Looking at venture investing in 2010 and beyond

Interview by JIM STOMMEN, Contributing Editor

John S. Taylor is vice president of research at the National Venture Capital Association (NVCA; Arlington, Virginia). He is responsible for developing and overseeing association data and research efforts. The key element in this effort is a research consortium which was created in 1998 involving the NVCA and Venture Economics, now Thomson Reuters.

In December 2001, PricewaterhouseCoopers joined the team and the tri-branded MoneyTree Report, which became the definitive source for venture capital investment information. Building on this information, the NVCA has been able to develop and encourage research and studies which provide greater transparency into the process of creating the companies of tomorrow.

His career began with the company now known as Accenture, where he was a senior consultant advising small business clients. He later held senior product manager and IT positions in both large and small organizations before joining NVCA in 1996.

BB&T: What is the outlook for venture capital overall in 2010?

Taylor: We saw a shift in the overall sizing of the industry, really starting in the middle of 2008. We saw the industry scale down from roughly an upper $20s billion to low $30s billion range of investment each year down to a much lower level. We have not yet announced our year-end numbers for 2009, but we expect those to be well under $20 billion. So the industry has shifted in its size band. But that is not a function of the public market liquidity problems in mid-2008, it's a function basically of post-bubble.

We have been expecting a downsizing of the industry, really since the dot.com bubble burst back in 2000 and 2001. We went from a period of time when in 2000 alone, the industry raised and invested more than $100 billion, back to the point where we were in the size band of mid-to-upper 20s, low 30s, depending upon the year.

We expect, over the next year, that we will have fewer venture capital firms open for business, and there will be less capital overall in play. A lot of this downsizing has really already occurred, and it occurred post-bubble, with firms that perhaps raised money in 1999-2001, raised their first fund or an early fund, invested right away and it did not come to fruition. Those were very, very difficult investing times. A lot of the firms that raised money then did not perform well. They basically spent the past three or four years nominally open for business, trying to find buyers for the companies still in their portfolio, perhaps trying to take some of them public, basically trying to harvest their investments. These are the folks that are leaving, this is the capital that is rolling out of the capital under management. The firms that are leaving are the firms that would not be able to raise another fund.

If you look at the history of the venture capital industry, it has been all about buying low and selling high, and this is an absolutely horrible time to be selling high. IPOs aren't happening, there are fewer acquisitions being done, even at fire-sale prices. So it's a very, very difficult time to try to exit a company.

We're hoping for some improvement in 2010, really into 2011. There almost has to be improvement; it can't get much worse. Let me give you an example of what that sizing is like. During the 1990s, 14% of all the companies that got their first funding from venture sources went public. In a typical year, 1,000-1,400 companies get their first-time funding. That suggests that there ought to be at least 140 companies – that's 14% of 1,000 – going public at that run rate. Well, we only had six go public in 2008 and 13 go public in 2009. So yeah, it doubled, but still, we're a long, long way from where we need to be, and there has been an ever-increasing backlog of companies that are trying to go public or trying to get acquired. So there's a lot of catching up to do – a lot of companies still in the later stage still in portfolios that need to move on. I think that will very much be the focus of 2010.

There's a time to buy low and a time to sell high, but there really have been no periods of time where it was simultaneously good to do both. Right now we're in a good time to buy low, and a lot of venture capitalists are taking advantage of this. If you ask, “What is the current downturn in the economy doing to venture capital?“ the answer is that it has really hurt the exit market, so the companies that have been in the process can't exit, but it also is causing a lot of very good people to leave corporations, corporations perhaps deciding that they're not going to invest in R&D going forward, or not invest in new products or projects. So the folks working with them come out and are looking for venture capital.

If you talk with the venture capitalists, they are extremely encouraged about the quality of the people and the quality of the ideas that are coming forward now. You add on top of that the fact that it is very easy to start many tech companies now, essentially on a shoestring. Companies have access to cloud computing and other location-independent computer applications, many of which are free. The type of IT infrastructure that companies needed a few years ago just doesn't exist anymore, so you can be more efficient with capital.

We have this interesting dynamic of venture capitalists who still have a lot of later-stage companies in their portfolios wanting to turn their attention to the next crop of companies which are coming along. If there is stress in the system, that's it – trying to get the focus on the early stage companies that are walking in the door with business plans.

