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Where’s the Venture Capital?

Investment activity is bouncing back, but startups still face a crisis in seed funding

You might think by scanning the headlines that America’s system for allocating capital to promising startups is working just fine. After all, Stanford University graduates Kevin Systrom and Mike Krieger were able to launch a company called Instagram that obtained seed capital and then, within 18 months, was able to raise $50 million in funding from venture capital funds. That placed a value of $500 million on the company, which allows the sharing of online photos via mobile devices. Then, a week later, in April, Facebook came calling and offered $1 billion for the company. A Cinderella story, to be sure.

The Instagram story is actually an example of what has gone wrong. Venture capital (VC) is increasingly concentrated on social media and software, industries where investors do not need to put up money for equipment or physical infrastructure. Rather than demonstrating patience for the three to five years it typically requires to build a company, they seek quick returns and early exits from their investments. Venture capital also is increasingly concentrated on the later stages of a startup’s development—VC funds actually declined some 48 percent in 2011 at the crucial seed funding stage, according to the latest statistics. Furthermore, the geographic areas of the United States where venture capital is available have shrunk—regions such as North Carolina’s Research Triangle, Orlando’s stimulation industry and Pittsburgh’s advanced robotics initiative all suffer from a lack of venture capital, while at the same time VC funds are taking major plunges on social media firms in California.

Even San Diego, which once boasted a vibrant venture capital industry that spurred the growth of the city’s biotechnology and genomics industries, has seen a retreat in the availability of capital for new startups. “This is the worst period for entrepreneurs to get funding in the history of venture capital, certainly in biopharmaceuticals and biotechnology,” says Ivor Royston, founding managing partner of Forward Ventures, one of the godfathers of San Diego’s venture capital community. “So many doctors and scientists come up with really great ideas. Ten years ago, they would have been funded, but today they can’t get the funding. The venture capital model in many ways is broken.”

Moreover, the increasing “flavor of the month” tendency in venture capital means that industries that were once favorites can suddenly come up short. That’s what seems to be happening to environmentally friendly “clean” technologies, particularly solar, once a darling of both angel investors and venture capitalists. The fact that BrightSource, a solar power company based in Oakland, California, had to withdraw an initial public offering (IPO) in March is having a cascading effect back up the deal pipeline, with diminishing prospects for new solar-related companies just trying to get started. Solar startups already were being buffeted by cheap competition from China, nose-diving natural gas prices, and funding pullbacks by the Obama Administration after the Solyndra bankruptcy, but now the funding challenge has worsened.

How the System Worked

When the American system for allocating capital to new ideas worked well, scientists or researchers in a university or research institute who developed a promising technology could start raising funding from family and friends, sometimes maxing out their credit cards in the process. The Small Business Administration, through its Small Business Innovation Research grant program, often could be tapped for $100,000 to $200,000. As an idea developed, company founders sometimes were able to attract the attention of “angel” investors—typically wealthy individuals who wished to find alternate investments while achieving a positive outcome for their communities or making social connections. Sometimes, these angels formed networks so that they could pool their capital and minimize risks. Angels have tended not to be activist managers and their networks have tended not to be well-organized over the long term.

Venture capitalists have been considered a different species; and even in the best of times, they have been very careful about lending money to companies in the earliest stages of development. However, some have done so, and they tended to bring with them more management expertise, capital and raw ambition to help the companies scale up. There could be several rounds of venture capital raising—A, B, C and even D. As these different rounds of financing occurred, the angels made a “handoff” to the venture capitalists and were richly rewarded. The VCs were able to do that because they knew that their own “liquidity event,” whether an IPO or M&A, was coming soon and they could repay the limited partners who lent the money to the VC firms in the first place.

One problem with this system has been that it has been profoundly local. To achieve efficiencies of scale, top-tier VC firms have always wanted to invest in a dozen or more companies and be involved in overseeing them or in some cases actively participating on boards or in management. It’s much easier to do that if their invested companies are located nearby, ideally within driving distance. VC firms located in northern California or the New York/Boston corridor have been able to follow this pattern. Some other regions, such as San Diego, Austin, Seattle and Minneapolis, have been able to attract occasional visits from the big VC funds or develop smaller, indigenous VC industries.

Other regions must achieve a critical mass in terms of deal flow before venture capital firms even consider visiting, much less locating a partner there. “For venture capitalists, it’s a question of time efficiency,” says Michael Zapata, an angel investor in Research Triangle, North Carolina. “If you’re losing a lot of time going to board meetings in other states, that’s less time you’re working on deals or raising funds.” Not a single, top-tier VC firm has an office in North Carolina, he notes.

What Went Wrong?

The system, however imperfect, has broken down in several crucial respects. Since the collapse of the dot-com bubble and the imposition of tougher financial rules under the 2002 Sarbanes-Oxley rules, many VCs have been underwater—unable to return profits to their limited partners, who are typically wealthy individuals or institutions, such as pension funds. “There is a lot of turmoil in the business,” says Tracy T. Lefteroff, global managing partner of the venture capital practice at PricewaterhouseCoopers in San Jose, California. PwC compiles the MoneyTree Report with the National Venture Capital Association. “For the past 10 years,” he adds, “venture capital has been in a negative position.”

