both in the M&A and the public markets. It’s given us all a lot of encouragement that early stage investing is going to make sense again and that the investments that we’ve made over the last three or four years are in fact going to bear some fruit. If you look at where we started at the beginning of 2006, we had a very interesting environment where you had what I’d call barbell investing. You had the early stage players who were still quite active in getting into the very fi rst round. You had a lot of investing in what would be seen to be last money, in last rounds, and you had a pretty awful environ-ment in between—the B and C rounds. This meant that VCs had to spend a lot of time and energy on fi nancing for companies that had not yet really hit their stride, while still working on their product. I think this will put a damper on some of the new investment activity.
Thus, we’ve had to attend to our existing portfolio a lot more than we would have liked to.
As the year progressed, that environment picked up quite a bit.
Valuations began to trend up, and in certain sectors you got very close to a speculative bubble, particularly in social networking; Web 2.0, and mobile video related companies. These are all going to be very big spaces, but I think you’re going to have to be very careful about where you invest. If you look at those particular segments, there aren’t really that many public market comparables. There have been a number of high-profi le M&As, but there really hasn’t been a substantiation of what these companies are going to be worth yet. Private markets have been paying pretty lofty prices, a lot of it because of acquisitions undertaken by Google, Yahoo and others who have been very aggressive.
Thus, what we saw in 2006 was a truly bifurcated business, where certain segments were being invested aggressively; with probably some hype and speculation in other areas that were being abandoned—particularly communications, telecom carrier-related businesses and enterprise software. That, to me, always argues that there’s going to be opportunities there, because you want to be a little contrarian in this business, especially as an early stage investor.
The other thing that certainly has happened during the year is an increasing amount of interest in cleantech, specifi cally energy technology start-up businesses. This is a good sector for investment.
On the other hand, it’s very uncertain as to what the timeframes are going to be before you really see these being built into sustain-able businesses, as opposed to fi nancial exits based on some pretty
good market comps. If you’re going after businesses that tackle the dollars-per-kilowatt problem, as I’d describe it, that is gener-ally speaking a capital-intensive project and related to commodity prices. However, one never knows how those business models are really going to play out at any given commodity pricing cycle, even though, in the long term, it makes a lot of sense for us to get off the oil- and coal-based power grid. Overall, I think that cleantech is going to be an interesting area.
Healthcare continues to be an interesting sector mainly because of long-term major trends in population aging as well as just the state of science in the healthcare fi eld. There’s a lot of momentum behind healthcare investment right now.
Ernst & Young: What are the short-term and long-term impacts, both on your portfolio companies and on your investment strategy, on the current challenging IPO landscape for venture-backed companies?
Steve Krausz: For our business to be really healthy we need a good public market, and we don’t have that yet, although we had some good IPOs in both the third and fourth quarters. Thus, if you look at the absolute number of IPOs from ’05 to ’06, there wasn’t much of an improvement. On the other hand, if you look at the after-market performance of a few of the IPOs, particularly in the communica-tions area, it was actually pretty good. So we’ve got a way to go yet before we’re back to a point where the venture environment would say that the exit markets are healthy enough for our business model to work effectively.
It is true that on a numbers or percentage basis, most of our exits are always going to be in the M&A area. The amount and the valu-ations on M&As are driven by the robustness of a public market, either as a potential competitive exit for a venture-backed com-pany—that the acquiring company has to deal with—or as a pricing mechanism for valuing these companies. Thus, you need a good public market and a healthy public market. Right now everyone is hopeful that it is better, particularly in the technology sector which has been generally behaving much better in the public markets.
However, I don’t think we’re quite there yet. The consequence for us is that we have to be very careful about capital intensity and going in valuations.
Perspective from Silicon Valley:
Interview with
Steve Krausz
General Partner, U.S. Venture Partners I think that 2006 has turned out to be a recovery year, both in the M&A and the public markets. It’s given us all a lot of encouragement that early stage investing is going to make sense again and that the investments that we’ve made over the last three or four years are in fact going to bear some fruit.
