Is the Venture Capital Market Getting Its Mojo Back?

The venture capital market appears to be bottoming out after a long decline, according to a Fenwick & West survey of the venture capital market for the third quarter of 2009.

There are two significant data points worth pulling out. First, the number of investment rounds for higher valuations (i.e. “up rounds”) exceeded the number of investment rounds for lower valuations (i.e “down rounds”) for the first time this year. Up rounds exceeded down rounds 41% to 36%, according to the survey. In the second quarter, down rounds exceeded up rounds 46% to 32%.

This the equivalent of a rising valuations in the stock market, suggesting that VCs are getting more optimistic about the value of venture-backed startups.

The second related point is that the average price of venture deals increased 11%, the first increase this year. That compares to a 6% decline in the second quarter, and a 3% decline in the first quarter.

Read the rest of the blog post here on BusinessWeek’s TechBeat.

Fenwick & West Q309 VC Terms Survey Report

Regulating Venture Capital: Off the Hook Now But “Very Far From the Finish Line”

Earlier this year, Silicon Valley freaked out when U.S. Treasury Secretary Timothy Geithner told Congress that large venture capital firms should be declared as systemic risks and put under tight restrictions as part of the broader re-regulation of financial firms.

Such regulations would force VCs to register with the Securities and Exchange Commission, and submit regular reports on their investors and portfolios, costing firms up to $1 million. Data collected by the SEC would then be shared with a new risk regulator to ensure that VCs aren’t “a threat to financial stability.”

But techies breathed a sigh of relief earlier this month when Financial Services Chairman Barney Frank proposed draft legislation rejecting the Treasury plan, carving out an exemption for VCs from the “Private Fund Investment Advisers Registration Act of 2009.” (see draft below)

That was good news for innovation. VCs do not pose a systemic risk to the economy, as Gordon Crovitz pointed out in this astute column in the Wall Street Journal. The venture capital industry is small compared to other capital markets. VCs do not use debt, so that sharply limits their risk. And they are not tightly interconnected with other financial firms, like AIG or Lehman Brothers.

But they do represent an incredibly important part of the economy that helps generate significant wealth and job creation–a unique economic pillar the Treasury Dept. should be strengthening, not weakening.

But National Venture Capital Association President Mark Heesen says the VC industry is not out of the woods yet. “We are very far from the finish line, but in a better place than many expected at this point,” Heesen wrote me in an email. “There is still no House or Senate bill, but House Chairman Frank’s comments certainly are encouraging.”

Financial reform hinges on, you guessed it, the passage of health care reform. “Many Senators sit on both Committees of jurisdiction so can’t focus of financial reform until they see how health care proceeds,” added Heesen.

To make sure VC regulation does not reappear in future versions of financial reform legislation, Heesen says the NVCA is continuing to work with the Administration and members of the House and Senate “to make certain Venture capitalists do not have to register under the 40 Act while giving the government the assurances they need to understand we do not pose a systemic risk to the economy.”

Discussion Draft of the Private Fund Investment Advisors Registration Act

Reinventing Venture Capital

Today, Paul Kedrosky released a report, “Right-Sizing the Venture Capital Industry,” as part of his work as Senior Fellow at the Kauffman Foundation.

Now, I couldn’t agree more that the venture capital industry needs to reinvent itself. That was the theme of my recent feature in BusinessWeek, Super Angels Shake up Venture Capital. But I was a little surprised by the way that Kedrosky goes out of his way to diss the venture capital industry’s role in nurturing innovation, even though I know the Kauffman Foundation has a bit of an anti-VC bent.

“The industry has become conflated with entrepreneurship in the popular imagination as well as in policy circles, with the result being a widespread and incorrect belief that venture capital is a necessary and sufficient condition in driving growth entrepreneurship,” writes Kedrosky.

Kedrosky’s big data point? Of the 900 companies on the Inc. 500 list between 1997 and 2007, he reports that only 16% received venture capital backing. It’s an interesting data point. But to then argue that “venture capital and entrepreneurship are separate phenomena,” as Kedrosky does, seems like an overstatement to me.

Obviously, most new companies do not require venture capital but the ones that do need it play a hugely important role in the economy because they tend to be the ones that grow the biggest and create the most value. Think Google, which got a $25 million injection of venture capital at a key moment in its evolution. Without that money Google might have never become Google. There are many examples like this.

