Venture Capitalists Go Exploring For Startups

While others toiled in the technology mecca of Silicon Valley, Trevor Loy — a former Intel manager and Stanford University-trained engineer — pursued the digital road not taken.

Nearly a decade ago, he moved to the New Mexico desert to co-found a small venture-capital firm called Flywheel Ventures. His aim: to find the next generation of startups where few others were looking.

Tapping into the wealth of technology talent and research in the region surrounding the Sandia and Los Alamos federal research labs, Flywheel Ventures has invested $34 million in 19 companies in solar, biofuel and other sectors. Most of the startups were “born global,” Loy says, with U.S. and overseas offices, employees and customers.

“This is the natural evolution of our industry,” the 37-year-old Loy says. “Venture capital has matured and reached critical mass in some markets, and now we’re seeing explosive growth and opportunities elsewhere.”

The nearly half-century-old U.S. venture industry appears to be entering a new era, what some call Venture Capital 2.0. Powerful forces, from economic globalization to weak markets for initial public offerings and acquisitions, are sweeping the industry and causing much soul-searching. To grow and survive, venture firms large and small are hunting for new global entrepreneurs and markets, and for fresh investment sectors such as clean technology and alternative energy.

Looking For Home Runs

Some venture capitalists believe that their traditional industry model needs shaking up. Over the decades, U.S. venture firms have poured hundreds of billions of dollars into thousands of young tech firms. Most died or failed to grow, while others — Intel, Apple, Amazon.com, Google — grew into business giants.

Since the dot-com boom and its 2001 bust, venture investment returns in the U.S. have dwindled. Too many venture firms and too much capital are chasing too few prized startups, many say.

Dileep Rao, a University of Minnesota entrepreneurship professor, contends that venture investing is mostly “a lottery system” won by a lucky few. He says that elite venture firms — about 4 percent of all firms — haul in most of the profits with big IPOs and acquisitions, while returns for others pale by comparison.

Venture capitalists, he says, “need home-runs such as Google and eBay to reach their financial goals, but there are not enough high-potential ventures to satisfy the large numbers of VC funds.”

Venture investors focus narrowly on short-term investments and what they believe to be the Next Big Thing, contends Tom Simpson, founder of Northwest Venture Associates in Seattle.

Instead, they should seek steady, long-run growth in young companies. Starbucks is a prime example of a former startup that resisted the early temptation to sell its stock until the company enjoyed steady profits and growth, says Simpson, whose firm manages $170 million in venture investments.

The debate comes at a tough time for venture firms, as the usual “exit strategies” for venture-backed young companies have dried up in the U.S.

Mergers and acquisitions in the second quarter of 2008 fell 59 percent from the same time last year, says Dow Jones VentureSource.

And there were no venture-backed initial public offerings — when private companies “go public” and sell stock — in the second quarter, reports the National Venture Capital Association. That’s the first time that has happened in 30 years.

With no way to cash out on their startup investments, venture capitalists say they must continue raising millions of dollars to sustain the young companies in their portfolios.

“It is like having a family of children that are still living at home in their 30s,” Simpson says. “The traditional VC model and mentality does not effectively accommodate this new ‘buy and hold’ reality.”

Not surprisingly, venture capitalists are gloomy about the near future. Their confidence last month fell to a record low of 3.0 on the 5-point scale of the Silicon Venture Capitalist Confidence Index, a quarterly survey by University of San Francisco entrepreneurship professor Mark Cannice.

Many Internet and software investments — core of the venture-capital industry for years — have hit a point of limited returns, say venture capitalists such as Josh Kopelman, managing partner at First Round Capital in West Conshohocken, Pa.

Take a typical $400 million venture fund, he says. For the fund to enjoy a 20 percent annual return over six years, it roughly would have to triple in value to $1.2 billion.

“The numbers just don’t work,” Kopelman says. “You’ve got a whole generation of venture capitalists who have never made money from their funds.”

Over the past 30 years or so, U.S. venture capitalists and investors have enjoyed attractive returns of 17 percent to 18 percent, says Josh Lerner, a Harvard Business School professor and co-author with Harvard colleague Paul Gompers of “The Money of Invention: How Venture Capital Creates New Wealth.” Returns peaked at 190 percent during the dot-com boom in 1999 and hit 20 percent last year.

The investments are high-risk, though, and the most lucrative returns are taken by mostly larger venture firms, Lerner says. And returns have slowed in recent years because of the weak financial markets.

Some Falling Out

A shakeout in the industry already is starting, according to venture capitalists. More than 1,000 venture funds sprouted during the dot-com era, but many of those will shrink or get absorbed by other funds, says Gompers. About 500 or 600 funds — the level of the 1980s — would be healthy for the industry, he says.

At the same time, the venture industry is growing abroad. Venture capitalists in Silicon Valley once joked that they’d never invest in a startup more than a 15-minute drive away. Not now.

Increasingly, Silicon Valley venture firms such as Draper Fisher Jurvetson and Sequoia Capital are looking beyond U.S. tech hotspots and investing from Dubai to Dublin. Since 2001, U.S. venture firms have raised $230 billion in venture capital worldwide — with $40 billion coming last year, according to Ernst & Young.

Of course, U.S. companies have long dominated IPOs. But in the first half of this year, only one — Visa — made the Top 10 IPOs in the world. The rest are based in China, Brazil, India, Saudi Arabia, the United Kingdom and other countries, according to IPO research firm Renaissance Capital.

“Entrepreneurship and innovative technology has gone global,” says DFJ managing director Raj Atluru. “Back in the early 2000s, a software engineer in India was maybe two years behind us. In 2005, he was six months behind us. Now, I don’t think there’s any difference.”

At DFJ, one-fourth of its core venture fund invests in foreign-based startups, including thriving search-engine firm Baidu, often called “the Google of China.”

DFJ also oversees a widening network of 20 foreign “partner funds” run by venture capitalists and investors from Asia to Europe. Managing director Don Wood says the DFJ-branded funds manage $6 billion in investments and are seeing “strong deal flow and a steady flow of exits” via IPOs and acquisitions.

As the economic slump drags on, venture firms are more closely scrutinizing their investments, funding only meaner-and-leaner startups.

During the IPO frenzy of the dot-com era, tiny startups with barely a few million dollars in sales typically rushed to market to sell their stock. Today, though, young companies must boast seasoned management teams, strong products and tens of millions of dollars in sales. They prudently manage their cash, not recklessly burning through it.

Then, after five to eight years, they’re prime to go the IPO route or get acquired by a bigger company. Even the slow economy gives startups the chance to streamline their business and toughen themselves.