Mixed Signals

Usually you can gauge the health and general attractiveness of venture capital by looking at what’s going on with fundraising, investment levels, valuations and exits. What is deemed healthy or attractive in most cases depends on whether you’re an entrepreneur, venture capitalist or limited partner, but it’s typically pretty clear if times are good or bad for you. Recently though, it seems as if the indicators are sending very mixed signals. Here’s a quick overview of what’s happening:

Fundraising: Fundraising has been brutally difficult for venture firms ever since 2008. It seemed as though the situation was improving in the first quarter when we got off to the best annual start for fundraising since 2001. However, the quarter’s improvement was really driven by three firms raising billion dollar funds – Bessemer Venture Partners, Sequoia Capital and JP Morgan (their Digital Growth Fund – not really a venture fund in the traditional sense). Non big-name firms have had real difficulties raising funds, as evidenced in the second quarter of the year which featured the lowest number of funds garnering commitments since the first half of 1995. It can be argued that this is actually a good thing (for limited partners at least) since historically, lower fundraising has been correlated with higher returns.

Investment Levels: Venture investment activity has been volatile since 2008 but generally has displayed an upward trajectory, in both, the number of deals and total dollars invested (in fact, in the second quarter investment in Internet-specific companies rose to the highest quarterly level since 2001). A couple things are troubling. For one, investment continues to outpace fundraising and at some point will have to come down as many firms currently deploying capital will be unable to raise new funds. Another issue is that the rise in overall number of deals is being driven by seed and early stage investments while the rise in overall dollars is being driven by later stage deals. This means companies in between are competing for a smaller pool of capital. It can be argued that this is good thing because only those companies with proven models are making it to later stages, but I think the dynamic is also reflective of the overly rapid institutionalization of seed investing and a huge interest that formed around specific later stage companies.

Valuations: According to the Fenwick & West Venture Capital Barometer, Silicon Valley companies funded in the second quarter of 2011 showed an average price increase of 71% - up significantly from the 52% reported for the first quarter and the highest such result since 2007. With the third quarter seemingly very unsettled it should be interesting to see where things go. Anecdotally, seed and early stage deals still seem to be commanding high valuations. This is in part due to a huge influx of capital competing for deals as so many more venture firms and individuals are jumping into seed investing.

Exits: The exit market often reflects what’s happening in the public markets and broader macro environment and so right now there seems to be a lot of uncertainty. Officially, according to NVCA statistics, we are on pace to have the best year for VC-backed exits (both via M&A and IPO) since at least 2007. However, a lot of the activity is being driven by Chinese companies and it seems as though exit activity seems to have slowed in the third quarter (we’ll know officially soon). Large companies still have lots of cash but seem to be getting more selective again. The IPO window looks to be shrinking and many companies that have recently IPO-ed have not performed so well post-IPO. Good companies are definitely “exitable” but the bar seems higher than it was just a few months ago.

So what do we have? Fundraising data indicates it might be a great time to be an investor in venture capital. Investment levels are telling us that venture capitalists are excited about young companies but valuation data tells us that deals are as pricey as ever. The exit market had been great through the first half of the year but things are starting to look shaky – in line with the public markets and the macroeconomic environment. On one hand things are great, on the other, maybe not so much. The only way I can make sense of it all is to remember that the venture industry is significantly more cyclical than most people realize. We clearly were headed up out of a trough but now I think the industry is in a holding pattern trying to figure out whether or not it should continue moving upward or if it’s already peaked. It’s important to note that venture capital returns of late have been great.

What I think will happen is that the lower fundraising levels (which are, or should be, the “new normal”) will eventually lead to a slowdown in investment activity and, in turn, a decrease in valuations. All of this can be considered good or healthy in many respects.  The exit market is hard to predict and hedges a lot on the macro environment but it’s safe to say that good companies can still be attractive acquisition or IPO candidates. On the whole though, I doubt even an amazing exit market will lead to a boost in fundraising so investment activity should really remain steady or decline. Perhaps the industry data has just been hard to make sense of because the effects of the “new normal” levels of fundraising haven’t yet trickled down to investment valuations. It should be very interesting to see how the rest of the year shakes out and where all the variables stand at year – only then do I think we’ll know if we’re moving out of this holding pattern and in which direction. 

