Venture Capital has been a great business and has provided solid returns for investors over the past 20 years. As an asset class Venture Capital has outperformed publicly traded stocks over all time horizons. Yet, the New York Times shouts “Angels Flee From Tech Startups” and “Venture Capital Returns Dip Below Zero.” True, perhaps, but VC still outperformed stocks and most other asset classes. Venture Capital is a long term investment, typically 10 years in a fund, so I’m not sure how Thomson Reuters calculates the one year return, but there is no doubt that all asset classes suffered in 2008.
Fred Wilson points out that one year returns are irrelevant for VC, but are required by accounting rules. Fred says “The thing that really bugs me is if not for FAS157, which I posted about a few weeks back, we wouldn't even see negative returns for VC in the past year. FAS157 is an accounting ruling which requires venture capital firms to mark their investments up in good markets and mark their investments down in bad markets. I am not sure if this was an intended consequence or not, but FAS157 is going to make venture returns more highly correlated with public market returns than they have been in the past.”
The question going forward is “with publicly traded stocks trading at historically low valuations will venture capital continue to outperform stocks?” Limited Partners, the investors who supply capital to the VC firms, will be making those choices over the next several years. Publicly traded stocks with low P/Es and high dividends look very tempting compared to a 10 year commitment to venture capital in uncertain times. But, these are very sophisticated investors. They will consider two things; current valuations, and future exits.
Current valuations of startups seeking capital have declined, and will probably continue to decline commensurate with the public market valuations. This levels the playing field for professional investors when deciding between public stocks and private VC investments. It is an imperfect comparison but valuations for startups need to be low enough that it doesn’t become a glaring issue with investors.
Future Exit potential is another concern. Here the story is grim. At least with public stocks an investor can cash out on any day, take their losses, and move on. Venture Capital investors rely on IPOs or M&A transactions for liquidity. The Technology IPO market has been essentially dead in 2008. There were no Tech IPOs in Q2 or Q4 of this year, and just 6 for the whole year. 2008 was the worst year for IPOs in 33 years.
Mergers and Acquisitions have been the bright spot for investors, but even M&A is down about 50% to $2.1B for the 4th quarter. This chart shows VC investments compared to M&A and IPO returns for the past 8 years. All amounts in $ Billions.
|
Year |
Investment |
M&A |
IPO |
|
2001 |
$40.6 |
$16.8 |
$3.5 |
|
2002 |
$21.9 |
$7.6 |
$2.1 |
|
2003 |
$19.7 |
$7.5 |
$2.0 |
|
2004 |
$22.5 |
$15.9 |
$11.4 |
|
2005 |
$23.2 |
$17.4 |
$4.5 |
|
2006 |
$26.7 |
$18.7 |
$5.1 |
|
2007 |
$30.8 |
$28.4 |
$10.3 |
|
2008 |
$28.1 |
$13.9 |
$0.5 |
|
Totals |
$213.5 |
$126.2 |
$39.4 |
Entrepreneurs need to keep these numbers in mind when raising money from VCs and Angels. Investors have lots of other options for their money, many of them much less risky. With potential exit valuations uncertain, the entry “pre-money” valuations need to be attractive.
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