Nov 17th 2009
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Loading ...Boosting venture capital funding won’t close the innovation gap.
The gap in funding for innovation is below the horizon of most venture firms. Until this is addressed, innovation won’t flourish, says Chris Beare.
A quick analysis of the economics of a typical venture firm reveals that supporting venture capital funds is not the way to nurture and encourage innovation.
An average venture fund makes four or five new investments a year and they will do that only in the investment period of the fund, which typically lasts the first three years of a ten-year fund life.
The average fund will have twelve to fifteen investments and each investment will be made with the expectation that a return of 10 to 100 times is possible. The fund will want a position of influence in, but not control of the investee company, and will play an active role through a seat on the board and the right of veto on major decisions.
A $100 million fund will invest up to $10 million in a company and if this is done over three or four rounds, the first investment will be for about $2 to $3m. To have the influence that it wants, the fund will need to own twenty to thirty percent of the equity in the company. This means the company must be reasonably established by the time the venture fund firsts invests, and have good prospects for rapid growth, and sizeable on-going cash needs.
A venture firm might look at 400 to 500 opportunities in a year and only make for or five investments for a 1 in 100 hit rate. Add to that the fact that you can count two hands the number of mainstream venture firms actually operating in Australia, and it is clear that the universe of companies that venture capital targets is small, and the number that get funded in any single year is even smaller.
There’s another dynamic happening as well. Investors in venture funds feel safer investing in bigger funds where the fund manager has a larger team and perhaps a better track record. Of course, the venture fund manager is not going to turn away interested investors. But having more investors doesn’t mean the fund will do a larger number of deals; they’ll just be driven to do larger deals, putting more money into each company. This pattern drives fund managers further away from where innovation is happening. In the case of web-based businesses, product development and market acceptance testing can be done on the smell of an oily rag. Take the many companies that build iPhone applications for example. A big win in these areas of activity can happen quickly and with minimal cash.
Thus the real gap in funding for innovation is below the horizon of most venture firms, and until this is realised and addressed, innovation won’t flourish. Supporting venture funding as it currently operates isn’t the way to promote innovation.
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