Top Ten Reasons Why VC-Backed Companies Fail

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IDG's Pat McGovern on Investing in China

By Eric Jackson, Senior Contributor11/30/10 - 06:00 AM EST

Pat McGovern is the founder and chairman of International Data Group (IDG), the world's leading technology media, events, and research company with 2009 revenues of $3.05 billion.

He is on the Advisory Board of IDG Capital Partners which manages $2.5 billion in capital to invest in China-focused technology companies. They are arguably the top VC firm in China today. I asked Pat how it happened in this interview:

Q: It's not conventional wisdom for a firm like IDG to make the move into venture investing. How and when did you decide to do that?

A: Our research has shown that the rate of growth of the technology market is related to how many new products and services are being introduced into the market.

Entrepreneurial start-ups have the best record of taking the latest technology from the laboratory and bringing it to the market with better price performance or application characteristics than those already available.

Therefore, we decided to help stimulate the growth of the technology market by investing in start-up companies which results in the long run in greater revenue growth and profitability for IDG.

Q: And when specifically did you decide to go into China?

A: IDG's mission is to help people worldwide increase their standards of living, productivity, and quality of life by learning how to acquire and use information technology well. Since China has the world's largest population, we desired to enter China as early as possible.

Fortunately, we were able to establish a joint venture in China in March 1980 to offer technology publications and information services. This was the first joint venture of any type between the U.S. and China.

Q: When I travel through China, I hear about IDG Capital Partners all the time. You're arguably the top venture firm there today. How did that happen?

A: In the early 1990s, a considerable number of people who had left China to get educated in the United States and Europe and had worked for one or more technology companies in the U.S. were beginning to return to China. They wanted to start new companies based on their knowledge of the latest technology and using the marketing methods and business practices that they had learned overseas.

At that time, local Chinese investors were focused on investing in asset-based companies, such as real estate, highway builders, manufacturing equipment producers, etc. They were reluctant to invest in the business founder who only had a paper plan to show them.

........

[** This post is an excerpt of the full article, which is available on TheStreet.com by clicking here. Free Site.**]

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Private Equity Firms May Get Scarce

From TheStreet.com

By Eric Jackson

02/16/09 - 10:20 AM EST

C , GS (Cramer's Pick) , GOOG , YHOO

Through this terrible stock market unraveling, we've seen denials of a housing bubble and over-charged credit environment give way to acceptance. We've seen the idea -- once laughed at -- of the investment banking model going the way of the dodo bird become reality.

With each new step down in the cycle, notions once perceived as sacred cows get skewered.

Much analysis and thought have gone into the future of financials. To a lesser extent, we've read about the implications of this downturn on hedge funds, retailers and consumer behavior in general. But, as time goes on, and the downturn continues to extend its pain in further job losses and stock market declines, there are second- and third-order effects occurring.

Even if the economy were to turn on a dime tomorrow and begin improving, there is psychological damage that has been done which will have ramifications for years to come. Although many investors have been scared away from the stock market with what's gone on, among sophisticated large investors, this downturn will cause them to be much more fearful of illiquid investments -- rather than the liquid equities market -- and it will lead to a sharp shrinking of venture capital, private equity and hedge fund firms who specialize in illiquid assets.
I'm not the first person to point out that private equity is going to go through some wrenching changes in the next few years. My RealMoney.com colleague Doug Kass was the first to say this several weeks ago. Barron's also did a cover story on this at the beginning of February. In both cases, they pointed out how the credit markets freezing up took away the lifeblood of private equity firms. They can't do new deals as a result and they're also stuck with the deals done in 2006 and 2007 at the top of the market.

The Harrah's deal was done by TPG and Apollo at $27 billion in late 2006. Its debt recently traded at 25 cents on the dollar.

But I want to approach the problem facing private equity and venture firms from a different angle than the credit side. From the institutional investor side, there is tremendous fear at the moment. Just as consumers have pulled in their horns since Lehman Brothers went under in September, investors -- retail and institutional -- have liquidated many holdings to seek out the comfort of cash or T-bills.

Hedge funds have felt the brunt of this fear over the last five months, as many investors have run for the exits. Even the funds with positive performance last year were heavily redeemed in December.

Some hedge funds have slammed gates on their investors, preventing them from redeeming their investments until a later date. Although the funds were well within their rights to do this according to their offering documents, it's created a further level of mistrust and desire for liquidity among some institutional investors. There will be further ramifications of this in the months ahead.

For the hedge funds who have used their gates, while still collecting fees (Citadel is one but there are many other examples), they will face a skeptical audience with a long memory when raising funds down the road. But the funds that will face the toughest audience from potential investors will be the VCs, PE firms and illiquid funds. There are three main reasons for this.

- Many of these investors are pension funds, foundations and endowments. Even five years ago, most of these funds knew that a 5% annual return was not going to be enough to face their foreseeable capital needs and distribution needs for retiring baby boomers. Most have known they needed 7% or more annually. Of course, they looked around for models of what they should do and found them in Yale, CalPERS, and Harvard.

For those three groups, alternative investments (meaning hedge funds, venture capital, infrastructure and private equity) have been an important contributor to their overall portfolio returns for years. And, much like Merrill Lynch and Citigroup (C Quote - Cramer on C - Stock Picks) tried to emulate Goldman Sachs (GS Quote - Cramer on GS - Stock Picks) in terms of taking on more risk when times were good, smaller pensions and endowments increasingly upped their allocation to this asset class over the past four years.

