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.