Start Up World

A Cogent Explanation for the Shrinking VC Industry

Jonathan Aberman — Wed, 26 Aug 2009 16:27:39 GMT

A growing story on the Venture Capital market is the shrinkage of the industry. There is a viewpoint that this is actually a good thing. I don't agree and am currently working on a White Paper to address these issues. But, whether you agree or not, the trend is in place and it will have a significant affect on the availability of early stage capital in particular.

I read a very good explanation of the reasons for the shrinkage of the venture capital industry. It's below and well worth reading.

What Is Really Happening to the Venture Capital Industry?

Abovethecrowd.com. Posted on August 24, 2009. Filed under: Internet, Venture Capital, Web/Tech | Tags: asset allocation, asset management, LBO, VC, Venture, Venture Capital |

Many are speculating that the year two thousand and nine represents a fundamental turning point for the venture capital industry. Some are arguing that the industry is in dire straits after years of poor performance. Others have argued that the math simply does not work for the industry’s current size. Another theory suggests that permanent challenges with the IPO market call into question the fundamental economics of the VC industry. Lastly, some credible authors have suggested that things are so bad that a federal bailout may be in order.

What is really happening in the venture capital industry? It is indeed quite likely that the venture industry is in the process of a very substantial reduction in size, perhaps the first in the history of the industry. However, the specific catalyst for this reduction is not directly related to the issues just mentioned. In order to fully understand what is happening, one must look upstream from the venture capitalists to the source of funds, for that is where the wheels of change are in motion.

Venture capital funds receive the majority of their funds from large pension funds, endowments, and foundations which represent some of the largest pools of capital in the world. This “institutional capital” is typically managed by active fund managers who invest with the objective of earning an optimal return in order to meet the needs of the specific institution and/or to grow the size of their overall fund. These fund managers have one primary tool in their search for optimal returns: deciding which investment categories (referred to as “asset classes”) should receive which percentage of the overall capital allocation. This process is known in the financial field as “asset allocation.”

Asset allocation is the strategy an investor uses to choose specifically how to divide up capital amongst asset classes such as stocks, bonds, international stocks, international bonds, real-estate funds, leveraged buys-outs (LBOs), venture capital, as well as other obscure classes such as timber funds. Some of these asset classes, such as stocks and bonds, are known as “liquid assets,” because these instruments trade on a daily basis on exchanges around the world. For these assets, investors can be quite sure of the exact value of their holdings, as the price is set continuously in the market. Also, if they need to sell, there is a ready market to accept the trade. Illiquid assets, also known as alternative assets, include all the other investment classes that do not trade on a daily exchange. These “private” investments (as compared to “public” liquid investments) are considered higher risk due to their illiquidity, but also are expected to earn a higher return. Some hedge funds are included in alternative assets either because they themselves invest in illiquid investments or because they put strict limitations on the trading capability of the institutional investors, rendering themselves “illiquid”.

Asset allocation is a well-studied area within the field of finance. A prototypical U.S.-based asset allocation model might allocate 25% to U.S. stocks, 30% to U.S. debt, 25% to international equity and debt, and let’s say 20% to all alternative assets. Within alternative assets, LBOs might be 60%, and venture capital could be as low as 10% (of the 20%). As a result, venture capital could be as low as 2% of a institutional fund’s overall capital allocation. Most people fail to realize just how small venture capital is in the overall scheme of things.

Very generally speaking, experts and academicians have considered it “conservative” to have a smaller allocation to all alternative assets reflecting the risks of illiquidity, the inability to ascertain price, and the higher difficulty in analyzing the non-standard vehicles. It is a fairly straightforward, conservative investment approach to favor liquidity and certainty over absolute potential upside (this is the same argument for holding bonds over stocks).

Over the past decade or so, a large number of very influential institutional funds have substantially increased their allocation in alternative assets. In some extreme cases, these investors have taken this allocation from a conservative amount of say 15-20% to well over 50% of their fund. Many people suggest that David Swensen at Yale was the original architect of a strategy to adopt a much higher allocation to alternative assets. Regardless of whether he was the leader or not, several funds simultaneously adopted this higher-risk, higher-return model. (For a more detailed look at how this evolved and why, see Ivy League Schools Learn a Lesson in Liquidity and How Harvard Investing Superstars Crashed. For an even deeper dive including comparative asset allocation models see Tough Lessons for Harvard and Yale.)

Contributing to this dynamic on the field, the early movers to this model were able to post above-average returns.* Also, due to the high disclosure policy of most universities, these above average performances were often touted in press releases. This “public benchmarking” put further pressure on competing fund managers who were not seeing equal returns, which as you might guess, led to them mimicking the same strategy. As a result, alternative assets have grown quite substantially over the past ten years. This is perhaps best seen in the size of the overall LBO market. The included chart shows the money raised in the LBO market over the past 30 years. As you can see, the amount of dollars pouring into this category over the past five years is nothing short of breathtaking.

The market contraction of late 2008 and early 2009 severely compromised the high-alternative asset allocation strategy. The liquid portion of average portfolio contracted as much as 30-40%, which had two resulting impacts. Initially, this resulted in most fund managers having an even higher portion of their funds in illiquid investments. Ironically this was largely an accounting issue. Most likely, the illiquid pieces of their portfolio had declined just as much, but as illiquid investments are not valued on a day-to-day basis, they simply were not properly discounted at this point (over time they “would” and “are” eventually coming down). But with one’s fund already down 30% or so, no one is eager to further decrement the value. Despite that this may have only been an “accounting” issue, it presented a problem nonetheless, as many fund managers have triggers that force them to reallocate capital if they go above or below a certain asset allocation. This is one of those policies that encouraged selling at a point that may be the exact wrong time, contributing to further declines.

A second and more complicated problem also emerged. It turns out that when an institutional investor “invests” in an LBO fund they don’t actually invest the dollars all at once, rather they commit to an investment over time, which is “drawn down” by the LBO manager (venture capital works in the same way, but once again is a much smaller category). As these funds substantially increased their commitment to the LBO category, they were de facto increasing a guaranteed negative cash flow in the future to meet these draw-downs. Now, with portfolios out of balance, and lack of new liquidity events from the M&A and IPO markets, these funds have cash needs (to meet the draw-downs) that are not offset by cash availability. If anything, the universities and endowments these managers represent want more cash now to deal with the difficult overall economic environment.