Seed Investment Sizes Rise But Stay In Check

I recently shared that seed investment relative to total venture investment neared an all-time high in the second quarter of 20011. One-third of all new venture deals were made at the seed stage according to data from the National Venture Capital Association and PwC. I thought it might also be useful to share what was going on with the average investment size for new seed deals. Is more of a focus on seed stage deals driving up valuations? Well, yes and no. The average seed investment more than doubled over the first quarter of the year – up from $1.5 million to $3.1 million. So yes, clearly there’s a significant increase from the quarter prior (but I have some issues with that data which I’ll discuss later). On the other hand, the average seed stage investment has averaged $3.3 million since 2006. So we’re actually still below the average in recent history.

Data Source: PricewaterhouseCoopers/National Venture Capital Association MoneyTree™ Report, Data:  Thomson Reuters

I think there are a few factors at play that have prevented seed valuations on the whole from rising too much:

• For all the attention some of high profile deals get, they seem to be the exception, not the rule. Huge early stage rounds like the one for Color garner a lot of attention, but I think on the whole, investors have all the talk about us being in a bubble in the back of their heads and are being prudent with deals.
• We also need to remember that most seed deals are in the IT sector, and specifically for internet companies. This means the amount of funding they need in a seed round, on average, is getting smaller because it’s so much cheaper to build a company out to at least to proof of concept. What this does leave room for though is the potential that the amount of investment going into seed deals is getting high relative to the amount they actually need. It’s hard to extract this from just basic investment data.
• There are also alternatives to funding – instead of higher profile companies and entrepreneurs seeking seed funding outright, many are increasingly going to incubators. These programs, such as YCombinator, TechStars and a whole slew of others, are growing in number and size.
• Finally we can question the data source – the NVCA and PwC gets their data from ThomsonReuters which captures data through surveys and only includes institutional investment. So, individual angel investment, for example, is generally excluded.

Back to that issue with the Q1 data - as with the data on the number of new investments, there’s a strange anomaly in Q1 of 2011 with the average deal size as well. It’s as if investors took a dramatic pause in the first quarter – did fewer seed deals, and invested less in each deal. Again, the reason is not quite clear to me because the general impression I got from observing the market was that seed and early stage investment was hot, driven not only by a rise in super angel/micro VC funds, but also more seed investment activity on the part of traditional venture firms. One reason why the data might not match up with anecdotal evidence is that maybe investors were really taking a wait and see approach on how the venture-backed companies that held IPOs in the first quarter did before actually closing on new deals. Clearly a record-setting second quarter in terms of venture-backed IPOs in the IT sector helped boost confidence and probably led to the spike in the relative number of seed stage deals and dollar amounts in Q2. I’m still open to hearing if anyone has any alternate theories. 

UPDATE: On his blog Reaction Wheel, Jerry Neumann shared that he has a nagging suspicion about early-stage venture capitalists: "About six months ago it seemed like they were slowing down their pace of investing while the corporates and newer super-angels were doing a lot more deals." If this is true, it surley can help explain the anomoly in Q1 the data. Since only institutional venture firms are included, the suspicion that they slowed up on seed stage deals can actually be confirmed. On the whole though, seed stage investment seemed like it was going strong because in reality, it was - just led by super angels whose deals do not make it into this data. As for if this is a warning sign, I think its too early to tell - but it is intersting that in the next quarter, relative seed stage investment by VCs hit levels last seen right before the bursting of the tech bubble. 

Relative Seed Stage VC Investment Nears All-Time High

Last week, US venture capital investment data through the second quarter of the year was made available by the National Venture Capital Association and PwC. What stood out to me most was that seed stage deals rose to account for one-third (33%) of all new venture capital investments in the second quarter. This was the highest such level since the first quarter of 1999 (yes, over 12 years ago!). Only three other quarters (all in 1998) come close to reaching the one-third mark (the data goes back to 1995). Essentially, we are just about at an all-time high in seed investing relative to all other venture investment. In absolute terms, $317 million was invested across 101 new seed deals. Both these figures have been eclipsed in recent history, however, looking at the relative level of investment gives us better insight as to what is happening in the venture industry at any time, regardless of its size. Also, as I have mentioned before, because most venture industry data is not consistent in terms of quality, it’s better to look at trends rather than focus on specific numbers.