BB&T: The reports we're seeing from some of the regional groups on VC activity seem to be emphasizing that there are a lot of deals being done, but for a lot less money.

Taylor: If you look at first-time fundings, or business plans accepted, there is absolutely less money for each, but some of the more popular and more promising sectors right now – meaning biotech, medical devices and clean-tech – actually require more capital per deal. Those tend to be more capital-intensive all the way through, so it's an interesting dynamic. There is no question that you're seeing a lot of very small rounds being carefully placed.

There is one thing that I think has been under-noted: One of the effects of the liquidity crisis that started in mid-2008 and hit the fan in late-2008 is that for an entrepreneur trying to start a company on a shoestring, some of the traditional sources just aren't available anymore. A lot of angel investors have seen their own portfolio holdings or their own liquidity shrink, so they're not able to help out as much. You also have some amazingly tight constraints on what you can do with homeowner lines of credit. We were hearing reports that if a bank catches wind of the fact that you're thinking of launching a business, all of a sudden your home equity line really shrinks.

You have friends and family as sources of money, but they don't have the liquidity they once did. So the whole idea of funds available to get things off the ground is actually crimped more than I think is recognized; that clearly is something that is a factor. There has to be a little more of a miracle that happens between the time that someone has a great idea or has a great technology and when they can actually get it in front of a venture capitalist and get it funded.

BB&T: I guess there's an offset there between the smaller amount of capital that's available from angel sources and others versus the lesser cost to get a venture going? The whole advent of virtual companies is a phenomenon and has grown exponentially in the last couple of years.

Taylor: That's right, and I think a lot of it is that the technology is in place to facilitate that. Interestingly, a lot of that technology is venture-backed.

BB&T: Where has healthcare venture capital spending fit into the overall picture? It seems to me that, historically speaking, healthcare VC is somewhere in the range of 15% of the total.

Taylor: It actually is more than double that now. That has been the historical level; during the height of the bubble, when everyone else was doing high-tech, the number shrank to about 3%, but historically, life sciences have been 10% to 15% of the total. But most recently, it has been 30% to 35%, depending upon the quarter. Biotech is about 18%, but medical devices have come on very, very strong in the past few years, and that is starting to reach the same number, in the mid-teens. Life sciences are generally far less volatile in terms of year-over-year changes such as having more consistent timing of IPOs and that kind of thing. The life sciences segment is a very important part of venture investing overall.

BB&T: Med-tech in general has had that whole “safe haven“ thing going for it in recent years. The difference between biotech and med-tech is that in the case of med-tech companies, their work usually involves a real product sitting there at some stage of development.

Taylor: Certainly when you look at how biotech interacts with the nature of venture capital, the amount of capital that is needed these days is absolutely mind boggling compared with even what a well-funded venture capitalist can do. So anything that is going to work its way through the process will get only so far with the traditional venture capital kinds of sources and then a strategic partner really needs to get involved. Historically that would be as an equity investment in the latter parts of the process, but that has shifted a little bit and now the equity partner now will typically get involved as part of a joint venture, some kind of a joint offering that is set up between the start-up and the larger organization. If you look at the history of biotech, you have to look at the environment that it is in, and the past couple of years have been very, very difficult for venture firms that are looking to raise money to invest in biotech, as well as for those who have the money to put into biotech.

One of the concerns, for example, is what's going to happen in healthcare reform to all the investment that is being poured into companies. Will the investors ever be able to recover that money, not only from the successful investments but the unsuccessful ones? Overall, it has to be profitable or the money doesn't keep flowing in. And perceptions have been such that it has been very difficult to bring money in recently. Even now with life science investors, with biotech investors looking to reach out to their investors, the question is, “Do you have a viable business model under healthcare reform?“

One of the proposals for the healthcare reform bill that struck us as being very, very difficult was in the area of follow-on biologics, where you have these very large-formula drugs, and the question is how long should the developer of those drugs have access to exclusive use of that molecule? There were those who felt that it was only five years, then the follow-on biologics, the clones, could hop in and lower prices, etc. We worked with several members of Congress to demonstrate the fact that the cost of capital for a start-up biotech company was somewhere well north of 20%, which requires a longer runway. It requires 12 years, which in fact is what is in the bill that it is bouncing around today. If it was five years, or the perception was that it was heading toward anything resembling five years, I think you would see investment in biotech go to zero. They listened to us. Once we went in front of them and said, “Here's what we think you need to know,“ they actually were very receptive.