To meet these new liquidity needs an institutional investor could:

Sell more of it’s liquid securities. This is problematic because it further compromises the target asset allocation.
Try to sell the LBO commitments on the secondary market. As you might suspect the secondary market is extremely depressed. Some have even suggested that due to the forward cash need on an early LBO fund, an institution might have to “pay” to get out of the position, and to encourage someone else take on the future cash commitment.
Default on the commitment. While this does have penalties in most cases, it would not be out of the realm of possibilities for this to occur if the investor has lost faith in the manager, and it is early in the fund (with more cash needs in the future).
Try to raise more capital. Not surprisingly, donations to foundations and universities are down dramatically due to the overall decline in the capital markets. This makes this strategy unlikely.

As you can see, none of these options are overly compelling.

If this is not bad enough, many institutional fund managers and the groups to whom they report (such as a board of trustees) are now second-guessing the high-alternative asset allocation model. As a result, they may desire to return to the more conservative and more traditional asset allocation of 10-20% allocated to alternative assets. Ironically, they are in no position to rebalance their portfolio precisely because they lack incremental liquidity. Think about it this way – it is very easy to shift a portfolio from liquid assets to illiquid. You simply sell positions in highly liquid securities, and buy or commit to illiquid ones. Going the other way is not so simple, as there is no ability to conveniently exit the illiquid positions.

This is a very long explanation, but the punch line is that as these large institutions adjust their portfolios and potentially abandon these more aggressive strategies, the amount of overall capital committed to alternative assets will undoubtedly shrink. As this happens, the VC industry will shrink in kind. How much will it go down? It is very hard to say. It would not be surprising for many of these funds to cut their allocation in the category in half, and as a result, it shouldn’t be surprising for the VC industry to get cut in half also.

One could argue that poor returns in the VC industry is the primary reason the category will shrink and that, as a result, the VC industry could be cut even further – or perhaps even go away. There are two key reasons that this is highly unlikely. First, one of the key tenets of finance theory is the Capital Asset Pricing Model (CAPM). The CAPM model argues that each investment has a risk, measured as Beta, which is correlated with return vs. that of the risk-free return. Venture Capital is obviously a high-Beta investment category. As of August 3rd, 2009, the S&P 500 has a negative 10-year return. As a higher-Beta category, no rational investor could reasonably expect the VC industry as a whole to outperform in a catastrophic overall equity market. In fact, the expectation would be for lower returns than the equity benchmark. This multiplicative correlation with traditional equity markets is the exact same reason that venture capital outperformed traditional equities in the late 1990’s. The bottom line is that no institutional investor should be surprised by the recent below-average performance of the entire category, all things being equal.

The second reason the category will not be abandoned is contrarianism. Most students of financial history have read the famous quote attributed to Warren Buffet, “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” One of the biggest fears of any investor is to abandon an investment at its low point, and then miss the corresponding recovery that would have helped offset previous poor returns. While this mindset will not guarantee the 100-year viability of the venture capital category, it should act as a governor on any mass exodus of the category. The more people that exit, the more the true believers will want to double-down.

So when will this happen? One thing for sure is it will not happen quickly. The VC industry has low barriers to entry and high barriers to exit. Theoretically, a fund raised in 2008, where all the LPs have no plans to commit to their next fund, may still be doing business in 2018. VC funds have long lives, and the point at which they decide to “not continue” is usually when they go to raise a new fund. This would typically be 3-5 years after they raised their last fund, but could be expanded to 5-7 years in a tough market. In some ways the process has already started. Stories are starting to pop up about VC funds that were unable to raise their next fund. Also, some entrepreneurs are starting to discuss favoring VCs of which they can be confident of their longevity. All in all, one should expect a large number of VC firms to call it quits over the next five years.

How should Silicon Valley think about these changes? It is important to realize that there are approximately 900 active VC firms in the U.S. alone. If that number fell to 450, it is not clear that the average Silicon Valley resident would take much notice. Another interesting data point can be found in the NVCA data outlining how much money VCs are investing in startups (as opposed to LP’s committing to VC firms). VC firms invested about $3.7B in the second quarter of 2009. Interestingly, this number is about half of the recent peak of around $8B/quarter. It is also quite similar to the investment level in the mid 1990s, prior to both the Internet bubble, and the rise of the aggressive asset allocation model. So from that perspective, this, meaning the investment level we see right now in Q2 of 2009, may be what it is going to be like in the future.

There are many reasons to believe that a reduction in the size of the VC industry will be healthy for the industry overall and should lead to above average returns in the future. This is not simply because less supply of dollars will give VCs more pricing leverage. We have seen over and over again how excess capital can lead to crowded emerging markets with as many as 5-6 VC backed competitors. Reducing this to 2-3 players will result in less cutthroat behavior and much healthier returns for all companies and entrepreneurs in the market. Additionally, at a stabilized market size of well over $15B a year, there should be plenty of capital to fund the next Microsoft, Ebay, or Google.

Is Seed the New Series A for VCs?

Jonathan Aberman — Tue, 25 Aug 2009 15:27:39 GMT

There are some interesting things coming out of the Valley at the moment. The posting below discusses a viewpoint held by some that SV VCs, at least some of the big ones, are approaching seed investing as a way to develop proprietary deal flow. I am not sure that this activity is increasing per se, or whether it is a new paradigm. But, for the companies that are able to create competition among VCs, the possibility of achieving seed capital funding from them is somewhat possible.

The question from my viewpoint, though, is whether an entrepreneur should really take $500K from a VC instead of bootstrapping. Even with the modifications suggested by the writer below, I am having a hard time thinking why an entrepreneur should do an early round of VC. Think about this carefully.

Seed is the new Series A for VCs

August 24, 2009 | Caine Moss

It shouldn’t come as a surprise to anyone that VCs have, over the past few quarters, been reluctant to put term sheets down on new investments. Most venture folks have instead been preoccupied with tending to their portfolio companies, either ensuring that their most promising companies have enough capital and resources to weather the downturn, or trying to sell off the others.

The statistics bear this out. U.S. venture-backed companies raised $9.28 billion in the first half of 2009, according to VentureSource. That’s 44 percent less than the $16.47 billion raised during the same period in 2008.

