We don’t care what stage a company is when we invest. In the last couple of years, the smallest we invested was $25,000 and the largest was $40 million, ranging from an idea on a napkin to a business that is already up and running.
—Jeremy Levine, Partner at Bessemer Venture Partners
One grand slam home run does not make you a Hall of Fame baseball player. When searching for a VC role model or mentor, it is more important to remember that it is easy to become impressed with those one-hit wonders who, whether by good timing or good luck, have had a “100+X bagger” or investment success. One big score is an historical event, but it is, in many cases, unrelated to the skill set required for long-term success in venture capital investing. That is an achievement marked by the repeatability of the successful exit in the prevailing and constantly changing investment climates. We should instead seek out the serial repeat players: those rare gems who are not just investing a fund’s money, but who also infuse the deal with their own intellectual capital, experience, and hard work. We want to find those power players who seem to have developed a sixth sense about achieving success.
Whether one is investing in a VC fund run by partners or making a direct investment run by a CEO, the key is not to be impressed with a single success or the power of their “branding.” The maxim “You are only as good as your last victory” is less applicable in the VC universe than “What have you done for me lately?” Complicating this task, is that once the list of successful VC investors has been pared down to the serial winners, the list is further narrowed by the natural human tendency for the successful to enjoy the fruits of their labor and either retire or become much less active in the funds they manage or companies they run. Once a person has achieved true financial freedom, it is hard to ignore the allure of travel, leisure sports, creative arts, or philanthropy.
Much has changed in the venture capital industry since those early days of Fairchild Semiconductor. Bob Noyce and Gordon Moore left Fairchild in 1968 to form Intel, and Eugene Kleiner invested in their new venture. Four years later, Kleiner would leave engineering for good and team with HP executive Tom Perkins to found Kleiner Perkins, one of the seminal venture capital firms on Sand Hill Road. These men were able to do this because Fairchild Semiconductor had been a wildly successful company and their 10 percent ownership stakes had made them wealthy men.
Their technology changed the world of electronics; however, no matter how great or needed the product may be, nothing happens until somebody sells something. In the case of Fairchild, that somebody was a non-engineer named Donald T. Valentine. He was a senior sales and marketing executive with Fairchild Semiconductor who happened to have connections with the military and convinced them to use Fairchild semiconductors in their Minuteman missile program.
Don left Fairchild to go to National Semiconductor, but kept in touch with his former colleagues at Intel. In 1972, convinced that the path to future riches was in semiconductors, systems, and software, Don founded Sequoia Capital. He was one of the original investors in Apple Computer (AAPL), Atari, Cisco Systems (CSCO), LSI Logic (LSI), Oracle (ORCL), and Electronic Arts (ERTS). According to Don, success in today’s venture capital world is reducible to a few words; dealing with change.
You have to be interested in managing change, and you have to recognize that change is necessary. Today’s solution is wrong for tomorrow. Technology changes rapidly, so you’re able to see it very quickly. The evolution of handheld computers happened in three years, and you have unbelievably good products right now that were not conceivable four years ago. That’s what I mean about embracing change. You have to recognize that what you have now is not the end; it’s not the limit. When you can’t do that change from the Walkman to the iPod, you become like General Motors. You cannot develop anything new. General Motors, in a very short period of time, lost their role to a Japanese company by the name of Toyota, who did embrace change.1
After having established the intellectual property (IP) while conducting our due diligence, one of the first questions we always ask our prospective portfolio companies is “What is the ongoing product development plan regarding future enhancements, such as version 2.0, version 3.0, and so on?”
Steve Blank is a consulting associate professor at Stanford University and a lecturer and serial entrepreneur. He has a blog that is widely read and has published several books on starting a successful enterprise. In a recent cover story for the Harvard Business Review, Blank discussed some of the changes taking place in the venture capital industry.
Another important trend is the decentralization of access to financing. Venture capital used to be a tight club of formal firms clustered near Silicon Valley, Boston, and New York. In today’s entrepreneurial ecosystem, new super angel funds, smaller than the traditional hundred-million-dollar-sized VC fund, can make early-stage investments. Worldwide, hundreds of accelerators, like Y Combinator and TechStars, have begun to formalize seed investments. And crowdsourcing sites like Kickstarter provide another, more democratic method of financing start-ups.2
These Angel, Accelerator, and Micro VC Funds, including our own GCA Catalyst Fund, are able to make the less than $1 million seed, start-up, or early-stage investments that the larger institutional VC funds cannot make due to their sheer size. Recognizing how underserved the sector is, GCA Catalyst is also completing diligence on a “crowdfunding” entity to take advantage of the popularity of this funding method once the 2012 JOBS Act is fully enacted.
