Tuesday, June 1, 2010

The Decline of Venture Capital

During the late 90's craze to label every region with a Silicon prefix, there were at least 10 states claiming to be in the top 5 for venture capital raised. Terrified of looking connected to the “old economy”, economic development officials from Utah to New York were anxious to tell people what venture capitalists were doing in their state.

While the recession of the early 2000s cooled the “Silicon Prairie, Forest, Alley, Dominion, Beach, Mountain” nonsense, regions still saw attachments to venture capital as essential for marketing themselves, as well as for financing startups that promised to employ hundreds of people. However, most of these efforts created more hype than jobs, and the 100 person startup remained a rounding error compared to the 18,000 people working in area hospitals.

Venture capital has gone in an even further decline the last few years, and many of the issues surrounding limited funds are not tied to the recession, but changes in the technology industry, specifically:

  • Startups seeking funding for operating costs, not capital expenditures
  • Poor performance of “Green Technology” investments
  • More people implementing technology than creating it – a key consideration for economic development

Venture Operating Expense
With the advent of Software-as-a-Service, $3 products designed for the App Store, and with virtually all semiconductor companies going fabless, many startups looking for money plan to use the cash to pay operating expenses, not for capital outlays. This is a major shift from the traditional VC investment which was too risky for bank finance, and too technical for just about any loan officer.

While there are still a handful of companies that need money for R&D and new production facilities, many companies seeking funding have a product, but they need money to hire salespeople and develop marketing campaigns. Software, a long-time VC favorite, has turned into Software-as-a-Service (SaaS), where companies pay a monthly fee, not one upfront charge to use the product.

Similar to the SaaS startups, small development shops running websites or placing products in the App Store do not have massive R&D budgets or capital requirements. But they need salespeople and marketing staff to turn their products into revenue. While these companies can bring some capital needs for servers and network equipment, these requirements are not all that different from non-technology companies which need the same products to run a network and maintain databases, which is also why there are more people implementing technology than creating it.

Implementing Technology vs. Creating New Products
Having one of the thousands of companies deploying Oracle 11g in your state is less exciting than having one of the few companies developing new business software, but the former is tied to far more jobs now that these products have been around so long and installed by so many. In an Indeed search last year, I found four times as many openings in Metro Boston for SQL Programmers than for people with biotech experience....in Boston. So many companies in different industries now USE technology, that having expertise implementing it will create tons more jobs than a venture-funded “innovator” developing it.

If Boston needs more people to deploy technology than to create it, you can rest assured Detroit, Cleveland, and Salt Lake City are in the same position. But there's little chance you'll see a database administrator performing routine maintenance on an econ development agency's glossy brochure, even though the lab coat guy whose picture is there represents a tiny share of regional employment.

Green Tech Disappointments
As Biotech and IT have matured, many venture capitalists have turned to Green Tech/Clean Tech/Alt Energy for new investments. But unlike Biotech and IT, many green tech companies have 20-30% gross margins, far lower than the 50-90% gross margins typically seen in venture-funded industries. Because unlike a pill, semiconductor, or software license, most clean tech products have high unit costs.

Historically, one of the chief financial justifications for VC was that unlike industrial manufacturing, high-tech manufacturing created tremendous cash flows past break-even, because raw material costs and labor costs per unit were extremely low, while upfront costs were much higher than industrial manufacturing because of specially-created clean rooms and much higher R&D. Venture capitalists would traditionally hold the company as it raced to cover its high fixed costs, and then sell it or let it go public as it got closer to profitability. But the economics of green tech manufacturing aren't all that different from old-school industrial manufacturing.

Like a car, solar panels (including the thin film products) have high raw material costs. While many use the same material as semiconductors, they don't get smaller every two years like computer chips do. As a result, they have much higher unit costs and are not a great fit for venture investment, in spite of the dreamy hype of the last few years that led to many bad investments in this sector. Fewer companies can get sold or go public when they're not just unprofitable, but need another $1 billion of capital to break-even.

Even with all the feel good clean/green euphoria, venture capitalists are moving away from green tech manufacturing and toward smart grid and energy management, but the companies in these sectors are basically industry-specific software developers.

 (there is nothing close to Moore's Law involved with the cost of making that offshore wind turbine)

It's the 2010s, not the 1990s
While VC never had a significant impact outside a few regions, its time as a catalyst for economic development has long passed. Boring companies implementing someone else's technology hold far more promise for new jobs than flashy companies trying to build something “cool”.


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