“Strangulation and triage” is how one friend recently described the new reality of the venture-capital business. “You spend half your time shutting down stuff that quite clearly isn’t going to work out,” he said. “You spend the other half doing everything you can to help companies with reasonable prospects reach profitability. Maybe, if you’re lucky, you recoup your investment. If you’re really lucky, you might actually make some money. But it’s a long way from where we thought we would be.”
The venture-capital paradigm has long been a “portfolio” proposition. A firm makes 10 investments. Eight of those investments fail or struggle. One is a success. And one is a home run. The home run and the success add up to a number larger than the losses on the eight stragglers.
In the latter half of the 1990s, venture capital entered the age of Home Run Derby: Everybody was swinging for the fences on every pitch. And then it ended. Home Run Derby was replaced by Scratching Out Runs.
According to Daniel L. Burstein, managing partner at Millennium Technology Ventures in New York, the abrupt shift represents something more than just a cyclical swing. “The venture-capital paradigm that prevailed for most of modern venture capital’s history is broken,” says Burstein. “The portfolio approach doesn’t work today and, in my opinion, will not work for the next several years. On the whole, there will be far fewer home runs. And if you can’t be sure of finding one giant winner, then you can’t afford to pay for all the failures.”
Burstein sees four key changes in the VC paradigm.
1. Hedging bets “VC firms will make more risk-mitigated investments,” Burstein says. There are a number of ways to hedge: The investments come in later stages, or the investors work more directly in building the company from the ground up, or the company is built with more sophisticated financial engineering than the all-equity structures of the past. The result: “Successful portfolios will have more moderate successes — and fewer failures.”
2. Changing the game “Emphasize later-stage, distressed, and post-public deals,” counsels Burstein. “Companies that are the diamonds in the rough in the post-2000 wreckage will enable VCs to buy more proven assets at lower prices, at least for the next two years.”
3. Looking in new places “VCs need to seek investments in areas they largely shunned during the Web-driven boom of the late 1990s,” Burstein says — for example, security services, medical devices, and small pharmaceuticals.
4. Getting real from the start “Successful VCs will find great, innovative businesses that can sell their product or service at a profit from the outset and that will not have to rely on multiple rounds of funding,” says Burstein. At the same time, the financial structure of successful companies will involve more-complex mixes of equity and debt and more-rational budgeting.
Assume that Burstein is right about all of these things — that venture capital will be equal parts merchant banking, bottom fishing, and financial engineering. Don’t we have enough merchant bankers, bottom fishers, and financial engineers? Isn’t there something oxymoronic about a risk-averse venture capitalist?
That is not a minor point. Part of the reason why the global economy has grown so fast since World War II is that great venture capitalists, from Henry Hillman to John Doerr, have been willing to roll the dice. Well, you might say, someone will fill the void. And that is partly true. Large companies are making bets on risky enterprises. But these big-company bets aren’t about innovation. They’re investing to drive demand for their existing and future products. They’re investing to protect the past, not to disrupt it.
There’s nothing wrong with that, but it’s not the same as venture capital. When you lose the willingness to dare greatly, you lose a key element of economic combustion. The people who started Netscape created a revolution. The people who now manage Netscape think that putting AOL buttons on your browser is clever marketing. If you’re rooting for the economy to spark to life, if you’re eager for innovation to kick in and propel business into a profitable, productive future, then you’re like me: You hope that Burstein’s assessment is wrong. The problem is, if you’re like me, you fear that he has it exactly right.