VC Q&A: Wilson Sonsini’s Sherman and Fockler Discuss the Changing VC Industry

July 14, 2014
Craig Sherman and Herb Fockler

Craig Sherman and Herb Fockler

Ahead of our 3Q 2014 U.S. Venture Industry Report, which publishes Wednesday, we asked Craig Sherman and Herb Fockler, partners at Wilson Sonsini, some questions about the VC industry, including how today’s environment differs from the dot-com boom and where they see it heading in the quarters ahead. Be sure to check out our reports library and the PitchBook newsletter Wednesday morning to download your own copy of the report.

Q: VC investment activity is approaching levels not seen since the Internet boom of 1998-2000. In your opinion, what are the two or three big differences between then and now?

A: During the Internet boom in the late ’90s, many venture-backed companies were in constant fundraising mode and assumed that they could maintain a high burn rate while raising new equity at least once a year, if not more frequently. When the well ran dry, many died of thirst. Most investors and entrepreneurs learned the right lessons, and have been storing jugs of water ever since for the inevitable next drought. And because the advent of cloud computing and open-source software has allowed startups to spend far less money to get far further, it’s even easier to avoid becoming addicted to easy money. So today’s startups are better prepared and better positioned to survive long-term.

The rise of larger financings, both in the private and public markets, also places venture-backed companies in a stronger position. The “hot” IPOs of the ’80s and ’90s were quite a bit smaller than today’s: Netscape, Apple, Ebay, Microsoft, Amazon, Cisco and Yahoo collectively raised $500 million in their IPOs, while in the last two years Facebook, Twitter, Quintiles, Workday, FireEye, Palo Alto Networks and Zulily together raised more than $20 billion.

Far more of the business ideas that startups are pursuing today make sense. That’s not to say they all make good sense, but there are a lot fewer that make no sense at all, if you think them through outside of an environment like the bubble of the late 1990s. So working with startups today typically doesn’t require a willing suspension of disbelief, and working with companies going public really doesn’t. Notwithstanding some of the buzz about social media companies, many other companies are going public right now selling tangible products satisfying important needs of other businesses. And even the social media and Internet companies going public are generating real revenues right now, rather than selling the future.

The flip side of all this, however, is that VC investment seems to us to be more concentrated in specific areas, while some traditional areas for investment in technology in the 1980s and 1990s are dramatically smaller. Part of this is just the maturation of industriesyou can’t invent something like a new PC or disk drive in your garage anymore and see it get traction in a market where low cost of production is crucial, and you can barely fund the development of a new chip in a capital-lite manner, even if you are outsourcing all your fabrication work. But it also may be that it’s just harder now to find low-hanging opportunities in traditional IT markets now dominated not by the slow moving behemoths of the 1970s and 1980s, but rather by reasonably nimble and forward looking behemoths who used to be the startups from those days. As a result, investment is concentrating in some places where opportunities that can be exploited notwithstanding existing behemoths still seem to exist, such as mobile apps and next generation Internet-based business solutions. But we also need to be careful to make sure we are looking broadly enough outside of all these traditional areas for new ideas to push forward.

Relatedly, where do you see venture capital, as an asset class, heading in the near future? For context, distributions back to LPs increased noticeably between 2009 and 2012, net cash flows have been positive recently and the first two quarters of 2014 VC fundraising almost matched the total amount raised in 2013. Is venture capital dead, as many argue, or is it rebounding?

The VC market has reset since the Internet bust, with a substantial decline in the number of firms actively investing. Many portfolio companies went belly up quickly in 2000 and 2001, but it took far longer for the nonperforming VC firms to wind down their operations. That said, the data from the last several years convincingly demonstrates a healthy rebound in activity and healthy returns to VCs and their LPs. Clearly, the reports of the death of venture capital have been greatly exaggerated.

An additional important element is what we already mentioned above: in recent years it has become significantly cheaper and easier for a startup to get farther in development before it needs to take on its first equity money. For example, the availability of cloud-based solutions to replace in-house server farms and SaaS applications to handle tasks that used to be the province of expensive up-front-licensed software packages has eliminated those line items from capital budgets and enabled those costs to be spread over time as operating expenses tied to the startup’s actual current needs.

Valuations are obviously very high right now. Does part of that have to do with how well startups are performing at the moment? Or is it just a function of the investment assumptions of VC firms?

Private company valuations continue to be closely linked to public market valuations, and the recent run-up in the public market has naturally flowed over to earlier-stage companies. We are seeing multiple disruptive companies experience business success, but clearly the ability of later-stage private companies to successfully go public or sell at an attractive valuation is driving the assumptions of VC firms on their expected returns. Another significant development driving early-stage valuations is the rise of angel investing and micro-VCs that are simultaneously cooperating with and competing with traditional VCs.

There’s been a lot of talk about the VC industry “bifurcating,” with one end of the barbell focusing on earlier seed-stage deals and the other end concentrating more on later-stage companies. Why the divergence? Does it reflect something that’s going on in the market right now, or is it a more fundamental shift in investment strategies for VC firms?

We haven’t necessarily seen some VCs focus exclusively on earlier-stage deals with others focusing more on later-stage deals, which tended to be the case in the past. If anything, we’ve seen many traditional VCs increasingly willing to make small bets in seed and even pre-seed financings, often side by side with angels or other VCs, while still engaging in their traditional focus on Series A and Series B deals.

At the same time, the VC market is different than it was in the past. Not only are there fewer firms, but there has been a lot of turnover within those that have survived. Also, the expectations of VC firms for results from their portfolio companiesand for the results of the VC firms themselves by their limited partnersmay have changed, with greater focus on finding blockbuster hits, or at least achieving respectable annual IRRs, and less willingness to nurture slow performers that have potential but may take a long time to achieve it. Is the primary goal to build companies and industries or is it to realize attractive financial returns? The idea that the former took precedence in some past golden age may be a myth, but we need to be careful not to swing too far in the other direction, but instead to have a balanced approach that seeks to achieve the latter through the former. To some extent, seed financing rounds have become the new Series A, and Series A rounds have become the new Series B. The numbers of deals in these groups has increased significantly in recent years. The problem is that the number of Series B deals, even if they are the new Series C, have not increased, leaving a lot of companies without follow on funding after their early financings. On the other hand, many venture-backed companies may never need to raise a Series C financing for the reasons discussed above.

How do you see the back half of 2014 shaping up? Do you see any signs of a slowdown in financing activity? Or valuations, for that matter?

We’re not seeing any sign of a slowdown in the near term, as healthy public and M&A markets continue to drive new investments and maintain historically high valuations. The pipeline of private and public financings in acquisitions remains fuller than it has been since the late-1990s. But, of course, there remain significant global risks, particularly in the Middle East and Ukraine, that could adversely affect the public equity markets and immediately spill over into the VC market.

Featured image courtesy of Wikicommons user Digon3

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