Venture capital firms ask themselves tough questions these days. Among them: how can they dig out of the dot-com collapse? How should they invest going forward? How should the leader of a firm strike the right note for the future? And is it a field that graduating MBAs should aspire to enter? According to experts at the conference session titled "From Bubble to Recession: The Current State of the Venture Capital Industry," none of the answers are simple, but a sense of perspective remains one highly valuable commodity. According to Walter Kuemmerle, a Harvard Business School professor who served as panel moderator, the money flow in venture capital may have been down 51 percent in 2001 compared to 2000, but the sum total was still greater than the previous eighteen or so years combined.
Ed Kania, managing general partner of One Liberty Ventures/Flagship Ventures, dissected the trend of overspending prior to the dot-com fallout, saying that venture capital firms must make more independent decisions these days. "You're making bets that are not obvious, that are not apparent to everyone in the industry. It takes more courage, and by the way, everyone can't do it."
It takes more courage, and by the way, everyone can't do it.
Firms do need to focus more than ever on industries they are good at, said Kevin Jacques, senior associate of Sevin Rosen Funds. "It's probably impossible" for a dot-com or information technology-focused firm to turn on a dime and move into life sciences or whatever the next trend is, he said.
Firms also need to grapple with their mission, added Kania (HBS MBA'82). Venture capital as an investment profession can be "hedge fund-like" with sector specialists placing bets and walking away, he said. "But I think what we've all found is that there is a place for venture capital that plays a profound role in helping build, that participates in situational coaching and hands-on partnering with an entrepreneurial team to make something happen," said Kania. Firms that installed large teams to manage funds of half a billion dollars or more now face the challenge of creating processes that are appropriate for a large team rather than individual venture capitalists, as in family-style firms of the past.
"On that question, you're going to see some firms succeed and some firms fail, because it's very, very hard to run a team-oriented process that addresses the type of decision making we've described," he added.
What Software Lull?
The software industry has been heavily over-invested in for the last few years, according to panelists at the session "Can Software Recapture Investors' Interest?" Y2K spending drove growth in the late '90s, followed almost immediately by a boom of broad e-implementations such as customer relationship management and e-commerce, while the threat loomed that smaller, more nimble software companies would put the large corporations out of business. The panelists, representing venture and software groups, described the challenges of getting investors to invest in software now.
If you take away the bubble, said Ajit Nedungadi (HBS MBA '98), vice president of TA Associates, there is a core of healthy spending that will continue in enterprise resource planning systems, security technology, and systems that enable enterprise applications to talk to one another. People can look at this as a lull, he said, or as a return to a more realistic pattern. The panelists suggested that the software industry is going back to its root strength with ROI-based, smaller implementations.
If most tech needs are being met through large application packages, why entertain the idea of having smaller software companies pitch? If you believe that the Web is the next new wave of technology, then you should probably invest in those firms, the panel agreed. Ullas Naik, managing director of JAFCO Ventures, noticed a trend toward more open operating systems. "People aren't buying dedicated servers," he said. "They're buying blades."
The new thinking is to avoid huge packaged platform suites and focus on spot applications for blocking hackers and preventing online invasion. There is a trend to invest in application and infrastructure hardware, said John G. Simon, a partner at General Catalyst. An opportunity exists, he said, for add-ons and plug-ins that ride on top of ERP systems. "People want to get things in digital form."
HBS assistant professor Thomas Eisenmann, moderator of the panel on "Shakeout in Telecommunications," asked the assembled VCs if they are better able to add value to equipment companies or service companies—or whether it is just tough all over in the telecom business. The panelists responded that there is not much distinction between the types of value VCs add. They are, in general, quite cautious as a result of an obvious shakeout in service and the inevitable shakeout in equipment. While most of the panelists agreed that they prefer early-stage investing, Apax Partners general partner Theodore Schell said, "An awful lot of B, C, and even D rounds look a heck of a lot like A rounds these days due to recapitalizing. The number of rounds that had preceded the capital going in has very little to do with value."
The best VCs are managing investments the same way in both areas. "We're helping them stay alive during a horrible economic downturn so they can last on a minimum amount of capital during a period in which their top line is not going to grow very much," said Kevin Maroni, of Spectrum Equity Investors. "We're waiting for the cycle to return."
Is it possible VCs didn't learn anything from the dot-com bubble and subsequent crash? Marc Fogassa, a principal at Axiom Venture Partners, said, "The industry has a herd effect—if you don't have the flavor of the month, it will be harder for you to raise money." He emphasized planning for lag time—the time between when a company is started and when it makes a profit—from the get go, and realizing that the industry has a cycle. Knowing when the cycle is in an upswing is the answer to the million-dollar question.
But just knowing a cycle exists doesn't make it any easier for investors to predict if and when an investment will pan out. If you hesitate, will all be lost? As William Quigley, managing director of Clearstone Venture Partners, put it, "Venture capitalism is always a balance between greed and fear. At some point we have to say, 'We're going to invest.'"