Dealing with the Venture Capital Crisis

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 dwindled—only 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 employment—for 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 area—New Zealand is as big as California or Japan) can add some new life to the venture capital industry.

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Perhaps the biggest future challenge will not be the sector but the geography.

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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:

• Endace (http://www.endace.com) sells products that probe and monitor networks by putting “time stamps” on Internet packets. Financial institutions, governments, and other organizations are using the technology to improve security and optimize network performance. The company is public on London’s AIM exchange and reported revenues in the last fiscal year of about US$30 million, with customers in 30 countries.
• Framecad (http://www.framecad.com) sells machinery and design software as well as consulting services that enable construction companies to create small or medium-sized steel-framed buildings. These are relatively inexpensive and do not require much skilled labor to construct. In addition to New Zealand, the company has found customers in developing economies such as China, the Middle East, and Southeast Asia.
• GFG Group (http://www.gfg-group.com) provides off-the-shelf electronic payment solutions (credit and debit cards, mobile phone applications, ATM and POS applications) and related services to 115 million customers in 40 countries. Most of its business outside New Zealand is in Australia, Singapore, the Philippines, and the United Arab Emirates.
• Inro Technologies (http://www.inro.co.nz) sells robotics technology to retrofit manual forklifts and turn them into automated vehicles. Fonterra, New Zealand’s largest firm and a major exporter of dairy products, invested because finding forklift drivers is difficult and expensive. It is even more expensive to build new automated warehouses from scratch.
• Methodware (http://www.methodware.com) provides customized risk management and internal audit software to financial services, energy, and utilities companies as well as the public sector. It originally targeted small and medium-size firms but through partnerships has been able to sell to 1,800 corporate clients in 80 countries.
• NextWindow (http://www.nextwindow.com) sells touch-screen computer displays and overlay touch-screen devices and software, initially for large screens and kiosks. It has grown very rapidly through international distribution partnerships and alliances with PC manufacturers around the world, especially in the U.S.
• OpenCloud (http://www.opencloud.com) sells a suite of real-time Java application servers (Rhino) as well as provides development tools and consulting for companies interested in building multimedia products and services, especially for mobile phones. It moved its headquarters to the U.K. to gain better access to customers.
• Smallworlds (http://www.smallworlds.com) is a 3D “virtual world” and social networking site that enables users to set up their own room spaces and then do instant messaging as well as share audio and video content or play games with their friends. Outside companies can use the site and tools as a development platform. The applications run inside a browser and do not require large (and slow) software downloads.
• Weta Workshop (http://www.wetaworkshop.com) is one of the largest video-effects design and production companies in the world serving the movie industry and now branching out into other markets, such as animation for children’s TV and technology for video game producers. It is best known for video effects in the Lord of the Rings movies (which were shot in New Zealand). It has won five Academy Awards for visual effects, costumes, and makeup.
• Wherescape (http://www.wherescape.com) combines unique in-house tools with an agile development methodology to build data warehouses quickly and cheaply for a variety of industries. It has hundreds of customers, mainly in New Zealand and Australia, but also works with partners around the world.
• Virtual Infrastructure Professionals (http://www.vipl.co.nz) provides custom-built virtualization, hosting, and disaster recovery solutions (using mostly VMWare and Citrix). It partners with most of the major software and hardware producers, but does most of its business in New Zealand.

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With the proper level of ambition, talent, and opportunity, even a small, isolated company can turn the world into its market.

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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 determine—before they put in too much time and money—which 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 export—which 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 big—and 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.

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