After last year's losses, the need to deliver high-single digit returns has never been greater for these investors, so they have become very demanding and very impatient. This has a direct impact on the next two reasons.

- Seven years of waiting is too long. All VCs, PE firms and illiquid funds promise strong returns, but state that it must be measured over the lifetime of the investment, which is typically five to seven years. Given what happened in 2008, these pension fund and endowment investment committees will be under great pressure to demonstrate that any dollar invested today will truly return a 10% internal rate of return over the next seven years.

It will be difficult for many investment committees to agree to tie up their capital for so long, when they can allocate to other managers who allow them much easier access to their capital if needed.

- Capital call structure is too uncertain. Typically, VC and PE firms get capital commitments from their limited partners, but only call on the capital when needed. Although this has been standard operating procedure in these industries for years, in this environment, it's become an annoyance for many investors. Because of a greater desire for more transparency and liquidity, investors will prefer to move their investments as much as possible to the ones with the best liquidity terms without a capital call structure.

There will always be an interest in venture and private equity because of a perception that this group is delivering uncorrelated returns with other aspects of a diversified portfolio -- and the world will always have brand name firms like KKR and Kleiner Perkins. But after the shock of 2008, many investors have come to see that principle of uncorrelated returns across the portfolio as less important compared with greater certainty around returns and liquidity.

With less capital allocated to the venture and private equity space, there will be fewer of these firms tripping over themselves to get deals done. The deals that do get done will be at lower valuations, as investors anticipate lower valuations for exits. With the drop in capital and deals, there will also be a great reduction in these firms -- by as much as 50% in the next five years.

Will there still be innovation? Of course. Angel investors like Ron Conway, Marc Andreesen, Roger Ehrenberg and Howard Lindzon and early-stage investors like Josh Kopelman's First Round Capital will still make early investments in the venture space. In fact, it's cheaper than ever for small investments to take companies like Twitter very far. (This bit of good news, sadly, doesn't apply to the PE industry.)

Many Silicon Valley cheerleaders like to point out that Google (GOOG Quote - Cramer on GOOG - Stock Picks) was started in the last downturn. The Valley came back from the 2000 bubble, so it will come back again, they say. The gray-haired men of the private equity megafunds also like to say that their industry has lived through downturns before and will get through this time. I don't think so. We are living in a moment where something's been broken in our midst and it will not soon be repaired.

Companies will still get taken private and tech companies will still get bought by Yahoo! (YHOO Quote - Cramer on YHOO - Stock Picks) and other big names, sure as night will follow day. There just won't be as many deals, and they won't be for as much.

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Are Angels the New VCs?

This week brought the announcement that Charles River Ventures would launch Quick Start -- a more angel-oriented approach to funding start-ups than traditional VC.

Combined with the earlier announcement that Sevin Rosen Funds would be returning money to investors instead of putting it to work (and not raising a new fund), speculation has started that the traditional VC model is dead.

The argument goes:

1. Large amounts of capital are no longer needed to launch very successful start-ups. Joe Kraus famously opined that it only took $100K to start Jotspot, and $3MM to start Excite.com.

2. The IPO window doesn't exist today as it once did, thanks to Sarbanes-Oxley.

3. There's too much VC money chasing too few deals.

Fred Wilson disagrees with this view and correctly points out that people have been complaining about the too-much-money-too-few-deals for 25 years. He thinks VCs will just get leaner and meaner by (1) raising smaller funds, (2) going for $100 - $250MM exits, and (3) doing more M&A exits than IPOs.

However, Josh Kopelman of First Round thinks that CRV's announcement does portend of a major shift in the VC market. He points out that angel investing has better risk-adjusted returns over the last decade than any other stage of investing. Plus, a more conservative going-forward assumption would be average exits far south of $150MM. Therefore, there are likely to be more CRV-type announcement from "traditional" VCs over the coming years. Will they be able to do it well? That's less clear.

There are winners and losers from these confluence of trends.

Winners:

• The bluest of "blue-chip" VCs. The Sequoias and KPCBs of the world shine brighter when the maddening crowd is rushing to chase the latest trend of VC investing. They've been there and done that time-and-again.
• Existing Angel Investors who have a track-record. When a space gets hot (i.e., angel investing), those who have been there for a while are the old wise men. Josh Kopelman, Jeff Clavier, and others will see a rise for their services even as others rush in. There will be a flight to quality.
• Traditional VCs who are able to make the leap and really differentiate from other angel investors. Although CRV is a great firm, their success is not guaranteed. They need dealflow; their GPs needs to be seen as credible by non-nascent entrepreneurs; and they really need to be able to deliver value to their investments (beyond the simple "we love to roll up our shirtsleeves alongside our investee companies" platitudes).
• 2nd and 3rd Time Entrepreneurs: They're even more sought after following this news than they were before. We are heading for a Hollywood-type star system where Bill Nguyen announces his idea for his next start-up at lunch and the deal is done by dinner.

Losers:

• Stuck-in-the-middle VCs: Those VCs who do a little bit of angel investing and a little bit of traditional are likely to do neither well.
• Former Great VCs who don't adapt to changing times: Remember when Softbank was king of the hill? Hot VCs who have yet to reach the echelon of Sequoia and KPCB are not assured of long-term success. They are also likely to stick-to-what-they-(think-they-)know-best. Dangerous, when the rules of the game are changing
• Later-stage/Mezzanine Investors: They just got even less relevant.

These are interesting times. Enterpreneurs are more exposed than ever to demonstrate whether their ideas will succeed or not. The same goes for traditional VCs. May the truly value-added players win.

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