Venture-Capital: Current Challenges and Future Directions

As venture capital sources slow their investments, experts see new models emerging to help fill the gap in funding

by John Douglas, M.D. and Marc Hermsmeyer Money Tree all dried up

Venture capital is a type of financing for new companies with high growth potential that is considered the economic lifeblood of technological development. This financing is one of the driving forces behind California’s economy. Companies supported by venture capital in California employ roughly 4 million people per year and produce revenues close to $1 trillion,1 accounting for more than half the state's gross product.2 Venture capital firms generally receive returns on their investments when the companies they invest in go public or are acquired by larger companies. However, the recent financial crisis has limited these events, which is a major threat to the economy of California and our nation.

This article explores why venture-backed companies are struggling to go public or be acquired as explained by Niall O’Donnell, principal at RiverVest Venture Partners. It then discusses how some venture capital firms are realizing returns despite this struggle through secondary private equity investments. Finally, the article discusses a new more efficient model of venture investing described by Duane Roth, chief executive officer of CONNECT and one of San Diego’s leading experts on entrepreneurship.

Current Challenges Realizing Returns

The money venture capital firms use to invest in new companies usually comes from large corporations, foundations, university endowments, state pension funds and high net worth individuals. Once these companies go public or are acquired, 80 percent of returns are generally distributed to the original investors while managers of the associated venture capital firms divide the remaining 20 percent. However, if these companies never go public or are acquired the money contributed by the original investors is typically lost and venture capital firms do not realize any gains.

The last two years have been the slowest consecutive years for U.S. venture-backed initial public offerings (IPO) since the 1970s.3 O’Donnell, who has worked in venture capital since obtaining his MBA in 2006 and holds a Ph.D. in biochemistry, helps explain why. According to O’Donnell, companies are struggling to go public because in the current economic crisis many of the traditional buyers of IPO shares such as hedge funds, large corporations and foundations have lost significant amounts of money. O’Donnell explained, “With these losses they are looking for more secure investments and have less of an appetite for buying risky shares of startup companies.” Traditionally IPO shares are in demand when the economy is strong and investors expect prices of these shares to increase soon after going public. In the current economic environment, investors lack confidence these increases will occur as reflected in the recent disappointing IPO of Anthera Pharmaceuticals in March. Anthera targeted raising $69 million, but only raised $32.2 million.3

The economy has also led larger companies to be reluctant to buy smaller venture-backed companies. Acquisitions in the U.S. of venture-backed companies declined 31 percent from 2007 to 2009.4 O’Donnell explained, “Larger companies are using their cash to acquire other large companies to increase stability.” Examples include Roche buying Genentech, Pfizer buying Wyeth and Merck buying Schering-Plough. Large mergers cause integration issues, management disruption and leave little cash to acquire smaller venture-backed companies.

Secondary Private Equity Investments

With venture-backed companies extremely limited in their ability to go public or attract larger companies to acquire them, some venture capitalists are looking for alternatives to realize returns on their investments. One of the main alternatives is for venture capital firms to sell equity in their portfolio companies to private investors. Such sales are called secondary private equity investments and are made by secondary investors. These investors are usually firms dedicated to buying secondary private equity, such as Opteris. Secondary investors usually receive equity in the entire portfolio of companies within a venture capital fund, but deals involving individual companies also occur.

Often the money venture capital firms obtain from secondary investments is distributed to their original investors. However, venture capital firms may also use this money to pursue new investment opportunities and correct over-allocations of capital to portfolio companies that have decreased in value.

Over the past few years, the values of portfolio companies across the venture industry have decreased dramatically, making secondary private equity investments much more attractive. Overall, the value of secondary investments rose by 83 percent from 2008 to 2009, setting a new record.5 Recognizing this increase in value has captured the attention of new investors, increasing the demand for secondary investments. As this demand increases, venture capitalists will receive greater value for selling equity in their portfolio companies to secondary investors, making secondary investments increasingly integral to the venture industry.