Data Source: PricewaterhouseCoopers/National Venture Capital Association MoneyTree™ Report, Data:  Thomson Reuters

The reasons for a rise in seed stage funding are seemingly pretty clear - the data helps perhaps confirm the growth and institutionalization of Super Angel/Micro VC funds as well as the recognition of the importance and benefits of seed investment by larger venture firms with more diversified strategies.  The interesting thing about the last time seed investment hit these levels was that it was right before the bursting of the internet bubble. Perhaps a high relative level of seed investment is a leading indicator for a tech/vc bubble. I think this is a controversial topic and I won’t stray into my thoughts too much but I think it’s very hard to tell if we are in a tech bubble. You probably can never know for sure if there has been a bubble until it pops.  In general, I do believe higher level of seed investment is healthy for the venture ecosystem, as long as valuations are reasonable.

One other thing that stands out when looking at the data is the temporary, but sharp, drop in the relative level of seed investment in the first quarter of 2011. I can’t help but think this was just a random anomaly, because no other stage of venture investment experienced the same volatility. I can’t think of any convincing reason why the drop would have been so large for just the first quarter. Feel free to comment if you have any suggestions. It should be interesting to see what the data shows us for the coming quarters. I’ll be sure to provide an update when new data is released.

UPDATE: On his blog Reaction Wheel, Jerry Neumann shared that he has a nagging suspicion about early-stage venture capitalists: "About six months ago it seemed like they were slowing down their pace of investing while the corporates and newer super-angels were doing a lot more deals." If this is true, it surley can help explain the anomoly in Q1 the data. Since only institutional venture firms are included, the suspicion that they slowed up on seed stage deals can actually be confirmed. On the whole though, seed stage investment seemed like it was going strong because in reality, it was - just led by super angels whose deals do not make it into this data. As for if this is a warning sign, I think its too early to tell - but it is intersting that in the next quarter, relative seed stage investment by VCs hit levels last seen right before the bursting of the tech bubble. 

The Rise of Funds of Funds Another Sign of The Times

The most recent release of Private Equity Analyst’s Sources of Capital Survey shows that in 2009, pension funds, historically the largest source of capital for venture firms, were overtaken by funds of funds. In 2009, funds of funds accounted over 23% of all capital raised by venture firms, while pension funds accounted for 18% of all capital raised. This is almost a reversal of 2008, when funds of funds were the ones accounting for 18% of capital raised and pension funds accounted for 25%. What’s more is that it may be the first time in a long time (maybe even ever?) that funds of funds were the leading source of commitments to venture capital funds in a given year.

 

Source: Dow Jones Private Equity Analyst

We know that all limited partners slowed their commitments last year, so why did the proportion of commitments coming from funds of funds rise? For one they were not impacted by the denominator effect. In addition, they had the freedom to act on attractive opportunities since their sole business is investing in venture (and other private equity) funds. It’s also important to note that funds of funds are not under the same political pressure public pension funds face. Nonetheless, let’s not forget that fund of funds  managers have to raise the capital they invest (just like ordinary VC firms do) and last I checked, fundraising for funds of funds was down just as it was for the rest of the private equity industry. This means that most funds of funds were probably investing capital out of pools that were raised two or three years ago and will have to raise new funds soon in order to continue investing in venture.

In a sense, funds of funds helped cushion the fundraising blow for the venture industry in 2009, but it makes you wonder what happens if funds of funds were not around, or if they are unable to raise capital for new funds in the coming years. Clearly 2009 would have been even worse for venture firms if it were not for funds of funds, which means that less capital ultimately flows to entrepreneurs and innovative new technologies. Since we can’t expect funds of funds to be leading investors in venture capital forever, you can add this funding shift phenomenon to the list of data indicating major changes in the venture industry/model (see my previous post on the VC overhang).

Funds of funds, this past year, showcased their value -for the industry, they filled funding gaps and prevented an even larger shock. For investors, funds of funds were able to provide exposure to what should be a great vintage year for venture funds (less competition for deals, lower valuations, with innovation continuing unabated) – all the while providing diversification and the administrative and monitoring expertise essential for quality venture capital portfolios. Even if the industry is shrinking and overall returns have been mediocre, there is a strong case to be made for keeping an exposure to venture capital in most institutional portfolios (less volatility, diversification, and greater return potential with continued innovation and an improving exit market). Because of this, we may see more investors choosing to go with funds of funds as a “one stop shop” for a smaller, more diversified venture exposure through the top venture capital funds.

