Venture investing has picked up from the post-dot-bomb era of a few years ago—but does the comeback signal good times ahead or a mini bubble of misguided exuberance?
To provoke discussion, HBS professor Bill Sahlman threw down the gauntlet at a discussion on technology venture investing at the 11th annual Cyberposium conference held at Harvard Business School on November 19.
As an industry, he suggested, venture capital has little to recommend it. "In the future, I see a median rate of return of zero or less," stated Sahlman, observing that the top thirty venture-backed firms contributed 50 percent to 70 percent of distributions in the industry in the past ten to fifteen years. With so much global liquidity, he added, it will become even more difficult to earn a respectable rate of return as too many dollars chase too few opportunities.
"What's going to prove me wrong?" he asked a panel of venture capitalists.
At first, Sahlman found little resistance to his gloomy forecast. "You're right in the aggregate," conceded Stan Reiss (HBS MBA '00), a general partner at Matrix Ventures. "We're in the lottery business—but we know we're in the lottery business."
"The statistics are correct," said Raj Kapoor (HBS MBA '96), managing director at Mayfield, a venture capital firm based in Menlo Park, California. "It's an extremely hit-driven business that's becoming more and more like the movie industry in that sense."
We're in the lottery business—but we know we're in the lottery business.
Mike Hirshland, general partner at Polaris Ventures, advised MBAs in the audience to think long and hard about why they want to be in venture capital. "It's a different, more difficult business than it was ten or fifteen years ago," he said.
Sean Dalton (HBS MBA '98), general partner at Highland Capital, said that dire predictions for VC were nothing new. Rather than worrying about the flow of capital into and out of the industry, however, he counseled a simple, head-down approach: "Do good deals. Focus on what you can control."
Improving The Odds
What are some other ways that VC firms can influence their rate of success, asked Sahlman. In an increasingly competitive environment, how does a firm differentiate itself?
"The odds are significantly against you when you're starting out," said Dalton. Even if you have a great deal of money, the best entrepreneurs won't care—they'll just want a good partner. And that comes by building a reputation over time: "It's all about performance—it's easy for an entrepreneur to make a few phone calls and find out what value you added to your last venture and how you behaved when things didn't go well."
History points to the importance of people skills in successful ventures, agreed Sahlman. But what roles do operating experience and technical knowledge play in a firm's success?
"At Polaris, we as partners will not be the smartest individuals in any given field," said Hirshland. His advice? Develop the ability to identify opportunities and judge character; over time, you can focus on various specialties and sub-specialties and hone your knowledge of these areas.
A lot of opportunities in the tech sector are about execution, not technical expertise, said Kapoor. A sense of timing and a good marketing instinct are two qualities at a premium in today's market.
"It's not about specialization," said Reiss. "It's about quickly figuring out new trends within your general area of expertise. The people who hop around a lot will be successful."
What about future trends, asked Sahlman. Many venture capitalists made money in enterprise software, until the space was saturated. Will venture capitalists have an impact in fields relating to healthcare, education, and the environment—all areas that show a great demand for new solutions?
"Clean energy is big on the West Coast," said Reiss. "Venture capitalists haven't traditionally invested in those areas that you mentioned . . . but given the amount of money that's in the business, somebody is going to try, and somebody will be right."
"Those spaces that you mentioned don't fit the venture profile for time frame and liquidity," said Kapoor. "They require a ten-year, $100 million investment. With that said, the profile around energy, particularly solar, is starting to look more standardized."
In a Q&A session with the audience, one participant wondered about the rationale behind VCs replacing a founder-CEO with a "professional" CEO, despite the fact that some of the best top executives in tech are entrepreneurs.
"VCs have very few buttons they can push in a company—one of them is whether to hire or fire a CEO," said Kapoor. "With so much information coming to them about a company, and so few outlets for them to act on that information, it makes it more likely that they will press that button at the wrong time."
"I love first-time CEOs," said Dalton. "They actually want to learn. I look at how hungry they are and how relevant they are. Look for the Desh Deshpandes," he told the audience of MBAs, referring to the founder of Cascade Communications and Sycamore Networks. "That's going to create your career."
Learning From Losing
One final question put panelists on the spot: What are your failure stories?
"We all have lots of those stories," said Reiss. The common thread running through his experience, he said, was being wrong about the market. "You can't run against the wind," he said. "You have to have the market with you."
Timing is everything, said Kapoor. The first time he sold Snapfish it was the right market but the wrong timing, and his investors didn't make any money. "We stuck around, got the opportunity to sell again, and did very well. The timing was right."
"Losing money is part of this business and I hate it," said Dalton. The real challenge, he added, is recognizing when it's over and cutting off funding. After seeing a venture he pulled out of go on to do very well, however, Dalton made a prediction that probably rang true for the other panelists: "I'm going to lose money again, I promise."