June 13th, 2005
Top Ten Percent Or Bust
"This world is mine for the taking
Make me king, as we move toward a,
New world order,
A normal life is boring;
Close to post-mortem,
It only grows harder…
You only get one shot,
Do not miss your chance to blow
This opportunity comes once in a lifetime
You better…" - Eminem, Lose Yourself
At a very well attended and very enthusiastic TIA awards banquet this week, the newly re-elected Premier (phew!) and the ex-BCTIA director, George Hunter, both exhorted us to be one of the top 10 technology centres in the world by 2010. Now, forgetting for a moment just how one measures that (perhaps David Letterman has the criteria for the top ten list), I'm here to tell you today that we better be among the best or we should just quit and go home now. I came to this conclusion after spending a few days among the best of the best in the world of the technology start-up company at a conference in San Francisco last week.
The IBF Venture Capital Conference has been run for 18 years now through boom, bust, boom and bust. This and the fact that it is in the backyard of the place where nearly 50% of all venture capital dollars are invested in the US any given year, gives it a unique opportunity to draw the most experienced people out. And this year, these folks were especially candid with respect to three major themes:
1) The venture capital industry is a-changin'.
2) Liquidity for start-ups is mostly M&A and a lot longer to realization.
3) The industry dynamics are tougher for the start-up than ever before.
Since exactly 0.05% of my readership are venture capitalists (thanks for reading Joe… that case of Moosehead is on its way), I won't bore you with the "exciting" industry details. But it would behoove all of you to know that things are changing in the venture business and it will impact us all.
First, some stats (as usual, Mr. Factoid):
- The median size of a new venture fund in the US was $180M in 2004, the highest ever. In fact, the previous high was in 2000 at $150M.
- The previous fact is interesting given that there were 637 new funds raised in 2000 and only 170 in 2004.
- According to the VC panel at the conference, the 10 year net IRR average for 776 reporting US venture funds up to the end of 2004 was 35% per annum (an awesome number compared to stock performance or bond returns). But wait, if you take out the top 10 of those funds, the average IRR drops to 17% and if you take out the top 50, the other 726 reporting funds made just 8% per annum. That was through the good times…
The investors in US venture capital (called limited partners or LPs) used to be family foundations and endowments. Since the mid-90's, the institutions have become more prominent (pension funds, mostly). These pension funds have gobs and gobs of money (our own manager of pensions in BC is managing over $60 billion and is a middleweight in this class). The reason the median size of funds is creeping up in the US is that there are less VCs (only 20% of venture funds ever raise a second fund in the US), and that the institutions won't go away. They keep putting money into the VC funds. However, they clearly want to be in the top performing funds with names like Sequoia, Kleiner Perkins, August Capital or NEA. It's hard to get into these funds. It's a very exclusive club. So the pressure is back on the best performing VCs to take more money. Hence, the increase in size of the funds.
What about the liquidity of VC investing? Here are some tidbits from the men and women that make all of the money at the top of the VC heap (Sequoia and Kleiner have just passed 500x their initial investment in Google… sigh). They make very good money after the IPO of their technology companies by holding on when typically VCs should be selling or giving the stock to their investors. The after IPO performance of Google is instructive. It went public last year at $85 in that funky dutch auction. It brushed $300 this week (that's 3.5x in less than a year for those of you scoring at home). Are you listening Crystal Decision shareholders? You punted on the IPO and took the stock from BOBJ… I wonder where you would be now as a standalone IPO. So, the veteran VCs were lamenting the dearth of technology IPOs in late 2004 and early 2005. In fact, Dick Kramlich of NEA, easy winner of the "comb-over" of the year, pointed out that their successful investments used to be about 45% IPO and 55% M&A transactions. In the last couple of years it has moved to 80% M&A. Most other veterans agreed and decided that this wasn't changing any time soon.
Why be down on M&A? Take the semiconductor industry as an example. A typical fabless semiconductor company requires $35M in investment to get to profitability. In the past 4 years, the largest M&A transaction for a semiconductor company was $122M. I happen to know that the investors did 3x on that deal. Big whup! A hits based business like venture capital does not get rich on 3x. And that is the BEST one. IPOs in the semi space, like Portal Player, SiRF and Atheros did much better, all going public at around $500M company value. That is great performance and closer to that magical 10x hit. Everyone grumbled that the best one can expect in an M&A transaction is $200 - $500M and there will be very few of those. Companies need to be tracking on $50-100M in revenue and profitable to go public these days (excepting life sciences of course). That is a big company. It takes time to get to that level.
Another panel of industry luminaries (senior staff from IBM, Microsoft, Cisco and Intel), talked to the issue of where does a start-up go to find $100M in revenue, five to ten years out of a garage. The fact is that the technology industry is much more mature than it was in the early 90's at the beginning of the last positive side of the business cycle. Category creating technology companies are harder to find because there are fewer places to try and hide from the biggest tech companies. When Microsoft was a puny, pimply-faced company with $500M in revenue (circa 1993), it was easier to stickhandle clear of their reach. Now they are a $10B in revenue EVERY QUARTER company with massive reach and distribution. How do you hide from them in enterprise software and become a $100M a year company? Starting today?
As another luminary VC lamented, it used to be that building a distribution channel for your product was a $20-30M prospect, usually raised over a couple of growth stage rounds of financing. Now, to be the branded product and own the lucrative distribution might be a $100M prospect, he thought. It only makes sense that most companies sell out to the giant that has the channels already humming. There will never be a new video game company to compete with EA, Acclaim, Vivendi, Sony, Nintendo or Microsoft, unless someone can raise $1B or more to build the channels. Talented teams leave these companies all the time and fund the development of a title or two and then get bought back in for $10-20M. Nice change for the founders, no hope for a venture fund.
So, you are detecting a theme, right? Be in the very top of your class and you get big rewards. Everyone else is getting dregs. The "swing for the fences" attitude of the Silicon Valley is looking at a higher and higher fence (or further and further away, take you metaphorical pick). And they are adjusting to it as best they can. All of this is not to say that you can't make an exciting company and find a nice niche to own, far away from the radar of the big players. It is also not meant to discourage the constant scanning for the new new thing that might break out and catch the behemoths by surprise (Google, iPod, camera phones all come to mind as examples of huge impacts that most of us didn't see coming). But the evidence is mounting. The playing field is shrinking and the smallest (dare we say, the bottom 80-90%) will not be players. We had better be in the top ten technology centres if we want to hit it really big in the world of technology, because eleventh might be just as insignificant as eleven hundredth. That's what I'm seeing out there…
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