The rest of the report tries to figure out why venture capital performance has been poor lately and suggests how the industry will reshape itself. The upshot? The industry must shrink, perhaps in half in the coming years.

I basically agree that the industry needs to shrink. That’s pretty much what I argued in my super angels feature. The industry has an inversion problem: Fund sizes have gotten bigger while the capital needs of companies have shrunk. $500,000 is the new $5 million, as Mike Maples said in my story.

Will it shrink in half? Maybe. Maybe not. All I know is that it will get smaller and that’s a good thing for industry and for the economy. An excess of capital ends up wasting money and the scarce time of entrepreneurs to create great companies.

The more important issue to me is that the industry needs to develop new models to finance and nurture innovation that fit today’s capital-constrained economy. Super angels will be part of the answer but it won’t solve the whole VC problem.

My colleague Mike Mandel blogged about this issue, making the point that science-oriented VC requires more money and a longer time frame to come to fruition. I think he’s right. And I’ve heard many VCs who invest in clean tech make this point.

Another big issue: Without an IPO market, there needs to be a new type of capital market that helps young companies finance their growth once they graduate beyond venture capital.

New Venture Capital Investment Nearly Comes to a Halt

It’s official: Institutional investors have put the kibosh on investing in new venture capital funds, though established firms with track records have been able to scare up some money. That’s the big news out of today’s announcement about fund raising trends in the first quarter of 2009 from Thomson Reuters and the National Venture Capital Association.

In the quarter, 40 venture capital funds raised $4.3 billion, down 40% from the first quarter of 2008 when 71 funds raised $7.1 billion. It was the smallest number of venture funds to raise money since the third quarter of 2003. The biggest shocker? Of those 40 funds, only 3 of them were new funds; the other 37 were raised by existing venture firms.

Read the rest of the post on BW’s TechBeat here.

New Review: Venture Capitalist Brad Feld Gives Creative Capital Five Stars

Check out this review that Brad Feld, co-founder of the Colorado venture capital firm Foundry Group, recently posted on my Amazon page.

5.0 out of 5 stars
Fantastic History of the Venture Capital Business
March 16, 2009
By Bradley Feld (Eldorado Springs, CO USA)

Most people that have been involved in a VC-based tech startup have heard the parable of General Georges Doriot and his famous $70,000 investment in Digital Equipment Corporation. However, few people actually know the full (and very extensive) story of Doriot and the creation of the Venture Capital business.

Spencer Ante does an awesome job of telling this incredible history. As a former entrepreneur and now VC, I’ve read many books that touch on parts of the history and have heard many anecdotes. Spencer brings them all together in one concise, well-written, fast paced book.

Every entrepreneur and VC should, along with anyone that is involved in creating companies, should read this book.

Come See Me Speak at Stanford Next Friday

A quick speaking update: I have been invited to moderate a panel at the Stanford Global Technology Symposium on Friday March 27. The event will be held at the Arrillaga Alumi Center on the Stanford campus. This year’s theme couldn’t be more timely “Entrepreneurship and Investment in a Turbulent Economy.”

T. Boone Pickens, Facebook COO Sheryl Sandberg and venture capitalist Steve Jurvetson are giving keynote addresses or fireside chats.

We’ve got a great panel. The topic is corporate venture capital and we’ve lined up top executives from IBM (Claudia Fan Munce), Microsoft (Dan’l Lewin) and Google (David Lawee) to participate. My panel is from 3pm – 4pm.

Please come and say hello. I may be selling books afterwards.

Entrepreneurs + VCs = Goodness (And why it will help lift us out of the Great Recession)

Yesterday, venture capitalist Brad Feld published a candid post in which he made the argument that entrepreneurs played a much more important than financiers in the startup ecosystem. Even though I wrote a book highlighting the importance of VCs, I totally agree with him.

It’s the entrepreneurs that drive innovation. They are down in the trenches building the businesses every day. They create most of the value.

However, without risk capital, the startup system ecosystem would be far less powerful and effective at generating innovation. You simply can not build a business without capital–even in these capital efficient Web 2.0 days. Look at any survey of a small business and the top concern is always money–having enough of it to run your day-to-day operation and getting more to grow the operation.

