Why the roaring '90s are dead and gone

The world of venture capital and entrepreneurship has changed dramatically over the past decade and not just in the obvious ways.

We've all talked ourselves to death about the foolishness of the "bubble," lessons we hope everyone (else) has learned, and the need to return to "basics." But the fact is, no matter how the statisticians interpret the numbers for us, we are not just returning to the early '90s and going "back to basics."

The world of venture capital and entrepreneurship has fundamentally changed. The challenges are different, and the opportunities are different. Investors and entrepreneurs who don't understand this change will find themselves left behind as the ecosystem of venture creation evolves beyond them.

Funds with over $200 million to invest face serious challenges as the ecosystem changes. They have to evolve to survive. Big funds can't afford to invest in seed stage companies, unless they are confident that they are investing in companies that will be billion-dollar exits.

If a home run means a $250 million exit in the world of revised expectations, and if a fund typically has a 25 percent stake at the time of exit, a billion dollar venture fund has to have 15 to 20 home runs just to return their investors' initial capital with zero return on investment.

Corporate investors and angel investors are now playing less of an active role in the venture finance ecosystem. Many corporations that were active venture investors in the '90s discovered that it was an expensive and unreliable way to outsource R&D and have since pulled most of their money out of the venture market. Similarly, angels found that as the later-stage and public markets declined, many of their early-stage investments could no longer raise subsequent funding rounds.

This leaves the boutique venture funds--firms with $5 million to $100 million in capital--to fund start-up companies. Most specialize by the expertise of their general partners, by region, or by sector. In the past, these small funds co-invested with the big funds, or acted as precursor investors for a select group of big funds. As a result, the boutique funds' investment criteria were pretty much the same as the big funds--start-ups targeting huge markets with plans for astronomical growth.

The world of venture capital and entrepreneurship has fundamentally changed. The challenges are different, and the opportunities are different.

However, now that their portfolio companies need more capital, the big funds are no longer there to plow the money in because the math doesn't work. And in the few cases where the big funds can be coaxed in, it isn't just the entrepreneurs who get crammed down; the early stage investors are also being crushed. The game isn't very much fun anymore.

Resetting expectations
In this new world, what should entrepreneurs and investors do? Is this a temporary hiccup? Or is there something more fundamental happening that could mean a long-term downturn in entrepreneurship and venture capital?

To begin with, all of the players in the venture community need to reset their expectations and pursue a sustainable path in the new venture ecosystem. Without this reset, however, the current paralysis will continue unnecessarily, and innovation and growth will be hurt.

On the investor side, limited partners and general partners, as well as angels and corporate investors, will have to accept lower rates of return for their portfolios. There will be some home runs--new companies that reach billion-dollar exit valuations and return 20 times or even 50 times what investors put in. But savvy investors will understand that most successful companies will reach $20 to $50 million of sales over a four- to six-year period, meaning perhaps $50 million to $100 million exit valuations.

In this world, the big funds will either have to play the role of mezzanine investors for those smaller companies that break out, or they will have to compete for the relatively few really big potential wins.

The smaller funds, if they can reset their models and wean themselves from the big fund food chain, will become the primary engines of growth in the evolving venture community. On the entrepreneur side, most successful companies (by this new standard of success) will not receive early-stage financing from big funds or corporate investors. The key to early-stage financing will be finding the right boutique.

Entrepreneurs also will need to embrace a concept that has been lost for a generation--capital efficiency. Now capital is dear, and entrepreneurs need to design companies that can reach critical mass on much less capital. This is not simply a return to traditional notions of frugality. It means understanding how to design all aspects of the business plan to make the most of partnerships, pricing models, industry standards and the infrastructure developed over the past decade.

One of the keys to resetting expectations is the emergence of an efficient mergers and acquisitions market at the low end. Over the past decade, the venture industry grew dissatisfied with acquisitions as an exit strategy.

The game isn't very much fun anymore.

"IPO or Bust!" was the prerequisite game plan for any CEO that wanted venture backing. Venture capitalists made it clear, "We don't want to invest in a company whose aspiration is to be sold for $50 million." For a $500 million fund, that makes sense. But there are lots of brilliant, nontrivial innovations that can offer marvelous returns for a smaller fund at the $50 million level, if both the entrepreneur and the investor can accept that outcome.

What's next?
None of this is intended to imply that there is no future for big funds. There will still be lots of start-up companies that fall into the category of "potential home runs," and there will be even more entrepreneurs that think they fall into that category. But the most fertile soil for entrepreneurs and investors is down on the forest floor.

The era of innovation and entrepreneurship is not over--far from it. There are an enormous number of problems that still need to be solved that will generate tremendous returns to those who solve them. And there is a continuous flood of innovations--from universities and corporate labs, and even from garages--that will create new product and market opportunities that we have not yet dreamed.

While the 1990s bred a generation of often overenthusiastic investors and entrepreneurs, it also left us with an incredible infrastructure of intellectual property, engineering talent, management talent, support talent, technical standards, international networks, public policy frameworks, and organizational practices that make the innovation and venture creation process more efficient. Successful entrepreneurs and investors will find and exploit these resources, giving them an advantage that the '90s generation did not have.