Polachi VC Survey: Pulse on the Industry

Interesting results in a survey of over 100 venture capitalists, run by Polachi.

According to the survey:

• Worries:

69% worried/very worried about ability to hold syndicates together

56.1% worried/very worried with new deals, no one in hurry to act

83.3% worried/very worried “Portfolio-it is all about survivability”

92.7% worried/very worried about when exit markets will return

• Hot areas:
  

Cleantech/Energy: 62.8%

Consumer Internet/Web 2.0:44.2%

Internet Marketing: 40.3%

Med Tech: 22.5%

Infrastructure: 17.8%

Biotech: 16.3%

Enterprise Software 10.9%


• 
  
• 52.9% of respondents believe the VC industry is broken
• 60% of VCs not more confident about state of VC industry compared to 6 months ago

So, what’s broken here?

1. For the moment, there is an exit problem, which brings with it a lot of other problems. But what is causing the exit problem? If the start-ups were working on things that had high barriers to entry, significant and sustainable competitive differentiation, and which efficiently solved important and valuable problems for some buyers, then the start-up would become profitable and have no trouble with exits (or with staying independent and running off cash-flow). In other words, too many companies are starting with the hope that they will find a business model eventually; some may find such a business model, but it is unlikely that they will be able to have a significant and sustainable competitive advantage without figuring it out at the outset.
   
2. Because there are few exits, there are few investors clamoring to put cash into the asset class. As the value of other asset classes has collapsed, investors have not shifted cash to the venture capital asset class, as there is no reason for them to believe that performance will be worth the risk. Venture has delivered a zero or net-negative return for most investors in this millennium.
3. Venture capitalists were very quick to pull the “extend your cash” ripcord (after Sequoia’s “memo of doom” became public), but very few followed their own advice. Many VC firms tried to keep existing portfolio companies operating, rather than winding some down while there was still cash to recover, and in some cases extended or reserved more cash for existing firms that had little hope of a successful exit. With few firms able to raise new funds, and with all existing funds committed to portfolio companies, precious little capital has been available to new start-ups.
   
4. This would be the perfect time for a start-up to get going; there is little chance of twenty other start-ups entering the same field, many costs are very low right now (e.g. developers, rent), and the economy should be in better shape for revenues and exits in a year or so when the company has built a product or service offering. Unfortunately, there is little or no funding available from venture capitalists, and so the valuations and terms being offered tend to be very unattractive to entrepreneurs.
5. I don’t believe many people think of VCs as “unfair” to entrepreneurs, but the traditional VC funding system is broken for entrepreneurs. Here’s an example. Assume a group of entrepreneurs work hard together, using their own money or obtaining funding from angels or “friends and family,” to produce some IP and a team that has value after one year of work. To continue the example, if they were to sell the company at that point, they may be able to get $5 million, of which perhaps $4 million would be the value of the IP, and $1 million would be the value of the team. The acquiring company would presumably have some earn out for the employees (in the amount of $1 million), but they’d immediately receive $4 million for their IP and begin to get paid a market rate for their work. Three years after starting the company, they might receive a total of $7 or $8 million after returning the money to their investors (with interest and some share of the proceeds) – plus, the team would be on the forefront of some very important initiative for a larger acquiring company. The traditional VC funding approach would offer the company $5 million in common stock for the same IP and team, and typically a below-market compensation package going forward. The chances are very low that the team would ever realize the $5 million in returns for the work they did prior to funding. Thus, the smart strategy for many technology entrepreneurs would be to avoid the traditional VC funding approach.
   
6. Anecdotally, I hear from many colleagues that they will stay with a larger company rather than starting a start-up at the moment because they don’t see much potential upside in a traditionally funded approach. Others I know are moonlighting, starting a start-up with friends while all are still employed “full time” at a company, drawing a salary and benefits and working in free time. Still others I know are raising money from those few friends and family members, and setting their sites on building a profitable business that may probably remain private forever.
   

This topic has been worked over to death by many people smarter and with far more experience than I. Most of the analyses I’ve read focus on the problem from the VC point of view, and thus don’t focus on the final three points from the entrepreneurs’ points if view. I’d be interested to hear back from readers on their thoughts, things I’ve missed, or ways to improve the analysis.

(Cross-posted @ Next Gen Enterprise)