It may be too soon to pop the champagne, but the mood in the venture community appears to be slowly improving.

The market is up (the Dow has climbed back to above 9000); cracks are emerging in the tech IPO deep-freeze (with Open Table and Solar Winds having had successful IPOs, and a number of other venture-backed technology companies announcing plans to go public in the near term); and VCs are starting to do deals at an increasing rate (VentureSource cites that the amount of capital invested in the U.S in Q2 2009 rose by 32 percent as compared to Q1 2009).

What is most noteworthy about the recent increase in funding activity is the structural change occurring in the market for early stage investments. In the early part of this decade (after the dotcom boom and subsequent bust), when VCs recommitted to investing in early stage startups, most simply dusted off their Series A term sheets and recommenced investing in the “Series A mold.” Series A deals can vary dramatically, but they often look something like this:

VCs invest $3-5 million of capital for a 33-50 percent post-money ownership stake in the company.
Investors receive a senior liquidation preference on an M&A exit, and will often “participate” with the holders of common stock on the distribution of proceeds beyond their preference, either until all proceeds get distributed or up to some negotiated cap based on a return multiple (e.g., 2x-3x the VC’s initial investment).
Investors enjoy control features such as special voting “block” rights on important corporate actions such as financings and M&A transactions, as well as on operational activities like hiring executives or entering commercial or strategic transactions.
Investors control the Board or at least negotiate for board neutrality (where neither the founders nor the VCs control board voting).
Attendant to the investment are a panoply of additional rights including demand registration rights to compel a company IPO after a period of time, first refusal rights on founder stock transfers and “drag-along” rights (which force founders to vote for a sale of the company under certain circumstances).

As investors dip their toes back into the early stage deal pool following the most recent downturn, however, many are opting for “seed” financings instead of the typical Series A described above.

Seed financings are “priced” like Series A deals, meaning a valuation for the company is set and an ownership stake is taken at the time of the investment. However, seed deals tend to involve much smaller amounts of investment capital than Series A financings: usually somewhere between $500,000 and $2 million. These seed deals are also sometimes called “Series 1” or “Series A-1” financings to distinguish them from Series A financings that follow them.

It used to be that seed financings were investment vehicles reserved principally for investors and “seed stage” VCs with small funds that can only deploy small amounts of capital in any given deal. These days, however, we are seeing big-fund VCs seeding early stage deals with a regularity we haven’t witnessed before. Based on internal private financing data, my firm (Wilson Sonsini Goodrich & Rosati) alone has closed 14 VC seed deals in the four months from March through June 2009.

So why the recent increase in seed funding? I believe there are three reasons.

First, VCs have to deploy capital and, as noted earlier, they’ve been reluctant to do so for the past several quarters. Over this time, however, entrepreneurs haven’t stopped pitching them great ideas, and with the market showing signs of improvement, they are now starting to fund these ideas.

Second, while the desire to deploy capital has re-emerged, VCs are still skittish. They are reluctant to put large amounts of capital at risk, and figure seed deals to be a suitable “low-risk” investment option for them. They can throw $500k at a founder and tell her to prove out a business model. If she doesn’t, then the VC is only out $500k. If she does, then that VC is probably in pole position to lead that founder’s Series A financing a few months later.

Third, for software, Internet services and other IT companies, the cost of innovation is a fraction of what it used to be a decade ago, and entrepreneurs starting these companies require less capital for their businesses.

From an entrepreneur’s perspective, VC seed investing isn’t necessarily a bad thing. After all, some activity is better than no activity. Moreover, investment decisions within the partnerships of these venture firms can be arrived at more quickly and with less friction when only $1 million of investment capital is at stake.

That said, entrepreneurs should be mindful to avoid Series A deal terms when negotiating a Series 1 financing. Many VCs will propose a seed deal using a Series A term sheet (whether by design or mere convenience), and this can end up costing the company much more than it bargained for. Here are some tips for entrepreneurs when negotiating seed deals (with the caveat that each deal is different, and rarely will an entrepreneur get their way in all of these categories):

Don’t give away too much of the company too early. VCs shouldn’t expect more than around 20-40% of a raw start-up when investing seed-stage.
Avoid giving investors more than a 1x liquidation preference, and try to ensure that it is “non participating” (i.e., after the investors’ preference is taken, all remaining proceeds are allocated only to the holders of common stock).
Don’t give investors Series-A-type control rights. A VC should expect to receive one board seat, but not to control the board, following a seed financing. Also, while it is customary to give investors voting “block” rights on financings and on a sale of the company, entrepreneurs should avoid granting voting rights that give VCs blocks on operational matters at this stage.
Keep other “investor rights” to a minimum. For example, try to avoid granting demand registration rights, ROFRs on founder stock transfers or drag-along rights.
Many VCs will want a “super-pro rata” right in seed deals, giving the VC the right to increase its ownership percentage in the next round. This is not necessarily unreasonable, but take care to ensure that in agreeing to super pro-ratas the company is leaving room for a new VC to lead the next round.
Beware of the negative market perception that results when the VC that seeded your company declines to participate in the Series A. This happens. Raise this issue with the seed VC early on to assess the risk of this happening, and always keep your communication channels open with other VCs interested in what you are doing.

Seed is the new Series A for many VCs, and this is fine. Just make sure that you, as an entrepreneur looking to raise capital, understand what seed financings are, and also what they are not.

The Funded Publishes Series A Terms -- Are They Market?

Jonathan Aberman — Mon, 24 Aug 2009 21:59:43 GMT

Today, Tech Crunch published a very interesting post on the Funded's proposed terms for a Series A financing. It is interesting reading, particularly with respect to Participating Preferred Stock. It is good reading for any entrepreneur who is going to look to raise money.

I do wonder, however, if the Funded really gets the realities of supply and demand for the larger entrepreneurial economy. By suggesting that their terms should be standard builds for most entrepreneurs, I am afraid, an unreal expectation. The Funded's terms are, in my experience, very entrepreneur friendly and unlikely to represent what an entrepreneur would receive, particularly in this difficult financing market.

The reality continues to be that if you need a Series A deal the money is hard to get and the terms will be difficult.

What is useful here is to see that if you have a deal that is hotly contested, whether an Angel Deal (note the link to the Y Combinator forms) or a Series A VC there are now terms out there which are "standard" and can be used by the entrepreneur to keep VCs and Angels honest.