Several major VC firms were started in the late 1960s to early 1970s period. Most were related to the rapid growth of technology being seen along the Route 128 corridor outside of Boston and Silicon Valley. Boston firms included Greylock Partners, founded in 1965, and Charles River Ventures (1970). The Silicon Valley area south of San Francisco Bay spawned several firms in that period which are still active, many of them located on Sand Hill Road in Menlo Park. These include Sutter Hill Ventures (1964), Morgenthaler Ventures (1968), Mayfield Fund (1969), Kleiner Perkins Caufield & Byers (1972), Sequoia Capital (1972), and Sofinnova Ventures (1974). Greylock Partners moved their headquarters to Menlo Park in 2010, but still have an office in the Boston area.
Like every other business, venture capital investing is subject to the ebb and flow of economic conditions. We created our first fund of funds in the early 1980s. Across the industry, 650 VC firms vied for a portion of the $31 billion venture capital pool that had flowed into the industry. By the end of the decade, the number of players and the size of the pool had reduced significantly.3 The industry returned and peaked in the first quarter of 2000 with more than $28.4 billion invested across 2,160 deals. The latest statistics for Q1 of 2013, shows that 319 firms invested an average of just under $7 million across 863 transactions.4
The trend is coming back down with respect to the number of VC firms and the quantity and value of their investments. More than ever before, it is imperative that today’s venture capitalist stay abreast of what the competition is doing. For some VCs, it is a matter of trying to determine where the trend is heading. If several firms are jumping on solar panel developers, that may indicate that someone either has or is about to make a technological breakthrough. For the contrarian, it might indicate that it is time to look for an edge in clean coal technology or more efficient steam turbines. Either way, one of the best trend references is the MoneyTree Report.
The MoneyTree Report (www.pwcmoneytree.com) is published on a quarterly basis by global business consultant PricewaterhouseCoopers in cooperation with the National Venture Capital Association. This report has become one of the basic VC reference sources for the financial community. Its purpose is to measure and report on venture capital investment activity across the United States, and it contains detailed quarterly results and aggregate trend data beginning with 1995 on up to the most recent quarter. The global business news organization Thomson Reuters compiles data on emerging companies that receive financing and the venture capital firms that provide it. This data are compiled and organized based upon several different criteria by PricewaterhouseCoopers, who produce and maintain the online report.
For the most part, geography matters to VCs. They want to fund businesses located in ecosystems with the requisite VC infrastructure in place to easily access and enable success, whether it be a pool of talented engineers to recruit, serial entrepreneurs to tap into, board member talent, other VCs to co-invest with, or the abundance of support professional service providers such as IP law firms, legal and audit. Many quite frankly just prefer the flexibility to jump in the car and easily meet with their companies.
The MoneyTree Report divides the United States into 18 different regions. In the report for the first quarter of 2013, 863 deals were financed, with the average size of the financing package being about $6.8 million. The total invested in this period across the entire nation for this quarter was more than $5.8 billion. Of that total, nearly 38 percent went to fund 274 companies in the Silicon Valley region. This region is defined as northern California, the San Francisco Bay area, and the northern half of the California coastline. The New England region, which includes Maine, New Hampshire, Vermont, Massachusetts, Rhode Island, and parts of Connecticut (excluding Fairfield County), came in second for the quarter with $677 million funding 88 projects. With 98 projects sharing $576 million, the New York Metro region, defined as the Metropolitan New York area, northern New Jersey, and Fairfield County in Connecticut, came in third with 9.83 percent. Texas had only 31 projects, but the $534 million in funding accounted for 9.10 percent of the 1Q total.
The LA/Orange County region, which includes all of Southern California (except the San Diego Metropolitan area), the Central Coast, and the San Joaquin Valley, came in fifth place with 55 projects sharing $365 million in funding. Sixth place went to the Southeast region with 33 projects spread across the states of Alabama, Florida, Georgia, Mississippi, Tennessee, South Carolina, and North Carolina. The DC/Metroplex, defined as Washington, D.C., Virginia, West Virginia, and Maryland saw 30 projects sharing about 5 percent of the total funding and was followed in eighth place by the San Diego region with 3 percent over 26 projects.
