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The end of early stage?

PEIM spoke with three veteran venture capital firms about why an exclusive focus on early stage investing has lost its lustre. Chief among the reasons: it's hard to move a big-fund needle with little deals.

The traditional “venture capitalist” is the risk taker who finds the two kids building paradigm shifting web search technology out of their college dorm, backs them early, and scores a 40x return when the company goes public on NASDAQ. Many of today's top tier firms made their name from investments not unlike this.

But as the Sequoias and Kleiners of Silicon Valley, and the Apaxes of Europe, grew up and started raising funds in the billion-dollar range, that model was seen less often. Particularly after the tech crash of 2000, when internet startups died off en masse, many firms have been devoting fewer dollars and less attention to seed and early stage, choosing to balance out their funds with later stage deals.

“With everything that's happened in the past six weeks, the old model is up for review. We don't know where the economy is going to be in five or six years. If you're going to do early stage, you have to be very cognizant that this is an extremely long process, and that a company is not going to go public in three or four years, it's going to be eight or nine years, and if it gets acquired that road is going to be tougher than it has been in the past as well”

There are many reasons for this. One is pure mathematics: bigger funds yield larger fees, and it's hard to deploy $1 billion in a timely manner on $500,000 deals. Not only is hard to find that many worthwhile start-ups in a reasonable investment period, but each partner at the firm can only look after so many portfolio companies.

“A venture capitalists most precious commodity is his or her time,” says Mark Heesen, president of the National Venture Capital Association. “What we learned from the bubble is you cannot sit on 10 or 15 boards of directors.”

Another reason is that early stage takes just as much, if not more, work than later stage deals, and yet because less capital is put into them, the potential reward is smaller. And the return on a $500,000 deal, even if it's a good one, can only move the overall return on a $1 billion fund so far. And the returns are not always good. Early/ seed venture capital returns markedly less than later stage or mixed early/later stage venture capital until 10 years out (see chart).

Early stage is obviously riskier as well. As a working rule, San Francisco's Union Square Ventures estimates that 1/3 of its investments in start-ups will fail, 1/3 of them will underperform expectations, and 1/3 of them will meet expectations.

A third reason is the potential for dilution. An early stage investment usually needs to be brought through several rounds of financing, and if a VC doesn't have the cash on hand to maintain his pro rata share with each round, he risks getting washed out.

The new terrain
There have also been systemic changes since the tech crash that have made it harder to get early stage companies off the ground. Early stage takes longer now, venture capitalists say. Once, a company with $20 million in revenues and a hair of profitability could go public on NASDAQ; now even $100 million in revenues isn't always enough, because public investors like Fidelity and Putnam have more money they need to put to work, and are buying up issues from larger companies. Likewise, strategic buyers are fewer and bigger after consolidation in the markets, and so are looking to buy bigger companies.

The Sarbanes-Oxley Act of 2002 isn't helping either. Compliance eats away at young companies' small profit margins; companies need to be larger in order to absorb those costs.

Now, with the IPO market shut and strategic buyers cashstrapped, the outlook for early stage exits looks even bleaker.

“With everything that's happened in the past six weeks, the old model is up for review,” Heesen says. “We don't know where the economy is going to be in five or six years. If you're going to do early stage, you have to be very cognizant that this is an extremely long process, and that a company is not going to go public in three or four years, it's going to be eight or nine years, and if it gets acquired that road is going to be tougher than it has been in the past as well.”

The tech crash brought about a sea change in how venture firms thought about investing and portfolio strategy, and the current crisis could do the same.

Austin Ventures: moving towards later stage
Like many of its peers, Austin Ventures has found that a portfolio that holds both early and later stage investments is a better business model than pure early stage. A mixed strategy enables the firm to capture the potentially spectacular returns of early stage deals with the comparative stability of later stage investments. Later stage deals also allow the firm to put more capital to work.

“In the 1999 to 2000 time frame we went to almost exclusively early stage technology,” says Chris Pacitti, a general partner at

Austin. “By late 2001 we learned to embrace again a more diversified portfolio. “Over the ensuing six or seven years we have really refined how we think about interoperating between those two sectors, and how we invest across a continuum and how they feed each other.”

Where Austin finds the best risk-reward dynamics is either at the very beginning or the very end of a project, Pacitti says. At the beginning, if Austin doesn't see itself making at least a 10x return on an early stage deal, the firm won't do it. With later stage deals, meanwhile, Austin expects somewhere between two and five times its money, with an appreciably lower risk of losing capital.

“From a portfolio theory perspective we've got a set of assets with a very well characterized return profile and a much lower risk profile as well,” he says. “Then we have a set of companies that have breakout potential and effectively add alpha to the portfolio, and on balance it's a pretty attractive set of companies.”

But current market conditions will likely lead the firm to shift towards the later stage end of the spectrum.

“In the current environment we're probably doing less early stage investing,” Pacitti says. “We're still very actively doing it, but as asset values have plummeted, obviously there's a lot of attractive later stage companies to buy at prices we haven't seen in a long-time.”

Institutional Venture Partners: too much risk in early stage
Institutional Venture Partners was one of the first residents of Sand Hill Road, founded in 1980. In its earliest incarnation the firm invested in only early stage start-ups – its first fund was just $22 million. But in the intervening years, the firm spun off its early stage life sciences and IT investing operations, and now focuses entirely on later stage venture deals and public market investments.

General partner Todd Chaffee explains that the decision was an obvious one for the firm: better to earn slower but steady returns than put up with the high risk of seed and early stage investments.

“If you use a baseball analogy, early stage VCs are going for 10x home runs,” he says. “Our model is completely different. We are consistently hitting doubles and triples in a very short timeframe. And every now and then we get lucky and hit a 10x home run. However, a key part of our model is that if we miss, we don't strike out. We still get a single and get out money back, because we're senior in the cap table. That's one reason why we have been able to consistently outperform the median returns in the industry and have a 43.2 percent IRR since 1980.”

“In the current environment we're probably doing less early stage investing. We're still very actively doing it, but as asset values have plummeted, obviously there's a lot of attractive later stage companies to buy at prices we haven't seen in a long time”

Chaffee also points out that the later stage playing field doesn't have the same competitive dynamic as early stage, where venture firms are scrabbling to snap up the most promising new companies. In later rounds of financing, the original investors tend to want to bring in outside investors in order to avoid the appearance of a conflict of interest in pricing.

Show me the money
Early stage and seed investments return less than other strategies until 10 years out, according to this NVCA study. But NVCA president Mark Heesen cautions that venture funds must be looked at over a 10 to 20 year horizon.

Fund Type 1 Yr 3 Yr 5 Yr 10 Yr 20 Yr
Early/Seed VC 2.1 4.9 5.0 32.9 21.4
Balanced VC 2.5 10.8 11.9 14.4 14.7
Later Stage VC 15.3 12.4 11.1 8.5 14.5
All Venture 5.1 8.5 8.8 16.6 16.9
NASDAQ -11.1 3.6 7.0 1.9 9.2
S&P 500 -13.8 2.4 5.5 1.2 8.0
All Venture (through 31.3.2008) 13.3 9.6 9.0 17.2 16.8
All Venture (through 30.6.2007) 25.5 11.3 5.1 19.3 16.4