Forest Fires and the Ecology of Venture Capital –

Yellowstone’s wildfire of 1988 consumed more than 1 million acres of the national park and surrounding areas. At the time the devastation was unfathomable. Yet park visitors today observe a new generation of trees rising next to blackened Douglas firs.

Catastrophic fires are a natural part of the forest ecosystem. Some say the bigger the fire, the stronger the rebirth. Likewise, boom and bust cycles are normal for venture capital and the companies and markets that it spawns.

Yet the venture capital world operates on faster time scale than a forest. While it takes a forest 10 to 30 years to grow back, markets can rebound quickly under the right conditions. Brand new seedlings (startups) typically take four to six years to mature.

Current signals are mixed and make it hard to predict recovery. Positive signs of rebound – such as the surge in gross domestic product and positive earnings from Cisco – are tempered by continued slow growth in the economy, falling venture capital investments and weak IPO and M&A markets.

A season of heavy rain and rampant growth, followed by a season of drought, can significantly increase the chance of forest fires. In a similar fashion, markets that are over-funded, especially going into an economic downturn, are likely to incinerate.

Mushrooms & Weeds

Overgrowth in technology markets typically happens in one of two ways. Sometimes what begins as a solid business plan mushrooms into a market teeming with too many companies, backed by too much venture funding, chasing a modest pool of customers. In other cases, an idea that never should have been funded is somehow billed as the next great thing, and a bubble market takes off like a weed.

During the Internet boom and bust, there were examples of both scenarios. Bad ideas, too many to list, mushroomed into massive clouds of hype, pent-up valuations and expectations before turning into fields of dust. Yet, some good companies were created, and while many did not survive, the groundwork is laid for future companies.

Markets swell and contract. That’s normal. Just like not all seedlings take root, only a few companies in a new crop become a long-term business. To remain standing, survivors out-adapt their peers; sometimes luck plays a factor. Companies that don’t change eventually die off. This cycle repeats itself.

During the mid-1980s, the disk-drive market had more than 50 manufacturers. By 1997 there were 22. Now there are only four: Seagate, Maxtor/Quantum, Western Digital and IBM/Hitachi.

Today’s personal computer market looks quite different than its initial explosion in the early 1980s. Remember Osborne, Commodore and Kaypro? How many PC vendors will remain standing after the current consolidation?

Not every technology invention finds a sustainable market. Pen computing was all the rage for a short time in the early 1990s, but the customer demand never materialized to give it legs. And remember PointCast and “push” technology’s moment in the sun?

Only The Strong…

When flames tear through forests, only the strongest few survive. Certain trees, such as the Douglas fir, Ponderosa pine and California redwood, have specifically adapted to survive by having a thick bark, and branch lines that begin high above the ground. After enduring the fires, they experience increased viability due to reduced competition for light and water.

Many plant species within Yellowstone have adapted to survive fires by creating new life. Lodgepole pines, which make up 80% of its forests, have cones that are sealed by resin until the intense heat of fire releases the seeds inside. Fires also stimulate regeneration of sagebrush, aspen, and willows. Certain grasses may be consumed by flames above ground, but root systems are mostly intact, and the plants often increase in productivity.

New technology innovations hold potential for the creation of many companies and the emergence from a slump. PCs, client/server computing and the Internet each prompted a new crop of startups. Now, Web services and Microsoft’s .Net initiative may well lead to a whole new generation.

The venture capital ecosystem has one huge advantage over forests: the ability to evolve very rapidly. New technologies and business models can be created all the time, allowing rapid adaptation to a new environment. Like new growth, new markets spring up quickly. Recent examples include security, Web services and nanotechnology.

While some trees thrive in direct sunlight and hot weather, others are better suited for partial shade and more rain. Markets in the technology sector, such as computer systems, software and communications, can fluctuate between periods of growth and stagnation from week to week, quarter to quarter and season to season.

Like certain species of trees can regrow quickly, some markets, such as enterprise productivity software, might come back fast and strong. Others, like semiconductors and telecommunications equipment, may take a while to come back. Still others, such as low-margin IT services companies and application service providers, may die off.

Companies that weather the toughest downturns exhibit unique behaviors. Most are among the first to see the downturn coming and take drastic actions. They hunker down and operate frugally, reducing headcount early on if needed. Until the firestorm passes, these survivors run lean and mean while focusing on one thing: selling to their target customer.

Fires can have long-term ecological benefits. Without fires, dead material accumulates, choking opportunities for new growth. After a fire, the soil is enriched and provides a life-giving fertile layer for a new generation.

Market busts and downturns lead to long-term benefits because they clear away the overgrowth, leaving fertile ground for new companies to be seeded and grow.

In Retrospect

Time and again, history has shown that hardship breeds greatness. Entrepreneurs who encountered tough times in the 1980s and 1990s came back strong just a few years later. Veritas, for instance, was born out of the ashes of the fault tolerant/multiprocessor computer wave of the mid 1980s. It was restarted and repositioned as a software company. Under great management, bold acquisitions and incredible perseverance, it has become one of the top software companies in the world.

Many redwoods of technology, from IBM to Microsoft to Oracle, were all formed during difficult economic times. Fertile ground and the right conditions make this an excellent time to start a company. Early-stage startups today exhibit the types of behaviors that Foundation Capital has always looked for. Management teams are wiser having lived through the downturn. Entrepreneurs are coming in with the expectation that they are building a sustainable company, not just a scheme that can be quickly sold or taken through an IPO. Valuations are back in alignment with reality. Venture capitalists are back to building companies and exercising time-tested virtues like patience and hard work.

At the same time, there are many signs that the current forest fire may still be burning, although not at the size and scope it once was. While some sectors are showing signs of new growth, others continue to burn or die off.

Yet brush away the soot and ashes, and you will find that there is already a significant amount of new growth in Silicon Valley and beyond. New companies are being created, but not at the blistering pace of a couple years ago. Now we all realize that it’s quality, not speed, that matters

Bill Elmore is a general partner of Foundation Capital, which he helped found in 1995. He is a director of Onyx Software, Wind River Systems, and Packet Design.