The remaining 12 percent of funding was spread over 228 projects in the following nine regions:
There were no funding reports from the final geographic classification region, which is the combination of the outlying regions of Alaska, Hawaii, and Puerto Rico.
Just as in geography, industry classifications matters, too. The VC wants to easily access the deal flow and intellectual capital pools of talent available that address his own sector expertise, be it a university, innovation center, research hub, or corporate R&D. Being close and having easy access to this sector expertise is a great value-add to a VC.
Venture capital investing has grown to cover much more than software and semiconductors. Users of the MoneyTree Report can monitor funding across 17 different industry classifications. The first of these is biotechnology. This industry includes firms that are developing technologies related to drug and pharmaceutical development, disease treatment, and a deeper understanding of living organisms. This industry includes human, animal, and industrial biotechnology products, services, and related hard goods like biosensors and biotechnology equipment.
Business products and services firms offer a product or service targeted at another business such as advertising, consulting, and engineering services. This category can also include distributors, importers, and wholesalers.
The computers and peripherals industry includes manufacturers and distributors of PCs, mainframes, servers, PDAs, printers, storage devices, monitors, and memory cards. It also includes innovators in digital imaging and graphics services and equipment such as scanning hardware, graphics video cards, and plotters. Integrated turnkey systems and solutions are also included in this category.
Consumer products and services industry members offer products or services targeted at consumers such as restaurants, dry cleaners, automotive service centers, clothing, toiletries, and housewares.
Electronics/instrumentation is a broad classification that covers business and consumer electronic devices such as photocopiers, calculators, and alarm systems. It also includes electronic parts and equipment, specialized instrumentation, scientific instruments, lasers, power supplies, electronic testing products, and display panels.
Financial services is an industry classification for providers of financial services to other businesses or individuals, including banking, real estate, brokerage services, and financial planning.
Healthcare services covers both in-patient and out-patient facilities as well as health insurers. Hospitals, clinics, nursing facilities, managed care organizations, physician practice management companies, child care, and emergency care are examples of fundable projects in this industry.
Industrial/energy is the category that contains producers and suppliers of energy, chemicals, related materials, industrial automation companies, and oil and gas exploration companies. Also included are environmental, agricultural, transportation, manufacturing, construction, and utility-related products and services.
IT services include providers of computer and Internet-related services to businesses and consumers, including computer repair, software consulting, computer training, machine leasing/rental, disaster recovery, web design, data input and processing, Internet security, e-commerce services, web hosting, and systems engineering.
Media and entertainment funding goes to creators of products or providers of services designed to inform or entertain consumers including movies, music, consumer electronics, sports facilities and events, and recreational products or services. Online providers of consumer content are also included in this category.
Those who manufacture or market medical instruments and devices including medical diagnostic equipment, medical therapeutic devices, and other health-related products come under the classification of medical devices and equipment.
Providers of data communication and fiber optics products and services fall into the networking and equipment classification. This includes providers of WANs, LANs, switches, hubs, routers, couplers, and network management products, components, and systems.
Retailing/distribution funding covers firms making consumer goods and services available for consumer purchase including discount stores, super centers, drug stores, clothing and accessories retailers, computer stores, and book stores. Also included in this group are e-commerce companies who sell their products or services via the Internet.
There are, of course, still funding requirements for new and exciting developments in the original venture capital classification of semiconductors. This industry classification typically includes those who design, develop, or manufacture semiconductor chips, microprocessors, or related components including diodes and transistors. It also includes companies that test or package integrated circuits.
Software is a major funding category, which covers producers of software applications for business or consumer use. This includes either bundled or unbundled software created for systems, graphics, communications and networking, security, inventory, home use, educational, entertainment, specific industries, or recreational applications.
Companies focused on the transmission of voice and data including long-distance providers, local exchange carriers, and wireless communications services and components are funded under the telecommunications classification. Also included are satellite and microwave communications services and equipment.
The final classification criterion is “other.” The category includes those unique or different products or services that are not appropriately or accurately described by the other classifications.
The MoneyTree Report uses three sector classifications, which can cross traditional industry classifications. The first of these sectors is clean technology. This sector is for companies that focus on alternative energy; pollution reduction; pollution remediation; or recycling, battery technology, and power supplies and conservation. The second sector is specifically for Internet-specific ventures. This discrete classification is assigned to a company whose business model is fundamentally dependent on the Internet, regardless of the company’s primary industry category. The final sector is life sciences. The life sciences sector focuses on all deals involving biotechnology and medical device companies.
