From the Ash's

I just read a very interesting article, "Tech Start-Ups Have Money to Burn, but Choose Thrift", published last week in the Wall Street Journal.  It discussed the recent trend of venture capital-funded companies to focus on keeping costs low, as opposed to the Dot-Com era practice of spending large quantities of cash on over-sized staffs and flashy marketing campaigns.

This change highlights the maturation of the tech start-up industry.  This industry really had its genesis only 30-40 years ago.  The professionalism with which companies are started today compared even with the start of Apple Computer and Microsoft in the late 1970s is incredible - those companies did not really even incorporate until years after they began, nor did they receive venture financing until they were in a late-stage and already cashflow positive.

It wasn't until the Dot-Coms that the start-up industry became prevalent enough to attract the critical mass of participants required to create a problem - and through that problem, the learning necessary to create a mature, stable industry.  Ideas on how to finance and run tech start-ups had to be tested and proven or disproven.  Unfortunately, this trial-and-error method - the only true way to solve a new problem (at MIT we were taught that often you can't theoretically solve a new problem until you're hacked your way through to a solution at least once) - cost an awful lot of money.  However, it also created the rapid buildout and growth necessary to create a generation of seasoned entrepreneurs and investors that can provide mature, moderate-paced growth over the next 20 to 40 years.

One of the primary understandings that came from the Dot-Coms is that financial discipline (aka cleanliness) is next to godliness.  Today, investment in venture capital firms is near an all-time high.  Tier 1 firms like Kleiner Perkins and Sierra Capital are managing well upwards of two billion dollars, whereas just ten or fifteen years ago they were managing funds on the order of two hundred million dollars.  That means that their average deal-size has to go up almost ten fold to provide the same performance returns as they did previously.

Therefore, there are a couple ways to solve this problem:

1. Invest in more mature companies (ie. mezzanine-stage or positive cashflow companies)
2. Invest the increased amount in the same companies as before, creating overvaluations or diluting the entrepreneurs' shares.
3. Invest in more expensive startup ventures such as biotech and nanotech that require large capital investments to develop their product offerings.
4. Invest the increased amount while exersizing the financial discipline to increase the average time between fundraising rounds, thereby reducing the number of rounds required for a successful company.

Some firms have, in fact, invested in more mature companies in order to "flip" them by selling them to bigger companies within 1-2 years of financing.  However, this investment strategy produces lower returns, requires more deals because most VC funds are designed to run for ten years, and underutilizes the skillsets possessed by VC firms (ie. professional management advice, great rolodexes for hiring senior executives).  While this approach was one of the most popular solutions in 2004 and 2005, the reduction in start-up M&A activity over 2006 suggests that VCs have already moved away from it.

Overvaluation or diluting entrepreneurs' shares lasted for far less time than the late-stage investment strategy.  Such an approach just doesn't work mathematically - it kills later rounds of financing because the market wises up, or demotivates the entrepreneurs since they no longer have enough skin in the game equity-wise for it to be worth their full efforts.

Biotech and nanotech enterprises do take more time, but that also makes them somewhat impractical as start-ups.  In the end they sort of fit the same VC investment approach as the silicon industry - a high capital expense (CAPEX) industry due to the cost of manufacturing machines and laboratory R&D.  There tend to be fewer successful start-ups in this space, and many do their work mostly on computers where R&D is significantly less expensive.  The development cycle makes it difficult for VCs to extract a liquidity event in the 5-10 year time horizon they need to make their results.

That leaves over-diluting a company and installing strict fiscal discipline practices in order to extend the duration between fundraising rounds.  What this strategy amounts to is giving the start-up a war chest with which to protect itself from the unforeseen and maybe make strategic acquisitions where possible.  This improves the overall stability of such start-ups and doesn't result in the long-term dilution of entrepreneurs shares because it's roughly equivalent to getting two rounds of financing at once.

In addition, the improved stability of the start-ups improves their overall chances for success, which changes the risk profile for the VCs.  By pursuing this strategy they can reduce their risk while keeping returns and their deal-rate steady, as well as capitalize on their unique competency in start-up management.

While we have yet to see how this new funding strategy will play out over the long-term, first impressions suggest that it is a mature strategy that possesses the insight of seasoned professionals who have learned from their past mistakes in the Dot-Com era.  Hopefully, we will see this model continue to play out for the foreseeable future as companies continue to make use of the new economies-of-scale afforded by Web 2.0.  At the same time, this maturation suggests that we will not see another truly disruptive technology enter the marketplace for quite a while, as the current industry is becoming so mature.