Tucked away on Pier 33 on San Francisco bay, KPG Ventures is among the many small companies in the area routinely eclipsed by the large venture capitalists (VCs) on Sand Hill Road. KPG makes seed-stage investments in start-ups, and had raised its second fund of $20 million in October last year. Partner David Hills, who joined the company at the same time, is as busy as ever in his career. He reads 15 business plans a week, and has made four investments already this year — three of them in new companies. The recession does not bother him and, in fact, does excite him as an investor. “I have been through five recessions, and they are always a good time to invest.”If you talk to VCs or entrepreneurs in the US, or if you attend conferences on entrepreneurship, it is sometimes difficult to feel the world is in the throes of a recession. Mark Cannice, associate professor of entrepreneurship at the University of San Francisco, does a study of VC confidence every quarter here, based on what VCs think of the investment environment over the next 18 months. The index of this confidence has been steadily declining in the Valley for the past five quarters. It rose again for the first time in the first quarter of this year. He has also been tracking the VC confidence in China, where it did not drop in the previous quarter. Cannice has also found an interesting positive correlation between VC confidence and the IPO market. “There is now an expectation of a recovery in the venture environment,” says Cannice.
The recent news about the VC industry has been very bad. The amount of VC money invested in companies fell significantly in the first quarter of this year all over the world. In the US, it was down 47 per cent in the first quarter, according to the MoneyTree report from PriceWaterhouseCoopers (see ‘Hitting A New Low’ on page 30). VCs invested 50 per cent less in international markets (Europe, Israel, India and China) as well in the first quarter, according to Dow Jones VentureSource. In the Silicon Valley, the drop was 43 per cent, and that too because of a decline of 95 per cent in investments in clean tech. Entrepreneurs are, however, as active as ever. “Entrepreneurs are blind to economic conditions,” says Brent Ahrens, general partner at Canaan Partners. “You cannot stop them.” Many VCs too like investing during a recession. “It keeps the noise out of the system,” says Vish Mishra, venture director of Clearstone Venture Partners.
Entrepreneurs are particularly active in areas that are VCs’ current favourites: consumer internet, software, healthcare and life sciences, and clean tech. VCs such as KPG are a vital cog in the entrepreneurial machinery in the Silicon Valley, as they invest in early stages and thus help many start-ups get off the ground. KPG’s recent investments include the National Payment Card Association (NPCA), Lexy and Wowd. NPCA has a technology that eliminates credit card transaction fees. Lexy provides audio content on demand on any device. Wowd, in its early stages now, is developing a platform that would help one find the best content online. Started in 2006, KPG has made 25 investments in three years. It has seen two exits last year. Hills says that as an early-stage investor, he is always on the lookout for disruptive technologies, and consumer internet — where his expertise lies — is always a good place to look.
Consumer internet is attracting the attention of entrepreneurs and VCs for several reasons. It offers a myriad opportunities in terms of technologies and business models. It also provides the opportunity to be capital-efficient. So both the investments and exits in this space are marked by smaller deals — investments are less than $10 million, and exits usually less than $50 million and often less than $25 million. It also offers an entrepreneur the opportunity to exit even before a large VC investment.
Technology is still in a state of flux on the internet. Web 2.0 companies themselves are in their early stages, and many new start-ups are now transitioning to Web 3.0, and are at a stage known as Web 2.5. New search companies offer consumers and advertisers more focused content and services. And the mobile device, led by the iPhone, is providing a new medium for the advertisers. Not surprisingly, a report recently published by the Seattle-based investment bank Cascadia Capital identifies social media and mobile applications as the areas where entrepreneurs are most likely to make money.
The fondness of the consumer for the virtual world is inexorable— entertainment is cheap. Spending hours on a video game, for example, is much cheaper than going out for a movie. In a June 2008 study, the specialised market research company DFC Intelligence predicted the global video game market to reach $57 billion at the end of this year. It is also a sector that is least affected by the recession, and is spawning new companies. For example, a deal that caught attention in the Silicon Valley this month was the $4.5-million funding of Booyah by Kleiner Perkins Caufield & Buyers. Very little is known about Booyah, except that it is founded by some gaming industry veterans and that it promises a combination of immersive experience, social media and iPhone and iPod touch.
The gaming market is undergoing a shift in at least three aspects. First, the definition of a game itself is changing as more and more people are shifting from console-based to browser-based games. Second, the distribution model is changing. Earlier they were shrink-wrapped and sold through traditional channels; now an increasing number is being downloaded directly. Thirdly, the gaming industry is shifting from an upfront payment model to a subscription model. “The next three years will see more changes in the gaming industry than in the past 20 years,” says John Borchers, general partner at the VC firm Crescendo Ventures. Gaming is thus a big opportunity for start-ups.
