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The Rise of Early and Seed Stage Venture Capital

Edwin Goodman Edwin A. Goodman
Co-Founder and General Partner
Milestone Venture Partners
New York, NY

Performance forecasts for 2005-2010 vintage funds indicate that seed and early stage venture capital (VC) investments will markedly out-perform their historical numbers.  However, the same forecasts show later stage VC and buyouts to be under-performers.  This suggests an acceleration of the trends evident in recent years which are summarized in the table below.

US Private Equity Performance

(Periods Ended June 30, 2005)

Fund Type

1 Yr

3 Yr

5 Yr

10 Yr

20 Yr

Early/Seed VC

2.1

-2.4

-10.5

48.8

20.2

Balanced VC

11.7

7.6

-2.6

18.0

13.7

Later Stage VC

8.8

3.2

-6.8

14.1

13.8

All Venture

7.8

3.0

-6.3

25.8

16.0

All Buyouts

26.9

11.0

2.9

9.0

13.8

Mezzanine

9.7

4.2

3.2

6.6

9.1

All Private Equity

20.4

8.2

.10

12.7

13.8

NASDAQ

0.4

12.0

-12.3

8.2

11.3

S & P 500

4.4

6.4

-3.9

8.1

10.6

Source: Thomson Venture Economics/National Venture Capital Association

While forecasts are not predictions, they point to forces of the venture business now driving future performance. A significant force, change in top VC management, will most likely drive performance downward.  More than a few great VC firms have replaced their extraordinary first generation general partners with unproven (albeit smart and talented) newcomers.

Another significant force is the VC investment market. According to French VC Jean Schmitt of Sofinova, prior to ten years ago some 40% of the largest U.S. companies didn't exist.  By contrast, of the 100 largest companies in Europe, none was founded in the past decade. Clearly the future will be filled with investment opportunities in new technology companies in rapidly developing new markets, particularly in the U.S.

The U.S. entrepreneurial culture is yet another powerful force, with its deep capital resources and leadership in technology research and innovation.  In the coming decade, count on the U.S. to produce a record number of exciting new companies.  Then, responding to the stimulus of these companies, look for increases in seed and early stage investment and overall allocation of capital in the VC market.
 
Driving the increased allocation of investment capital to new and innovative companies is the law of large numbers. Simply put, it is less challenging to achieve outsize venture returns with a $150 million fund than with a $1 billion dollar pool, so seed and early stage funds will play a major role. 

Additionally, larger VC investment funds will most likely respond to other market forces that will diminish their roles in the earlier investment stages.  Larger VC investment funds will continue to be significantly affected by growing sizes of pension funds.  As pension funds have gained an overall share of the private equity investor base, they have increasingly influenced the decline of later-stage VC presence in earlier investment stages.  Pension funds’ allocations to "alternative investments" will push capital to a finite number of private equity investment opportunities, especially the larger "later-stage VC" or "buy out" fund categories.  To illustrate: a $4 billion pension fund with a 10% allocation target ($400 million) for private equity will likely invest in chunks of $25 million and up, a strategy designed to deploy capital efficiently and wisely within a reasonable time frame.  This helps avoid creating an extensive portfolio of funds and allows the fund to avoid a limited partnership position in excess of 10% of the targeted fund. 

But as more pension funds invest in later-stage VC and buy-out funds, they create pressures on recipient funds to fruitfully absorb and deploy large amounts of capital.  So, typically it is large enterprises within mature industries with historically stable cash flows that receive their attention.  Such pressures are increasingly driving capital to the high end of the market, heating up competition and pricing, and, consequently, driving down returns. Although some large funds may achieve double-digit returns under these conditions, most are likely to show single digit performance.

These same forces are creating a solid base for optimism at the early-stage end of the market.  As large institutional capital sources mainly ignore the market’s low end, there is relatively light competition for venture firms managing less than $200 million and, in turn, fewer sources of capital for entrepreneurs who seek to raise $5 million or less.  This generates a prospect of higher fund performance and allows VC funds within this space to negotiate more favorable (lower) pricing and other preferable deal terms.

Part of the optimism, and this is the most exciting aspect of the low end of the investment market, comes from prospects for lucrative returns from new company development and rapid growth within new markets. Smaller funds, with a tolerance for greater risk and an aspiration for dramatic growth and attendant higher returns, will shun mature markets in search of newer high growth sectors.  Many of their managers will perceive and take advantage of these opportunities well before they are generally visible.

One of the most obvious of these opportunities is the Internet.  It is our new, largest and most pervasive public shared resource that possesses great investment potential. Some Internet-based markets and opportunities now rapidly expanding include: vertical market search tools, query tools to search unstructured data such as emails and blogs, compliance tools to cope with Sarbox and other regulatory requirements, compression and streaming technologies to permit the downloading of rich content (e.g. films), pod casting of music, video, and text, and on-line gaming. 

Then, beyond the Internet, biotechnology and clean energy are just two emerging markets offering exciting investment opportunities.  As an example, a recent report showed that BP sold $400 million of photovoltaic products during 2004 and has realized its first profits in this area.  More such reports will surely follow.

Early venture capital dollars in search of explosive growth will increasingly flow to “insurgent” companies like SUGARCRM, an open source CRM (customer relationship management) software company that initially allows its customers to download its software from the Internet for free. After capturing 235,000 customers to date, it is stalking market leaders, Siebel and Salesforce.com, both offering conventional SAAS (software as a service) business models.  By contrast, SUGARCRM, after a customer signs up, charges $40 per month for support and offers a deluxe product for a per user annual cost of $239. 

The harbingers are everywhere for attentive observers.  Those who seek high private equity returns are now reading them   Many savvy investors will abandon the idea of large volume private equity deployments, then seek out and select modest size funds that embrace strategies tied to innovation.  To manage the risks associated with early stage funds, they will back numerous discreet managers across different markets. Their investments will be the ones optimizing the opportunity for outsized early and seed stage investment returns that now are forecast for the 2010-2020 decade.

NOTE:
Based on Edwin Goodman’s article “Look for Early Stage Returns to Surge” in Venture Capital Journal, September 2005

For more information go to www.milestonevp.com.

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