Home' Technology Review : June 2005 Contents 43
By Invitation Howard Anderson
G - ! We venture ca-
pitalists like to think of
ourselves as giants strid-
ing across the technology
landscape, showering mo-
ney on terri c young entrepreneurs, add-
ing value, creating jobs, nurturing real
companies. We are nancial samurai. But
I am giving it up. Why?
First, technology supply is bloated. In-
novation is not dead, but demand for new
technologies is moribund and will con-
tinue to be weak for at least the next ve
years. During the boom times, VCs -
nanced more than 5,000 new companies a
year in information technology, commu-
nications, biotechnology, and the Inter-
net. The problem is that the buyers of new
technology cannot possibly utilize all this
stu . There is a very real limit to what can
usefully be deployed. IT and communica-
tions spending is no longer growing at 15
percent per year; growth will be in the
middle single digits for at least the next
ve years. Therefore, few software and
communications companies will enjoy the
double-digit growth that in ames com-
pany valuations and makes VCs rich.
Second, there s a good reason why
technology spending is stagnant. The
hype machine is broken. For years, tech-
nologists told the world that "information
is strategic"; we said that if companies
didn t overspend to protect against Y2K
they were committing corporate hara-kiri.
Executives spent like crazy people. No
longer. Their new mantra: spend no more
than last year.
Third, the nancial markets for tech-
nology companies are no longer exuber-
antly irrational. VCs hate rational markets:
rational markets value companies at two
and a half times their sales at an initial
public o ering or one and a half times
their sales at a merger. We need a little ir-
rationality to earn a living---but the total
capitalization for the leading technology
companies is now one-sixth of what it was
ve years ago.
Fourth, these changes in venture fund-
ing are structural, not cyclical. VCs actu-
ally like cyclical markets; we can buy in
cheaply and wait for exuberance to bail us
out. Traditionally, we knew that if we
picked the right sector we could make 10
times our money. In fact, we knew if we
picked the best two or three companies in
that sector, we could make 50 times our
money---but you get my point. But those
days are, regrettably, over.
Here s why: it takes about $30 million
to get a startup software company to break
even---and even great software companies
rarely grow more than 100 percent a year.
In irrational times, a software company
with $30 million in sales would have been
worth $180 million, or 600 percent of a
VC s investment. Which is good, but not
great. Unfortunately, in rational times, the
company would be worth $47 million to
the investors, or only 157 percent of their
investment. But that s over five years! Per
year, it s a return of only 11 percent---and
that s for a winner. Remember: in venture
funds, only 20 percent of investments are
winners. Forty percent are in the middle,
20 percent are losers, and another 20 per-
cent are write-o s.
Venture funds all strive to rank in the
top quartile. But the returns of the top-
quartile funds depend on when they were
launched. Take a look at these numbers
for venture capital returns from Cam-
Year Percentage increase
If you were a VC between 1994 and
1997, you couldn t help but make money.
But by 2000, you were underwater.
Finally, it s not just supply of new tech-
nology that is too abundant. Ten years ago
there were 240 member rms in the Na-
tional Venture Capital Association. Today,
that membership has nearly doubled, and
our fund size under management has in-
creased eightfold. There s too much ven-
ture money pursuing too many deals.
There s nowhere for all that money to go:
we can t spend the money we ve raised.
Venture capitalists view themselves as
pragmatists, but if they think the dynam-
ics of the business haven t changed, they re
as self-deluding as the next person.
Ever wonder what we did for a living
in early-stage venture funding? I bet you
think we spent the day searching for the
next insanely great company. But we spent
most of our lives in endless meetings with
people who were lying to us: scientists
who swore that their patents were solid
and entrepreneurs who insisted that they
had no competition. We lied right back at
them: said our money was di erent.
That was the old way, and it was tons of
fun, and we all made too much money. I ll
miss it. But now the markets are too ratio-
nal, and the returns are too small and un-
certain. So, time to leave. ■
Technology finance has turned
rational---so I m outta here.
Howard Anderson is the William Porter
Distinguished Lecturer at MIT s Sloan School
of Management, where he teaches courses on
early-stage companies. He founded the
Yankee Group and cofounded YankeeTek
Ventures and Battery Ventures. He plans to
raise no new monies for his venture funds.
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