The Funded Publishes Ideal First Round Term Sheet

by Michael Arrington on August 23, 2009

Adeo Ressi, founder of The Funded, a site where people rate venture capitalists and the Founder Institute, an incubator of sorts, has long ranted about what he calls “the atrocities of investors.”

Now, a lot of people, including prominent angel investors and venture capitalists, are starting to listen to him. Tomorrow Ressi will announce a new, basic term sheet for use by investors and founders. The goal is to protect founders and reduce legal fees, which average $50,000 or more per venture round.

Earlier this month angel investor and Hunch founder Chris Dixon wrote a blog post requesting that venture capitalists start to use standard, founder-friendly deal terms for venture rounds. He set out the terms he proposed in that post. Said Dixon: “My preference is to keep all terms as above and only negotiate over 2 things - valuation and amount raised.”

Investor Fred Wilson agreed with Dixon. In a post titled The Ideal First Round Term Sheet, Wilson said: “Chris laid out the ideal set of first round terms and I agree with them. What’s interesting is that Chris is a serial entrepreneur and I am a VC. And yet we agree on what the term sheet should say. That’s progress.”

Now Ressi has published an actual term sheet that investors and founders can use that reflect those basic terms. The term sheet is here, and is also embedded below.

The key terms include the elimination of participation with preferred stock, a 1x liquidation preference, and single trigger vesting acceleration on acquisition.

What this means: VCs try to increase returns by asking for large liquidation preferences. A 3x liquidation preference, for example, means the VC gets to take out 3 times his/her initial investment before founders and employees get anything. So if you raise $10 million at a 3x liquidation preference and then sell for $25 million, founders and emplyees get nothing. With a 1x liquidation preference, the VC is only able to get the initial investment back before others take their share.

More importantly, participation is eliminated. VCs often ask for this. What it means: Participation rights means the VC gets to take a pro-rata share of money in a sale even after the liquidity preference. With it eliminated, the VC has to choose - either take their 1x liquidation preference or convert and share with common pro rata. For any large deal, they will convert and be treated like the founders and employees.

The single trigger vesting provision is also important. VCs like to keep their founders locked up so they have to keep working even after an acquisition. The provision, called double-trigger acceleration, usually requires a sale followed by a firing without cause. VCs want this because it’s easier to sell a company if the founders are locked into staying on. Founders don’t like it because it sucks.

Most importantly, though, is the cost savings. VCs really need to move to a deal structure that doesn’t burn up so much lawyer time negotiating provisions that are almost never used. I could write 10 posts on how this nonsense works, and may in the future. A term sheet like this can be closed with $10k - $20k in legal fees. When you’re only raising $1 million, that’s a big deal.

Also see the Y Combinator investment docs that they published a year ago. Their documents are ideal for small angel rounds, and strip out a lot of the stuff covered in Adeo’s term sheet here. There are some terms included below that are needed in larger deals and which aren’t absurd for VCs to ask for. So both documents are highly relevant. Start with the Y Combinator docs for your first early angel round, and move to Adeo’s document in your first real round of venture capital.

We’ll highlight VCs that we talk to who indicate that they are willing to negotiate deals under these terms.

FFI Plain Preferred Term Sheet -

VC Funds Headed for More Regulation?

Jonathan Aberman — Sat, 08 Aug 2009 19:33:58 GMT

One of the more interesting issues facing the venture industry has been whether it was going to be swept into greater regulation as a result of the Madoff fiasco and other high profile frauds relating to blind pool investments. For those of you who are in the know, blind pool investments are when a fund manager aggregates money from wealthy individuals and institutions and then invests the money with a high degree of personal independence and very little disclosure or accountability to the government. The Hedge Fund, Private Equity and Venture Capital industry all rely on a very loose regulatory treatment, which has existed since the mid 1930s. The general regulatory philosophy has been that so long as you marketed these investments to the wealthy there was little need for government intervention -- the wealthy could look after themselves.

But, that loop hole in the securities laws allowed for some unbelievably bad behavior on the part of some fund managers. It also has allowed the creation of massive concentrations of capital in the hands of a small number of private and secretive funds that roil financial markets. You might remember last summer's oil spike? Many put that at the feet of speculative trading fueled by these concentrations of capital.

Now the government wants to regulate these concentrations of capital, which are largely organized as hedge funds. The venture industry has been arguing that it should be treated differently. It appears that this differentiation is not working and venture capital funds are going to be subject to additional regulation. The article below discusses some of the implications of this.

If these regulations are applied as described they will undoubtedly have an adverse affect on the venture industry and likely cause funds to become larger still. The reason being that regulatory compliance will cost money and require more overhead to comply with. This will make it very hard for a medium sized venture firm (say $100 to $200 million) to maintain current compensation for investment professionals. The natural reaction will be for funds to get bigger. This will, of course, make it harder for them to make small, early stage investments.

So, if you are worried about the growing gap in early stage financings, these regulatory changes are extremely bad news.

From the Wall Street Journal, August 7, 2009 -- Review and Comment

Here’s a stumper: In the Treasury financial reform proposal, who comes in for more regulatory retooling: Fannie Mae, or your average 14-man venture capital shop? If you said venture capital, you understand why one of America’s greatest competitive advantages is now at risk in Washington.

As part of their regulatory redesign, Team Obama and Congress still don’t have a plan for reforming the giant taxpayer-backed institutions like Fannie that caused the credit crisis. Yet they’re moving to rewrite the rules for investing in tiny technology companies that had nothing to do with the meltdown. Under the proposed rules, venture firms will be declared systemic risks until they can prove themselves innocent. The typical venture capital (VC) firm has nine principals plus five support staff and doesn't’t use leverage. Yet Treasury Secretary Timothy Geithner wants VCs to be regulated as investment advisers by the Securities and Exchange Commission.

This means the firms will be required to send heaps of data to the SEC and be subject to unannounced examinations that can last days, weeks or months. The firms will also have to appoint a chief compliance officer, create written procedures to comply with the various securities laws, and follow new regulations on record-keeping, privacy of client information, marketing, and so on. Information gathered by the SEC will then be analyzed by the Federal Reserve or some other systemic-risk regulator to decide if there is a hidden danger buried deep inside these companies. Never mind that VCs don’t trade derivatives, or much else for that matter.

