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Venturing beyond the margins27/04/2005. Source: Initium Venture Capital. Mark Montgomery 
We are witnessing the early stages of globalisation in venture capital, accompanied by the predictable increased protectionism within regions and multi-nationals, providing an interesting challenge throughout the stormy global economy. With the forecast ahead no less turbulent, says Mark Montgomery of Initium Venture Capital, it's essential for stakeholders to carefully consider what is changing within venturing and equally important, what is not. With this new format I will share my observations on a regular basis with the hope that it will add value to the practice as well as stimulate dialogue. Safe travels - Mark.
The Starting Gate
When successful entrepreneurs are asked to look back and describe which factor was the most important in their success, the reply is often something like - "We were too young and naive to know what we were attempting was impossible". For most the curiosity ends at this point with the thought that luck is king in the business world.
Serious students of venturing however dig deeper to discover that risks had been mitigated at every stage throughout the evolution of the new company. Luck plays an essential role at times, and should never be discouraged, but building successful companies today is about taking the best starting position at the gate, and then reducing risks while increasing probabilities throughout the life of the company.
In most technology start-ups that enjoy substantial accelerated success, the emerging company has been the beneficiaries of well-orchestrated symphony to include the combined efforts of human and financial capital representing local geographical and global topical communities that share an interest in the success of the company.
Often referred to as start-up infrastructure, individual members of this extended team include customers, universities, local governments, associations, corporate partners, angel investors, professional service firms, and of course the maestro - a no longer naive entrepreneur in the role of venture capitalist.
While individual global companies can emerge over time from almost anywhere, very few regions in the world to date have been successful in establishing a local sustainable venturing cluster. In the past decade however, in part due to the previous impact of the few successful regions, every major market in the world is attempting to establish some variant of sustainable venturing with many making significant progress.
This conundrum in the venturing environment has resulted in a variety of strategies and products, including single office mega funds, corporate partner firms, regional firms, affiliate networks, direct investing fund of funds, regional economic development funds, and the emergence of the global venture capital firm. In order to wrap one's brain around the topic of capitalizing a new company today, it's essential to understand the structure and impact of each.
Economic Development Venture Funds
Among the most significant trends in early stage venturing during the past decade has been the growth of institutionally backed economic development funds (ED), which are designed either directly or indirectly to benefit a specific geographic region. Ranging from small rural funds to state, country, and continental fund of funds, ED funds are strategic in nature, sharing many of the same conflicts, impacts, and challenges as corporate strategic funds.
It is not surprising that regions of the world that have not been beneficiaries of previous cycles of technology-led economic expansion would seek to participate in the next tide. With the powerful incentives for clustering in building businesses combined with the inability to compete on costs within globalization, local and national leaders are struggling to compete, with many concluding that they must enter the business of venturing.
Unfortunately, most communities have failed to properly assess their strengths and weaknesses relative to global market trends, which should direct decision-making, but instead have simply followed the trendy herd into the fog. The trouble with herding is that the stampede is rarely focused on the fundamental issues that determine success and failure, such as competitive position, sustainable funding, supply and demand ratios, and the needs of knowledge workers and customers.
The two most notable recent examples of herding have been the Dot Com bubble in the late 1990s when we witnessed in some cases hundreds of entries in each niche capable of supporting perhaps five. The fundamentals for e-commerce were excellent in1995, but deteriorated rapidly to unsustainable levels in most segments by the year 2,000, which interesting enough was also the peak of investment flows into venture capital funds - five years behind the peak of the opportunity.
The current hot ED target is life science (LS) where every ED strategist in the world it seems, except a few brave (and probably correct) contrarians, are attempting to establish a sustainable life science cluster, most of which should be pursuing other options. That is not to say that promising life science companies will not emerge in each of these regions, but a few small companies does not a sustainable cluster make. It appears to me that perhaps as few as five to seven of the forty-something states in the U.S. have the foundation and capacity to compete as a new sustainable LS cluster.
