Venture capital is a class of long-term private equity funding that emerged after World War II and has become a global financial force – to the tune of tens of billions of dollars – for funding the commercialization of a wide variety of innovative products and services that we take for granted today.
Roughly one-third of the total market value of NASDAQ is in computer and communication stocks; many of these companies, such as Google, Intel, Oracle, PeopleSoft, BEA Systems, Symantec, Adobe, eBay, Amazon, and Cisco, were venture capital-funded. Despite this, we claim that the venture capital industry as it exists today does not foster innovation.
This is based on our review of the numbers. For some time, there has been limited VC funding for significant innovation. In April, 2005, Michael Weingarten and I co-authored an article for IEEE Spectrum where we reviewed 1,303 electronic high tech IPOs from 1993 to 2002 and rank-ordered the level of technology innovation on a scale from 1 to 5, with 1 being a significant disruptive technology. Only three percent of all IPOs met this criterion. The great majority of IPOs did not involve profoundly new technologies.
Despite the fact that most startups in that "golden age" of VC funding were not that innovative, the market rewarded VCs willing to fund startups with disproportionately high return, making it at least possible to fund innovation. Over a 10 to 20 year time horizon early/seed stage VC funds outperformed balanced and later-stage funds by up to four times, and public equities by even more. There was a reward for investing in new companies with new ideas.
Despite this, the proportion of VC funding for new startups has been declining steadily since 1995, and now is no greater in absolute terms than the levels seen in 1995. In addition, the most recent one, three, and five-year VC investment returns indicate that early stage funds since 2002 have been lagging balanced and late-stage funds by a substantial margin.
What’s going on? For one thing, having experienced lots of good startups dying during the high tech nuclear winter of 2002-2005, the private equity market has become extremely risk-averse. Valuations for Series B/C/D rounds no longer sell at step-ups. They frequently sell at flat levels or even step-downs. Series A investors who don’t invest their pro capita shares in the later rounds typically find that their investments are washed out by converting to common.
As a result, even VCs willing to invest in Series A rounds must reserve most of their capital for later rounds. In other words, in today’s environment, one cannot be an early stage fund. To survive, you must be balanced.
Another factor is the sheer size of A-list VC funds and the need to find investment homes for billions of dollars of committed capital; we are told that 50 or so of the 700 odd VC funds return half the the total returns of all VC funds. It’s hard to do this investing $2 to 5 million in Series A rounds, but a lot easier to invest $20 to $50 million in later rounds. So the very success of some of the A list VCs in raising capital inexorably pushes them into looking more like LBO funds than true VCs.
Net-net, we’re not that sanguine about VCs as a robust source of innovation. Even in the good old days, there was less VC-funded innovation than one might believe, and now the cash engine has moved to late stage funding. What is the lesson for entrepreneurs with good ideas? They will need to figure out alternative ways to make it to the expansion phase, when capital becomes broadly available.
Stuck is co-founder and managing director of Signal Lake, an early-stage private equity venture fund with offices in Westport, CT, and Boston, MA. He worked with Bell Laboratories in Murray Hill from 1972 to 1984, before striking out on his own. From 1984-1998, he was an independent consultant, involved with more than 450 client engagements and $60 billion in capital placements. He holds bachelor’s and doctoral degrees in electrical engineering from MIT.