The Uncertain Future of Venture Capital and Tech Valuations

Those were the good old days. There has been a decline in the amount of capital committed to venture since 2000. That decline is tied inextricably to the decline in returns that tech companies and their IPOs have generated since the dotcom era.

And the anger you may have sensed at the disappointing performance of the Facebook IPO was a reaction to its role as a confirmation of those worst fears: the easy returns were gone, probably never to return.

Further, as the following article explains, the data reveal that even the positive returns from that era were skewed by the outsized performance of a few companies' IPOs which were not consistent with the broader experience. The thesis of venture capitalist Bill Janeway and others who share his view, is that the venture capital industry of legend was built on the 20 year bull market that ran from approximately 1982 to 2001. It has not yet returned.

Subsequent to the dotcom period, firms in the business of funding innovation have contributed to the overall decline by their inclination to sell to larger corporations as soon as the new idea shows signs of realizing enough of a return to cover the investors' initial stake and a bit more. This has inadvertently stifled improved performance as the investors in this space seek to offset the longer term trend for which they have been at least partially responsible.

There is a need for this form of investment and affected economies will suffer without it. Changes in strategy, in tax policy and investment philosophy will be required before we are likely to experience opportunities comparable to that now bygone age. JL

Igor Stenmark interviews Bill Janeway in Forbes:

Since 2000, the VC returns have actually under performed NASDAQ. That in turn is no doubt in significant part due to the very substantial closing of access to an active speculative market for initial public offerings.

Bill Janeway:  First of all, the venture capital industry as an industry is contracting.  The capital under management by venture capital firms, and the number of venture capital firms, are both declining from the absurd and unsupportable spike of the end of dot.com bubble. Then the amount of money committed to venture capital firms went from order of magnitude of $10 billion in 1995 to a $105 billion in the year 2000 – that’s a $140 billion in today’s terms.

The decline in capital under management and in number of firms tracks the radical shift in venture capital returns since 2000-2001.  I have just been reviewing the data because of updating the course that I teach at Cambridge and Princeton on venture capital in the innovation economy. Through 2000, the returns to venture capital firms, while highly skewed by a small number of persistent out-performers, had substantially exceeded the NASDAQ index. Since 2000, the VC returns have actually under performed NASDAQ. That in turn is no doubt in significant part due to the very substantial closing of access to an active speculative market for initial public offerings.  There have been obviously some highly visible major IPOs and a modest recovery in the number of IPOs in the last few quarters, but in general, since 2001, the IPO market has been running at a rate below where it ran for almost 20 years from 1982 to 2001.  Put it this way, – what we think of the venture capital industry was built on the back of the greatest bull market in the history of capitalism and that bull market came to a speculative peak in 2000-2001.

So, there have always been venture capitalists, there always will be venture capitalists.  It is only the notion of an industry that I think needs to be questioned.  What we are seeing today is a bifurcation between a small number of very large venture firms who are investing funds well in excess of a billion dollars and a much larger number of smaller VC firms. The larger VCs are challenged to learn how to invest the money in other than a classic start-up. Some of them are doing a pretty good job of that, investing as growth equity rather than start-up venture investors.

On the other hand, there are a larger number of small firms who reckon that what they are really doing is funding distributed research and development for large companies.  They are funding projects, which if they succeed should be sold on to big companies before the challenge and risk of attempting to create new sustainable cash positive independent business is accepted.  Now that is a legitimate and even needed economic role, and it actually shifts the burden from venture capitalist and entrepreneurs conducting distributed research and development to the large companies, so they have to learn how to absorb innovation from the outside without smothering it the day after the closing. That is a big, big problem that I do not believe is nearly sufficiently accepted, understood, or addressed by corporate America and America’s business schools.

Igor Stenmark:  One of the things that really caught my interest in reading your book was your comparative analysis of gaps in venture capital returns between a few top firms and the rest of the pack.  The data seems very compelling so why does capital continue to flow into the venture funds? 

Bill Janeway:  First of all, there is a great deal of inertia in institutional limited partnerships, the limited partners who invest in the venture funds.  When a pension fund, particularly a state pension fund, decides that it has an allocation for venture capital, it may be three percent of a $40 billion fund, they are committed to putting that money to work.  It can take a decade, even two decades for them to make that allocation.  It is not surprising that it should take a decade for them to cut it back, or eliminate it but that is why the money that is going into the venture capital is being reduced.