Venture firms were invented in the 1960s to fund the California semiconductor companies that would change the world but needed investors willing and able to take a flying leap into the unknown. Under the Silicon Valley model that has since spread around the country, experienced technology executives at VC firms inject advice and cash into young businesses.

Neither too big nor too interconnected to get a taxpayer bailout, VCs are nonetheless critical to America’s ability to stage an economic rebound. While early-stage venture investments are tiny by Wall Street standards—often $3 million or less—they are a big part of the reason the United States has for decades grown faster than other industrialized economies. Companies once backed with venture capital now generate more than 20% of U.S. gross domestic product. Looking forward, will America be better off if venture investors are justifying themselves to Washington regulators, or evaluating new software platforms?

The entire VC industry invested a total of $28 billion in start-ups last year. To put this number in systemic perspective, that’s less than half the amount Bear Stearns was borrowing every night before its collapse. Unlike a Bear Stearns or Lehman, venture capitalists aren't’t borrowing the money they invest in small businesses. There is no risk beyond that borne by the investors and the companies they fund, and the risk isn't’t very big. All U.S. venture funds combined add up to less than $200 billion. Mutual fund companies like Vanguard and Fidelity each manage more than $1 trillion.

Treasury’s position is that if it doesn't’t drag VC firms into the bureaucratic swamp, then high-rolling hedge funds playing with borrowed money will present themselves as venture funds to avoid regulation. Yet any firm calling itself a VC is already subject to the antifraud provisions of federal securities laws. VCs also have to describe the funds they raise in annual Form D filings with the SEC. Washington could let the SEC address any concerns simply by adding three questions to the form: Do you use leverage? Do you trade equities or debt? Do you trade derivatives? Anyone answering “no” to all three would be free to go find the next Microsoft.

The reality is that the venture industry is already shrinking, for market and political reasons. Too many funds chasing too few ideas after the dot-com boom have limited returns. And thanks in part to earlier VC investments, cheap tech tools are allowing some Web entrepreneurs to bootstrap their businesses without having to sell pieces to VCs.

As for the politics, Sarbanes-Oxley compliance costs, Eliot Spitzer’s stock-analyst settlement and the economic downturn have created an historic drought in venture-backed companies going public. This week Dow Jones VentureWire warned readers not to expect more such companies going public “anytime soon.” It boggles the mind that Washington would enact new policies sure to prolong this drought and strike at the heart of American innovation.

Fenwick & West Notes Falling Valuations

Jonathan Aberman — Sat, 08 Aug 2009 04:42:56 GMT

Below is an article from the NY Times. My old law firm, Fenwick & West is seeing a dramatic change in the valuations in venture financings in Silicon Valley. Last year at this time, most financings that occured were up valuations. This means, of course, that for the limited sample of companies that received second (and later) rounds of venture capital, the valuations in these rounds stepped up from earlier rounds. Since this data did not include companies that didn't require or couldn't receive another round, you would expect that the sample woudl show a majority of "up rounds."

That the data shows that down rounds are prevalent means that for even the most desirable companies (those that are able to obtain subsequent rounds) valuations are falling. One of two things is happening -- either valuations are generally down, or the more desirable companies are holding off on raising capital (i.e, the ones that would be up rounds) because the market is perceived as "bad."

My experience continues to show me that experienced entreprneuers are doing everything possible to avoid raising venture capital in the current environment. I continue to believe that the best path forward for entrepreneurs is to approach venture capital as a financing tool that has merit, but only as part of a large range of corporate finance alternatives, which includes a heavy dose of bootstrapping.

The article follows:

August 7, 2009, 1:20 pm

Falling Valuations: Poison for Venture Capital

By Brad Stone

Here’s more proof that Silicon Valley’s financing ecosystem is under assault: the value of the start-ups they are investing in just keeps dropping.

In a quarterly study of venture financings published Friday, Fenwick & West, a Silicon Valley law firm, found that so-called “down rounds” in the second quarter of 2009 exceeded “up rounds,” 46 percent to 32 percent. Last quarter was similarly bad – with 46 percent down rounds and 25 percent up rounds.

In a down round, a start-up issues more stock with a lower valuation than in previous rounds, which means that the equity of previous investors has shrunk. This is poison for the V.C. industry, which depends on returning large bounties to its investors, who have plenty of safer asset classes in which to invest their money.

For context: in the salad days of 2007’s third quarter, there were some 79 percent up rounds and only 14 percent down rounds.

“These two previous quarters were by far the worst quarters for valuations in a good number of years, going back to the dot-com bubble bursting,” said Barry Kramer, a partner at Fenwick & West. “For the venture capital environment to work, you are supposed to have nontrivially more up-rounds than down-rounds. This is depressing to venture capitalists.”

The law firm, which surveyed 89 deals, or around half of the financings in the Valley last quarter, also found that the average valuation for companies receiving venture capital during the quarter decreased by 6 percent from the companies’ prior financing round. That’s slightly more of a drop than the 3 percent decrease the survey reported in the first quarter. These are the only two negative quarters since the law firm began reporting these statistics in 2004.

The VC industry has other, related problems. The shortage of I.P.O.’s and M&A deals is killing liquidity and reducing the ability V.C. firms have to make other investments. As my colleague Claire Cain Miller also recently reported, venture funds have grown too large and older partners have lost touch with what’s new in technology.

But Mr. Kramer sees some reasons for hope, with the Nasdaq rallying since the start of the year. “Corporate America is going to be more willing to make acquisitions when their stock price is higher,” he said. “And hopefully people are more willing to reconsider I.P.O.’s and maybe the windows open a little more. That is the potential light I see here.”

Microhoo Good For Who?

Jonathan Aberman — Sat, 01 Aug 2009 17:33:50 GMT

It is interesting to me that the Internet is becoming more and more like the railroad industry as it matured. If you go back into our economic history the railroad industry originally was financed by lots of venture capital and many competing railroads. Eventually you ended up with tremendous concentration and less innovation. I don't buy the argument that it is good for consumers and start ups to have search and on line advertising in the hands of an oligopoly.

check out this article in the NY Times which provides a good discussion:

July 30, 2009, 5:40 pm

Behind Microsoft-Yahoo: The Online Economics of Scale

By Steve Lohr

In their persuasion assault on Wednesday, Carol A. Bartz and Steven A. Ballmer repeatedly explained the Microsoft-Yahoo deal using a term from classical economics: “scale.”

