Why is Silicon Valley Underperforming? Part I: The Returns of the Venture Capital Funds


(T) OpenTable, an online restaurant reservation, is the first Silicon Valley Initial Public Offering (IPO) this year! And it is the second technology IPOs after SolarWinds, an Austin-based network management software company. But is OpenTable the beginning of Silicon Valley Come Back?

Until the fall of 2008, Silicon Valley public companies were enjoying record profits, increasing margins by reducing costs, putting cash into their balance sheets, and hiring new staff. In March 2008, unemployment in Santa-Clara County was only 5.5%. Of course, since then, the 2008 credit crisis has affected all large tech suppliers. The Oracle, Cisco, HP, and NetApp have traditionally generated between 10% and 20% of their revenues from the financial industry. With the collapse of the financial industry in 2008 and as a consequence the slow-down of worldwide economies, those 10% to 20% in revenues have disappeared and unemployment in March 2009 in the Santa-Clara County is now 11%! However, with the recovery of the credit and financial industries and better worldwide economies, large tech companies should increase their revenues in the next few quarters and employment in Silicon Valley shall resume.

Venture Capital fund returns have been miserable

According to the San Jose Mercury News from May 17th, VC funding in Silicon Valley was $1.2 B in Q1 2009, a 61% drop from the $3B invested in Q1 2008 and an 80% drop from the $6.1B invested in Q1 2000. In 2008, a total of $11B of VC funding was invested in Bay Area companies while it was $25B in 2000 and only $2.6B in 1996.

Except for a few quarters in 2006 and 2007, the level of tech IPOs has not reached the levels of IPOs in the 1990s. According to the National Venture Capital Association (NVCA), there were 1,776 IPOs from 1990 to 2000 and only 392 IPOs from 2001 to 2008.

In the meantime, the expansion of the credit industry from 2001 to 2008 has enabled hedge funds and private equity funds to produce record profits. With limited IPOs and M&As since 2001, the return of venture capital funds has been miserable, to say the least! And so, their limited partners have increased their investments in their portfolios in hedge funds and private equity funds to the detriment of the venture capital funds.

Too many start-ups were started to be quickly sold during the good times

In 1995, Centillion Networks, a profitable token-ring switching start-up, started by Bobby Johnson was acquired for $140M after only 18 months in business. After Centillion Networks, Bobby Johnson founded Foundry Networks that was acquired by Brocade Communications for $2.6B in 2008. Centillion Networks had only three competitors while Foundry Networks had, at some point in time, up to 20 competitors in the Gigabit Ethernet switch market (when venture money is plentiful, too many start-ups are chasing the same opportunity).

Centillion Networks was one of the first start-ups to be so quickly sold without having the time to grow.

And, from 1996 to 2000, venture capitalists encouraged many entrepreneurs to start companies that could quickly be sold instead of building a company to last. And that trend is probably one of the roots of the present stagnation of the venture capital industry but not the only one.

From 1996 to 2000, venture capital funds have enjoyed annual returns which for the best funds reached even 100% while since 2001 those returns have decreased to the point they are close to zero or negative on an annual basis.

And, to improve their returns some venture funds are even selling their shares in some start-ups at huge discounts. For instance, SecondMarket facilitates transactions of such illiquid assets. VC firms are also investing in public traded companies instead of in new ventures. Recently, for instance, Greylock Partners invested into publicly traded company Aruba Networks.

It goes without saying that both of those practices are unhealthy for the venture industry.

Entrepreneurs are now bootstrapping their new ventures

According to the San Jose Mercury News, the average deal value from VC dropped for Q1 2009 to $6.7M, its lowest level since 1998! So with this lack of venture capital funds, most Silicon Valley entrepreneurs are bootstrapping their companies or funding their companies with Angel Investors instead of raising capital from Sand Hill Road.

And with much less venture capital to start a new company, entrepreneurs are mostly focusing on starting Web-based services that can be done with only one individual or a small team and very little funding. A 15-year-old teenager does not VC money to develop and to market an iPhone Apps!

With the dry up of M&As, successful Silicon Valley start-ups need to plan for an IPO

With the explosion of the Internet from 1995 to 2000, new applications and new infrastructure were required that provided significant new market opportunities for established tech companies that use M&A much more than organic growth to expand to new markets and fill quickly the holes in their product portfolios. Cisco even created its corporate culture around fostering the integration of acquired companies.

Since the implosion of the NASDAQ in 2001 from 5,000 to today 1,692, tech stocks are not anymore a currency to acquire new start-ups and lower tech stocks dried significantly the M&A activity for start-ups.

With less hope to be acquired, start-ups need to plan for an IPO but they need to reach to that end $100M in revenues which has been one of the requirements for an IPO for the last few years.

Silicon Valley’s business model is broken

With smaller venture capital funds, fewer start-ups are funded, less competition exists for a given market segment and Silicon Valley is hiring fewer tech workers.

It used to be that successful entrepreneurs seed new start-ups and employees from past start-ups start the new start-ups. The whole process attracts, in addition, the best entrepreneurs and the best talents outside California from other states in the country or the rest of the world. But with fewer IPOs and M&As and therefore lower returns for the VCs, less funding is available for future start-ups.

Entrepreneurial teams need two things to be in business: an idea and capital

New disruptive technologies have never come from thorough planning and careful design but are always the fruit of Positive Gray Swans.

Great technologies always came from nowhere. If Tim Berners-Lee did not have the idea in 1994 to create the Web to share his ideas at the CERN, there will be probably no Internet today.

But ideas need capital to grow like the fire needs oxygen. If Bill Gates did not raise $100,000 from his dad, a successful attorney from Seatle, there will be probably no Microsoft today.

To prosper Silicon Valley needs a healthy venture capital industry

Even if nearly 4 out of every 10 dollars of US venture capital funds were invested in Bay Area companies in Q1 2009, there are still too many commercial buildings available to rent from South of Market Street in San Francisco, on University Avenue in Palo Alto or along the 101 freeway to South San Jose.

Silicon Valley is definitely underperforming and we need to change that.

But to prosper Silicon Valley needs a healthy venture capital industry.

Note: The picture above is from the Adobe campus in Mountain View now occupied by Google.

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