There are many other websites, like CB Insights (www.cbinsights.com) and StrategyEye Cleantech (www.strategyeyecleantech.com), who provide the serious venture capital investor with all of the data about the deals that have been made. There are even private services costing thousands of dollars that try and pick winners even before they formally pitch their ideas. The trick is finding the golden needle in the haystack. There doesn’t appear to be a secret formula for picking winners ahead of the fact, but there are firms who seem to have built pretty good track records. There are also a few VCs who have established themselves as somewhat prescient. We will discuss the process for arriving at the decision about who to fund and why, but let’s take a quick tour of who is doing what today.
AlwaysOn (http://aonetwork.com) describes itself as “the leading business media brand connecting and informing the entrepreneurial community in the Global Silicon Valley.”5 The editors of AlwaysOn, in concert with New York–based 451 Research and the Investment Research group of Morgan Stanley, compiled the data for the total number and dollar amounts of successful M&A and IPO exits that the top 300 VC firms completed between October 1, 2010, through September 30, 2012. From this data, they determined the Top 10 VC Firms of 2012 and announced the winners at the 2012 Silicon Valley Venture Summit, held December 10th through the 12th, 2012, at The Ritz-Carlton luxury resort overlooking the Pacific at Half Moon Bay, a perennial favorite venue for VC fund annual meetings.
The analysts at AlwaysOn were not privy to the valuations paid by investors at each respective round of financing, so their list is admittedly a best educated estimation; however, the 2012 list nears an astounding $350 billion in exit value, proving that the strength of the venture-backed entrepreneurial community remains undiminished.6 To put some context on that number and to illustrate the multiplier effect of venture capital in the economy, Microsoft paid a $33 billion dividend to its shareholders in December 2004. It was the largest payout of its time and made up 6 percent of the total increase in personal income in America for that year.7
The first-place firm selected for this honor was Accel Partners (www.accel.com), who were chosen not solely on the estimated $53.938 billion in exit value, but also on the strength of the underlying portfolio. These included the mobile advertising platform Amobee, which was acquired by Singapore Telecommunications; Brightcove, a global provider of cloud content services; Facebook, the ubiquitous online social networking service of which Accel still holds 10 percent equity; the electronic commerce and couponing website, Groupon; Kosmix, the Internet advertising platform, which was acquired by Walmart; NextG Networks, the consumer electronics developer, which was acquired by Crown Castle for a reported $1 billion; and Trulia, the online residential real estate platform. The Palo Alto firm was founded in 1983 by Arthur Patterson and Jim Swartz and currently manages nearly $12 billion in funds.
Second place went to venerable Greylock Partners (www.greylock.com). The 48-year-old Waltham transplant manages nearly $2 billion. Their 2011–2012 exits were worth an estimated $67.2 billion and included some familiar names such as Instagram, the online photo sharing application, which was acquired in April 2012 by Facebook for $1.01 billion. Greylock was also involved in the Facebook exit as well as the $9.31 billion IPO of professional networking site, LinkedIn. Also included were hardware firewall experts Palo Alto Networks, SaaS HR and payroll solution Workday, and online gaming platform Zynga.
Andreessen Horowitz (www.a16z.com) came in third with $60.3 billion in exit valuations. It is a $2.5 billion venture capital firm that was launched on July 6, 2009, by Marc Andreesen and Ben Horowitz. Its 2011–2012 exits of note were Instagram, Facebook, and Skype, the voice and video conferencing application that was acquired by Microsoft in May, 2011, for $8.5 billion.
All of the Top 10 VC firms honored at this gala have offices in the Silicon Valley area, and many people believe that that is the only place where one will find the serious venture capitalists. That simply isn’t true. There are many active and dynamic venture capital firms located around the country.
Harbert Venture Partners (www.harbert.net/) of Birmingham, Alabama, has over $200 million in committed capital and recently exited Agility Healthcare Solutions in a 2008 acquisition by GE.
Highway 12 Ventures (www.highway12ventures.com) is in Boise, Idaho. The VC firm was co-founded in 2000 by Mark Solon after he left Atlantic Capital Group in Boston. Highway 12 focuses on startups based in the Rocky Mountain region. Solon and company recently celebrated the exit of travel blog platform Everlater, which was acquired by AOL for incorporation into MapQuest.