A venture industry that relies on funds of funds for capital is not healthy, nor sustainable. While funds of funds should remain at proportionately higher commitment levels, don’t expect them to remain the driving force behind venture commitments.  In the future, commitments to venture will have to be driven by public funds (or of course single public client funds of funds). Commingled funds of funds, those fed by smaller investors realizing the importance of maintaining a venture capital exposure can only have so much of an impact, even in a leaner venture capital landscape. 

Investing In Emerging Managers

Limited partner interest in “emerging managers” has grown impressively over the past decade. Many pension plans have programs targeting emerging managers or have made substantial efforts to increase their exposure to funds run by emerging managers in their venture capital/private equity portfolios. The definition of an emerging usually varies slightly for everyone, but in general, it usually refers to:

• Firms raising their first, second or third fund from a broad base of institutional investors.
• The firm may be a spin out of one or more members of an existing venture firm.
• It may also be the spin out of a group that was previously captive, i.e. they were the venture capital arm of a corporate parent.
• It could also be the coming together of investors from multiple venture firms or corporations.
• Many pension plans have mandates for emerging mangers which include a women/minority component, or a component targeting underserved markets.

In a time where funds are hard enough to raise for established venture firms with good track records, how can emerging managers compete? Why would anyone invest in them? First, here are some drawbacks associated with emerging managers:

• They often have no track record of investments or their track record is not substantial enough to qualify them. Basically, they’re unproven.
• Inexperience managing a venture firm. – an investor may have been great at working within an established firm with a developed structure, but when running their own firm, it’s a different dynamic and they are sure to run into situations not encountered within a larger organization.
• Team risk. Emerging managers often have difficulty in building out their team. An individual may be a great investor, but to have a successful venture firm it takes an entire team. There is risk around having emerging managers build not only a competent team, but a team that can work well together.

That said, emerging managers do feature characteristics which make them attractive, and in some cases even more attractive than established firms:

• They have comparable, or in some cases even deeper, domain expertise in the given sectors their strategy targets and often have relationship networks just as good as larger firms may, which means their access to deal flow is just as good too.
• They have the desire to build their firm’s brand and respect which lends to emerging managers being more hard-working.
• Being a smaller organization, they are more nimble when it comes to adapting to changes in the market.
• Without the influence of a larger organization, they can thoughtfully build a team that works best for the strategies they will be pursuing.
• Having a smaller LP base, emerging managers usually value their investors more and are able to give more attention to their needs.
• Investors are often able to get better economics in the form of a lower management fee and/or carry with emerging managers (although the argument can be made that emerging mangers need more fee income so they can build the proper infrastructure).

Manager selection is extremely important when investing in emerging managers. Understanding team dynamics, having a sense of their infrastructure, and the principals’ ability to run a firm are all factors that have heightened importance when evaluating emerging mangers. If the right group with the right backgrounds is coming together pursuing the right strategy the results could be impressive. Take for example Spark Capital, the firm was formed by Todd Dagres, formerly of Battery Ventures, and Santo Politi formerly of Charles River Ventures to pursue investments at the intersection of media and information technology. They’ve been early investors in great companies such as Twitter, Boxee, and Tumblr. A larger more established group may not have taken the risk to invest solely in such a narrow focus, but Spark’s nimbleness allowed it to identify and pursue companies in this exploding space. Investors would be foolish not to at least give emerging managers a fair shake when considering investments in venture funds, but they must be extremely prudent in their evaluation of managers because for every Spark, there is a firm that doesn’t make it.

The Venture Capital / Growth Equity Opportunity in Brazil

Apologies for the brief hiatus from posting – I was in Brazil for a good part of last month, which actually provided a great opportunity to examine first-hand the opportunity for private equity there. Why private equity and not venture capital? In almost all emerging markets, venture capitalism as it is practiced in the U.S. simply does not work for a number of reasons, including weak intellectual property laws, infrastructure and markets as well as limited innovative and entrepreneurial spirit. Private equity investment, particularly growth equity (growth capital for mature companies) is most appropriate in emerging markets. Growth equity, which involves making minority investments in mature but growing companies, trumps even buyouts in emerging markets because of issues gaining control and limited availability of leverage. I’m not close to being an expert on the Brazilian economy, but the following is some of my thoughts on the growth equity opportunity in Brazil based on a few observations.