Martin Sundberg, via Associated Press, via Yahoo Carol Bartz

“What this deal is really about is scale,” Ms. Bartz, the chief executive of Yahoo, said in the morning conference call with analysts and journalists, adding that advertisers, consumers and the two companies themselves would all benefit as a result.

Mr. Ballmer, the Microsoft chief, said during the conference call that in Internet search “scale drives knowledge,” which, in turn, fuels innovation. That was his shorthand description of what he said was the particularly powerful “feedback loop” in search and search advertising.

In traditional economics, scale typically refers to the efficiency gains that result from size. These observations were originally applied, and measured, in industrial markets. In high-technology markets, like software and the Internet, scale advantages can sometimes behave as if on steroids — faster and stronger. The mechanisms include the feedback loop Mr. Ballmer described and “network effects,” the concept that a technology or online marketplace becomes more valuable the more people use it.

Microsoft’s Windows operating system is the textbook case of a supercharged scale technology. The more people use it, and the more developers write software applications to run on Windows, the more valuable it is to everyone in that technology ecosystem.

Just how powerful the scale economics and network effects are in Internet search is a subject of considerable debate among economists, antitrust experts, investors and business executives. In the conference call, Mr. Ballmer seemed to be suggesting that the snowballing effects of scale in Internet search were even stronger than in operating systems.

But understatement is not Mr. Ballmer’s first instinct. So in an interview after the conference call, I asked him if that’s what he meant. “In my view, scale is more important in this business than any other technology business I know,” he replied. Which helps explain why Mr. Ballmer has long been so intent on getting hold of Yahoo’s search traffic, one way or another.

The Microsoft-Yahoo partnership will now have nearly 30 percent of the search market. In Microsoft’s thinking, that figure may well be significant. David Yoffie, a professor at the Harvard business school, and co-author with Michael Cusumano of M.I.T. of an insightful book on the browser wars, “Competing on Internet Time: Lessons from Netscape and Its Battle with Microsoft,” pointed out that the 30 percent threshold has been important to Microsoft’s strategy in the past.

In 1996, Microsoft’s goal in catching Netscape was to move from about 5 percent to 30 percent share of the browser market in a year. “The view inside Microsoft was that until you got to 30 percent, you weren’t credible in that market with business partners and developers,” Mr. Yoffie said.

There is another dimension of scale behind the deal, according to Murthy Nukala, chief executive of Adchemy, a Silicon Valley startup that uses statistical models, advanced data mining and machine learning to help target online advertising.

The pursuit of “data scale” in search, Mr. Nukala said, fueled the Microsoft partnership. The data-scale benefit, he added, comes from more than just generating more search traffic, though sheer volume is crucial.

A key challenge in search, he explained, is estimating the likelihood that a given user will click on a particular ad from a certain advertiser. In the search world, this problem is called “pCTR estimation,” for probability of click-through rate. The ranking algorithms for search advertising, Mr. Nukala explained, incorporate not only the price per click an advertiser is willing the pay, but also the estimated click-through rate (calculated by applying clever algorithms and machine learning to vast quantities of query data).

“It is well understood,” Mr Nukala said, “that as pCTR estimates improve, the quality of ranking is better, which leads to higher revenue per search.”

It is also important to understand, he added, that the click-through estimates do not improve merely proportionately as search traffic increases but by something more like an exponential multiplier. Presumably, that is the sort of thing Mr. Ballmer had in mind when he said “scale drives knowledge.”

Mr. Nukala concluded, “I believe that ‘data scale’ drove the strategic imperative and the structure of the deal.”

Continued Woes in On Line Advertising, or not?

Jonathan Aberman — Sat, 01 Aug 2009 17:20:59 GMT

Here's a useful take on the state of online advertising trends from today's Tech Crunch:

The Online Ad Recession Continues. Is This What A Reset Looks Like?

by Erick Schonfeld on July 31, 2009

The recession in online advertising, which began in the first quarter of 2009, continued into the second. Every quarter we keep track of the combined advertising revenues of the four largest Web advertising companies (Google, Yahoo, Microsoft, and AOL), which together represent the lion’s share of all online advertising revenues and is a decent proxy for the market as a whole. In the second quarter of 2009, their combined global ad revenues were $7.864 billion, down 3.4 percent from a year ago.

In economics, a general rule of thumb is that two down quarters marks a recession. Last quarter saw the first annual decline in advertising revenues of 2.1 percent. And the annual decline this quarter got a little worse. However, on a sequential basis compared to last quarter, it is actually pretty much flat (but still down 0.18 percent). So we now have two down quarters on both an annual and sequential basis.

Will this recession continue into the current quarter, or did we just witness a fundamental “reset”, as Steve Ballmer likes to call it. What that implies is that advertising revenues have been reset to a lower level from which they can once again grow. We’ll see what happens in the third quarter, but anecdotally I am hearing from advertising startups that the worst is behind us.

This may be wishful thinking, of course. But barring any new economic catastrophe, the advertising levels of the past two quarters seems like the new floor. But how long will it take to get up off that floor?

These numbers represent global advertising revenues, and include network revenues paid to affiliates through AdSense and Yahoo’s ad network. Google’s licensing revenues for Google Enterprise Apps have been stripped out. For the other companies, we include only the advertising portions of their online revenues as reported in their quarterly earnings statements.

Below is a table with all the numbers:

Online Advertising Revenues (in millions)

	4Q07	1Q08	2Q08	3Q08	4Q08	1Q09	2Q09
Google	$4,758	$5,086	$5,185	$5,352	$5,504	$5,331	$5,336
Yahoo	$1,590	$1,572	$1,587	$1,563	$1,594	$1,383	$1,378
Microsoft	$860	$840	$840	$770	$866	$721	$731
AOL	$620	$552	$530	$507	$507	$443	$419
Total	$7,828	$8,050	$8,142	$8,192	$8,467	$7,878	$7864
Sequential Growth Q/Q		2.84%	1.14%	0.61%	-7.00%	-0.18%
Annual Growth Y/Y					8.21%	-2.10%	-3.41%

Do You Ever Worry About Skynet?