This means that certain sectors that we’ve historically invested in are really areas that we have to look at extremely carefully—com-munications equipment, semiconductors, and large projects such as cleantech. We’re trying to bring down the capital intensity of our investing, and we’re probably going in a little bit earlier and doing a little more of the smaller, more speculative investments, but ones where we think that we can measure the milestones adequately before we put more money in. The end result is a change in our sector diversifi cation.
Ernst & Young: What are the main reasons for the challenging public market?
Steve Krausz: It’s a combination of factors. One is the continuing overhang of the 2000 tech bubble bursting. It takes a long time for people to start making money again and to move back into an asset category. There is just an overall change in market focuses and mutual fund focuses. Then there’s the question of how much is it costing us in the Sarbanes-Oxley tax and the increased compliance tax on small private companies, in terms of the dollars required to get the cash fl ow break-even. The extra money that we’re spending and the extra oversight that we have to pay for, all of which may be appropriate, mean the company has to wait longer to go public.
Ernst & Young: Do you see an increased role for private equity with venture-backed companies if the capital markets continue to be challenging?
Steve Krausz: Yes, you’re already seeing it. People are getting much more creative about it and part of it is private equity coming in and providing some amount of liquidity and taking on the capital raising requirements. I don’t know how long or how successful those will be. Thus, capital markets are doing what capital markets always do, which is to very effi ciently step into the breach, step into the gap that has been created. What we haven’t seen is proof that there’s a lot of liquidity in these alternatives, and that’s the piece that remains overall. If you look at a lot of these alternative approaches, the next question is whether you have suffi cient liquidity, because you might be able to write up your portfolio, but, can you exit an investment in the same way that you are able to with IPOs or M&As?
Ernst & Young: What have you seen as the major developments in the last 12 months in China and India, and what challenges and opportunities still exist?
Steve Krausz: We’re carefully watching and observing. It appears that in India, you’re beginning to see the emergence of the venture capital industry there, a domestic market moving away from purely service-based up businesses to more product-oriented start-up businesses. Thus, I’m hopeful that you’re going to begin to see
an exciting landscape for start-up industries. Having said that, the infrastructure challenges there remain, and they are acute. It’s easy to get something started, but it’s not easy to get up to scale.
China is a much more challenging long-term environment—its growth rate is better, its infrastructure is certainly better. There’s a lot more interest from U.S. VCs because of that. The potential for building companies there is truly interesting, but I for one still wonder how much will be left for U.S. VCs, and, what kind of busi-ness model you can execute in China from Silicon Valley. China is a big country. It is historically one that has found a way to take in foreign capital quite nicely and keep most of it. There are still issues with regard to transparency and IP. There is no doubt that China is going to be a vibrant economy with all the important pieces in place for starting to build big businesses. I just don’t know how many U.S.
VCs are going to be successful at extracting returns out of it, at least not for a while. For early stage VCs, it’s hard; you have to commit a lot of GP talent, you have to put people on the ground there, and you have to get local talent who understand the environment and have the relationships. That’s a big investment and one you have to make over many, many years.
Ernst & Young: What are the right ingredients needed for a company CEO to not only compete but become a market leader?
Steve Krausz: The entrepreneur today has to be much more global in terms of their understanding of markets and relationships. If you go back 20 years in our business, it was successful because the entrepreneurs knew the market landscape, they knew the important companies, but many of them were on a freeway between San Jose and domestic U.S. companies. That’s no longer the case. Products have become much more global, markets have become much more focused on consumers, and technology is very much driven by consumer markets. It used to be driven almost exclusively by enter-prises. However, the entrepreneur will have to understand who the global customers are and how to do business development with them and large multinationals.