In my travels I was able to explore second and third-tier cities and even some semi-rural areas of the country, which I think provided a better sense of the country’s potential than if I had just visited larger cities such as Rio or Sao Paulo. Compared to rural areas of fellow large emerging market (and BRIC) countries India and China, the more rural parts of Brazil seemed further developed, or more ready for development. Large infrastructure investment is not as necessary as a precursor for growth as it may be in India and China. But it is still needed, particularly in the northern part of the country which is growing faster than the south. I think the government and private investors realize this, and it was evident in the many roads and bridges under construction as I traveled through parts of the north. In many ways, investing in Brazil seemed like less risky of an endeavor than investing in India or China. There’s probably less of an upside to growth investments, but also that there’s less risk and more immediate potential, a tradeoff that is probably attractive to many investors.

Brazilian consumers seem ready for growth but I did notice that the aspiration factor was lacking, or it was at least not evident, especially when compared to Indian consumers. Examples include consumers shying away from higher quality goods even if they are priced the same, or diners shying away from nicer restaurants simply base on the aesthetics (assuming it would be too expensive). I made this observation much more in the north than in the south, which brings up another point – the country’s diverse culture. The population is not as homogenous as other emerging markets and investors will have to adjust for this, especially when it comes to investing in consumer goods and service companies.

Another thing I noticed was that there were few signs of recession or that there had even been a recession – Brazil was relatively insulated from trouble in the broader world economy. The country’s quick recovery had a lot to do with government policy (which has after many decades seems properly aligned for economic growth) but a lot of is also has to do with the fact that Brazil’s domestic growth is so resilient. It may not be as fast growing as India or China, but it’s strong and also somewhat sheltered because the country is not reliant on trade with the rest of the world, even though Brazil has been expanding international trade in recent years, particularly with the U.S., China and Europe (driven mostly by natural resource demand). Growth equity investment decoupled from the world economy provides true diversification for limited partners investing in a private equity fund - which gives Brazil a leg up on many other emerging markets.  

When it comes to private equity investment, Brazil consistently ranks behind China and India in terms of amount of capital deployed and number of deals. But in recent LP survey’s I’ve seen, interest in Brazil is growing and is often higher the level of interest in India or China. In Brazil, local pensions are a huge source of capital. They’re now allowed to invest up to 20% of assets in local private equity funds, but most only invest 1-2%, which still accounts for a little less than 20% of all commitments to brazil-focused private equity funds, according to the Emerging Markets Private Equity Association. Even though there’s currently plenty of dry private equity capital in Brazil, I’d expect to commitments to increase in the coming years. Expect investment to remain heavy in the energy/natural resources sector, but other sectors will see growth for sure.

Infrastructure investment in Brazil, both private and public, will probably see increase over the next few years, driven by the need for infrastructure improvement ahead of the 2014 World Cup and 2016 Olympic games. As I had mentioned though, the infrastructure need is not as great in Brazil as it is in other emerging countries. As such, other areas, particularly industrials, manufacturing and consumer goods and services will surpass infrastructure as a destination for private equity. What about technology and more venture-type investments? Despite what I mentioned at the onset about emerging markets not being ideal for venture investment, I actually think Brazil has promise - perhaps more near-term promise for venture capital than India and China. We’ve seen so many venture capital funds fail or pull out of India and the environment in China is too murky for venture to be attractive there. But in Brazil, the regulatory, legal (intellectual property), tax and corporate governance environment is advanced, stable and reliable enough to harbor venture investment. Furthermore, I get the sense that there is a growing entrepreneurial spirit, aided in part by government programs supporting innovation and developing technologies from universities.

There should be plenty of opportunity in the internet, and mobile sectors. Both have a lot of potential for expansion in Brazil, both from an adoption and evolution point of view. Increased broadband and mobile adoption will be a basic driver, which means me-too copies of successful internet and mobile technologies from the U.S. will do well, but also expect there to be innovation from within Brazil. Still, growth equity investment remains more attractive now (especially in the manufacturing and consumer goods/services sectors). Brazil is primed for it from many angles and it should be one of the least risky emerging markets. Investors will need to be careful they are in tune to cultural and operations nuances, which means experience is key to success, as it is in almost any emerging market. It should be interesting to monitor Brazil’s growth in the coming years and as the environment for venture capital improves, look for more innovative technologies coming out of Brazil. 

