Let the Sparks Fly!

Capital Efficiency

There has been lots of talk lately about whether the venture capital model is “broken”. It is quite a complicated question (with no obvious answer) that I will leave to others more adept at statistical analysis than me to try and answer. I have been watching and listening though.

I was at an early stage investor’s conference in the Valley a couple weeks ago where this very question was asked to a panel of well-established, Sand Hill Road-based, VCs. These investors ran the gamut of pure early-stage $150M funds, to $1B+ plus funds who also claim they do early stage. Their answers?  Well, it’s been two weeks of racking my brain and I’m still not sure that what they said makes sense.

Basically they said the model is not broken if you invest properly, and of course, they all invest properly. It must only be the guys at Sevin Rosen funds that are stupid investors I guess!

All sarcasm aside, there were a few very important issues that came up during this panel (and conference) that are worth discussing further. By far, the greatest recurring theme was CAPITAL EFFICIENCY. The tech IPO market is still on life support, and even though the M&A market is strong and providing liquidity opportunities, without a strong IPO market to goose up valuations, the average M&A valuation of less than $50M is a big problem.

Some high-level stats from the U.S. for 2006 YTD:

• $23B paid over 311 M&A deals for an average of $73M per exit, BUT the median exit is actually closer to $25M
• The median amount invested in these 311 companies - $50M
  

For a $250M fund, the math doesn’t work if portfolio companies continue to get funded with $50M when the exits average what they do...something has to change.

Hence, Capital Efficiency. Companies need to do more with less. Not exactly a novel idea here in Canada, but one that VCs in the Valley are (finally) talking about more and more. No more over-funding of companies – this is where the current VC market falls apart and appears broken. Whereas software and internet companies were being funded to the tune of $40-50M prior to an exit, the new reality is that they must be able to reach the same end-game with as little as $10-15M. The popularity of blogs, open source, the continual increase in powerful computing chips provides start-ups with a lot of options to appear much bigger, and move much faster, than previously with less capital.

So, I see two challenges with this new-found approach to the VC market:

1. While you still have less money going into companies, you still have way too many “me too” companies all chasing a limited number of exit opportunities
2. The balance between “Capital Efficiency” and being “Penny Wise, Pound Foolish”.

This second point is especially important, and one that separates the successful companies (and VCs) from those that could be, but aren’t successful. The recurring argument in Canada as to why the VC community has not posted the same positive results as the US is that we don’t fund our companies to reach $1B+ in value and are happy to settle for the $50M exits – not the “go big or go home” attitude.

How to balance this with the new realities of Capital Efficiency will separate the truly successful VCs from the rest of the pack.

Angels and VCs

I have attended a number of early-stage investment conferences over the past month and I've taken note of some common themes and controversial comments that I thought I would share over the coming days. 

The most controversial comment I heard was from a prominent U.S.based angel investor who said during his presentation (and I paraphrase) that “Angels and VCs should never co-invest”. His rationale? The interests between the groups are not aligned. Angels are investing their own money as opposed to VCs who invest the money of other people and institutions. Angels are not interested in or motivated by raising their “next fund” and therefore are much more patient investors, are not motivated by IRR (which has a time to exit aspect to it) but rather cash on cash return. Therefore time is the angel’s most valuable resource and the strategic decisions to be made by the Company are very different.

I personally don’t buy this, and neither do many of the angels I have spoken to, both locally and in the U.S. We at Brightspark have been developing a strong relationship with the angel community because we believe that our vision of early-stage investing is very much aligned with angels, and have co-invested with angels on occasion. Angels investing their own money are motivated by the same end-game as early stage VC funds – creating tremendous value for the shareholders and founders and positioning the company for the appropriate exit at the appropriate time. Angels I have spoken to are not interested in tying up their own money for 10-15 years in a single investment and while I agree that cash on cash returns are important to VCs as well, the time aspect to an exit has an absolute bearing on investment decisions for any investor. A 5x multiple on an exit within 5 years is much more motivating to an angel than a 5x multiple in 15 years. There is always a time value to money. In the latter case, they may as well buy a 15 year bond and there is much less risk.

At a Early stage investing conference in the Valley, there was a whole panel on how angel organizations presently work together with the VC community – and to a man, they all expounded on the importance of bringing the VCs into the process early on.

In my mind, this was one angel trying to motivate the angel community and give them a feeling of self-importance that they don’t need – the VC community already values the important services they provide to the start-up ecosystem.