Second, there is the kind of home run sort of momentum herding that contributes to the slow rate of change.  So, Facebook goes public and there can be humongous returns earned, even if the odds against earning them remain very high.  Put those together and you can see why.  Even though the very best venture capital firms by and large can turn down and select the limited partners, there is still demand for participation in venture capital partnerships even at a much-reduced level.  Frankly, what I said to my friends who are on the limited partner side is examine closely the historical record of any fund that approaches you, look for persistence across multiple funds in different economic and financial environments. If the funds that pass this test are prepared to accept your money, give it to them, but if not, then don’t just hand capital out to the mediocre followers.

Igor Stenmark:  Let us flip the conversation a little bit and talk about some of the start-ups Many of the start-ups we see today are created by people who previously have had two, three, in some cases four ventures with successful exits. They have more than sufficient amount of capital to start the business, they have access now to very robust technological tools, and they have the cloud available as a development platform with lots of open source and lots of talent around.  What is the role of the venture firms in this context?  Can they remain relevant; can they structure deals that remain attractive for everyone?  What is your view forward?

Bill Janeway: Well, first of all, there actually is a very interesting academic literature that says that for the serially successful entrepreneur, it does not matter who they take money from, whether they have a mediocre venture firm based on historical track record or a top notch one. They know what to do and they know how to do it.

Having said that however, particularly in the world I know best, – enterprise software, there has been a shift.  It is partly the function of the availability of open source software, so it costs very little to begin the process of launching a start-up by writing code.  Even in the initial build of market, there is the availability of Twitter and the social media tools to get some attention. But, – the shift from proprietary license to software as a service model has profound financial consequence for enterprise software start-ups.  Very simply in the enterprise software world the poor start-up was  funded by the rich customer who wrote big upfront checks for the expected future value of the software being bought while at the same time committing to annual maintenance payments. More capital came in from customers than from venture capitalists, so you could get to positive cash flow with no more than $20 million in capital.

Today, the model has shifted in mathematical terms from selling the integral of the expected future value to selling the differential; the incremental value delivered per unit of time or customer or transaction and the balance has shifted the other way.  Now, the poor startup is in effect financing the rich customer and what that means is that the revenue needed to achieve a positive cash flow is typically well over $100 million. If you are going to trying to go all the way and build a sustainable business, having a lead venture capitalist with a track record and a network and standing and resources to fund that really matters even to the previously successful entrepreneur.

Igor Stenmark: Bill, – I could not agree more of you on that point.  We follow the SaaS space very closely and see this in spades on a daily basis in our research and advisory practice. We also see that 15-20 years ago when you were at Warburg-Pincus and I was at Gartner we saw companies that were crossing 100 million dollars in sales, 40-50% top line growth, 20% operating margin and this company would be valued at three, three and half, or maybe four times revenue on a good day.  Now, we see SaaS companies fetching 6, 7, 10, 15 times revenue. Are we in a bubble?

Bill Janeway: Can you rationalize that?  How do you rationalize that?  You know I actually gave an interview to the New York Times about the brilliant success Amazon’s Jeff Bezos had in being able to convince the Street to value Amazon on the basis of multiple of revenues with maximum growth subject to minimum necessary cash flow – something that is under his control because he can slow down growth and generate more cash.  I think it must be a function of the perceived, almost limitless scale of the market available to the early leaders in each of these spaces.  I myself don’t think it’s indefinitely sustainable as a mode of valuing businesses but those who funded and who valued salesforce.com on this model have been rewarded and it has become a bit of a model for others as they move into the historically proven large space of enterprise applications.  I think it is unlikely that it will be maintained indefinitely.

Igor Stenmark: Do you have any thoughts you can share on the valuations of social media companies, Linkedin, Yelp, Facebook or for Twitter.

Bill Janeway: Well, the whole point of thinking about the valuation of the companies at the frontier of innovation, is that it is not possible in any plausible disciplined manner to derive the net present value of the expected future cash flows, which constitute “the fundamental” definition of value in the mainstream conventional neoclassical economics.  Obviously, the valuations are huge relative to any set of metrics.  It is new ground.  Each one of these companies represents a new foray into what appears to be a limitless market space with evidence from Google and Facebook and potentially Twitter, that it can be monetized and generate positive cash flow over time.

The way to invest in all the candidates for this seems to be what I guess is now known to the younger generation as the investment strategy of “spray and pray”, – a little bit of money to a lot of startups knowing that most of them will fail but one or two might just possibly break out.  As soon as they show any evidence of breaking out the valuations for a C round, forget about the IPO, becomes a nosebleed.  That is not an investment model that I am temperamentally oriented towards.  I am much more interested as you know from my book in following the cash and generating the cash earlier rather than later, but this is the kind of phenomenon that emerges when a new economy becomes sufficiently mature to open up space for these radical new business models and application types.

