Venture Beta

Stuart Ellman

Eric Wiesen

The Q1 numbers on Venture Capital investing were released last week. As is often the case with VC numbers, especially when they’re bad, there was no shortage of press and blog attention to the drop in both venture investing (in terms of capital deployed) and venture liquidity. And the general narrative that initially emerged was largely one of panic and, schadenfreude.

Shortly thereafter, however, people started to dig into the data a little bit further. We want to give big kudos to our NYC brethren, Fred Wilson, for his blog post on this topic. Two interesting analytical slices have emerged from this further examination. First, there was a meaningful disparity amongst geographies, with Silicon Valley seeing a much larger drop (even as a percentage of capital) than sectors in the Northeast like New York or Boston. The second was that certain sectors (like CleanTech) saw a far larger decline than other sectors (like health care).

And in looking at these second-order narratives that have emerged from this major change in venture behavior on both sides of the equation, it starts to become clear that there may be a sort of “beta” attached to different sectors within venture capital, much like there are differing levels of beta within sectors of the public market.

Beta, for those who aren’t familiar with the term, means that while most securities move in the same direction as the overall market, some tend to move more than the market while some tend to move less. A stock with a beta of 2.0 will generally increase by a percentage twice that of the overall market when the market is up, and correspondingly will decline twice as much as the market when the market is down. A stock with a beta of 0.5, by contrast, will only be up (or down) half the amount of the overall market. High-beta stocks are great in a go-go market and really bad in a down market. Low-beta stocks are generally less exciting when things are good, but hurt much less when things turn south.

The data emerging out of the down numbers for venture capital start to suggest that perhaps certain sectors (like health care, thought by some to be a safe source of “singles and doubles”) will generally act lower-beta than others (like CleanTech or the consumer web, which enjoyed massive momentum in the years prior to the downturn). Similarly, areas like New York and Boston start to look generally lower-beta than Silicon Valley. There have been fewer massive high-priced companies in New York, but the fall has been far less precipitous. We can only assume that the beta may be directly correlative with the supply of capital in those regions. In NYC, where there are fewer venture firms, there tends to be less upward (and obviously downward) pricing jumps because there are fewer firms to both jump in and jump out of the markets when sentiment changes. In the NY venture market, we have seen pretty rational pricing over the past few years, while other regions were seeing significantly higher pricing as the funding markets picked up steam. Since our region’s pricing never got too high, it has not fallen nearly as dramatically either. It is reassuring to see Fred’s analysis back this up.

Is Capital Efficiency the Enemy of Innovation?

Eric Wiesen

I’ve been thinking about two themes that have generated a lot of discussion lately. The first is a growing sense that we are in a period of weak innovation; that Silicon Valley (and the rest of the US tech ecosystem) is broken, and that most of what’s being invented today is incremental, with no real innovation taking place. The second is strong focus on capital efficiency within the technology startup world.

At this point, given both the trends in web development and the macro economy, it’s practically a race between the entrepreneur pitching and the investor being pitched as to who will bring up how capital efficient the business is. The large majority of companies we see these days make a point of how capital efficient their models are, and the majority of investors (VCs and angels alike) are quick to dismiss companies that are viewed as capital inefficient.

Let’s step back for a moment and talk about what capital efficient means, and then we can get to the heart of the question. Capital efficient, in its simplest form, means you can accomplish a lot with a small amount of capital. And of course if you stop there, it sounds like an unadulterated good thing. More for less, right? And as a first-order question, I think the answer is yes. Doing more with less is a good thing.

But the second theme contextualizes the first for purposes of our question. We are in a period where much of the technology innovation taking place is in “soft technology”, be it software, web services, technology-enabled services or data businesses. And while it’s certainly an enabling environment that so many of the tools required to create these businesses have become commodity and free, there is an increasing concern that people are simply using free, easy tools to create slightly better versions of things that already exist.

Because how many of the really innovative technology companies throughout history were actually capital efficient? Whether we’re thinking about Edison Electric or Google, Amgen or Intel, Nvidia or Nucor, we often find that companies that really transformed industries with new technology or approaches took a large amount of capital and significant time to achieve it. And while these are clearly cherry-picked data points, I think that even on the web most of the really significant, innovative companies have taken in quite a bit of resources along the way.

I was recently on a panel with a friend of mine who’s an angel investor. And what shocked me was when he said that his group was looking primarily to invest in businesses that could, from a dead start, achieve profitability on significantly less than a million dollars of capital. And while, on its face, this sounds amazing – who wouldn’t want to invest in businesses like that? – another part of me really had to wonder, can you build anything interesting or important if that’s the hurdle you establish at the outset? Would any of the companies who have significantly raised the innovation bar have fit that screen, back then or now?

So I don’t think there’s a clear answer – we at RRE Ventures are clearly going to continue to seek businesses that can accomplish their goals with as little capital as possible, because it’s essentially obvious to do so. But I also agree with the criticism that “Web 2.0” has been at least in part an exercise in excessive capital efficiency, and that people were building incremental products and services with no real innovation in the hope of a quick flip or tuck-in acquisition. In the back of my head, I’m still going to be thinking about opportunities to create something really transformative, even if the road is a little longer and tougher.