Milestone Group Quarterly: July 2005
Articles
Q&A with Howard Anderson on The State of Venture Investing
Milestone: Howard, as the founder of The Yankee Group, YankeeTek, and as
the co-founder of Battery Ventures - what's the five year forecast for early
stage venture capital?
Anderson: Grim. Triple witching hour. Risk is up; too many VCs, too much
money that has to be put to work, soon. Then there are too many venture
backed companies fighting for traction in smaller and smaller sectors. We
are going overseas now, so we have not only financial risk, market risk, and
technology risk; we have added ‘country risk’ to the equation. The
biggest problem is insufficient demand.
Milestone: Are you saying innovation is dead?
Anderson: No. Innovation is doing fine. The problem is that for the two
sectors, software and communications (that are the historic engines of
venture capital), demand is and will be in low single digits.
Milestone: What's that mean?
Anderson: Rational markets. A Nasdaq that is under 2700. Venture capitalists
count on IRRATIONAL markets to make extraordinary returns. We need a 20X or
some 10Xs, but those winners are going to be rarer and rarer.
Milestone: Why?
Anderson : We used to sell our companies at ten times sales, or we could
flip them in two years. Game over. Those will be the wonderful and rare
exceptions.
Milestone: Give us an example.
Anderson: Sure, take enterprise software: It takes $25 - 30 million to get
a new company to cash break even. About the best a company can do is grow
100% per year, which means five full years to get there.
Milestone: And then?
Anderson: If you assume four rounds of financing, where the investors at the
end own 80%, and the company is sold either IPO or bought for 3x sales --
and that its current sales rate is $25 Million, then the price is $75
Million and the investors would get 80% or $60 Million.
Milestone: And...
Anderson : That's only a 24% return over 5 years or 8%, and that's for an
out and out winner.
Milestone: What's your conclusion?
Anderson: The top quartile funds formed in 2004-2006 will do about a 7-9%
IRR, but the days of 20%+ are over.
Milestone: Where does the capital flow?
Anderson : Who knows? LBOs, Hedge Funds, Timber. Venture capital is
enshrined as "an official alternative" category, so it won't wither -- but
increasingly smart LPs are going to see that early stage venture is going
through a systemic change and not a critical one.
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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