Think about what happened in the 1880s, as Railway Express provided the layer of “infrastructure software” on top of the railroad network in North America, which in turn enabled Montgomery Ward and Sears Roebuck to deliver the “killer app” for the railroad age known as mail order retail, which completely transformed the economy, created national brands like Procter & Gamble and re-architected the physical and economic architecture of North America. That is the kind of phenomenon that Google, Facebook, Amazon, EBay, Twitter represent.  Trying to value them on a net present value of expected cash flows is just not relevant yet.  Sooner or later, it will become so.

The value now is driven by supply and demand amongst speculators who have liquidity and will not have to stick around to find out what the fundamental value turns out to be over time. Because of this phenomenon of bubbles more risk will be taken, more capital will be mobilized than would be the case if investors were strictly investing based upon the net present value of the expected future cash flow, which as I began by saying cannot be determined in plausibly rigorous manner.  Now having said all that, one of the laws of life is, as I used to tell my young colleagues, nothing ever sells for 50 times earnings for very long.  So when it does, you, who are in a position of influence, have a positive obligation to raise all the cash you can as cheaply as you can, and then distribute as rapidly as you can the liquid securities, which you happened to own.

Take the example of Elon Musk at Tesla who had an extraordinary opportunity to do what Jeff Bezos did at Amazon at the top of the dot.com bubble – mainly to buy from the market – that is from speculative investors, a vast quantity of financial resources, billions and billions of dollars at a minimum cost.  If he does not do that and does not emulate Jeff Bezos, you will have learned something about Elon Musk’s strategic judgment as an entrepreneur.  This was an extraordinary opportunity for them.  Having said all that, I actually think the value of social media companies that are addressing markets, which are effectively limitless from today’s perspective have relatively trivial significance to the overall health and prospects of the innovation economy.

Igor Stenmark: Do you think that the constantly increasing size of new private equity and venture funds contribute in any way to creation of these bubbles?

Bill Janeway:  That is not happening.  The magnitude of private equity funds has effectively been kept in the low double-digit billions.  There has been a major phase shift towards somewhat greater discipline on the part of limited partners.  The market has loosened up a bit this year but it’s not what it was in 2006-2007.  The number of venture capital firms is declining and the amount of capital dedicated to those firms is at best stable at around $20 billion, equivalent to the roughly $10 billion it was back in mid 1990s.  What is happening in the venture world is the bifurcation between a small number of very large firms that are transforming themselves into growth equity and even low-to-middle market buyout firms  and a significant number of small firms, with less than $100 million in capital under management. The smaller firms are focused on funding distributed research and development for big companies intending to sell only rather than trying to build businesses or practicing the “spray and pray” strategy of investing across the host of social media and similar kinds of very low cost, very high risk start-ups.

Igor Stenmark: What are the characteristics of someone who is a successful venture investor in this century? What separates those who are outstanding vs just average?  Do you have any examples of people who you think are really outstanding in this business right now?

Bill Janeway:  I do not want to get into naming winners.  The winners are pretty well known by their track records.  The only way to evaluate them is their actual achieved track record particularly in identifying the persistent success through different market environments and across different parts of technologies.  What I can tell you is that after 40 years of trying, I have definitely decided that there is no prospective basis for judging who will be a successful investor.  You simply have to let the younger members of the firm have the chance to lose money, and if all they do is lose money then you have got your answer.

Igor Stenmark: Looking back at 40 years of your career, what were some of the most positive and negative surprises in your investment career?

Bill Janeway:  The first one which is discussed at length in the third chapter of my book, the founding of Life Technologies. This involved the most intense fundamental education in dealing with the radical uncertainty of financing of new companies. My colleague and I delivered $20 million to a company called Bethesda Research Laboratories to fund the two years it would take to get to positive cash flow. In two months this money was spent thus leaving us with a potentially catastrophic liquidation. We managed to turn the situation around by joining forces with an outstanding operational leader – Fred Adler – and with Fred we took control of the situation and raised the necessary cash to fix the company.  Ever since then, the core lesson that I learned and teach at Cambridge and Princeton has been that the sole hedge against the inescapable uncertainty of financing startups is cash and control. Unequivocal access to enough cash to buy the time necessary to find out what is going on, meaning what has gone wrong, and enough control to change the parameters of the problem.  Now, in the world of venture capital that typically begins by firing a CEO, but it can involve re-purposing the venture.  It can involve selling the assets before they lose all value. It can involve even adding to the assets by acquisition under new trusted leadership.  I learned this lesson of cash and control in roughly 1981 and it has guided my investing practice ever since.

