Where Venture Capital is Flowing

Stephen DeAngelis

April 5, 2011

Last October Pui-Wing Tam and Cari Tuna reported that California’s “Silicon Valley’s start-up economy [had] quietly broadened beyond information technology. It now includes a growing cadre of bioscience and ‘clean technology’ firms, presaging a more-diversified economic base and bolstering the valley’s status as the world’s innovation hotbed.” [“Silicon Valley 3.0: Tech’s New Wave,” The Wall Street Journal, 21 October 2010] The focus of their article was on Edenvale Technology Park in San Jose and the companies that are headquartered there. In the article, Tam and Tuna report:

“Today, less than half of the region’s venture capital, which is used to finance start-ups, goes to tech companies—compared with nearly 70% five years ago, according to research firm VentureSource. The amount of venture capital going into Silicon Valley and Bay Area companies—at $8.3 billion in 2009—is far below its peak of $11.8 billion in 2008, according to VentureSource. Nationwide, venture capital expenditures fell to $22 billion last year, down from its peak of $32 billion in 2007, according to VentureSource.”

Those figures may be changing. According to Geoffrey A. Fowler, “Silicon Valley venture capitalists are betting on a new generation of companies that hope to unshackle social networking from personal computers—and shift it to the cellphone.” [“Money Rushes Into Social Start-Ups,” The Wall Street Journal, 24 March 2011] But an article by Colleen DeBaise and Scott Austin indicates that IT start-ups will probably continue to represent just under half of the businesses backed by venture capital. They write, “In what may be a sign of a re-inflating Web bubble, The Wall Street Journal’s second annual ranking of 50 venture-capital-backed companies shows investors are chasing after Internet firms, many with a consumer focus.” [“The Top 50 Venture-Backed Companies,” The Wall Street Journal, 10 March 2011]. They report that “to be eligible for the ranking … companies must have received an equity round of financing in the past three years and be valued at less than $1 billion, as the aim is to identify lesser-known contenders. That excludes a number of prominent companies, including Facebook, Twitter and Groupon Inc. Some 5,743 candidates were considered.”

 

DeBaise’s and Austin’s column is accompanied by an interactive table that lists the top 50 venture-capital-backed companies along with their location, industry sector, founders, investors, product or service, number of employees, year founded, “why it’s hot” blurb, and total equity raised. You can also read short write-ups on each of the top 10 companies on the list. DeBaise and Austin assess the list this way: “Start-ups with potential for technological breakthroughs in health care, mobile communications and business software” sit at the top. Of the 50 companies, 23 of them are in the information technology (IT) sector, 12 more are in the business and financial services sector, 8 come from the healthcare sector, 6 from the consumer services sector, and 1 from the energy and utilities sector. In an earlier article by DeBaise, she answers the question: “If you’re an entrepreneur looking to raise money from the venture community, what’s the best sector to be in?” [“What’s Hot in Venture Capital in 2011,” The Wall Street Journal, 9 February 2011] She writes:

“That was the question posed … by Lori Hoberman, who heads up Chadbourne & Parke LLP’s emerging-companies/venture-capital practice in New York, at her annual ‘State of the Union’ Venture Capital Lunch Club. The panelists at the lunch … offered a mix of responses, though most (not surprisingly) involved technology. ‘Highly innovative green tech,’ said David Wells, of Kleiner Perkins Caufield & Byers, the Silicon Valley venture-capital firm that counts Al Gore, former vice president and environmental activist, as one of its partners. … ‘E-commerce and data analytics,’ offered Peg Jackson of Cava Capital, an early-stage VC firm that targets start-ups in the New York area. … Charles Scott of Intel Capital, the investing arm of Intel Corp., says he’s keeping a close eye on companies that help datacenters work more efficiently, especially as smart-grid networks roll out. … Owen Davis from NYC Seed, which invests in seed-stage tech entrepreneurs in New York, says he’s looking at firms that integrate enterprise software with social-media capabilities, and companies that offer specialized cloud-computing services. … Josh Wolfe from investment firm Lux Capital didn’t predict a hot sector. Rather, he’s looking out for ‘entrepreneurs with crazy ideas’ — some will work, some will not, but one might be the investment that pays off.”

