VC Perspectives

VentureSource just released their Q1 numbers for the US venture investment, not surprisingly the IT industry was the hardest hit with the lowest levels of investments since 1997, in numbers 231 companies received  $1.68 billion, down 52% compared to the same quarter last year.

For a long time, technology companies have been the focus of the venture industry, but today when the IPO market is closed and the few larger companies that still are actively pursuing acquisitions pay a lot less, the return expectations becomes very hard to match. Fewer exits also means that the average holding time increases, thereby further decreases the returns. In addition longer holding times means fewer investments since more capital is need for non profitable companies already in the portfolios. To further reduce the available capital for new investments, a majority of the large institutional investors in venture capital funds, have a percentage allocation to investments in unlisted companies and when the overall valuations of listed companies go down the percentage becomes a smaller absolute amount.

That venture capital, as most industries, are affected by the cyclic economic climate should not be a surprise to anyone, but it judging from externally visible information, this pattern is generally not reflected in type of investments made by venture firms, only in number of investments.

For example, let’s assume a seven year period between peaks in the economic climate and that exits are most frequent and gives the highest return around a peak, then you should invest in companies that are mature for exit in the next peak.

Being an engineer at heart I’ve half seriously put it in a formula:

Next assumed peek (NAP):          2014
Current year (CY):                2009
Company plan to maturity (CPTM):  4yrs
Delay factor (DF):                25%

Investment timing fit:            =1/(3/2)^ABS(NAP-(CY+CPTM*(1+DF)))

In my example above this would be a perfect fit, i.e. 1.

If you vary the planed time to maturity from 1 to 7 years you get the following graph:

Conclusion: Today you should invest in companies with a 4 year planed time to maturity, assuming a 25% delay in executing the plan.

My intention is not to create mathematical formulas for how to invest, but rather to highlight the fact that to make optimal investments and building companies, the economical cycles should be taken into account, both for investors and entrepreneurs alike. Ideally both in what investments you make and what plan you follow in building the company to hit the next peak.

As most entrepreneurs probably have already noticed, there has been a drop in venture activity in the later part of 2008. According to Dow Jones Venture Source (which is one of the more reliable sources although by no accounts perfect) the venture activity during Q4-2008 on a European level fell 38% to €875 million (199 deals completed).

However, for 2008 in general, half of the deals were seed and early-stage investments, the highest level since 2000. Although most of these were made in the first half, it seems like later-stage venture investing was more negatively affected than early-stage during last year, maybe contrary to what many people believe.