Venture Capital Overhang: Shrinking

With 2009 now behind us, full final year-end venture industry data is available. There’s plenty to glean from all the fundraising, investment and exit data. Much of it tells us what we already knew or expected: fundraising and investment are down, and exits have improved, but just slightly. There’s so much you can analyze, but I’ll focus on something I’ve done in the past, which is looking at the “venture capital overhang.” This is the difference between the aggregate capital raised by venture capitalists and the amount invested. It gives us a rough idea of how much capital VCs have available for investment, sometimes referred to as “dry powder.” The chart below shows venture fundraising, investment, the difference between fundraising and investment (as the overhang) and the cumulative overhang for the last ten years.

The cumulative overhang for the last decade for the U.S. venture capital industry totals close to $90 billion, using my methodology and data from PwC, Thompson Reuters and the NVCA. As with so much of the data on the venture capital industry, the calculation is not perfect. Things like management fees and recycled capital are unaccounted for. There’s also the issue of investments made outside of the U.S.  which are not captured in the PwC MoneyTree data.  Rather than focusing on exact numbers, its more important to focus on trends and to look at the big picture.

For one, there’s clearly capital out there for venture capitalists to invest. It’s probably becoming more concentrated across a fewer number of firms - as I mentioned in my last post, good firms will continue to be able to raise capital. The overhang number is down from my previous calculation earlier this year, which signalz to that capital will be a bit scarcer.  Going forward, we should see more years like 2009 and 2003 where the levels of investment and fundraising have less of a gap and less of an overhang is created. Now, you don’t want things going in the other direction, where we have more capital invested than raised because that would of course be unsustainable. But then some would also argue that the huge levels of overhang amassed in years past were also unsustainable, which is probably true.

There needs to be certain level of reasonability maintained in the industry and less overhang will force venture capital firms to be more prudent in deploying capital. This doesn’t mean, however, that great new ideas won’t get funded, because VCs clearly have plenty of dry powder. If anything we’ll see more early / seed stage deals which not only require less capital, but have more potential upside and also bring the industry back closer to its roots of more risk taking. 

Drawing From Y-Combinator - A More Perfect Crowdsourced Venture Fund

I've written a few times now about the idea of a crowdsourced venture capital fund - where there would be a large number of small investors, each playing a role in the fund's investment decisions. It’s my belief that as the venture industry evolves, the disconnect that exists between investors, venture capitalists, entrepreneurs, and the tech community can be bridged well through such a fund. If you'd like some more background on what my ideas for a crowdsourced venture fund are you find it here, and here.

 I got thinking about a crowdsourced venture fund again after reading some more about the great stuff Y Combinator does. Y Combinator provides seed funding for startups, but money is just a small part of what they bring - typical investments are less than $20,000. Instead, where Y Combinator really provides value is in their work with the startups they fund. They provide hands-on guidance to help startups become successful, including forming the company, legal issues, developing the product(s), managing the company's growth, and even finding future funding. In an age where the cost of starting an internet company has gotten pretty low, Y Combinator, which has helped spawn great companies such as Disqus, Loopt, Scribd, Xobni, and Reddit, provides something more valuable through its expertise and connections. It got me thinking that a crowdsourced venture fund would need to be able to do something similar.

A crowdsourced venture fund would be best suited for making tech investments; particularly early-stage tech investments where the backing of a crowd (in this case the LP base as well) could help propel portfolio companies. You would also be able to draw from the wisdom of the crowd to help with any problems faced by the startups invested in. Here, you have an instant network, as long as the LP base remains on the tech-savvy side, which you would expect. But what about the nuts and bolts of a company and nurturing it properly early in its life? The truth is that most traditional venture capitalists don't do much there as you would think, which makes YCombinator special. In a crowdsourced fund you would ideally want Y Combinator-type VCs armed with their own connections which, along with input and backing from the crowd, would really create an ideal situation. You would be able to help entrepreneurs effectively through a variety of issues by drawing from the crowd, only having to make sure that the crowd is sufficiently engaged to want to lend support. Part of this is achieved through their investment into the fund itself. Part of it is also making them involved in the investment process.

What would a crowdsourced fund do with a very large pool of capital? It would be able to do what Y Combinator can't do: continue to fund the companies at later stages. Instead of having other venture firms come in for a series A or B round, ownership could be maintained in the companies as they grow. Of course you could always push for a larger ownership with the seed funding as well, but you have to be careful there as you want the entrepreneurs to be motivated with significant interest in their companies.