Venture capitalist Luke Johnson claims that “investors and entrepreneurs [often] look at the wrong financial numbers and ratios when analysing companies. They focus obsessively on the latest year’s pre-tax profits, or perhaps post-tax earnings. But these can often be manipulated, or temporary. What matters much more are underlying sales, strong gross margins and free cash flow.” [“Don’t be fooled by illusory numbers,” Financial Times, 11 January 2011]. He indicates that he personally looks for “industries where you can capture at least a 60 per cent gross margin.” When looking to back start-up companies, venture capitalists don’t often have earnings numbers they can examine. It is the upside potential of start-ups (i.e., companies with potential gross margins like those described by Johnson) that draw their attention. With capital once again flowing into start-ups, some analysts are concerned that “Silicon Valley has been edging into … bubble territory.” [“Investors See Web Boom, Not Bubble,” by Pui-Wing Tam, The Wall Street Journal, 24 March 2011] Tam writes:

“Greylock Partners venture capitalists David Sze and Reid Hoffman, also a founder of LinkedIn Corp., argue that is far from the case. The investors, whose firm has backed Facebook and daily deals site Groupon Inc., among others, say Silicon Valley’s latest crop of Web companies have real revenue and viable business models—unlike the dot-com companies that crashed after the 2000 tech bubble. Mr. Sze, 45 years old, and Mr. Hoffman, 43, add that all the Web activity is helping to spur a broad economic recovery here. In a reflection of their optimism, Greylock reopened its most-recent venture fund and raised an additional $425 million to invest in start-ups, for a total of $1 billion.”

As a side note, venture capitalists must also be aware of potentially costly collateral issues that could undermine the value of start-ups, like legal and privacy issues. One of the start-ups mentioned in the article by Geoffrey Fowler is “Color Labs Inc., a phone-based social network founded by veteran entrepreneur Bill Nguyen.” The company has created applications for both iPhone and Android mobile phones. “The idea behind Color is that a phone’s location-sensing abilities can build a user’s social network for them, allowing users to share photos, video and messages based simply on the people they’re physically near. The company’s view on privacy is that everything in the service is public — allowing users who don’t yet know each other to peer into each other’s lives.” Fowler notes, “Services like Color raise questions about how people might use them and deal with privacy. Mr. Nguyen said Color doesn’t ever promise that photos, location and other information will be private. Such capabilities will require good faith from users (for example, to keep public photos G-rated) and could push people to change their social behaviors.” My suspicion is that such applications could result in litigation as unwilling participants (people whose pictures have been unknowingly captured by the app) claim invasion of privacy. According to John D. Sutter, “Photos taken through the app … are public by default. They’re stored on Color’s servers and the company owns them.” [“New Color app promotes mobile voyeurism,” CNN, 24 March 2011]. Sutter continues:

“Other apps or websites that allow strangers to share photos and videos of themselves — think Grindr, the gay dating app, or Chatroulette, the live online video chat that got tons of buzz last year — have had problems keeping photos streams on the up-and-up. There’s something that feels a little grimy about seeing the photos of dozens of strangers suddenly populating your screen, especially since you can’t remove them from your feed.”

According to Sutter, Peter Pham, president and co-founder of Color Labs Inc., isn’t concerned. Sutter explains:

“Pham said vulgarity won’t be a problem with Color because peoples’ photo streams follow them throughout the day. So you wouldn’t want to play a prank by posting a gross photo at a bar only to have your co-workers see this when you show up to work the next morning and they open the app. As for privacy concerns, Pham dismissed those. ‘If you don’t feel comfortable having that public, then don’t use our application,’ he said.”

What if you’re not a rich venture capitalist but would like a chance to invest in an early stage start-up? Babson College Professor Joel Shulman may have just the vehicle for your money [“Betting on ‘Entrepreneurial’ Stocks,” by Angus Loten, The Wall Street Journal, 15 December 2010]. Loten reports:

“[In November of last year,] Mr. Shulman soft-launched the EntrepreneurShares Global Fund, a mutual fund of publicly-traded companies from around the world that are hand-picked for their entrepreneurial, small-business characteristics. These include family involvement, organic growth opportunities, transparent governance, and an above-average ownership stake held by key stakeholders, among other qualities in a proprietary set of 15 ‘entrepreneurial’ features. ‘We’re looking for the opposite of bureaucracy,’ says Mr. Shulman, an associate professor of entrepreneurship at Babson, in Babson Park, Mass., and a certified financial analyst. Shares in companies selected through this process consistently outperform the market, he says, citing a five-year track record for a $15 million fund he managed on behalf of a private, independent investor and based on an identical strategy that generated an annualized rate of return of 11%.”

Loten reports that “the fund is made up mostly of U.S. small-capitalization stocks, accounting for 60% of the 200-plus companies in the portfolio, with firms in China, Canada, the U.K. and Hong Kong together representing less than 20%. By sector, they span utilities, telecommunications services and information technology, to healthcare and consumer staples.” Small investors assume the same kind of downside risk as large venture capitalists. Loten explains:

“For all their entrepreneurial spirit, the prospectus acknowledges that small- and medium-sized companies typically have ‘more limited liquidity and greater price volatility than larger, more established companies,’ along with ‘limited product lines, markets or financial resources and their management may be dependent on a limited number of key individuals.’ All potential red flags for investors.”

If you have a tolerance for risk, an entrepreneurial spirit, but a limited amount of capital, there are opportunities for you invest in the future. Most venture capital firms are having an easier time raising investment money — a sign that the economy is getting better. With interests rates remaining at historic lows, returns on investment capital is an attractive alternative for many.