The venture capital industry, like financial services in general, has fallen on hard times. Venture funds historically have returned about 20% annually to investors, twice the average of U.S. stocks. Like stocks, though, returns over the past year have been sharply negative and investing has fallen dramatically. U.S. investments have dropped from the 2000 peak of $105 billion to a low of $20 billion in 2003 and recovered only to $28 billion in 2008.1 The 2009 numbers are running at half the 2008 level. Other countries see similar trends, including Israel, which usually has the highest level of venture capital investment given the size of its economy.3 Investment there was merely $800 million in 2008, down from $2.7 billion in 2000.a
Part of the problem is that large payoffs have become increasingly scarce: Average valuations of venture-backed startups in 2008 were half those of 2007, while public offerings (IPOs) have dwindledonly six in the U.S. in 2008, compared to 86 in 2007.b But creativity may be another problem for the industry.
Venture capital firms have been investing recently in energy and the environment as well as more traditional areas, such as software, health care, biotechnology, medical devices, multimedia, and communications. But perhaps the biggest future challenge will be not the sector but the geography: VC firms put most of their money in home markets to keep a close watch on their entrepreneurs. U.S.-based VC firms also can argue that their home market offers the biggest public offerings and asset sales. But a recent survey of 700 VC firms found that 52% are now investing overseas. Nearly this same number planned to invest more in China, India, and other parts of Asia, while others want to invest in South America.2 It makes sense to explore these big, growing regions. But there is still a lot of competition. What really might jump-start the industry is more creative globalization, with an eye toward using some overseas markets as "natural incubators."
Governments and universities have long supported entrepreneurs with incubators that offer seed money, office space, financial and business advice, and introductions to potential executives and customers. But most incubators I know of have done poorly (I was an advisor to four firms in the late 1990s and worked for several venture funds). In the U.S., entrepreneurs with the best ideas usually do not need to be incubated and get funding directly from VC firms, private individuals serving as "angel" investors, or corporations. During the Internet boom, incubators also funded weak ideas and weaker teams. Nonetheless, in markets with limited venture capital or angel funding, incubators are still useful to help entrepreneurs get started.
It also occurs to me that potentially even more useful are markets that serve as natural incubators: small countries usually overlooked by international VC firms, either because of their size or isolation, but which have advanced economies, sophisticated customers, good universities, strong intellectual property rights, favorable tax laws, and vibrant entrepreneurial cultures. They might spawn ventures that become important new sources of wealth, social welfare, and employmentfor the hosts and the world.
Israel (population seven million) used to be one of these natural incubators. It is the source of numerous important technologies (for example, instant messaging, security software, software testing tools, and SAP's NetWeaver) and was discovered in the 1980s and 1990s by the VC community as well as American and European multinationals. Also, the U.S. provides nearly $3 billion a year in aid to Israel. This, along with large defense and security spending, helps fuel demand for high technology. Another small, advanced market is Finland (population five million). But this country is an integral part of Europe, and Nokia's huge international success has increased the level of international attention and investment. Ireland (population four million) may fall into this category (see my October 2005 Communications column, "Software in Ireland: A Balance of Entrepreneurship and...Lifestyle Management?"), though its entrepreneurs generally prefer to remain small and benefit from proximity to the U.K., with 60 million customers, and Europe, with a half-billion people. There may well be other interesting markets to explore in Southeast Asia, Africa, and Latin America.
But a truly remote country I have come to know well is New Zealand (population four million). Over the past two years I have visited there twice, sponsored by the Foundation for Research, Science, and Technology (FRST; http://www.frst.govt.nz/), a government agency that invests in R&D projects at early-stage companies. This experience has encouraged me to think more about how small, isolated markets (though not small in land areaNew Zealand is as big as California or Japan) can add some new life to the venture capital industry.
Perhaps the biggest future challenge will not be the sector but the geography.
Economically, New Zealand is an advanced nation, though per-capita income used to rank with Western Europe and has fallen below Spain. The majority of the economy is services, like other industrialized nations, but it also relies heavily on tourism as well as large-scale exports of agricultural commodities. The desire for more variety in the economy is one reason why the government has promoted software, biotech, and other technology-based entrepreneurship. FRST, established in 1990, annually invests about 500 million New Zealand dollars (US$300 million) in local company R&D and other promotional or educational efforts. The government works with local venture capitalists, who in 2008 invested NZ$66 million (US$40 million) in 52 deals (down from NZ$82 million in 60 deals in 2007).4 Americans have not ignored New Zealand entirely. Motorola has invested in Opencloud (mobile software), Vinod Khosla in LanzaTech (bio-fuel), and Sequoia Capital and others in Right Hemisphere (visual collaboration software). In general, though, most of the world's VC firms view New Zealand as too small and remote to merit much attention; this is shortsighted. The following brief descriptions of software-related firms I visited suggest a wide variety of technologies and ideas are being commercialized in just this one sector:
With the proper level of ambition, talent, and opportunity, even a small, isolated company can turn the world into its market.
These firms seemed very interested in exports, though many lack capital and experienced difficulties growing beyond a certain size. Some companies succeeded only because there was little international competition. The critical decision for government as well as private investors is to determinebefore they put in too much time and moneywhich firms can export in volume. "Horizontal products" that can be sold to almost anyone in any market because they represent common needs, are highly standardized, and do not need customization or specialized knowledge are the easiest to scale and export. But these businesses attract the most competition (see my July 2003 Communications column, "Beware the Lure of the Horizontal"). The easiest markets to gain a foothold in are "vertical services," such as custom-built applications or specialized services for a particular industry. But labor-intensive or skill-dependent work is difficult to scale and more difficult to exportwhich is why having an incubator and time to experiment can be important.
The population, physical characteristics, or other unique local requirements of a country can also inspire entrepreneurial creativity. For example, New Zealand has a severe shortage of people, so we see firms use software and other technologies to foster automation (such as retrofit forklifts) and devise inexpensive, fast solutions to common problems (building construction, data warehouse design, virtual hosting, electronic payments). Other firms take advantage of New Zealand's breathtaking scenery and creative art communities. But perhaps most important is for VC firms as well as entrepreneurs investing in small markets to think bigand follow the lead of Nokia or one of the 70 or so Israeli companies that have been listed on the NASDAQ stock exchange (more than any other foreign country). With the proper level of ambition, talent, and opportunity, even a small, isolated company can turn the world into its market.
1. Cain Miller, C. What will fix the venture capital crisis? The New York Times (May 4, 2009); http://bits.blogs.nytimes.com/2009/05/04/what-will-fix-the-venture-capital-crisis/ and Sales of startups plummet, along with prices, The New York Times (Apr. 1, 2009); http://bits.blogs.nytimes.com/2009/04/01/sales-of-start-ups-plummet-along-with-prices/
2. Global Economic Downturn Driving Evolution of Venture Capital Industry, National Venture Capital Association Press Release (June 10, 2009); www.nvca.org
4. New Zealand Private Equity and Venture Capital Association and Ernst & Young, The New Zealand Private Equity and Venture Capital Monitor 2008; http://www.nzvca.co.nz/Shared/Content/Documents/
a. Israel Venture Capital Research Center; http://www.ivc-online.com/
b. See VC Industry Statistics Archive from the National Venture Capital Association at http://www.nvca.org/
Figure. New Zealand-based special-effects company Weta Workshop, whose work includes King Kong shown here, has been awarded NZ$5.8 million in government funding for a research partnership with TechNZthe business investment program of the Foundation for Research, Science and Technology.
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