Igor Stenmark:  What advice would you offer today to founder CEOs who are looking to raise capital for a new venture?

Bill Janeway: Define a path towards positive cash flow from operations. Understand what is involved in pursuing this path in terms not only of the capital required but also the degree of technical difficulty and, above all, understanding of competitive market conditions and channel to market.  All of these things need to come together into a credible business plan.

Understand the challenges of going public and gaining access both to cheap capital and to liquidity for the early investors.  Given all of these circumstances, my advice to the entrepreneurs and those who finance them is to be thinking consistently and repeatedly about when to sell.  When we plug in the new stuff and it lights up, do we sell now.  When we have three customers who will stand up and say, I bought it, it works, I will buy more, do we sell now or do we accept the very substantial dilution, particularly if the business is a SaaS revenue model?  I am talking about a very substantial dilution and incremental risk of attempting to build a sustainable cash-positive business which today typically requires at least $100 million of risk equity capital to get to sustainable positive cash flow from operations.

Igor Stenmark:  Bill, when we look at the transition to cloud computing and mobile, a lot of the incumbent players such as IBM, Dell, and HP have really been more hurt than helped?

Bill Janeway:  Clearly, they are trying to transition.  It is always the case that the incumbents are vulnerable.  Their profitability is based on franchises they built using the previous architecture, and consequently they are slow to respond.  That is the innovator’s dilemma. Clearly, IBM is trying to catch up by being very acquisitive.  Oracle is trying to move into the new environment.  It has been very acquisitive in technology now, and not just in customer-base oriented acquisitions such as PeopleSoft and Siebel. Since its acquisition of BEA Systems, it has been acquiring core technologies.  So, the big guys are definitely awake to the challenge and for the new guys, as I say, breaking in and disfranchising the incumbent will be somewhat more difficult this time round than it was in the 1990s. Compounding the challenge is the lack of available technology to acquire and the shift to a SaaS revenue model which radically increases the equity capital required to get to positive cash flow.

Igor Stenmark:  What do you think is going to happen to a company like Dell?

Bill Janeway:  Warburg Pincus did not participate in any of the activity around Dell.  There may be a path towards some kind of milking of a revenue stream that leads to time horizon and the return goals of Silver Lake. I have enormous respect for Silver Lake.  I have known the firm from when it was founded.  I knew its founders.  I am not going to second guess their investment.  It is a challenge obviously to turn around a business of this scale and efforts were made to do the similar kinds of transactions back when the world shifted from the vertically integrated proprietary computing model to the distributed model.  You may even remember ComputerVision and companies of that sort that were the subject of first generation private equity buyout deals.  It is critically challenged, but as I say, I would also expect that Silver Lake went into the deal with their eyes collectively very wide open.

Igor Stenmark:  Do you think that HP has a reasonable chance to transform itself again?

Bill Janeway:  HP is so big and has so many diverse businesses.  I have no doubt that within HP there are some very attractive businesses.  I actually agreed with the older very high-level strategy of one of the several former CEOs, Leo Apotheker, which I thought came in two pieces.  Piece one was: HP had managed to miss the transfer of value from hardware to software that took place in roughly 1995 and over the following decade it completely missed that transfer.  The only significant software business it had was deep down in the systems management space and in between the stacks of software and operating systems.  The commoditized relational database owned by Oracle and applications based on the relational database owned by Oracle and SAP, left no room there, but those applications were all based upon the management of structured data.  The one space of blue sky and blue water that was available was the management and exploitation of unstructured data.  Hence, the obviously highly controversial and unfortunate acquisition of Autonomy–at the highest strategic level I get what Apotheker was thinking about.  Similarly, I certainly get what he was thinking about in saying that “we have got to get rid of this anchor of the PC business from around our necks”.  The acquisition of Compaq was a categorical error under Carly Fiorina just as the acquisition of EDS was a categorical error under Mark Hurd. Liberating HP from both of these will have to happen sooner or later.

 Igor Stenmark: IBM has become giant services and financing operation. What are your thoughts about IBM these days?

Bill Janeway:  Absolutely right. I think Sam Palmisano (previous CEO of IBM) did an outstanding job of shifting towards being a first-class services business. IBM’s financial performance for a period of years shall we say was enhanced by very aggressive financial engineering.  But IBM is clearly established.  IBM is going to be here and it is going to be part of the environment.  I think, as the world of enterprise application itself increasingly becomes one of IT-enabled services, IBM has a very clear opportunity to play higher up the value stack.