As a result, VCs have moved away from the earlier, riskier stages of financing startups, accounting for the 48 percent decline in seed capital deals in 2011 over the prior year, according to the MoneyTree Report. A mere $919 million was invested in 396 start-ups. Top-tier VC funds increasingly perceive that they cannot earn enough return on small deals with startups. “If you have a $600 million fund, you need to make enough investments fast enough to sustain your infrastructure,” says Sean Carr, director of intellectual capital at the University of Virginia’s Darden School of Business in Charlottesville, Virginia. “You can’t make a $200,000 investment. The big players need a home run to succeed.”

Big VC firms also are demonstrating less patience in dealing with angels and other individual investors. “Venture capitalists don’t like dealing with a disaggregated set of early investors with different opinions and attitudes,” Carr adds. “It’s too complicated. It’s too messy.”

In cases where the VCs do see a profit opportunity, they have become increasingly aggressive in low-balling the managements and investors of emerging companies by placing lower valuations on them. They also have gotten tougher by diluting the shares of previous rounds of investors, converting special classes of shares to common stock or diluting previous investors’ representation on boards. Angels call these actions “cram downs” or “push downs.” “The market has been very rough on the venture capitalists and they are making it tougher on the angels,” says Zapata. “They are killing their future deal flow by cramming them down, crashing them out.” He is active in the management of three of his invested companies—ProtoChips, which makes equipment that allows scientists to observe chemical reactions in real time; Array Xpress, a genomics company; and Xanofi, which makes nanofibers.

The result is that more angels are insisting that they will only get involved in deals where managements promise never to seek out venture capital. The angels are trying, unsuccessfully in many cases, to assume responsibility for multiple rounds of financing to create liquidity events, either IPOs or sales of the companies—or they’re simply sitting on the sidelines. “There are fewer angel investors who can handle multiple rounds of financing, so they’re just not doing deals,” says Scott Faris, CEO of Planar Energy in Orlando, Florida, a startup maker of semiconductor materials for energy storage. “It is creating a dearth of capital in these early-stage transactions.”

In this tougher, less trustful environment, the VCs appear to have retreated to their two dominant geographies—California and New York/Boston. Smaller VC communities in San Diego and Austin have shrunk, and other areas of the country that used to receive occasional visits from major VCs are no longer on their travel itineraries.

What Are the Consequences?

One implication is that startups will have to look offshore for funding because governments, particularly in East Asia, are targeting certain technologies. Planar, for example, raised some seed capital from a firm in Maryland, but to complete its A round, Faris has given up on looking in America. “If you’re in a hot space, the money will flow to you,” says Faris. “But if you’re in energy storage, you have to travel to the money and most likely have to travel outside this country to find the money.”

He has been on the hunt for money in China, Japan and South Korea, where large conglomerates and state-owned Chinese enterprises have patient, long-term capital. That increases the risk that ideas like his will be siphoned off or that actual manufacturing takes place in East Asia, not the U.S. Sources of finance often can exert powerful influence on where a startup launches full-fledged manufacturing.

Increasingly, entrepreneurs also will be obliged to try to develop safer, more incremental technologies rather than trying for big breakthroughs that create new industries. Zapata, of North Carolina, says he is looking for deals that can make it to the exit stage without the need for venture capital. “The trade-off is that you have to focus more on deals that can produce revenue earlier and therefore they are less likely to be the gazelles that will create large numbers of jobs,” he explains. “It’s lower risk for the angel than playing with the VCs, but there’s a smaller potential payout on average.”

The broadest consequence of the seed-stage funding crisis, however, is that only a tiny percentage of the intellectual property in American universities, research institutes, national weapons laboratories and hospitals will be commercialized successfully. At a time when the U.S. is hungry for new sources of growth and job creation that is obviously unfortunate.

What Can Be Done?

Some angel investors and VCs are mildly optimistic about the Jobs Act that President Obama has signed into law because it will relax some of the paperwork that Sarbanes-Oxley imposed on startups trying to raise capital. But the SEC must interpret the intent of the law and issue regulations, which will take time. Another element of the Jobs Act, allowing crowdsourcing from potentially hundreds of online investors, is untested and the jury is still out on whether that will open large, new flows of capital.

In the best possible case, the new law appears to be just a small step in attacking the underlying crisis in seed-stage financing. Simply reverting to the old system of handoffs does not seem to be an option. “There has to be a new model developed,” says San Diego’s Royston, whose firm is overseeing investments of about $150 million in a dozen companies.

Although there are steps that can be taken at the state and regional level, Royston says that Obama, or his successor, should lift the clouds regarding the tax treatment of gains that limited partners make by investing in VC funds. Some within the Obama camp are suggesting that those profits should be taxed as regular income, not at the much lower capital gains rate. “What a terrible time to be proposing something like that,” Royston argues. “They don’t understand. It’s like throwing out the baby with the bathwater. Venture capital is not the same as Blackstone or a hedge fund. If you’re going to tax, try to find a way to carve us out. We are job creators.”

The bottom line? If America wants to get serious about encouraging startup companies to create jobs and economic growth, it had better fix the early-stage funding system.

For more on spurring capital flow to startups, read “What Can be Done at the State and Local Level” at ChiefExecutive.net/venturecapital

About william j. holstein