November 1, 2005

Is the Need for Venture Capital Changing?

Posted in Economic Model, finance, management, VC Roles at 5:29 pm by scottmaxwell

I met with Jan Hichert, CEO of Astaro, over breakfast yesterday morning. As we were catching up on industry gossip, he asked me the question if VCs were becoming unecessary for internet start-ups. We had a good discussion on the topic and then I came back from breakfast and read Rebecca Buckman’s article, Many Internet Start-Ups Are Telling Venture Capitalists: ‘We Don’t Need You,’ in today’s Wall Street Journal (October 31, page C1).

The article was about Venture Capital effectively becoming superfluous. The basic argument of the article, and the question posed by Jan, was that the cost of getting to “product” release in an internet start-up has gone down considerably over the last decade (which it has by at least an order of magnitude) and many companies, therefore, do not need Venture Capital. It cites Flickr as an example (which was sold to Yahoo for an estimated $25 million). Clearly a good payoff for the management of the company and it looks like a wise purchase for Yahoo. Everyone involved won. And no VCs involved…cased closed. Right?

Some Good Points…

The article (rightly) points out that the current issue is at least true for a subset of companies that, perhaps, focus on the consumer market. We also have seen many B2B companies bootstrap themselves with services revenue or low cost product downloads and get to a level of revenue and profitability with very little capital consumption before we invested in them.

But…

My view on this issue is that it all depends on the goal for the company. If your goal is to build something useful (a feature that belongs in another company’s hands, for example) and make a reasonable amount of money from a sale (or create a lifestyle business), then clearly partnering with a VC is not for you (it is also not for the VC). But if your goal is to build a meaningful long-term enterprise, I would surround myself with as many smart, helpful, networked people as I can (good VCs fit in this category), and you will most likely need and/or want outside capital.

Expanding a Company- Uses of Capital

If you want to build a meaningful long-term enterprise, there are several uses of capital, even for profitable companies (yes, there are extreme outliers, but the following simple math is generally true):

1. As your revenues grow, your receivables grow, creating the need for working capital (cash turns into receivables). This point is generally true, but not true in certain consumer businesses that take credit cards and receive customer payments prior to paying suppliers (the negative working capital companies such as Amazon.com). If you run a financial model on your business including the balance sheet, you will get a good idea of the relationship.
2. As you grow your Sales and Marketing, the expenses are generally paid before the revenue/gross profit is received. Most great companies have the opportunity to grow (with a positive Net Present Value using a high discount rate) their companies faster than they can self-fund (that is, using the free cash flow of the business to fund this expense) sales and marketing. Again, the credit-card payment model is less sensitive to this point (due to days receivable outstanding being 3-5 days), but it still exists. On the other end of the spectrum, the B2B Software as a Service (A.K.A. On-Demand or ASP) “subscription” model (Salesforce.com is my best example), uses a lot of capital as the sales and marketing ramps up, as the timing for cash flowing out is much earlier than the timing for cash flowing in (btw, this is an extremely attractive business and economic model as Salesforce has been demonstrating in the public markets…my point is that it used capital to grow).
3. Experiments and “mistakes” use capital. Generally, as companies build-out, there are two major areas of expansion, one on the product development side and one on the product distribution side. I think of these build-outs as “grand experiments,” as you can do all of the up-front analysis that you can, but it is all theory until you put it into practice and see the results. Long-term sustainable businesses need to continue evolving their products’ feature/functions, build new products, and build out their channels of distribution. All of this takes capital, as the uses come before the benefits…even more capital if you make a few “mistakes” (and everyone does).
4. Missed Quarters (sometimes) Use Capital. Most emerging growth companies miss their quarters at some point. You want to make sure that you have “rainy day” money on the balance sheet to be used in circumstances like this.
5. Acquisitions use Capital. Several companies that I have been involved in have made small “tuck in” acquisitions, mostly to expand their product footprint. Generally, these types of acquisition candidates want at least a portion of their consideration in cash.
6. Large Enterprises want to see Capital on the balance sheet. If you are selling to a large enterprise customer, they generally are spending a large chunk of change on your product and many times will be integrating your product with some of their systems. They do their analysis and want to make sure that you are going to be there to serve them several years from now. Once of the items that they ask about is your company’s capitalization (note: my sense is that this issue peaked about 18 months ago and is now on the decline. I do still here about the issue periodically, however).
7. Finally, Founder Liquidity uses Capital. Many founders of great companies find themselves in the situation where a significant portion of their net worth is tied up in the business. Some VCs (including my firm) will make investments in a company to partially/fully liquidated certain shareholders (the key is that all key employees have enough of a financial stake in the company post the transaction that they remain highly incented). These types of transactions are useful to founders, as it allows them to take more risk (that make business sense) without worrying about their nest eggs.

I believe I have captured the major uses of capital as companies grow. I did not get into things like the company being subscale, but this implies that a company is unprofitable, which clearly requires capital.

I am actually a strong believer that VC is more about the help than the money, but given the question of capital need was raised, I thought I would direct my comments in that direction.

Is the need for venture capital changing? My answer for companies that want to build meaningful businesses over time, regardless of sector, is “no”…

Advertisements

5 Comments »

  1. Scott, another wonderful post.

    Whether the financing needs of Internet start ups have changed or not is an open question. You’ve suggested “no” and you are right to some extent in as much as Rebecca is also right to some degree. Things always change.

    What hasn’t changed, and never will change is that all early stage and expansion stage businesses need supporters, cheerleaders and champions. This is one role where venture capital will never become redundant.

    Actually…it’s got me thinking that for a sector living on the cutting edge of business practices, it seems venture capitalists have rarely done a good job of branding their money. It’s just sort of “assumed” that there is value add, which is an assuption often inconsistent with reality.

  2. scottmaxwell said,

    All good points. thanks for the comments.

  3. […] Two recent posts have stood out for me on this topic. Paul Kedrosky recently posted a presentation that looked at the question (message: “some of this is just wishful “God is dead? thinking on the part of some VC-loathing entrepreneurs, there is an element of truth to the idea”), and Scott Maxwell, a VC whose focus is investing in and building companies starting at the expansion stage recently wrote an interesting post about the topic as well (message: no, “for companies that want to build meaningful businesses over time”). […]

  4. […] I wrote a post the other day on whether the need for capital is changing among emerging growth companies. As I read the comments and looked at some of the other postings on the topic (MikePK has a write-up and some good links to others, so I won’t repeat them here), I realized that another issue is that some (many?) companies might be more happy not having a VC (for them, it wasn’t that they were happy not to need the money, but rather they were happy not to need the VC that came along with the money). […]

  5. […] “sledgehammer” in my previous post. A good read, Scott Maxwell’s post is titled “is the need for venture capital changing?” Check out YAJAF!, for the next generation in rich internet […]


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: