Is the Venture Model Really Broken?
Proclaiming the venture model broken is in vogue. The lingering aftereffects of the Internet bubble have cast a shadow over the industry for a decade now; and while venture capital has consistently outperformed most equity asset classes for years, recent returns have not lived up to historical norms. Despite the grim headlines, there are signs of success all around us that prove that the venture model is far from broken.
Venture capital is, at its core, about helping to build innovative, high-growth, market leading businesses. The easiest way to measure success is to look at the exit market for venture-backed companies.
A sampling of transactions since September of 2009 in Massachusetts alone:
• Quattro Wireless was acquired by Apple for $275M
• Gomez was acquired by Compuware for $295M
• Nova Analytics was acquired by ITT for $392M
• E Ink was acquired by Prime View International for $400M
• Gloucester Pharmaceuticals was acquired by Celgene for $640M
• Ironwood Pharmaceuticals had a post-IPO market cap of $1.1B
• A123Systems had a post-IPO market cap of $1.3B
With all of this exit activity and value creation, it’s hard to understand why industry returns have lagged in recent years. The underlying data gives a good sense of the dynamics. The insights below are based on data from Thomson ONE.
There are some clear positive signals:
1. Exit volume is healthy. The IPO market has functioned on an intermittent basis in recent years, but M&A volume for venture-backed companies has taken up the slack and become the predominant exit path. When combining M&A and IPO exits, the activity has actually been fairly consistent over the years: about 300-500 per year since the mid-’90s.
2. Acquisition valuations are healthy. The average reported acquisition value for a venture-backed company hovered around $60M in the mid to late ’90s, and (after a spike in 1999 and 2000) has been averaging far more than $100M in the last few years, including 2009. Pre-IPO valuations for venture-backed companies have similarly increased over the years from around $150M in the mid ’90s to around $400M in the last few years. The increase in average exit valuations confirms that substantial equity value can be created within successful venture-backed companies.
There are negative signals too, of course, including:
1. Too many companies backed. The substantial increase in the number of companies receiving venture funding has created a glut of companies seeking an exit. In the early ’90s, there were about 1,000 companies backed by venture capital firms each year in the U.S. The late ’90s brought a rapid increase in investment activity that peaked at more than 6,000 companies funded in 2000. That trend has since reversed, and in 2009-2010 the market is tracking to about 2,500 companies per year.
2. Too much capital invested per company. The average capital invested in venture-backed companies acquired in the mid to late ’90s was around $10M – $20M. This has grown to $40M – $50M in recent years (nearly $60M for 2010 M&A exits). Even though exit valuations have risen, the amount of capital deployed prior to exits has climbed even more rapidly.
It’s simple math to see that returns will lag if there are three times more companies chasing the same volume of exits and if the average capital invested in a company is rising more rapidly than exit valuations.
Bursting the Bubble
Many things contributed to the imbalance, but one of the biggest culprits was the massive, bubble-fueled influx of capital into VC funds.
Leading venture firms in the mid-’90s managed funds typically in the range of $100M – $200M, and many of those funds did phenomenally well. With that success came the opportunity to access greater amounts of capital, leading many venture firms to scale their funds to sizes of $1B and beyond.
Predictable consequences resulted:
• Start-ups were encouraged to take more capital than they needed and to spend aggressively in anticipation of potential growth.
• Strong competitive bidding for deals led to inflated pre-money valuations, which left little room for capital appreciation.
• Numerous “me too” companies were funded—all chasing after the same bounded market opportunities.
These factors served to degrade the investment returns of venture funds over the last decade. While weak returns can’t be blamed entirely on the overabundance of capital, the need to put excess capital to work from oversized funds certainly contributed to the problem.
For the firms that continued to embrace a more traditional approach to venture capital with properly sized funds, the results were far more successful. SVB Capital recently published a report analyzing the performance of more than 850 venture funds over the last couple of decades. The study found that a “higher portion of smaller-size funds have achieved significant returns…relative to large funds across most vintage years.”
VC on the Rebound
The venture model isn’t broken; it just failed to scale. Many of the venture firms that formed during the Internet bubble aren’t around today, and many firms with decades of investing are downsizing recently raised funds in an effort to regain the strong returns delivered in the past.
These trends will bring the venture market back into balance, and the venture industry will once again deliver the outsized returns that are expected by institutional investors. Innovation and entrepreneurship continue to accelerate, and venture firms can and will continue to play an important role in bringing that innovation to market. This is especially true in Massachusetts, where the country’s second-most-active cluster of venture capitalists is still counted on to create—and fund—competitive advantage in the local innovation economy.