NGN -- The Broken VC Model

The venture capital (VC) model has never been as broken as it is now, said Dr. John McQuillan, co-Chairman of the NGN conference. The rates of return for venture funds used to be over 20% and yet for the past three years they have averaged a negative 25%. On top of this, there is a huge overhang in venture funds leftover from the peak years -- money that is still waiting to be committed or returned to investors. McQuillan said he still sees start-ups as playing a key role as innovators for the industry, but expects that many of the major advances in the future will once again come from the labs of the industry's major suppliers -- those with pockets deep enough to afford the cost of innovation.


No only has it been a brutal year for venture capitalists, said Rod Randall, General Partner with St. Paul Venture Capital, but the funding model for future start-ups will be seriously constrained. An on-going saga of "down rounds and zero pre-deals" have essentially wiped out the value of early round funding, punishing the early investors in many start-ups. This means that for start-ups that can actually deliver an "exit strategy," the last money in reaps the reward. Randall said this process is undoing the conventional wisdom that higher risk should equal higher reward. Moving forward, Randall believes start-ups will still have a vital role in the industry, but their funding model will be more selective. Numbers that he cited indicate that the market's sweet spot might be for a start-up to achieve an exit value (acquisition or IPO) in the range of $150 million. In order to achieve the return on investment expected by VCs, this would mean that a total of $12 million in funding would be available to a start-up -- far less than the hundreds of millions often raised by start-ups during the boom years.


Great companies are started in both bull markets and bear markets, said Roland Van der Meer, a Partner with ComVentures. In the bull market every idea gets funded, competition is fierce and investors are mostly betting on market momentum. In a bear market, only the best can survive, the field will not be as crowded, and the potential margins are greater. Van der Meer argues that the venture capital model is not broken and that we are at the tail end of the bust cycle. As he sees it, communications is a $1.4 trillion per year global industry (equipment + services), second only to health care. Each year, people are communicating more and spending more. He also believes that Series A funding is where technology breakthroughs really happen.


Michael Feinstein, Senior Principal with Atlas Venture, agreed, saying "the VC model has not been broken...only people's expectation that they could get rich quickly has been broken." Feinstein noted a number of inhibitors to investment that continue to haunt the market, namely too many companies, not enough "wiggle room" in business models, and overall uncertainly about the U.S. and world economies. On the positive side, he believes that the "thinning of the herd" is having a healthy effect and recently a few positive start-ups exits have occurred (WaveSmith, TiMetra, IPAS and NTGR).


The most optimistic outlook for the panel was given by David Furneaux, Managing Partner with Kodiak Ventures, who said the hurricane has blown past and the real question now is where to go from here. For new money entering the market, he said, VCs are open for business. As evidence, Furneaux cited the 40% rise in the NASDAQ this year, new money flowing into mutual funds and new spending for IT systems. Specific areas where he sees opportunities include data centers, wireless networks and security.
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