sadly, while in times of prosperity even failing companies sometimes can raise capital and make it to an exit, hard times are also difficult for good companies (for a discussion of the dissolution of startups, see Chapter 18).
Companies that cannot yet demonstrate revenues are entirely dependent on the infusion of capital by investors (in most cases) or by future customers who are prepared to pay in advance for future developments (rarely). In addition, when the possibilities of raising capital on the stock market are more limited and the speed at which capital is raised has also slowed in the private market, the importance of orderly business planning is greater than ever, and funds and other investors will demand that their portfolio companies observe tight control measures.
Many companies conclude that in order to survive they need to join forces with other small firms to augment their power in the market and to reduce costs. Sometimes it is the investors themselves who push in the direction of mergers, and funds may even encourage mergers between their own portfolio companies, in order to increase the likelihood of their survival, by combining their financial and managerial resources, while eliminating redundancies.
Closing down and mergers of funds In difficult times in the capital markets, many funds which did not manage to raise capital before the crisis, close down. Other small funds tend to merge in order to increase the amount of money they can manage and support their portfolio firms. Many newly established funds and incubators were closed down in 2001 and there are funds who suffer from the departure of partners, mainly new ones, who do not foresee high likelihood of large profit-sharing.
Establishment of specialty funds During the crisis, investors started voicing complaints that some funds had ventured into areas in which they had no comparative advantage. It appears that the coming years will bring a phenomenon of funds specializing in narrower areas, similar to the phenomenon which took place in mutual funds in the last decade. An increasing number of institutional investors will channel investments to specific areas and compare funds with similar investment profiles in order to choose the most promising funds. These specialized funds may be managed by the same large VC fun management companies, but we'll address specific niches. This pattern is similar to the one observed in the mutual fund industry during past decades.
Moreover, the differences between experienced and large funds and less experienced funds will become more evident. Experienced funds, which usually also command more resources, often focus in times of crisis on cultivating and investing in their portfolio companies, either by providing financial resources or by vigorous assistance in the search for strategic partners which could assist, or even buy, the companies. Smaller funds with fewer resources have a limited ability in these areas, particularly in difficult times.
Globalization In the late 1990s, U.S. funds have expanded operations overseas (mainly in Europe and in the Far East) and European funds were expanding operations to the United States. Most of them have done so to assist in the business development of their portfolio companies and to better support them.
The reasons for the shift to global investments were clear. The technologies used around the world are similar, and the educational systems around the world allow innovative technologies to be created almost anywhere. In addition, communication networks have created a situation in which the entire business world is run on a global basis. The cooperation among venture capital funds operating in different countries is expected to grow tighter. Since venture capital activity does not, in itself, require highly staffed establishments in each country, there is justification for opening separate branches as part of a single fund or as part of funds having a specific geographic destination. This is in contrast to networks of attorneys or CPAs which constitute, in practice, a network of independent offices under a single marketing and direction umbrella, or that are serving multinational clients.
The phenomenon of establishing separate funds for investments in different countries is inconsistent with the globalization phenomenon. However, it is important to understand that in many cases, the separation of the funds was a result of investment restrictions imposed on the entities investing in the funds (for instance, restrictions on some institutional investors with respect to investing outside their native countries). The trend of global expansion and the proliferation of country or region-specific funds had almost completely stopped in the years 2001 2002, but we anticipate that the leading VC funds will continue to search for investment opportunities on a global basis. This pattern will further widen the differences between these leading funds and the funds with weaker resources.
A decline in investments by angels and operating companies In times of crisis, the share of professional investors who specialize in venture capital investments increases. Angels, particularly those who are not familiar with the industry, steer clear of venture capital investments after being discouraged by the decline of the public market and seeing their hopes for a fast exit drift away. Operating companies also focus more on their main business and less on venture capital investments at these times. Only venture capital funds, whose entire existence revolves around venture capital investments, remain in the market.
An Analysis of the Phenomenon and an Outlook to the Future
It is important to keep in mind that, despite the crisis in the capital market, an unprecedented technological revolution has been taking place in recent years. The changes which the Internet has brought about and is yet to bring, as well as the far-reaching changes in the communications and biotechnology markets, will have a dramatic impact on the business world for decades to come. We cannot ignore this fundamental economic phenomenon due to a stock market slump following a period of euphoria.
From the economic viewpoint, is it really surprising that the majority of companies in these infant technology fields have either disappeared or plummeted? Looking at the early 20th century, we may see that at the beginning of the revolution which accompanied the first motor vehicles, hundreds of automobile manufacturers emerged, each backed by the venture capital investors of the time. Most of these companies crashed within several years and some merged. Consequently, the American automotive industry is now represented by three important manufacturers, each created by dozens of mergers over the years. It should be kept in mind that these are only U.S. manufacturers and that the industry is far less innovative than most of the technology fields with which we are familiar today.
Whenever a new technology creates new markets or changes existing ones, many competitors emerge in the first stages of the industry's development. It takes several years for the industry to undergo the process which reveals who is to survive and which companies do not offer a package of added value sufficient to justify their existence. For instance, does anyone still use an Osborne computer? Osborne was one of the first companies to offer laptop computers and was deemed as the pioneer of the mobile computing concept. Yet, the company could not survive the steep competition in the industry. On the other hand, can we envision our lives today without laptop computers?
The communications and Internet industries developed much faster than other industries; it is therefore not surprising that many companies in this field crashed so quickly. When the pace of innovation is so high, the identity of the victors is revealed much sooner. In addition, the existence of new competitors in the market, backed by huge venture capital resources, has created the existence of many companies without any economic justification. Once more, the principles of economics prevail: When companies resemble one another and there is a sufficient number of competitors, the projected competition erodes any possible profitability which justifies investing in companies at high prices. Therefore, investors demand that the prices of companies be adjusted downwards and prefer to focus only on the companies which are expected to lead the industry. This is also why it is increasingly harder to secure financing for companies whose plans do not include a realistic expectation of gaining a substantial share of their defined target market.
The process is one of painful disillusionment. The technology industry and the investments in it will not disappear. The value of companies will be lower at the time of financing rounds, since any decisions on investments and valuations will be based on established economic models and not mainly on the euphoria in the public capital market or on market trends. Similarly, the returns of venture capital funds are expected to go back to their normal level of 20 25% per year after profit-sharing. In addition, the anomaly of an employment market with high and fast salary increases will cease to be, and the loyalty of employees to their employers will rise again. At the end of this process, we expect that the technology industry will emerge stronger and more mature.