VC Investors: Go Early Or Go Late, Then Wait Out The Storm

This challenging new environment is forcing a return to old-school investing. Gone are the days of funding features and products. Now, we’re returning to investments in companies and management teams. We can no longer afford to invest in concepts. Now, we’re investing in businesses. We’re unlikely to see 200-plus IPOs a year. Now, we’re focusing on 50 or 70 offerings annually, similar to the 20 years preceding the boom.

It’s only a matter of time before we see mass failures among venture-backed companies, which will push the success metric up to about one-in-10, possibly for the next several years. In the end, to get through these tough times and fuel the resurgence, today’s venture funds must replace impudence with prudence.

I’m not buying the “it’s bad, but it’s getting better” mantra. With IT spending on the skids and the recent past littered with spectacular failures, the outlook for venture-backed companies is grim, and it will likely remain so for five or six years. Venture capitalists would be wise to choose a point of entry – early or late – and settle in for a long ride.

The Case For Going Early

Nothing’s going to change significantly until IT spending picks up – which won’t happen for the next few years because corporate IT customers are saturated. During the good times, they spent millions developing e-commerce/Internet capabilities, preparing for Y2K, and establishing optical networking functionality. That kind of build-up is unprecedented in the history of technology. As a result, most big companies looked at their IT budgets and said, “We bought too much.” And with that, the corporate coffers were slammed shut. Only a handful of vendors, very few of them early-stage companies, were invited to stick around.

After the epic burns of the last few years, start-ups dangerously low on cash continue to be a hard sell. Enterprise customers now require more than a concept to embrace a new technology. The good news is early-stage investors with deep enough pockets, long-term vision, and patience can use the economy and early-stage start-ups to their advantage. New companies with new ideas need time, typically five or six years, to mature and meet enterprise customers’ new standards for accountability. It could be just that long before spending is back up anyway. At that point, these portfolio companies will be mature and ready to hit the market, either to go public or be acquired by a known entity.

The Case for Going Late

Another way to ride out the storm is by investing late. The opportunity here lies in getting portfolio companies through the slow period of IT spending until the budgets are back up – and they can cash in before cashing out.

Approximately 3,000 of the 4,000 start-ups founded between 1999 and 2000 are still in business (about 230 went public; about 750 went bust). Historically, one in three will ultimately become successful investments.

Depending on your perspective, that means 300 will succeed or 2,700 have yet to fail. Most of these companies are surviving (some just barely) off the proceeds of huge rounds that netted more than they actually required at the time. But they’re bleeding and it will take another round to stanch the flow and help them make it out alive.

Late-stage investors can find solid opportunities among the survivors if they avoid wave investing – funding companies in one hot sector. This strategy doesn’t work in the present environment because there isn’t a “next big thing” to latch onto – no new wave of overwhelming technological innovation on the horizon. The economy will separate some of the wheat from the chaff. It will be up to venture capitalists to separate the rest.

Steven Bird is a co-founder and general partner of Focus Ventures. He focuses primarily on investments in the enterprise software and electronic commerce areas.

Prior to co-founding Focus Ventures, Bird was a managing director at Comdisco Ventures, where he provided debt and equity capital for emerging growth companies.

He holds an MBA from the Stanford Graduate School of Business, where he graduated as an Arjay Miller Scholar, and Master of Science and Bachelor of Science degrees in mechanical engineering from Stanford University.