Is the VC model broken?

I consider myself to be only a part-time student observer of the venture capital world, largely because I have a full-time job that requires me to focus on one technology startup, and getting its product out into the market. However, I am intrigued by the institutional energy that VCs bring to early stage ventures. VCs are not always useful to early stage ventures (for example, my company is so far not VC funded), but when they understand the markets and have experience in them, they can bring quite a useful support system with them to take companies to success.

However, all has not been well recently in the VC community, at least as reported in the publications I try to follow. Howard Anderson, a prominent VC, partner at Battery Ventures, and then founder of YankeeTek Ventures was among the first people to declare that the VC model was broken. Or at least that the current market was not favorable to VCs. Now there is news that Sevin Rosen Funds has also indefinitely postponed fund-raising for its tenth fund, and in a letter to the LPs they have argued that the exit environment for VC-backed companies has fundamentally changed for the worse.

Well, is that really true? Is the VC model broken? And if yes, what are all the VCs doing, especially those who are pumping millions into the cleantech sector, some without even fully understanding the technologies or the markets that they are invested in?

A note by Dan Primack in the PE Wire today was very useful in clearing up some of my thoughts:

Please forgive my impertinence, but SRF is wrong in its premise. The VC model isn’t severely damaged. It’s the VC firms themselves.

 

I spent 40 minutes on the phone last night with Steve Dow, a general partner with SRF for more than two decades. He elaborated on a letter sent last Friday to prospective limited partners, in which SRF argued that the exit environment for VC-backed companies has fundamentally changed for the worse. Part of the blame will sound familiar to those who read last week’s discussion with MPM Capital’s Paul Brooke, in that VC-backed IPOs have been hindered by (A) SOX-required separations between I-bankers and analysts and (B) Impatient hedge funds becoming larger IPO buyers than more patient mutual funds.

 

Dow also does not believe that the M&A market can adequately make up for IPO market failures, because VCs have created a buyer’s market by over-funding just about every sector. Sure there are a few homeruns, but a surprisingly high number of M&A deals actually are $1 dispositions that don’t get included in the quarterly “disclosed value” data. And, without a viable exit market, VCs are setting themselves up for a second-straight decade of cash-on-cash losses (which could begin in 2008). SRF doesn’t want to be a party to that.

 

All good points, and ones that have been raised previously by Battery Ventures founder Howard Anderson, Matrix Partners founder Paul Ferri and Greylock partner Bill Hellman. The key difference, however, is that both Matrix and Greylock keep raising new funds, while Anderson continues to invest in them as an indivudal limited partner (even though he officially said “Goodbye to Venture Capital,” after shuttering YankeeTek Ventures).

 

Why? Because Anderson, et all realize that a strict early-stage discipline – with just a few opportunistic expansion plays — can still produce strong results. Even Dow acknowledges that some of SRF’s best hits lately have come from companies that it seeded, not from ones it jumped into bed with at Series B or Series C. Too many firms have spent the past few years rushing downstream in the name of risk aversion, without realizing that the water is actually safer up above. These shops might get shaken out when all is said and done, but that’s more on them than on the VC model itself (which they abandoned).

 

The exit environment is undoubtedly tough, but early-stage investing means that you don’t need your average exits to be quite so enormous (since your starting valuations are lower). This opens up plenty of alternative exit avenues, including reverse mergers with public shells, AIM-listings and sales to small-cap or mid-cap buyout firms. Marry a few of these with one or two homeruns – which VC funds of any era have required for success – and you’ve produced strong ROI for your limited partners.

 

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