The gaming and consumer internet industries go in close conjunction — and often overlap — with the media and entertainment sector, another area under the VC radar now. The print media is going through a difficult phase in developed markets and may never recover, but the digital media is in the early stages of its evolution, and attracting entrepreneurs and VCs. In particular, the movie industry is adapting technology in a big way. “The merger of Hollywood and technology has only started,” says Steve Bengston, managing director of PriceWaterhouseCoopers Emerging Company Services Group, which produces the MoneyTree report.
While new areas such as these come up, old areas such as enterprise software have ceased to interest VCs. However, VCs are still interested in certain kinds of software. Prominent among them are SaaS (software as a service), cloud computing and virtualisation, and the semantic Web. SaaS, in particular, is attracting attention as a good way. “We like (in SaaS) the ability to lower costs, target the small-and medium-sized businesses, and to push out software releases seamlessly through the internet,” says Vispi Daver, partner of Sierra Ventures.
Down, But Not Out
Outside IT, and probably overlapping with it, are the sectors that are still the hot favourites of VCs — clean tech, healthcare and life sciences. For the past three years, clean tech has been attracting large investments from the VCs (see ‘The Holy Grail Called Clean Tech’, BW, 23 March 2009). The sector has seen the steepest fall in investments in the first quarter of this year, but VCs are still upbeat on the sector as it is expected to grow continuously for decades.
One of the biggest problems of the sector is that some companies require large amounts of money; a start-up may require hundreds of millions of dollars in several rounds of funding. VCs are no longer keen to fund such companies. But many of them have already invested considerable amounts of money, and would like to see returns on the investments. Since all VCs are keeping aside money to invest in their portfolio companies — one reason why total investments have come down — we could see more investments in clean tech in the future after a lull.
One associates the word clean tech usually with a firm that is developing the next-generation solar technology or a new biofuel. However, it is a large area that is as much concerned with energy efficiency as it is on new and renewable sources of energy. Innovations such as a new software system to increase efficiency or a power management chip fall under this sector, and neither requires enormous capital. Large projects, however, may need to look for debt financing.
Like clean tech, the healthcare and life sciences sectors have been the hot favourites of VCs for a while. The pharma industry in the West has traditionally been very profitable. The sector becomes more attractive as the population in developed countries starts ageing. Despite a high failure rate, the life sciences sector is attracting firms developing drugs for cancer, and cardiovascular and neurological diseases. In fact, the declining new drug pipeline of large companies is seen as an opportunity for smaller players, who may not have the capacity to take their innovations to the market. Medical devices and diagnostics are also attracting attention.
Two weeks ago, in one of the largest rounds of VC funding recently, the New Jersey-based VaxInnate Corporation raised $30 million from several VCs to develop vaccines for various diseases, including influenza. It is developing a swine flu vaccine that will be available for testing in a few weeks. While the biotech funding dropped significantly in the first quarter of this year, well-known clusters such as the Bay Area and Boston held out better. With US President Barack Obama keen on healthcare reform, the sector is likely to attract large investments.
While these areas interest VCs the world over, there are specific technology areas in specific geographies that interest them. In India, for example, education and infrastructure are hot areas. And mobile applications, one area where Indian firms can develop globally innovative technologies. “There are plenty of opportunities in mobile applications for Indian companies, but it is not easy either,” says Mohan Kumar, executive director, India, of the Silicon Valley firm Norwest Venture Partners.
Going Small Is The Way Ahead
As entrepreneurs try their best to seek VCs for financing new companies, the VC companies themselves are undergoing a big change. On the one hand, they have not been raising funds. According to the National Venture Capital Association in the US, 40 funds raised $4.3 billion in the first quarter of 2009, compared to $3.5 billion in the last quarter of 2008. However, it represented a 39 per cent drop compared to the same period last year. The number of funds that raised money was the smallest since the third quarter of 2003.
The Valley, like many other places, is beginning to be filled with “VCs walking dead”, a jargon for firms that continue to be in business but with no capacity to make fresh investments. The returns for VCs have also declined over the years. However, many VCs and entrepreneurs also feel that it is a period of structural change in the industry, including the nature of investments. So we may see the end of an era where VCs used to invest a hundred million dollars in a single deal, and the beginning of an era where they invest tens of million dollars in a large number of companies.
One could argue that VCs have been raising a lot of money in recent times, and thus did not need to do so this year. More worrying for the VCs is the lack of exit opportunities. The US saw the first zero-IPO quarter after a long time. In the Silicon Valley, the number of public companies has been declining every year for the past eight years and now stands at 261, compared to 315 in 1994 (the Valley newspaper San Jose Mercury News has been keeping track since then). It shows a change in how VCs exit companies: from IPOs to mergers and acquisitions. VCs say that two-thirds of the exits are now through mergers and acquisitions.
The VC industry is generally cyclical: it has seen five-six cycles so far. However, the present events show a far deeper trend than a business cycle. The tech industry is maturing and is thus slowing down. It may no longer support billion-dollar VC-backed companies. VCs may thus have to look at building companies of a few hundred million dollars rather than billions of dollars. Huge returns may no longer be possible, with occasional exceptions, unless a new technology wave happens.
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