In the Great Lakes region, Arboretum Ventures (www.arboretumvc.com) is a venture capital firm specializing in the healthcare sector. They invest throughout the United States, but place special emphasis on startups in the Midwest. Jan Garfinkle spent 20 years in senior management positions with bioengineering and medical device companies before she founded Arboretum in 2002. The firm is headquartered in Ann Arbor, Michigan, and currently manages approximately $235 million in capital.
Sadly, while our firm did not make the list of top 10 VC funds in generating absolute dollar IPO/M&A realizations, I am proud to share that we have been a serial investor in the VC space since 1981 and deserve an honorable mention for longevity. Gerken Capital Associates (www.gerkencapital.com) is located in Mill Valley, California, which is, figuratively speaking, light years away from Silicon Valley. We are a Registered Investment Advisor, and our asset management business is dedicated to alternative investments, with a core focus on leading—yes, doing the heavy lifting—early-stage/inflection point investments for both private and micro-cap listed companies. Our alternative investment products include both dedicated funds and separately managed accounts, aka customized accounts. Since our formation in 1989, we have been fortunate to participate in and generate top-quartile investment returns for our investors. Maybe we’ll make the next AlwaysOn top 10 list!
Benno C. Schmidt, Jr., is the son of the co-founder of seminal venture capital firm J.H. Whitney & Co. and an accomplished man in his own right. He is the former president of Yale University and the former dean of Columbia Law School. In 2012, while serving as interim president and CEO of the prestigious Ewing Marion Kauffman Foundation, he oversaw a general review of the state of the venture capital industry as a whole. This review was conducted by Kauffman Quantitative Director, Bill Weeks. The foundation oversees an endowment of $1.89 billion, of which $249 million is invested in various VC funds. These are brand name funds; however, because of confidentiality provisions signed at the time of investment, neither their names nor detailed information about the funds’ performance or structure can be divulged.8 The report was targeted to an audience of institutional investors and their investment committees and trustees. It was conclusive that the traditional model of venture capital investing, which had been developed by the larger, well known firms, was not performing up to expectations. The great problem was that too many limited partners (LPs) invest too much capital in underperforming VC funds on misaligned terms.9
Methods and assumptions that worked in the three decades prior to the mid-1990s are no longer effective or necessarily applicable. This is borne out by a Wall Street Journal article that appeared in the Small Business news on September 19, 2012. The article, written by Deborah Gage, looked at research by Harvard Business School’s Shikhar Ghosh. He found that if one were to change the definition of failure from the industry standard to an investor-relevant definition, the results would be dramatically and significantly altered. Industry associations like the National Venture Capital Association like to say that only about 30 percent to 40 percent of startups have a high potential of failure; meaning the company has to liquidate all assets, with investors losing all of their money.
Ghosh asserts that if the definition of failure were changed to the startup failing to see the projected return on investment, whether that means achieving a specific revenue growth rate or hitting a milestone date to break even on cash flow, the failure rate would climb to more than 95 percent of startups on an annual basis.10
My intention with this chapter is to better educate and build the knowledge base that VC-sector investors need in order to spot the next generation of successful VC funds and investment opportunities. Only by understanding the inner workings of the process and the motivations of the participants at every level can investors realize the returns on investment and the inner sense of positive contribution that can only come from venture capital investing.
Notes
1. Donald T. Valentine, “Early Bay Area Venture Capitalists: Shaping the Economic and Business Landscape,” an oral history conducted by Sally Smith Hughes in 2009. Regional Oral History Office, The Bancroft Library, University of California, Berkeley, 2010, 59–60.
2. S. Blank, “Why the Lean Start-Up Changes Everything,” Harvard Business Review, May 2013.
3. Andrew Pollack, “Venture Capital Loses Its Vigor,” New York Times, October 8, 1989.
4. PricewaterhouseCoopers, “MoneyTree™ Report: Historical Trend Data,” May 28, 2013.
5. http://aonetwork.com/aboutao/.
6. http://aonetwork.com/announcing-the-top-10-vc-firms-of-2012/.
7. “The Goliaths: The Fate of Large Firms Helps Explain Economic Volatility,” The Economist, June 22, 2013.
8. D. Mulcahy, B. Weeks, and H. Bradley, We Have Met The Enemy . . . And He Is Us: Lessons from Twenty Years of the Kauffman Foundation’s Investments in Venture Capital Funds and the Triumph of Hope over Experience (Kansas City, MO: Ewing Marion Kauffman Foundation, 2012), 2.
9. Ibid., 6.
10. D. Gage, “The Venture Capital Secret: 3 Out of 4 Start-Ups Fail,” Wall Street Journal, September 19, 2012.