One of the big reasons that America is the world’s engine of innovation is that we were the first country to develop a professional and robust venture capital market. Now, other countries are following us, but our risk capital market is still one of the nation’s competitive advantages.

It’s also one of the reasons why I think we will lift ourselves out of this recession more quickly than we did in the Great Depression. There was no venture capital market in the 1930s. We have one now and the capital being put to work in startups will create companies and markets that will help grow the economy and revive our animal spirits. In fact, as I detail in my book, the VC industry was born out of the Great Depression when a group of businessmen in New England in the late 1930s realized the U.S. had created a “risk-less economy” and needed to find new ways of creating new companies.

I struggled with this tension in writing my book. I was writing about a VC but I came to see that what I was really writing about was the birth of this startup ecosystem, the entrepreneurial economy. I was writing about the largely symbiotic relationship between the entrepreneur and the venture capitalist. You can’t talk about one without including the other.

Sure, there will always be tensions between owners of a business and the managers. And that’s OK. But instead of pitting entrepreneurs against VCs I think it’s better and more appropriate to view them as partners in a mutually beneficial relationship.

Michael Moritz: Lessons from a Long-Ball Hitter

Yesterday, BusinessWeek published my profile/Q&A with venture capitalist Michael Moritz. The news cycle is insane these days, so I am reposting the top of the piece here as well as a link to the rest of the interview. Plus, Moritz doesn’t give many interviews, so it’s worth spreading the thoughts of perhaps Silicon Valley’s most successful investor.

Michael Moritz: Lessons from a Long-Ball Hitter
The journalist-turned-venture capitalist was early to ring the alarm bells about the weakening economy, but he remains optimistic

In 1984 a young British journalist named Michael Moritz wrote a short piece in Time magazine about the legendary venture capitalist Arthur Rock with the title “The Best Long-Ball Hitter Around.”” Today, the 54-year-old Moritz is the guy who swats investing home runs as a partner with the Silicon Valley venture capital firm Sequoia Capital. Moritz joined the firm in 1986 after leaving Time (TWX) and writing a book about Apple (AAPL), The Little Kingdom: the Private Story of Apple Computer.

The deal that made Moritz’s reputation as one of the top venture capitalists in the business came in 1999. That year he pushed Sequoia to make a $25 million co-investment with Kleiner Perkins in a little search company called Google (GOOG). When Google went public five years later in 2004, Sequoia’s $12.5 million investment was worth just over $2 billion—160 times its original bet. Before then, Moritz had put himself on the map with investments in Yahoo (YHOO), eToys, and Flextronics (FLEX), among other successful Web startups. Since the Google deal, Moritz has maintained his slugging percentage, scoring another big win with his investment in PayPal, which eBay (EBAY) bought in 2002 for $1.5 billion.

Moritz typically shuns publicity. But in early February I met him at his office on Sand Hill Road, in the last office park on the lane that serves as home to the kingpins of venture capital. A secretary ushered me into a conference room, but when Moritz showed up he invited me to sit in his office.

Efficiency, Even While Eating
Moritz wore the standard business casual uniform of the Valley: striped dress shirt and slacks, with a sport coat hanging on the wall. He has a small and simple office, with a desk and a table with a few chairs, and a window overlooking the woods. An old and weathered notebook case rested on the table. On his desk sat an Apple (AAPL) iMac computer, an Apple laptop, and a BlackBerry (RIMM), all plugged into the wall. Having visited China seven times last year, Moritz needs to recharge his batteries when he returns to the Valley.

When reporters interview people over lunch, they often can’t find enough time to eat. But Moritz was extremely efficient, downing a fruit plate and Cobb salad, even while picking out the eggs and bacon to set them to the side of the plate. As we discussed the history of Sequoia Capital, the state of Silicon Valley, and the future of investing, Moritz would stab a fork into a group of berries, stick them into his mouth, and gaze off into the distance, before offering up some quip or bit of insight.

Moritz’s presence belies his firm’s reputation for toughness. While Sequoia has made many bold bets over its 36-year history, it has also gained a reputation in some quarters for walking away from portfolio companies that fail to perform. As one head of an investment firm that invests in venture firms put it: “They take the portfolio out back and shoot it. They stop funding companies quickly if they are not working.” Moritz calls the criticism “unfounded” and says there are several instances when Sequoia and its startups “soldiered forward together when times were very bleak.”