Jonathan Aberman — Sun, 26 Jul 2009 20:13:48 GMT

Every now and then reality and Scifi just converge. This just seemed to me like the kind of article that someone would have written in the world of the Terminator.

More seriously though, there are some very interesting and important social issues that are going to come out of the automation of tasks now done by humans. Often we in the technology industry are so focused on the excitment of new ideas that we don't focus on the larger social affects. For example, as we continue to mechanise warfare, making it easier to bomb terrorists (or innocents) across the world without any possibilty of US casualties, are we making war more effective or merely easier?

Or, as we expand the role of home care robotics (something the Japanese are doing with greater acceleration), are we helping the aged, or further alienating them from contact with other human beings.

I am not sugesting that progress is bad -- far from it, but an article like the one below does make me stop and think.

By JOHN MARKOFF

Published: July 25, 2009 , NY Times

A robot that can open doors and find electrical outlets to recharge itself. Computer viruses that no one can stop. Predator drones, which, though still controlled remotely by humans, come close to a machine that can kill autonomously.

This personal robot plugs itself in when it needs a charge. Servant now, master later?

Impressed and alarmed by advances in artificial intelligence, a group of computer scientists is debating whether there should be limits on research that might lead to loss of human control over computer-based systems that carry a growing share of society’s workload, from waging war to chatting with customers on the phone.

Their concern is that further advances could create profound social disruptions and even have dangerous consequences.

As examples, the scientists pointed to a number of technologies as diverse as experimental medical systems that interact with patients to simulate empathy, and computer worms and viruses that defy extermination and could thus be said to have reached a “cockroach” stage of machine intelligence.

While the computer scientists agreed that we are a long way from Hal, the computer that took over the spaceship in “2001: A Space Odyssey,” they said there was legitimate concern that technological progress would transform the work force by destroying a widening range of jobs, as well as force humans to learn to live with machines that increasingly copy human behaviors.

The researchers — leading computer scientists, artificial intelligence researchers and roboticists who met at the Asilomar Conference Grounds on Monterey Bay in California — generally discounted the possibility of highly centralized superintelligences and the idea that intelligence might spring spontaneously from the Internet. But they agreed that robots that can kill autonomously are either already here or will be soon.

They focused particular attention on the specter that criminals could exploit artificial intelligence systems as soon as they were developed. What could a criminal do with a speech synthesis system that could masquerade as a human being? What happens if artificial intelligence technology is used to mine personal information from smart phones?

The researchers also discussed possible threats to human jobs, like self-driving cars, software-based personal assistants and service robots in the home. Just last month, a service robot developed by Willow Garage in Silicon Valley proved it could navigate the real world.

A report from the conference, which took place in private on Feb. 25, is to be issued later this year. Some attendees discussed the meeting for the first time with other scientists this month and in interviews.

The conference was organized by the Association for the Advancement of Artificial Intelligence, and in choosing Asilomar for the discussions, the group purposefully evoked a landmark event in the history of science. In 1975, the world’s leading biologists also met at Asilomar to discuss the new ability to reshape life by swapping genetic material among organisms. Concerned about possible biohazards and ethical questions, scientists had halted certain experiments. The conference led to guidelines for recombinant DNA research, enabling experimentation to continue.

The meeting on the future of artificial intelligence was organized by Eric Horvitz, a Microsoft researcher who is now president of the association.

Dr. Horvitz said he believed computer scientists must respond to the notions of superintelligent machines and artificial intelligence systems run amok.

The idea of an “intelligence explosion” in which smart machines would design even more intelligent machines was proposed by the mathematician I. J. Good in 1965. Later, in lectures and science fiction novels, the computer scientist Vernor Vinge popularized the notion of a moment when humans will create smarter-than-human machines, causing such rapid change that the “human era will be ended.” He called this shift the Singularity.

This vision, embraced in movies and literature, is seen as plausible and unnerving by some scientists like William Joy, co-founder of Sun Microsystems. Other technologists, notably Raymond Kurzweil, have extolled the coming of ultrasmart machines, saying they will offer huge advances in life extension and wealth creation.

“Something new has taken place in the past five to eight years,” Dr. Horvitz said. “Technologists are replacing religion, and their ideas are resonating in some ways with the same idea of the Rapture.”

The Kurzweil version of technological utopia has captured imaginations in Silicon Valley. This summer an organization called the Singularity University began offering courses to prepare a “cadre” to shape the advances and help society cope with the ramifications.

“My sense was that sooner or later we would have to make some sort of statement or assessment, given the rising voice of the technorati and people very concerned about the rise of intelligent machines,” Dr. Horvitz said.

The A.A.A.I. report will try to assess the possibility of “the loss of human control of computer-based intelligences.” It will also grapple, Dr. Horvitz said, with socioeconomic, legal and ethical issues, as well as probable changes in human-computer relationships. How would it be, for example, to relate to a machine that is as intelligent as your spouse?

Dr. Horvitz said the panel was looking for ways to guide research so that technology improved society rather than moved it toward a technological catastrophe. Some research might, for instance, be conducted in a high-security laboratory.

The meeting on artificial intelligence could be pivotal to the future of the field. Paul Berg, who was the organizer of the 1975 Asilomar meeting and received a Nobel Prize for chemistry in 1980, said it was important for scientific communities to engage the public before alarm and opposition becomes unshakable.

“If you wait too long and the sides become entrenched like with G.M.O.,” he said, referring to genetically modified foods, “then it is very difficult. It’s too complex, and people talk right past each other.”

Tom Mitchell, a professor of artificial intelligence and machine learning at Carnegie Mellon University, said the February meeting had changed his thinking. “I went in very optimistic about the future of A.I. and thinking that Bill Joy and Ray Kurzweil were far off in their predictions,” he said. But, he added, “The meeting made me want to be more outspoken about these issues and in particular be outspoken about the vast amounts of data collected about our personal lives.”

Despite his concerns, Dr. Horvitz said he was hopeful that artificial intelligence research would benefit humans, and perhaps even compensate for human failings. He recently demonstrated a voice-based system that he designed to ask patients about their symptoms and to respond with empathy. When a mother said her child was having diarrhea, the face on the screen said, “Oh no, sorry to hear that.”