The other important ingredient for entrepreneurs is they’ve got to be better fund raisers. They have to know that they can’t just come to a select group of VCs on Sand Hill Road, because liquidity is further out. You to have to build the company longer before you can access
The entrepreneur today has to be much more global in terms of their understanding of markets and relationships. If you go back 20 years in our business, it was successful because the entrepreneurs knew the market landscape, they knew the important companies, but many of them were on a freeway between San Jose and domestic U.S. companies. That’s no longer the case.
60 GL O B A L VE N T U R E CA P I TA L IN S I G H T S RE P O RT 2007 continued from page 57
Antoine Colboc: Crédit Agricole Private Equity has created a fund specially dedicated to this sector. This fund will invest at all stages of development, sometimes jointly with the venture teams, but it is not the latter that manage this sector.
Ernst & Young: Angel investments are a critical factor in a growing and healthy venture capital ecosystem. What have been recent devel-opments in the angel community in the last year? What do you expect in the next 12 to 24 months?
Antoine Colboc: The business angel community is not yet suffi ciently developed in France, but I have noted two signifi cant trends:
There is a general awareness among the political parties that growth and job creation are driven not only by large centralized proj-ects, but also by the creation of small and innovative businesses. The signifi cant improvement of the business angels’ tax environment is proof of this.
We start to see the French virtuous circle: successful entrepre-neurs are increasingly numerous, and they then become angels, in turn contributing to the emergence of new entrepreneurs.
Ernst & Young: In the last couple of years we have seen the desire of more and more large corporations to get closer to the innovation pipeline. What are the major changes you have seen in the corporate world as it relates to the venture capital industry? And what do you anticipate will happen in the next 12 to 24 months?
Antoine Colboc: In France, corporate venture capital is still very mar-ginal, and that’s a good thing. Personally, with very few exceptions, I consider the presence of a corporate venture fund in a project to be a handicap. There is a good chance that the fund will no longer exist a few years later, just when it’s needed for further fi nancing. The life-time of a corporate venture capital fund is unpredictable, such funds are created and disappear quickly. This does not correspond to the core business of the parent company. It is therefore normal that, as soon as the latter’s market requires it to refocus on its core business, the CVC fund is abandoned. Also, the quality of the decision-making teams in these funds is very variable. Lastly, CVC funds operate according to industrial rather than fi nancial logic. It’s not easy to make VCs with the same fi nancial logic work together. Thus intro-ducing a player with different objectives can be challenging. the public markets. The VC-backed CEO needs to be much better at
raising money, whether it’s the equity debt, business development relationships or strategic partnerships. The other important ingredient is that you have to have a different kind of sensibility and sensitiv-ity to where your competition is coming from. Last but not least, you have to be open to and capable of handling virtual organizations that are likely to have people all over the globe. It is not rare to see a development team that is based in India, Russia, China and West Virginia. It is very unlikely that you’re going to have a single loca-tion company, like you did 20 years ago.
Ernst & Young: Where do you think the next class of entrepreneurs will come from, and what would distinguish this class from previ-ous classes?
Steve Krausz: Entrepreneurs are going to have to understand both the global and consumer markets. The next generation of entrepre-neurs is going to come out of some of these fast-growing emerging companies that understand the consumer, how technology plays in the consumer market place and how to get a global reach, and how to build companies quickly and by using distribution channels such as the Internet. This suggests that companies such as Google—in the sense that they have fast global-reach business models and are a little different—will produce the next generation of entrepreneurs. I mention Google as an example, as opposed to the traditional old-line technology companies such as HP, Intel or Cisco; because you have to have a different sensibility. You’ve got to understand that your big markets, with a few exceptions, are likely to come from things that are about consumer products and less about markets that the tradi-tional enterprise-driven company in the past has focused on. Thus, they don’t have those kinds of relationships. And entrepreneurs are going to have to be comfortable with travel and even with interna-tional markets and with those kinds of networks.
The next generation of entrepreneurs is going to come out of some of these fast-growing emerging companies that understand the consumer, how technology plays in the consumer market place and how to get a global reach, and how to build companies quickly and by using distribution channels such as the Internet.