Revising Expectations:
The Outlook for Venture Capital and Entrepreneurship

The world of venture capital and entrepreneurship has changed dramatically over the past decade. Not just in the obvious ways. We've all talked ourselves to death about the foolishness of the Bubble, about the lessons we hope everyone (else) has learned, and about how we are all sensibly returning to "basics." But no matter how the statisticians interpret the numbers for us, we are not just returning to the early '90s and going "back to basics." The world of venture capital and entrepreneurship has fundamentally changed. Investors and entrepreneurs who don't understand this change and adapt accordingly will find themselves left behind as the ecosystem of venture creation evolves beyond them.

In the coming decade, both venture investors and entrepreneurs face a new, more competitive world. There are more innovative technologies and more investors interested in funding the best of them. Success in this next era, however, will more likely mean 3x and 5x returns, not 20x and 50x returns. But the '90s also left us with an incredible infrastructure of intellectual property, engineering talent, management talent, support talent, technical standards, international networks, public policy frameworks, and organizational practices that make the innovation and venture creation process more efficient going forward. While the '90s bred a generation of over-enthusiastic entrepreneurs and investors, the next generation of successful entrepreneurs and investors will revise their expectations and find ways to exploit the resources left behind, giving them an advantage that the '90s generation did not have.

The venture world today and going forward is not like the old world of the early '90s. The challenges, and the opportunities, are different.

Challenges for the Future

The venture community is like an ecosystem, not like a balloon. When a balloon expands, and then contracts, it looks like it did before. When a balloon expands, and then bursts, there is nothing much left. But when an ecosystem expands and develops rapidly, and then has a crisis - being starved of the nutrients of capital spending and venture investing - it must adjust. It cannot simply shrink, but rather it must somehow withstand or absorb the withering away of its varied constituents. Some will survive by retreating (carving back). Others will survive by evolving (changing strategy). Still others will not survive.

Funds with over $400 or $500 million to invest (roughly the top 60 venture funds) face serious challenges as the ecosystem changes around them. They have to evolve to survive. Big funds can't afford to invest in seed stage companies, unless they are confident that they are investing in companies that will be billion dollar exits. If a home run means a $250 million exit in the world of revised expectations, and if a fund typically has a 25 percent stake at the time of exit, a billion dollar venture fund has to have 15 to 20 home runs just to return their investors' initial capital with zero return on investment.

Corporate investors and angel investors are now playing a much less active role in the venture finance ecosystem. Many corporations that were active venture investors in the '90s discovered that it an expensive and unreliable way to outsource R&D and have since pulled way back, if they haven't shut down their venture investing activities altogether. Similarly, angel investors found that as the food chain of follow-on investing broke, many of their early-stage investments could no longer raise subsequent rounds. With their portfolios in tatters, angels have gone into hiding-except for those who need to find jobs.

This leaves the boutique venture funds-firms with $5 million to $200 million in capital-to fund startup companies. Most specialize by the expertise of their general partners, by region, or by sector. In the past, these small funds co-invested with the big funds, or acted as precursor investors for a select group of big funds. As a result, the boutique funds' investment criteria were pretty much the same as the big funds-startups targeting huge markets with plans for astronomical growth. In the current environment, however, the big funds aren't taking the baton for the next round, no matter how hard early stage investors try to pass it. In the few cases where the big funds can be coaxed in, it isn't just the entrepreneurs who get crammed down; the early stage investors are also being crushed. The game just isn't very much fun anymore.

Resetting Expectations

In this new world, what should entrepreneurs and investors do? Is this a temporary hiccup in the inexorable upward path of innovation and new venture creation? Or is there something more fundamental happening that could mean a long-term downturn in entrepreneurship and venture capital?

To begin with, all of the players in the venture community need to reset their expectations and pursue a sustainable path in the new venture ecosystem. Without this reset, however, the current paralysis will continue unnecessarily, and innovation and growth will be hurt.

On the investor side, limited partners and general partners, as well as angels and corporate investors, will have to accept lower rates of return for their portfolios. There will be some home runs - new companies that reach billion dollar exit valuations and return 20x or even 50x multiples to their investors. But savvy investors will understand that most successful companies will reach $20 to $50 million of sales over a four to six year period, meaning perhaps $50 million to $100 million exit valuations.