Pivotal PowerPoint Presentation
Sequoia’s hard-nosed nature was accidentally put on display last year when Moritz’s firm put together a PowerPoint presentation detailing the coming economic downturn in stark terms. The 56-slide presentation advised companies to cut costs and become cash-flow-positive more quickly in order to avoid falling into a death spiral. Although the presentation leaked out on the Web, Moritz swears the leak was not intentional. “A couple of the CEOs asked us to send them the presentation to help them convince their management teams that this was the deal,” says Moritz. “It was not a cynical attempt to spread the Sequoia name.”

Even though Sequoia was early to ring the alarm bells about the weakening economy, Moritz says he remains optimistic. He is particularly excited about two recent investments he led. One was in digital camcorder maker Pure Digital Technologies, which he claims is the world’s leading maker of digital camcorders, having shipped 1.5 million units last year. He is also bullish about another investment in Green Dot, which he says is a leader in prepaid credit cards. And contrary to word on the street, Moritz says Sequoia still invests in young seed-stage companies from time to time.

The day I met him, in fact, he said he was talking to a 20-year-old about investing $500,000 in an embryonic idea. (He wouldn’t discuss the venture in detail.) “It’s as easy for me to be excited today by the unknown 23-year-olds as I was in the past,” he says. “Those sorts of encounters lift your spirits in imagining what is possible.”

Here’s an edited version of my interview with Moritz:

Can great companies be built in bad times?
Some of that is true. In bitter and cold times only the brave are going to venture out into the cold and the lily-livered posers are going to stay tucked into their bed clothes. It makes life easier for us. The people we are meeting are the genuine article as opposed to the pretenders. The only people who venture out are on a mission, which is what you need.

Click here to read the rest of the interview.

Survey Says: More Pain for Startups and Venture Capitalists in Q4 2008

Today, BusinessWeek published my story based on an early and exclusive look at Fenwick & West’s survey of trends in venture capital financing from the fourth quarter of 2008. It’s the first survey I know of that digs into the gory details of the venture world from the end of last year when the recession gripped the economy.

Here’s the top of the story:
Venture Capital and Startups Feel More Pain, Study Says
Startup valuations are falling and venture capitalists are driving harder bargains, according to a survey by California law firm Fenwick & West

Like the rest of the economy, the world of venture capital and startups is starting to feel more pain from the deepening global financial crisis.

That’s the main takeaway from a new survey detailing trends in venture capital investments during the fourth quarter of 2008 by the California law firm Fenwick & West.

The survey, which analyzed the terms of venture deals for 128 companies headquartered in the San Francisco Bay Area, found that valuations are falling for startups and that venture capitalists are driving harder bargains. The silver lining: The fallout so far is not nearly as bad as it was during the dot-com bust, when hundreds of companies went under and stratospheric valuations came crashing down to earth.

DOWN ROUNDS ON THE RISE
Sure, there were some startups last quarter that secured a higher value on their latest investment round, such as online vacation rental site HomeAway. But, of the 128 companies that received financing, 33% of them experienced so-called down rounds, or an investment that placed a lower valuation on the company than it received in the previous round of investment. More ominous, the percentage of down rounds rose every month at year’s end, hitting 45% in December. “Each month things got worse in the fourth quarter,” says Barry Kramer, the Fenwick & West partner who runs the survey. The highest percentage of down rounds occurred in the first quarter of 2003, when 73% of the companies surveyed by Fenwick & West suffered down rounds.

With the recession worsening, most financiers and lawyers do not expect the situation to get better anytime soon. They predict valuations will continue to decline until the overall economy begins to improve. “Private values really do lag,” says Kate Mitchell, managing director with Scale Venture Partners. “More down rounds will come in 2009.”

Click here to read the rest of the story.

The Great Firewall of China

BusinessWeek’s Digital Dish gang considers the sale of equity in Facebook by insiders, and what it means not only for Facebook, but for other venture-capital-backed startups, as well as predicting that China’s tight grip on information will encounter resistance at the Summer Olympics.

Check out the video by clicking here.