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 The excitement around venture capital investment in early-stage companies largely comes down to one thing: It's cheaper than ever to build a startup. Yet the plunging cost of launching companies has led to a breakdown in the traditional venture model, says Paul Kedrosky, a venture partner with Canadian firm Ventures West, senior fellow for the Kauffman Foundation and noted blogger at Infectious Greed. Kedrosky recently spoke with Tech Confidential about his views on the early-stage investment scene.Tech Confidential: With the increased focus on seed funds, early-stage capital firms such as Union Square Ventures or The Founders Fund and startup accelerators like Y Combinator, have you seen the early-stage venture model bifurcate between rounds of, say, $2 million or less and larger Series A fundings? Paul Kedrosky: The business of investing in early-stage technology startups has changed, but the financing vehicle didn't change with it. The industry has always done these kinds of tiny deals and knows that's where the returns are. But as the firms got more and more assets under management, that means they had to walk away from doing smaller financings. That meant that segment of the market was largely abandoned to angels. But what happened, of course, is that you could make money from larger funds for only a little while and now there is nowhere to deploy millions of dollars in a deal at a time. So some of the smaller guys, like First Round Capital, The Founders Fund and O'Reilly AlphaTech Ventures, which have smaller funds, played in a relatively uncrowded field. In that way the market has bifurcated, but over the long term it's going to get a lot more crowded at the early stages because the guys who are now managing $250 million early-stage funds are going to have to do something different in order to survive. TC: What will they do? PK: There are a couple of firms playing around with this, such as Charles River Ventures and their debt fund, which will invest $250,000 in a seed round, and a few firms trying to invest in a couple of early-stage deals and working on deal origination. There will also be a lot of firms moving further up-market and a few who will eventually adjust the size of their funds. TC: What's driving this change? PK: What's going on here is that information technology has changed. IT accounts for most of the venture capital investments, and very few orthodox IT plays require $12 million across the life of a company anymore. There are not enough of those to matter after the last bubble burst and that has gutted the business. It has been a struggle ever since. At first VCs were in denial and told companies, "We'll give you this much money," and they would try to mutate the company to require that capital. That's not happening anymore, but now firms are abandoning IT and making investments where you need a lot of money over the life of a company, such as in cleantech. That's what Kleiner Perkins is doing. You also have people try to go backward and resize their funds for the amount of capital IT guys need. That's kind of the Y Combinator model. The only model that won't work is the $250 million IT fund that's found everywhere today. TC: Several venture firms have recently announced new IT-focused funds of around $250 million in recent weeks. What do you think about that? PK: I'm really surprised. Without either conceding your partners are going to do 15 deals each or going to other areas where you can put a lot of money, it's a bit of a puzzle. Where exactly do they propose to put that money except for places that run counter to the IT side of things, such as cleantech and drug discovery? TC: You keep mentioning IT-focused funds, but a lot of the excitement now is around digital media and Internet content. Some of these startups seem perfectly able to constructively use the millions of dollars they're raising over the life of the company. Could this be the savior for IT-focused funds? PK: There's really not that big of a difference between digital media and enterprise software and telecom. What's needed to fund any of these has dropped by a factor of at least two. That said, it's not uniform, so some can regularly take in $15 million in capital, but there's not a bunch of them. And that's really the root of the problem today. It's all being driven by capital. When you have a $250 million fund, management fees are good, but it's a denial of what's going on in the market. There will always be people who raise a $250 million fund and who will do fine, but there will be a lot who don't. TC: What about these smaller seed-stage funds that have $15 million or even less to invest. A lot of those don't even take management fees. Is that the model of the future? PK: Those firms have existed for as long as the venture business has. Generally, it's someone who is doing it as a hobby or is trying to demonstrate they have investing chops so they can then try for an institutional round. What I always tell entrepreneurs considering taking money from those funds is to think about their staying power. These are not people being paid to invest in companies, so if they get bored or encounter difficult personal circumstances that could be an issue. There are lots of people doing it, and the danger is they will drop out and smoke dope rather than stick with the investment. TC: What about the idea that many of the companies getting funded today are really more of a feature or service than a full-fledged business? PK: At the low end you can always invest in companies building features and hope to sell them. And if that's all there is, then the venture industry will continue to shrink, and that will be the death knell for the traditional venture investing model. TC: What will happen to venture capitalists as they face the changes wrought by more capital-efficient startups? Will there be fewer VCs running around? More angels? PK: If you look at activity data, the numbers of funds who are active investors today are off by 50%, and a huge number of those firms are out raising new funds. Not all will make it. You're already seeing junior partners and principals walking out the door. Most that are leaving are bubble babies and are some of the IT investors who have yet to have their first major exit. They've been in this business for six to eight years with no exit, so they'll have to go out and get real jobs. You might fund a few of these just to keep them out of the economy causing trouble. Putting it in context, there is a certain amount of denial and a certain amount of history that matters. People got comfortable running $200 million funds, but the IT business can't absorb that anymore. So folks have to adjust, and most will have to go out and get new jobs. TC: What about the limited partners who want to put billions of dollars into venture capital and other alternative assets? PK: By shrinking the way it has, the venture business has become such a small amount of money to them. Of course they are irritated about the returns, but because it's not a huge part of their portfolio anyway they're not going to demand that funds publicly give back their money. No one is going to say, "I'm a good person and I'm giving back a portion of this pension money," like they did back in the bubble. They'll just put their money some place else. - Stacey Higginbotham
Comments
From: Dr. Michael C. Graham,
A few months ago I saw you Paul on PBS Wired Science where you said that getting funding from your company would be easy. I have made many attempts to contact your or your company to get funding for my inventions. I have been waiting to hear from someone about seeing if our corporation could get a loan for start up two of our new inventions. Please if someone could tell me how I can get venture capital for my patants this would be wonderful. I find it flustrating to not be able to get in contact with Paul Kedrosky's corporation so that we could launch these two great ideas. So please if you can call me or email me and tell me what I need to do, to find funding for my business that at this point is going no where without help from someone like Paul. MY EMAIL IS Discwrangler50@aol.com and my direct line for my cell phone is 810-814-4551. Please if you can get a hold of me so that we can get started on selling millions of the discwrangler. Thank you, Dr. Michael C. Graham
Posted on:
January 18, 2008 8:06 AM
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A few months ago I saw you Paul on PBS Wired Science where you said that getting funding from your company would be easy. I have made many attempts to contact your or your company to get funding for my inventions. I have been waiting to hear from someone about seeing if our corporation could get a loan for start up two of our new inventions.
I difficult to understand why if others can get funding through your company, why my company can't even get a response to my inquiries at all.
I have a great new patent pending product called the Disc Wrangler. A simple little thing for the user to pick up their discs or DVDs and not touching the disc. We also have a medical product that is an improvement to the Naso-gastic Tubes used every day in hospitals world wide.
Please if someone could tell me how I can get venture capital for my patants this would be wonderful. I find it flustrating to not be able to get in contact with Paul Kedrosky's corporation so that we could launch these two great ideas. So please if you can call me or email me and tell me what I need to do, to find funding for my business that at this point is going no where without help from someone like Paul.
MY EMAIL IS Discwrangler50@aol.com and my direct line for my cell phone is 810-814-4551.
Please if you can get a hold of me so that we can get started on selling millions of the discwrangler.
Thank you,
Dr. Michael C. Graham