ED funds pursuing life science investment, particularly in pharmaceutical start-ups, provides an excellent example of how politics and successful venturing are anything but natural allies. Pursuing advancements in life science is a noble cause that is very popular as virtually all families have suffered from a terrible disease. Most of us, certainly to include myself, would like to improve the lives of those suffering, and when it's packaged as an excellent economic investment, who wouldn't jump on board? Combine this reality with the demographics in the U.S., neutral observers can begin to see that LS is an easy sell from the political perspective. From the scrutiny of the professional investment perspective however who has a fiduciary responsibility to investors, a much different view emerges.
(Note: I will cover specific industry clusters and regions in detail in future editions to include what is required to succeed in establishing a sustainable cluster, and which regions I believe have the highest probability of succeeding).
Strengths of ED funds
- Politically correct nature means more community support in some regions than private efforts enjoy, including more local media coverage.
- Once voted in, the funds are generally made available in a timely manner and not subject to the whims of fickle investors in SF, NY, London, or Zurich.
- Often have multiple bottom lines, none of which individually need to be high to meet the goals of political entities.
- Direct investment model occasionally works well with small business, government contractors and regional companies.
- At the macro fund of fund level, carefully crafted funds that are also professionally managed, protected from politics, and invested in fiduciary VC firms, can provide an ROI for investors.
Weaknesses of ED funds
- Very few local direct investment models have proven to meet even the lower bar of ED entities.
- Political entities often lack the discipline and talent internally to compete.
- Restrictions in ED funds on entrepreneurs impair their competitiveness.
- Political winds often dictates where the capital flows.
- Corruption and inefficiency are consistent threats.
- Difficult to attract top tier general partners to ED funds.
- Influence and value of management rarely extends beyond region.
- Third party fund management firms often have conflicts.
Independent Venture Capital Funds
While each fund is unique and only those with copies of the partner agreements are privy to each structure, the normal priority of private venture funds is to maximize profits for the investors in the fund. Private companies are of course free to structure operations however they desire within the governing local law and are otherwise only driven by their fiduciary interests to their limited partners. This may sound straight forward, but in practice we find the issue as complex as each individual in each firm. We are dealing with human beings.
For example, many VC firms claim to cover a large geographic region, but history shows that most investments actually made are close to the office, particularly at the early stages when start-ups tend to require the most time and energy. VC partners have strong ties to their communities, often to include substantial investments in the local economy, families at home, friends at the office, and spend far too many days in airports attending mandatory meetings with their existing and prospective investors and at endless conferences.
In addition, like many other specialists, VC partners have a strong incentive to congregate in clusters in order to hedge against the need to displace their families if a change in firms becomes necessary. The same is true for their professional partners, serial entrepreneurs, start-up executives, and engineers. Despite the advances in information technology and the ability to work remotely, with progress being made in many markets, these geographic factors still dominate venturing.
The result today is much the same as it has been for decades. Most young tech companies with global ambitions have been required to relocate to one of few VC clusters in order to raise capital and build their companies, creating a massive centralization of human and financial capital to occur over decades, particularly in the vicinity of Silicon Valley. By the 1990s when the centralization reached its peak, the bay area had become very expensive, during which time much of the rest of the world had been exporting their best and brightest to Silicon Valley, Boston and a few other metro areas. By about 1998 it became apparent to me that the Silicon Valley miracle had become unsustainable at its current levels, but few investors were willing to take risk on new funds elsewhere, and fewer still were qualified, preventing markets from correcting imbalances - so it is with inefficient markets.
Despite the frustrations for those of us who have attempted to build accelerated world class companies in underserved markets, one cannot argue against the most successful model in history with any degree of credibility. The critical mass of talent surrounding leading early stage venture capital firms provide not only among the highest returns of any type of investment, but they do so by building the most successful new products and companies. In addition, independent VC firms often play an essential role in maintaining healthy markets by providing the only viable option for disruptive products that threaten entrenched vendors - an essential and valuable service to society that has rewarded investors handsomely in the few big successes.