The healthcare bill affects a lot of people. The thing that we are most concerned about now is the whole idea of a high excise tax on medical devices. We're hoping that at a minimum, smaller medical device companies can be carved out or relieved from that. Certainly there is some receptivity there. If you put large taxes on different parts of this, all you're doing is recycling what is called a tax versus what is called a fee, and somebody will have to pay for that along the way.

One of the things that we were able to get woven into the legislation is to be sure that there is ability for new, innovative drugs and treatments to come in. It was important to us that new things that come along be given an honest chance to compete against something that has been out there for awhile. The devil is in the details, and a lot of it depends on how the FDA implements everything, but it looks like there is an acknowledgement that a lot of the treatments that might be used five years from now don't even exist in the marketplace today.

BB&T: Each area of business that a VC firm might choose to become involved in has its own set of metrics forming the rationale for such activity. What, in general, are VCs looking for as they make their allocation assessments?

Taylor:I think one of the misperceptions that is out there is that a VC raises a fund and then says, “OK, I have $100 million to invest, and then the business plans come in, and then they look at med-tech plans alongside of biotech alongside of IT. In fact, a lot of that allocation is thought through before a fund is put together. These days the actual agreements between the venture capital firms and the limited partners – the investors, who are typically pension funds, or charities or college endowments and so forth – are pretty much agreed on up front. That lines up with the expertise of the partners. So a firm will raise money, saying, for instance, “I am going to do primarily early stage biotech, and these are my priorities.“

A lot of that concerning the sector and stage is defined up front, and we know from looking at the industry that the sector is becoming much, much more sector-specialized and subsector-specialized. It's not enough to be a biotech VC anymore; it has become very specialized, to the point where geography really doesn't matter as much. In fact, a lot of the coastal firms are now re-establishing relationships with firms in the Midwest that maybe have an inside track on some technologies, maybe with some universities that have some good, promising technologies that they want to look at. So a lot of that is built in as a fund is put together.

One thing that I think is not appreciated from outside the industry is that the industry does not scale. To make these companies successful, you have to have a VC with good experiences, as well as the bandwidth to actively engage in a company. A study we did with Dow Jones recently was the third iteration of a survey we had done twice before. The question, “What is a reasonable board workload for a venture capitalist?“ and the answer is six, if they are early stage companies. What that says is that one of the venture partners will take a board seat with that company – that's a pretty full workload for a VC. If they are later-stage companies, maybe the figure is eight. Someone who is looking to make an investment in a company is probably thinking less about the specifics of the dollars and cents going in than is thinking, “I have exactly six bullets, and I have $100 million to invest. How am I going to do it?“ That really means that only the exceptional companies can bubble up to the top.

Many two-person companies have received venture financing, but no two-person companies have ever gone public. Somewhere between the two people and a dog in the garage up to the company in a big IPO, people have to be added. One of value adds is the Rolodex and the network of the venture capitalists who will bring people in to these businesses as these companies mature.

BB&T: Are incubators going to play more of a role? Many of those that I'm familiar with seem to do a great job of percolating their companies up to the point where they attract more venture funding and more VC board leadership and get on their way toward a realistic exit.

Taylor:The ones that will have the best outcomes will be those that have good relationships with venture capitalists who have a good deal flow and know the handoffs, who know the attorneys to draft the papers correctly at the very beginning to enable a smooth transition to venture capital funding and being in the venture capital ecosystem. As with everything, it's all a deal-by-deal thing. If the incubator produces the best deals, the best entrepreneurs and then hands them off, it can be a very effective way of doing things. There are some good ones, especially in the life sciences area. As personal financial sources become scarce, and if current economics stay as they are, then incubators could play a much larger role just to get over the initial hurdles, maybe to develop a prototype or robust business plan that would then be fundable.

BB&T: You mentioned geography, so let's talk about that for a minute. When you were on a panel during the MidAmerica Healthcare Venture Forum in Madison, Wisconsin, in November, one of the observations you made was that recently, 50% of VC dollars had gone to California companies. Does that mean that at least for a while areas such as Georgia, Michigan, Ohio and other emerging life sciences centers will have a harder time attracting the attention of VCs?