A physician told him afterward that it was wonderful that the system responded to human emotion. “That’s a great idea,” Dr. Horvitz said he was told. “I have no time for that.”

Q2 venture investing looks like it’s 2005 (and that’s a

Jonathan Aberman — Sun, 19 Jul 2009 19:38:17 GMT

July 17, 2009 | Anthony Ha of Venture Beat

Hey, that wasn’t so bad. Dow Jones VentureSource has released its data on venture capital investments during the second quarter of 2009, and while the numbers might look bleak in most years, given the broader context, they look … okay.

In Q2 (from April to June), venture capitalists invested a total of $5.27 billion in 595 deals. That’s pretty meager compared to the $8.33 billion invested in 726 deals during the same period last year but, as you may be aware, that was a very different time, economically speaking. It’s a big jump from the $4 billion invested last quarter, so we might even begin to start talking about a recovery. To look at it another way, last quarter’s investment numbers were the lowest since 1998, while this quarter is about on-par with 2005.

Of course, not all startups are created equal, from a VC’s perspective and otherwise. For example, software startups probably shouldn’t feel too relieved — investment in the sector dropped 52 percent from the same period last year, to $696 million. Information services startups, which VentureSource says includes most Web 2.0 startups, dropped 29 percent to $562 million; renewable energy, which includes most cleantech companies, fell 70 percent to $317 million.

Meanwhile, previously released data shows that the market for exits (initial public offerings and acquisitions) is improving. It hasn’t come back completely, though, and VentureSource says some of the corporate money that previously went to acquisitions is going into startup investments instead: There were 10 corporate rounds totaling $401 million last quarter (or $201 million, if you exclude the $200 million raised by Facebook).

After the Q1 numbers came out, Adeo Ressi of TheFunded wrote that the numbers weren’t as bad as they looked and predicted that investments would pick up towards the end of Q2. That seems to have been borne out. He also predicted that despite a small uptick, the VC industry as a whole was still due for a big contraction — and that, too, may be coming true.

Normally, VentureSource and the National Venture Capital Association/Thomson Reuters release their venture investing numbers at the same time. This quarter, however, we’ll have to wait until Monday to get the NVCA data and see how it matches up.

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Google Adds Operating System

Jonathan Aberman — Wed, 08 Jul 2009 16:14:39 GMT

Google Plans a PC Operating System

By MIGUEL HELFT and ASHLEE VANCE

Published: July 8, 2009 , NY Times

SAN FRANCISCO — In a direct challenge to Microsoft, Google announced late Tuesday that it is developing an operating system for PCs that is tied to its Chrome Web browser.

Will Google's new Chrome operating system have what it takes to compete with Microsoft Windows?The software, called the Google Chrome Operating System, is initially intended for use in the tiny, low-cost portable computers known as netbooks, which have been selling quickly even as demand for other PCs has plummeted. Google said it believed the software would also be able to power full-size PCs.

The move is likely to sharpen the already intense competition between Google and Microsoft, whose Windows operating system controls the basic functions of the vast majority of personal computers.

“Speed, simplicity and security are the key aspects of Google Chrome OS,” said Sundar Pichai, vice president of product management, and Linus Upson, engineering director, in a post on a company blog. “We’re designing the OS to be fast and lightweight, to start up and get you onto the Web in a few seconds.”

Mr. Pichai and Mr. Upson said that the software would be released online later this year under an open-source license, which would allow outside programmers to modify it. Netbooks running the software will go on sale in the second half of 2010.

The company likely saw netbooks as a unique opportunity to challenge Microsoft, said Larry Augustin, a prominent Silicon Valley investor who serves on the board of a number of open-source software companies.

“Market changes happen at points of discontinuity,” Mr. Augustin said. “And that’s what you have with netbooks and a market that has moved to mobile devices.”

But while Google has deep pockets and a vast reach, it is in for a difficult battle when it comes to challenging Microsoft in the operating system market. Many companies have tried this over the years, with little success.

Google’s plans for the new operating system fit its Internet-centric vision of computing. Google believes that software delivered over the Web will play an increasingly central role, replacing software programs that run on the desktop. In that world, applications run directly inside an Internet browser, rather than atop an operating system, the standard software that controls most of the operations of a PC.

That vision challenges not only Microsoft’s lucrative Windows business but also its applications business, which is built largely on selling software than runs on PCs.

Google said Chrome OS will have a minimalist user interface, leaving most space on the screen to applications.

“All Web-based applications will automatically work and new applications can be written using your favorite Web technologies,” the company said.

Google has already developed an open-source operating system called Android that is used in mobile phones. The software is also being built into netbooks by several manufacturers.

But Google has not encouraged netbook makers to use Android. The company appears to be positioning Chrome OS as its preferred operating system for netbooks, though it said competition between the two systems would likely drive innovation.

“It makes total sense,” Mr. Augustin said. “Android wasn’t really meant for netbooks.”

Google had planned to unveil the project on Wednesday but moved up the announcement after receiving inquiries from The New York Times, which reported the company’s plans on its Web site late Tuesday. Ars Technica, a technology news site, also reported the outlines of Google’s plan late Tuesday.

Google released Chrome last year, describing it as not only a Web browser but also a tool to let users interact with powerful Web programs like Gmail, Google Docs and online applications created by other companies. Since then, Google has been adding features to Chrome, like the ability to run such applications even when a user is not connected to the Internet.

Google said Tuesday night that it still had work to do to develop a full-fledged operating system. In a recent interview, Marc Andreessen, who created the first commercial Web browser and co-founded Netscape, said Chrome itself was already well along that path.

“Chrome is basically a modern operating system,” Mr. Andreessen said.

The first wave of netbooks relied on various versions of the open-source Linux operating system, and major PC makers like Hewlett-Packard and Dell have backed the Linux software. Intel, the world’s largest chip maker, has worked on developing a Linux-based operating system called Moblin as well. The company has aimed the software at netbooks and smartphones in a bid to spur demand for its Atom mobile device chip.

To combat these efforts, Microsoft began offering its older Windows XP operating system for use on netbooks at a low price. In addition, the company has vowed that its upcoming Windows 7 software, due out this fall, will run well on the tiny laptops, which have stood out as the brightest part of the PC market during the global economic downturn. Microsoft’s current Vista operating system is designed for more powerful machines.