In this world, the big funds will either have to play the role of mezzanine investors for those smaller companies that break out, or they will have to compete for the relatively few really big potential wins. The smaller funds, if they can reset their models and wean themselves from the big fund food chain, will become the primary engines of growth in the evolving venture community.

On the entrepreneur side, most successful companies (by this new standard of success) will not receive early-stage financing from big funds or corporate investors. The key to early-stage financing will more frequently be finding the right boutique funds to provide the early stage capital. In this environment, entrepreneurs need to embrace a concept that has been lost for a generation - capital efficiency. We lived through a surrealistic era when capital was cheap and plentiful, and so the focus was on speed, growth, and critical mass. Now capital is dear, and entrepreneurs need to design companies that can reach critical mass on much less capital. This is not simply a return to traditional notions of frugality. It means understanding how to architect all aspects of the business plan to leverage partnerships, pricing models, industry standards, and the infrastructure developed over the past decade.

A related challenge for entrepreneurs will be deciding whether to pursue a horizontal or vertical market strategy. A horizontal strategy addresses a bigger, broader market. But the reality is that a lot of horizontal success stories are really an aggregation of vertical successes. (Hewlett Packard started as a niche play.) Any given customer is not really interested in a company's ability to solve all problems for all markets. The customer wants to know two things: Can this company really solve my problem? And will this company be around to support that solution? Unfortunately, investors tend to get more excited about horizontal models because they appear to address a big market, and so for clever companies with vertical solutions the answer to the second question appears to be, "No." If, however, a new breed of venture investors learns how to fund and support these companies, we will see more vertical market solutions emerging and thriving.

One of the keys to resetting expectations is the emergence of an efficient M&A market at the low end. Over the past decade, the venture industry grew dissatisfied with M&A as an exit strategy. "IPO or Bust!" was the prerequisite game plan for any CEO that wanted venture backing. Venture capitalists made it clear, "We don't want to invest in a company whose aspiration is to be sold for $50 million." For a $500 million fund, that makes sense. But there are lots of brilliant, non-trivial innovations that can offer marvelous returns for a smaller fund at the $50 million level, if both the entrepreneur and the investor can accept that outcome.

None of this is intended to imply that there is no future for big funds. There will still be lots of startup companies that fall into the category of "potential home runs," and there will be even more entrepreneurs that think they fall into that category. Most likely the big winners in the IPO game - once the game resumes - are likely to pass through the portfolios of the big funds as their capital needs expand. But the most fertile soil for entrepreneurs and investors is down on the forest floor.

Opportunities

Certainly the era of innovation and entrepreneurship is not over. Far from it. So where are the opportunities for entrepreneurs and investors today? There are an enormous number of problems that need to be solved, and the innovative companies that solve these problems will generate healthy returns to those who invest in them. Meanwhile, the continuous flood of innovation from universities and corporate labs, and even from garages, will create new product and market opportunities that we have not yet dreamed of.

Some examples: The way applications work over the Web is terrible. Our computing experience has regressed to slow, cumbersome, page-defined frames and forms. Someone needs to fix the Web-its speed, user interface, application integration, security. Or maybe we can toss out the Web altogether and create a whole new method of ubiquitous connectivity. The way enterprise applications don't work is a scandal. The way cell phones don't work is another scandal. The fact that the police department can't communicate with the fire department is a tragedy. Why is videoconferencing so hard? Why does my computer still freeze up? Why can't I watch "West Wing" when I want to? (I can't even record it because there's currently no NBC affiliate broadcast that reaches my neighborhood near the heart of Silicon Valley.) And this does not even touch on the opportunities for innovation in the life sciences, materials sciences, and energy technology.

Maybe some of these problems are more important, and bigger opportunities, than others. But the point is, we have plenty of work to do, which means there are plenty of opportunities for entrepreneurs and investors. The growth and trauma experienced by the venture community over the past decade has created tremendous exhilaration and pain. The opportunity now is to take advantage of this experience, reset our expectations as entrepreneurs and investors, and push forward with innovation.

(About the Author: Bill Reichert is President and Managing Director of Garage Technology. Prior to Garage he was involved as a co-founder or senior executive in several venture-backed technology startups. He has also held positions at McKinsey & Company and Brown Brothers Harriman & Co. Bill holds a B.A. from Harvard College and a M.B.A. from Stanford University.)

9/30/02