Taylor: No, not at all. The venture industry is so industry-focused right now, sector-focused and sector-specialized, that the money will find deals. There is a recognition that the deals can pretty much be any place. California sprang back post-bubble faster than the rest of the country, there's no question, but there also are good things going on elsewhere. History shows that it is all driven by sector. Austin is a great example. During the 1980s, Austin was successful because you had a great university, you had great VCs, you had a good public-private partnership, the ecosystem was in place. But don't underestimate the role of semiconductors being the sector they chose to focus on, and semiconductors becoming hot – it was a very promising and a very fruitful sector.

As we see new technologies come out – clean-tech, med-tech, biotech – it will be very much dependent on the individual technologies, not the geography. There's a secondary question about the availability of certain skill-sets of people in given areas. You need to have enough talent available to add on to a company as it grows – no one wants to start a company and get it to 30 people, then realize “Oh my gosh, we're going to have to move the whole thing if we're going to take the next step.“ That's very difficult for a number of reasons.

BB&T: One of the areas I'm watching is how Michigan is developing a life science focus. One of the arguments they use is, “Hey, we have all these engineers here who used to be involved with the auto industry. If you're a med-tech firm, we're a great place to grow your company.“

Taylor: One of the things that is true about venture capital is that it is the most effective mechanism that I know of to get capital to the most promising projects and the most promising teams. The marketplace will decide this. I certainly could see where you have good technologies being developed in Michigan, the Midwest, the Southeast. There's good stuff going on, but not in the numbers people there want to see. These areas certainly could emerge, just as Austin glommed onto semiconductors and San Diego put together a very effective biotech community.

BB&T: Do industries that are heavily regulated, as healthcare is, face particular challenges in attracting VC dollars, or is regulation simply another piece of the decision-making puzzle?

Taylor:The VC model tends to be that you invest in things that you make once and sell many times. So yes, the regulatory environment is a concern for medical devices, and that's known. That's factored in. I don't see it being an impediment. If a regulated business by its nature doesn't scale well, it's probably not going to get any investment in the first place.

BB&T: Beyond 2010, what is the long-term outlook for VC investing?

Taylor: I think it's very, very positive. Going forward in 2010, if we can get the IPO markets going and the corresponding acquisitions markets, we'll see a lot of the companies in these portfolios find new homes and the VCs will raise new funds and turn their attention to the future.

The new funds that are being raised will be invested cautiously. Someone making a first-time investment in a company, somebody raising a fund and putting a first round of financing into a company, historically has reserved three times the original investment amount for future investment in that company, but we're now hearing four times and five times the original investment amount as the amount the VC is reserving for follow-on investing in that portfolio company. People are seeing that whatever they invest in now could be in the portfolio for eight or 10 years if needed.

As for the size of the industry, I don't think we will hit $20 billion once all the precincts report for 2009. I think we're going to be in that size-band for a while. It might creep up a little bit because we have a lot of later-stage companies and those take a lot of capital, so the deal numbers may stay constant, but the actual dollars go up because of that sector shift. There are a lot of folks out there saying that maybe $12 billion, maybe $15 billion is the right number for the industry, that maybe we're too large and can't put this much capital to work.

BB&T: One of the comments that jumped out at me when you were on that panel in Madison was that we're now at a point where about one-third of total venture investment is in later-stage companies compared, historically, to about 11%. That seemed like a startling statistic.

Taylor: Very startling, and troubling. We have never had this many later-stage companies around. When you think of it post-bubble, basically nothing happened in the way of exits in 200l, 2002 or 2003. Google exited in 2004 and there were some other exits that year, but not really much since. So there is this backlog that has been accumulating and accumulating and accumulating. There is a risk to the industry that these companies, especially those that need the IPO or need a strategic acquisition in order to grow and roll their services out, could die on the vine if they don't get the capital they need to go to the next step in time for their product to be leading-edge.

BB&T: Is there a question I haven't asked, but you wish I had?

Taylor: The one thought that I have is that the venture capital industry has been successful by taking small amounts of capital and making them into big companies. This is a good time to be an investor if you have the capital to invest and if you have the patience. Despite everything else that's going on out there, there is good stuff in the pipeline. I feel great about the future of the industry. If we can get through the next year or two, I think the future will take care of itself.