While secondary private equity investments provide liquidity for venture capitalists, they do not offer the financial gains necessary to incentivize venture investing in risky new technologies. The struggle in venture capital remains creating an investment model that supports and financially incentivizes the development of early stage technologies. Such a model would drive economic growth and financial recovery.

Distributed Partnering Model

Duane Roth, CONNECT CEO

CONNECT is an internationally respected organization that fosters entrepreneurship in San Diego through providing guidance to startup companies. Since its inception in 1985, CONNECT has helped over 1,500 startup companies raise over $10 billion.6 As chief executive officer of CONNECT, Duane Roth has helped numerous startups obtain funding and become successful. He is one of San Diego’s leading experts on entrepreneurship and believes technology development is trending toward a more efficient model.

According to Roth, a major problem in the current model of venture investing is that “it focuses on the creation of companies rather than products.” Typically a new startup company will license and receive funding to develop a single lead product. This system is grossly inefficient when considering the money startup companies spend to establish their own research and development infrastructures.

Another major problem, according to Roth, is the expertise necessary to guide technology development is often concentrated in a few individuals. To recruit and attract these experts, startup companies must offer financial incentives, often beyond their means in early stages. Thus, many startups lack the management expertise necessary to succeed, resulting in the failure of promising technologies. To overcome these problems, Roth sees technology development trending toward what he and his co-author Pedro Cuatrecasas call in their recent paper published by the Ewing Marion Kauffman Foundation, the “Distributed Partnering Model.”7 In this model, “the focus is on developing products, not companies.” Roth envisions wealthy individuals, such as angel investors, funding a team of experienced entrepreneurs to identify and license 10 to 15 technologies in a focused field from research institutions. Each member would have expertise related to the technologies licensed.

The team of entrepreneurs would identify crucial steps to reduce risk and guide the early stage development of new technologies. During these early stages, the high risk of new technologies often scares away investors and prevents their development. Through licensing multiple technologies, the team would lower the risk of developing any one technology because the successful development of only a few of the technologies is necessary to generate attractive financial returns for the original investors.

In the current model of technology development, individual companies establish their own research and development infrastructure. Under the Distributed Partnering Model the entrepreneur team would outsource research and development to contract service providers that have the facilities, staff and expertise necessary to develop new technologies.

In the high-technology industry, contract service providers such as D&K Engineering may be hired to develop and manufacture complex electromechanical products.8 For the biotech and pharmaceutical industries, contract service providers are called contract research organizations. These organizations, such as Clinimetrics Research Associates, conduct all aspects of clinical trial work from conceptualizing how clinical trials should be structured to obtaining Food and Drug Administration approval.9 The advantage of using contract service providers is that their infrastructure is already in place and can be used to develop multiple technologies within an industry. Using established infrastructure rather than building it in house for each new product saves money and time.

Roth further explains that once early milestones in the development process are achieved, the entrepreneur team would sell the rights to their technologies directly to venture capitalists. In the life sciences industry these sales would occur when products are through preclinical or into early clinical trials. Structuring the transactions as direct asset sales gives the original investors a reasonable timeframe to realize significant returns on their initial investments. These returns are generated by venture capitalists buying the licensed technologies for approximately what they would invest under the current model into startup companies at similar stages of development.

After the asset sale, venture capitalists would continue using contract service providers to develop technologies. No new companies would be formed to develop these technologies, which would save resources. Experts hired by or within venture capital firms would coordinate with contract service providers similar to how venture capitalists presently manage their portfolio companies.

Under the Distributive Partnering Model, once technologies reach later stages of development, the rights to these technologies will be sold from venture capital firms to typical acquirers of their portfolio companies, such as large pharmaceutical and telecommunications companies. These sales would occur in similar time frames and for approximately the same large returns venture capitalists expect under the current model.

Some potential barriers exist to adopting the Distributive Partnering Model. Under the current model, venture capitalists invest in startup companies with products. Venture capitalists may resist changing to the Distributed Partnering Model where they buy products directly and manage their development with contract service providers. The main skills of venture capitalists often lie in identifying new technologies but not necessarily in developing them. The Distributed Partnering Model's emphasis on managing the development of products will require venture capitalists to further develop these skills and change how they currently conduct business.

