Tuesday, September 13, 2005

Early Stage Haven?

Recent numbers suggest that early stage investing may yet prove to be a bastion of IRR and extraordinary returns. Why? Recent data provides interesting insights into industry dynamics.

In 1H05, VC firms raised roughly $11bn in IT Venture Capital. Over the same period, IT VCs invested roughly $5.5bn, for a ratio of IT$ invested YTD/IT$ raised YTD of .5. Not a sustainable number.

If IT VCs stopped raising money today (which will never happen), it would take ~12 quarters to invest the $32bn of IT VC$ available for new investment at the Q2 run rate of $2.747bn.

As we all know, the surplus capital appears to be a secular rather than a cyclical shift in the fundamentals of the venture industry.

A key question is, where is the capital going? Apparently, not in the early stage. According to VentureOne, the percentage of VC IT $ going into early stage is falling precipitously:

  • 2000 Early Stage $/Total $ = 34%
  • 2003 Early Stage $/Total $ = 20%
  • 2004 Early Stage $/Total $ = 20%
  • 1H2005 Early Stage $/Total $ =16%

With a -53% change in the amount of money flowing into early stage investments btwn 2000 and 1H05, it appears that the surplus will continue to flow into later stage deals. In later stage investing, winning is almost always a function of share price. Price discipline is eroded as firms bid deals up to deploy capital and "win."

With fewer dollars chasing early stage deals and meaningful non-share price based differentiators - deal flow, company evaluation in absence of customers/revenue, syndication, post-deal value add, etc - it may be that while extraordinary returns for the industry as a whole look challenging, early stage investing may prove to be a bastion of IRR and extraordinary returns.

I believe that smaller funds, specialized focus areas, and early stage investing are the way to go.



  1. Couple of points:
    - Alongside the amount invested, the number of deals has to be taken into account. As I and others have written, it does not take much capital to get a "Web 2.0" service up and running, and some of these startups will break even on just a few million dollar invested. This might lower the total amount of capital invested early stage.
    - There might be great IRRs to be had on early stage deals, but the issue is how much does a given deal contribute to the overall performance of a fund. i.e does a 10X return on a $1M investment count (for example). Well it does if you have a $100M, but not really if you have a $500M.

    As you suggest, smaller funds might be better off on that front, because they can benefit from smaller deals. But the economics can become challenging because the management fee can only pay for so many investment professionals, who can work on only so many deals. And an early stage deal requires a lot of work, if you really want to support the company and its management team.

    The right balance ? $150 to $200M ?

  2. Will - certainly lots to think about...

    As an early-stage; software-only investor in the UK and Ireland - we do get to see lots of interesting stuff... and the specialist focus and our network makes it possible on a small budget ($50M fund...)
    Jeff then makes a valid point about scale... Though Mangrove through Skype should probably N times return their fund... very much an outlier on all the european VC stats of 2000/2001 early stage funds...
    Indeed, whilst already too much has been blogged about Skype, I think it is most phenomenal aspect of the result Niklas et al brought in is the capital efficiency with which they did it...

    Our fund is doing well - though next one we would prefer to be closer to the $150M (at current exchange rates...) and be less worried about losing the "value created" with limited "pay to play" resources to direct to our companies... (in my view the riskiest part of this early stage business...;)

    Keep the brain fodder coming... Sandy McKinnon - Pentech Ventures