And what about the vetting investments? Y Combinator has an application process for companies, but for a crowdsourced fund, you would probably want a combination of companies applying for backing as well as the fund's VCs going out and sourcing investments in a traditional manner. Both sources of dealflow would be pooled and, as I've mentioned before, the crowd, or LP base, would be able to vote on the most promising companies, which the VCs would then use as input in making their final decisions. The reason you wouldn't leave it up purely to a vote is that you need to protect the confidentiality of potential investment and so voters would not have complete information when making decisions. You would also use the wisdom of the crowd by voting/collaborating on solutions to problems companies face that can't easily be solved by the VCs and would benefit from having input from the crowd. While the crowd, or LPs, wouldn't be compensated for their participation, they all have their investment in the funds at stake as a motivator.

The thought of a crowdsourced venture fund is definitely idyllic, and maybe even more so if you want to try to do some of the things Y Combinator does, but as capital starts to take a back seat to the other things venture funding should provide, it’s a model that seems to make more and more sense.

Previous posts on Crowdsourcing Venture:

Crowdsourcing Venture

Another Take on Crowdsourcing Venture

Observing Larger Trends in Healthcare VC

This year, venture investment into the healthcare sector surpassed investment in the traditionally heavyweight information technology sector for the first time in over a decade. This trend has been well covered and there are plenty of reasons as to why venture capitalists have shifted focus to healthcare (less cyclical, lower valuations, less fundamental change, etc).  What’s interesting about the trend is that there’s been a historical correlation between difficult economic environments and the relative level of healthcare venture capital investing.

Here’s a look at healthcare investment as a percentage of all venture capital investment over the past 10 years: 

 

What you notice, besides the clear increase in relative healthcare investment over the past decade, is two dramatic spikes: The first in the years following the tech bubble – which is partly the result of VCs shying away from the tech sector while those investing in healthcare maintained their investment pace. Plus, many tech VCs looked for safety in the relative less volatile healthcare sector. The second spike is more recent - starting last year as the recession took hold and what can be considered a small venture bubble burst.  The reasons for this spike are similar as the previous, and as with the previous spike, the absolute dollars invested in the sector have still declined.

What’s also interesting about the two spikes is that they are predicated by a short decline in relative healthcare investment, which makes you wonder - is the relative level of healthcare investment perhaps a leading indicator for venture capital bubbles? It appears so. During bubbles, VCs are more apt to pour cash into what can be more lucrative, but also more risky technology investments.

This recent spike, where healthcare investment has reached almost 40% of all venture investment, is probably just that - a spike. Unlike earlier this decade, the levels of healthcare investment should come back down again as clean technology and IT investment pick up. But the case for healthcare investment remains and we’ll probably see it remain around 30% of venture investment going forward. Demand will continue to be driven by an aging population, continued technological progress, declined pharma productivity and government programs such as those pushing healthcare IT and increased access to healthcare.

Data Source: PricewaterhouseCoopers/National Venture Capital Association MoneyTree™ Report, Data:  Thomson Reuters

VC Shift To Seed Stage Investing Is For Real

Third quarter venture capital investment data was made available last week which prompted me to re-examine the data I looked at in my previous post on the recent spike in seed stage investing by venture capitalists. More specifically, I wanted to see if the data trend held true to what seems to be going on anecdotally - are venture capitalists really dramatically shifting their focus to early and seed stage deals? The answer still seems to be a resounding yes. The chart below is a more detailed look at the percentage of all initial investments allocated to seed stage deals by venture capitalists by quarter since the post-bubble period (2001-2003).

You’ll notice the spike in the second quarter of this year, but the third quarter still represents the highest level of relative seed investment since the second quarter of 2005. Furthermore the data trend still clearly shows that venture capitalists have indeed continued to shift more of their focus to seed stage investing. Why? Well, as I’ve covered before, it’s a reflection of a few factors:

• Lack of syndicate partners for later stage deals
• Lack of capital or adequate reserves for later stage deals
• Skepticism around the medium term prospect for exit (IPO and M&A markets)
• The realization that more risk needs to be taken to achieve desired returns
• A rise in the number of quality “venture-backable” start-ups and entrepreneurs (partially a product of the state of the US economy)

Data Source: NVCA PricewaterhouseCoopers/National Venture Capital Association.