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january 06, 2013 • 01:05 PM

What's Ahead in 2013 for Venture Capital

 

The year 2013 will be one of climbing out from a long era of darkness for venture capital. After all, you have to go all the way back to 1999 to find a time when VC earned market-beating returns.

Here’s how dark things have been. The National Venture Capital Association has made available an analysis by Cambridge Associates of the internal rates of return for the average venture-capital fund that normally has a 10-year life.

Simply put, VC has been underperforming the average stock index since venture returns peaked in 1999. In the decade ending in 1999, the average VC generated a whopping internal rate of return of 83.4%. By 2010, the typical VC fund was a big money-loser, generating an internal rate of return of -5.2%. But by the mid-2012, the typical VC fund had recovered to generate a positive internal rate of return of 5.3%.

The Issues

In the past two years, I have interviewed about 200 entrepreneurs from venture-backed companies. From what I can tell, issues such as a possible recession, rising raw-material costs and unstable capital markets that seem to bother big companies do not seem to trouble many start-up CEOs. What keeps them up late is worrying about how they’ll turn their vision into a reality. But they don’t see macroeconomic forces as the impediment. 

They are concerned with keeping enough cash in the till to pay their suppliers and their people. For that, they rely on a ladder of cash sources: customers who pay enough for them to make a profit, suppliers who extend generous payment terms, their own frugality when it comes to items that don’t add value to customers, friends, family, angels, and venture capitalists -- many of whom can be supplying cash at the same time.

The capital is mostly for paying talent chart-topping salaries. When it's in short supply, they must mint their own emotional currency to continue hiring and motivating their industry’s top stars. Given the war for talent, this means start-up CEOs are concerning themselves with how to craft a vision that persuades the best job candidates that they will be missing out on a great opportunity unless they join their start-up.

In the past several years the battle for that talent has intensified because so many individual investors have become fabulously wealthy in recent years. According to a start-up chief executive officer I interviewed recently, these wealthy investors have been pouring seed capital into start-ups at the earliest stages of development without sufficient discipline. These investors expect only one in 10 of these companies to succeed. But the availability of the seed capital is driving up the salaries of top technical talent. 

And that means entrepreneurs cannot compete for that talent unless they can pay top dollar and offer a compelling mission. Not only that, but the rise in seed capital has been accompanied by a plunge in the availability of Series A funding. This means that unless a start-up can become cash-flow positive after using up its seed capital, it will struggle to get the next stage of funding -- checks in the $5 million to $10 million range.

The Milestones 

Silicon Valley insiders will be closely following:Breakthrough products: At trade shows such as the Consumer Electronics Show and others, from time to time there are big surprises that become game-changers. When they appear, venture investors could be motivated to place more capital in those companies and related businesses.Quarterly NVCA reports: If the NVCA reports show rising VC-fund internal rates of return of higher than 8%, it could become be easier for the funds to go to their limited partners and raise fresh capital. And it would be particularly useful for entrepreneurs if those reports show high single-digit returns for Series A investors.The Startup Visa Act: This proposed measure would change U.S. immigration laws to create a new visa for immigrants who can raise $250,000 for their startup company. Another possible legislative change would be to expand the existing EB-5 visa program for immigrant investors.

These changes, should they occur, could point the supply of venture capital in a new direction. The supply of talent would rise and start-ups would be better off.

Winners and Losers

Winners in 2013 will be owners of enterprise information-technology companies that go public, while losers will be those who bought consumer Internet companies at their initial public offering prices and investors in clean tech.

Startups in enterprise IT are also more likely to come out ahead, whereas startups in the consumer space are likely to have a harder time getting funding.

For example, SugarCRM, an enterprise software company, is expected to go public in 2013. And if it follows in the footsteps of another enterprise software IPO winner, Workday, an enterprise software-as-a-service provider whose stock popped from $28 to $50 on its first day of trading in early October and is now at $55, more such start-ups will go public in 2013.

It's the consumer-tech companies that seem to be having more trouble. As of December 20, people who bought Facebook, Groupon and Zynga at their IPO prices are underwater to the tune of 11%, 81%, and 75%, respectively.

The Predictions 

An NVCA survey of 600 entrepreneurs and venture capitalists conducted between Nov. 26 and Dec. 7, 2012, reveals that many believe a shift in VC investment is underway that will benefit some sectors and hurt others.

More specifically, capital is expected to flow into start-ups that provide information technology to businesses. More specifically, 61% of respondents expected increased investment in business IT, while 57% predict a rise in investment in health-care IT.

Consumer IT investment appears to have peaked out, with only 35% of respondents expecting an increase in that field. But pessimism reigns for investment in other sectors: 61% see a drop in clean-technology investment, 53% see a drop in medical devices backing and 40% expect biopharmaceuticals funding to decline.

My sense is that these expectations are based on the returns to investors in these sectors. For example, Facebook’s disappointing IPO and a flood of money into consumer IT have created something of a bubble aftermath. Meanwhile, VCs expect companies to spend more heavily on enterprise IT, thus boosting the prospects for start-ups that sell IT to business. And the absence of attractive investment returns in clean technology, medical devices and biopharmaceuticals is also dimming expectations in these areas.

When it comes to liquidating their investment, VCs are more optimistic than CEOs in 2013. Of those VCs who responded to the NVCA survey, 40% expected a boost in 2013 IPO volume, while 52% envision a boost in IPO quality. Start-up CEOs are less optimistic: 29% see an increase in IPO volume and 37% envision IPO quality to improve. 

Moreover, VC optimism for IPOs is higher for those sectors, such as business IT, where they expect to see more capital and lower for life sciences and clean technology where they see a drop in capital. 

The coming year promises to be a mix of old and new for VCs. The old: Entrepreneurs will execute on strategies to boost market share, raise capital and attract top talent, while VCs will try to maintain their slow upward trajectory after more than a decade in the desert. The new: That success will depend on whether VCs are right that enterprise IT will generate high internal rates of return after disappointments from consumer Internet, clean tech. and medical devices.