3 Myths and 1 Reality about Early-Stage Investing

To paraphrase Mark Twain, reports of early-stage investing’s demise are greatly exaggerated. If the market holds true to form, there should be between $2 billion and $3 billion invested in first-round financings during the first half of 2007.

But to many, the bloom is off the early-stage rose, with some VCs even going so far as to say the model is irretrievably broken.

While I would agree that the investing environment is different than it was before the bubble, we’re still seeing more excellent early-stage deals than we can fund, and have no plans to shift our focus from early-stage opportunities.

But the naysayers persist, and they have put forth three central “myths” about the early-stage market that it is time to debunk.

Myth #1
There’s too much money chasing too few deals

I’ve been hearing this one since entering the business in 1996, and know that it was being said long before I came along.

In the early stage, it’s just not the case. At least, it hasn’t been the case over the last five years. In 2000 and 2001 — as Bubble Era investing peaked — so did early-stage investing, with $25.7 billion invested in 2000 and $8.7 billion invested in 2001 in early-stage companies. But that was clearly an anomaly.

Let’s look at the five-year period since then. The first half of 2002 was an inhospitable time to be starting new companies, and in fact, after investing $6.3 billion in the first half of 2001, VCs invested only $2.3 billion in the first half of 2002, a drop of 63%. A year later, in the first half of 2003, early-stage investing bottomed out at $1.7 billion.

I think we can all agree that the environment has gotten a lot better since then, so if this myth were in fact reality, we would be seeing a major surge of VC investment over the past several years. But we’re not. In the first half of 2006, VCs invested $2.2 billion in early-stage companies – less than during the nuclear winter of 2002. 

Myth #2
Valuations for venture-backed companies are going through the roof.

Truth is, overall valuations for VC deals are going up. From a trough in the first half of 2003 of $10 million pre-money, the average VC-backed company is now worth $20 million pre-money, a 100% increase.

But let’s disaggregate the data and look at valuations in the first, second and later-stage rounds.

From a low of $4.1 million in the second quarter of 2003, venture-backed companies receiving their first round of VC financing are now worth, on average, $5.6 million, a 36% increase from the trough. A healthy increase, but not unrealistic given the improvement in market conditions.

But look at second round and later-stage deals. They are up 74% and 89% respectively from the low point in 2Q 2003. So clearly, that’s where the lion’s share of the overall increase in valuations have occurred.

As an early-stage investor, I love seeing this. It means that (a) we can get into early-stage deals at appropriate valuations; and (b) we’ll be compensated for taking early-stage risk when our companies go out for follow-on financing.

Myth #3
The “flavor-of-the-month” market is overheated

Pick your favorite market — networking, storage, software, nanotech, cleantech, Internet — and at some point, someone will say it is overheated. Part of our job as VCs is to chase opportunities in what we perceive to be hot markets, so you’re going to see certain markets get flooded with investment when VCs decide it’s the place to be.

However, let’s look at one particular segment, early-stage Internet companies, and see if this myth stands up to scrutiny. Surely, if this myth were reality, we would be seeing an explosion of investment in Internet companies now, in the wake of events like the YouTube and MySpace M&A deals and Google’s IPO.

But again here, we see that while Internet investments are up 50% from the trough in 2003, we’re not even back to the level of early-stage Internet investing of the first half of 2002.

In fact, a case could be made (albeit in another post) that there’s actually too little early-stage venture money being invested in start-up Internet companies — given the new business and consumer-related opportunities driven by the rapid growth in broadband access and improvements in Internet tools and infrastructure since the bubble.

Now it’s time for a reality check.

Reality: Early-stage investors are moving down the road and investing more and more of their funds in later-stage companies.

A lot of venture investors like to say they are “early-stage” investors, but the reality is that most of them are investing an increasing percentage of their funds in later rounds, leaving fewer firms like El Dorado that do the bulk of their investing in Series A.

Let’s look at the data on this. In 1996, 42% of all venture dollars were invested in Series A. Ten years later, that figure is down to 20%. Meanwhile, the percentage of money invested in Series B or later has risen from 56% in 1996 to 73% in 2006 (note that seven percent of capital deployed in the first half of 2006 went to restart financings – another post in itself but also a clear sign that the aftermath of the bubble is still with us). Later-stage investments alone have risen over the last 10 years from 33% of venture dollars invested to 49%.

Why has this happened? For one thing, time-to-exit has lengthened considerably over the past decade, and not everyone has the ability to be patient and wait for the liquidity event to occur. For another, being the first venture money into a company requires expertise and time — there are major issues to work on, from filling out the executive ranks (sometimes from scratch) to finishing and launching products into the marketplace and scaling the business from there. And finally, given the large size of many venture funds, it’s just not a viable model for them to invest $2 million in a first-round financing and commit 10-15% or more of a partner’s time working with that company over the five-to-seven years it may take to reach a liquidity event. With a $500 million-plus fund, it would take a lot of partners and a lot of deals to get the fund invested in a 3-4 year time horizon, which makes $10 million investments into later-stage companies much more attractive, even if the cash-on-cash return potential is significantly lower than could be found in a Series A.

My Conclusion: The reports of early-stage VC’s death have, in fact, been exaggerated. Simply put, without early-stage capital available to start-up companies and investors willing to provide their time and expertise to helping these companies grow, the vast majority would not get off the ground and become opportunities for our later-stage brethren to fund (at a significant mark-up to our Series A, of course). 

The market will sort out the appropriate split between early-stage and later-stage dollars invested, but it is a safe bet that as money shifts towards later-stage rounds, the groups that continue to focus on early-stage will benefit from an increasingly large valuation gap, thanks to the simple economic principle of supply and demand.