As globalization continues however and the market power of the multi-national has grown, it has become increasingly difficult for new entrants to gain sustainable momentum, requiring a rare investment proposition, deep pockets and very sophisticated VC partners. The cost of building a world class company has skyrocketed since the early days of venturing a few decades ago. In the U.S. for example, it has become routine for start-ups to spend between $20 million and $100 million in law suits to protect intellectual property (IP), and this is in addition to all other essential costs to build a competitive company. One court case in one portfolio company within a VC firm protecting a single invention routinely surpasses the total fund size managed by larger firms just 15 years previously.
The independent VC firm has also simultaneously experienced an exponential increase in competition from a variety of sources, including a sharp increase in government backed economic development funds, strategic corporate funds, publicly traded funds, university funds, non-profit funds, direct investments from institutions, and sophisticated angel groups.
Strengths of independent venture funds
- Lack of conflicting missions.
- Able to attract the best talent globally.
- Freedom to pursue the best opportunities globally.
- More talent applied at the early stages.
- Contrarian style can provide higher ROI.
- Creates more sustainable industries and businesses.
- Independence creates competition and healthier industry markets.
Weaknesses of independent venture funds
- Need to operate in stealth, particularly in disruptive technologies.
- Larger gap between the top and low tiers.
- Bias for centralization contributes to unhealthy local markets.
- Very few regions enjoy top tier firms.
- Qualified independent VCs are rare.
- Very difficult to establish new top tier firms.
- Institutions have a poor record in recognizing/creating emerging leaders.
- Many have become too large to operate effectively.
Comparing Independent VC Firms with ED Funds
The comparison of these two models is not a perfect exercise due to the vastly different goals and metrics employed by their investors for ROI, but it does provide value in part due to the impact each has on the other. ED funds for example may be considered a success even if the fund itself loses money due to the broad positive economic impact for the regional investors, often in the form of governments. In contrast, a pure private independent venture fund is measured solely by the cash returned to investors who generally expect a very high ROI given the inherent risk in building new companies.
While mistakes have been repeated in all types of venture funds, resulting in many failures, significant progress has been made in the past few years around the world accompanied by an expanding knowledge base of lessons learned. The reality is that the lines have often been blurred between these models all along.
Hybrids of these and other venture fund models have been around for decades and are now emerging in many evolved forms around the world. In the U.S. the most common hybrid has been the regional SBIC fund which is a federal program administered and subsidized by the Small Business Administration. In the past few years the EU has established a similar program with varying degrees of success in each country. And in most of the world the local government employee pension funds have become primary sponsors of regional venture funds with varying degrees of discipline, professionalism, and independence from political forces.
Among the many challenges in tracking the success of VC funds is the 5-7 years of patience required before an accurate portrait of returns begins to take shape, often followed by 3-5 additional years before funds are returned when the final ROI can be tallied. This is particularly true for those outside the firm who lack either the confidential information and/or domain knowledge to assess each venture. The jury is therefore still out on any fund in the embryonic stages, including in historically top tier firms, so despite the model each fund in each firm must be considered individually given a myriad of factors, including the team, target, environment, and the competition.
To date however, despite the many changes occurring within venturing worldwide, no model has proven more effective on a consistent basis than that of the classic independent venture firm, whether for entrepreneurs, investors or communities fortunate enough to enjoy their presence. The reason is really quite simple - firms that offer the most autonomy, highest pay, the most fun, the greatest challenge, and the opportunity to work with the best in the world in one's craft tend to attract the most capable team members.
Mark Montgomery is founder of Initium Capital, an early-stage venture capital firm based in the US. He operated a business-consulting firm from 1985 until 1995, when it became a private technology incubator. He is also founder and acting CEO of KYield, a start-up recently invited to bid on several of the world’s most advanced knowledge systems, including for the US National Security Agency and Department of Defense. Mark can be reached at: markm@initiumcapital.com
Copyright © Mark A Montgomery 2005
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