An additional barrier is that as this model develops, larger companies may become more comfortable buying very early stage technologies for cheaper prices directly from the original teams of entrepreneurs. Traditionally, larger companies are risk averse and look for well-established, later-stage technologies to acquire. However, if these companies determine acquiring technologies at earlier stages is beneficial, they can skip over deals with venture capitalists. Such transactions would limit the number of venture capital firms and increase resistance to adopting the Distributed Partnering Model.

Conclusion

According to the National Venture Capital Association, 90 percent of venture capitalists believe their industry will contract over the next five years.10 Evidence of this contraction is clear in the fundraising trend and number of new funds raised in 2009. This year saw a 47 percent decline in fundraising from the previous year and had the fewest new funds raised since 1993.11

Contraction of the venture industry will pressure it to become more efficient. This pressure will likely encourage the growth of secondary private equity investments and changes mirroring those described in the Distributed Partnering Model. Regardless of these changes, venture capital is expected to remain the fuel that drives economic growth. By advancing new technologies that push forward the development of entire industries, it will continue to create jobs and ensure economic prosperity for California and the United States.

ENDNOTES

1“Venture Impact: The Economic Importance of Venture Capital-Backed Companies to the U.S. Economy,” National Venture Capital Association, 5th Edition, 2009: 1-19

2“Regional Economic Accounts.” 31 January 2010. Bureau of Economic Analysis. http://www.bea.gov/bea/regional/gsp/

3Carroll, J. “Anthera IPO limps out at half price." Published 1 March 2010. Fierce Biotech. Retrieved 17 March 2010. http://www.fiercebiotech.com/story/anthera-ipo-limps-out-half-price/2010-03-01

4Levy, A., Galante, J., & Guglielmo, C. “Silicon Valley's Cisco, Twitter See More Technology Takeovers.” Published 20 January 2010. Business Week. Retrieved 18 March 2010. http://www.businessweek.com/news/2010-01-20/silicon-valley-s-cisco-twitter-see-more-technology-takeovers.html

5“U.S. Private Equity Fund-Raising Plummets 68% in 2009; Worst Year and First Sub-$100 Billion Year Since 2003.” Published 12 January 2010. Dow Jones PR Newswire. Retrieved 19 March 2010. http://dowjones.mediaroom.com/index.php?s=43&item=337

6“About Connect.” CONNECT. Retrieved 24 February 2010. http://www.connect.org/about/

7Roth, D. & Cuatrecasas, P. “The Distributed Partnering Model for Drug Discovery and Development.” Published January 2010. Ewing Marion Kauffman Foundation. Retrieved 19 March 2010. http://www.connect.org/resources/docs/distributed-partnership-model_12510.pdf

8“Company Overview.” D&K Engineering. Retrieved 19 March 2010. http://dkengineering.com/About-D&K/Company-Overview/

9“Our Company.” Clinimetrics. Retrieved 19 March 2010. http://www.clinimetrics.com/company.html

10“Venture Capitalists are Optimistic for 2010 Despite Predictions for Industry Contraction.” 16 December 2009. National Venture Capital Association

11“Despite Fourth Quarter Increase Venture Capital Industry Experiences Slowest Annual Period For Dollars Committed Since 2003.” 11 January 2010. Thomson Reuters and National Venture Capital Association

John Douglas, M.D. (’09) is a psychiatry resident at Emory University with experience working in venture capital for Burrill & Company. He earned his bachelor's degree in microbiology and molecular genetics at UCLA, a master's degree in physiology and biophysics at Georgetown University and a medical degree at Georgetown University.

Marc Hermsmeyer (’09) is a co-founder and principal at Opteris, a private equity firm. He has over 10 years of consulting experience advising startups and entrepreneurs in the high-tech and information technology services industry on corporate strategic development and business growth initiatives.

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