Status of Venture Capital Sector, and what’s needed for the VC model to work

Published in the Irish Times in my column of April 29th,  2013.

Venture capital investment in the US has just had its worst quarter in the last two and half years, according to a report this month from Dow Jones VentureSource . Between last January and March, 752 venture capital investments were made across the US, with a total of approximately $6B invested. This represents an 11% decrease in the number of deals, and a 12% decrease in the total invested, relative to the same quarter of 2012.

For those unfamiliar with the venture capital investment model, it may be helpful to give a brief precis. A start-up company is often funded in its early days by its founders, friends and family. Sometimes ‘angel’ investors will join as further shareholders: these are relatively wealthy individuals, who have successfully worked in particular industry sectors and have their own money to re-invest. Usually, the total amount of funding raised in this early stage of a company will be less than $2M. For 2012 in the US, the recent Halo report by Silicon Valley Bank, CB Insights and the Angel Resource Institute showed that the median angel financing was about $600K, and likewise for the total early stage financing, about $1.5M.

The first financing usually suffices to allow the founders to build a working prototype of their innovation, and perhaps undertake early testing of its acceptance in the market. At this point, the company may raise venture capital by selling further shares in the company, and perhaps over several financing rounds. The first round provides capital to move the innovation beyond a prototype to a real and commercially acceptable product. The second and any subsequent rounds are intended to increase the company’s customer base and market share, frequently worldwide. The financing provided by each round usually lasts for about a year, and the amounts raised over series of rounds usually increase. The total amount raised over multiple rounds varies widely across companies, and over several years may run from a few millions to hundreds of millions of dollars.

Once a company has a consistent track record of market growth, venture investments are usually recouped either by selling the company to an established multinational, or by floating the company on a stock exchange. Venture capitalists naturally expect a return on their investment. Two or three times the total investment are usually considered a reasonable return, but much higher returns occasionally result. Elevation Partners, in which U2’s Bono is in investor, reportedly made approximately $160M for those of its shares which it sold at the Facebook flotation last year, and for which it had originally paid about $22M.

If venture capital investment decreases, then clearly it becomes more challenging for start-up companies to raise risk capital. Perhaps the most significant indicator in the Dow Jones VentureSource report was the dramatic fall in company valuations. At each investment round, a value for company is negotiated between the parties involved before the new money is invested – this is the ‘pre-money’ valuation. VentureSource reported that the median pre-money valuations fell to just $6M during January to March, down from 29M$ in the prior quarter – the first time that this median has dropped below 10M$ for several years. If the amount of venture investment is falling; if the number of companies successfully raising funds is falling, and if the values placed on these companies are falling, then clearly the venture capital industry is currently much more cautious than usual with new investments.

The finance which venture capitalists invest typically originates from pension funds and other larger investment funds. Venture capitalists raise money from these funds, invest into high-risk but potentially high-return companies, and ultimately share the profits back to their own investors. VentureSource reported that venture funds raised $4.2B in new funds in the last quarter, a 65% increase on the prior quarter, and with a median raise of $140M per fund. Thus it would appear that although the venture industry is being more cautious than usual with investments, it is nevertheless managing to raise new funds for further investments.

What of the situation in Ireland ? The UK based Unquote analysts report that venture activity in the UK and Ireland reached its lowest point in five years, during January to March. The Irish Venture Capital Association have yet to publish their quarterly industry results for January to March, but for the full year 2012 reported that the total amount invested in Ireland was about €270M, which is approximately the same as the previous year. However the number of companies that raised funds in 2012 was up 18% to 159, compared to 2011. Thus the average amount raised by any single company in Ireland has fallen.

Our own Government clearly views a healthy venture capital sector as an important pillar of its Action Plan for Jobs. It has announced a €175M exchequer catalysis for seed and venture funding. Nevertheless, the recent drop in activity in the sector illustrates that for successful venture capital activity, the key factor is not the quantity of venture capital available but rather the returns generated when that capital is deployed. If venture capitalists do not believe that they can generate reasonable returns from the money which they have available, then they will not necessarily invest. A healthy pool of start-ups in which to potentially invest is thus insufficient. There must also be healthy opportunities to recoup investments, through acquisitions of companies and stock market flotations.

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About chrisjhorn

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2 Responses to Status of Venture Capital Sector, and what’s needed for the VC model to work

  1. cpuguy says:

    The VC sector is broken permanently.

    The only people making money are opportunists who are picking up deals when the initial investors can’t follow their money.

    Giving the money to traditional VCs is a waste of time and will not generate returns.

    http://thenextweb.com/insider/2012/05/07/kauffman-foundation-the-venture-capital-model-is-broken/

    My own view is that life is short and time in short supply.

    The biggest problem as an entrepreneur is that you only have so many ideas in you and it is better to fail quickly and move on to the next idea

    For this reason I believe the crowdsourcing model to be superior in that it removes all of the artificial hoops of building channels to market over years and allows the entrepreneur to deal directly with alpha customers

    If the idea doesn’t fly you don’t get funded, simple as that

  2. cpuguy says:

    From the Kaufmann report

    Only twenty of 100 venture funds generated returns that beat a public-market equivalent by more than 3 percent annually, and half of those began investing prior to 1995.

    The majority of funds—sixty-two out of 100—failed to exceed returns available from the public markets, after fees and carry were paid

    In summary they’re saying the govt can kiss their €175M goodbye

    http://www.kauffman.org/uploadedFiles/vc-enemy-is-us-report.pdf

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