Alternative Models of the Venture Investing Process

Alternative Models of the Venture Investing Process v3

Alternative Models of the Venture Investing ProcessBill JanewayVice ChairmanWarburg Pincus

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“IT Doesn’t Matter”Nicholas CarrHarvard Business ReviewMay 2003

Technological infrastructure has been commoditized

No competitive advantage from investing in IT

Spend less and cut costs

“Focus on vulnerabilities, not opportunities”

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The Fifth WaveCarlota PerezTechnological Revolutions and Financial Capital

The Bubble of 1999-2000 marked the MID-POINT of the “Fifth Wave”of transformational technology

Like railroads and electrification: two phasesFrom infrastructure to applicationsFrom experiment to existence proofsFrom speculation to common sense

The promise of technological revolutions is transformational

Speculative Bubbles are endogenous

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The “Killer Apps” of the Fifth Wave

The Bubble financed experiments in:Customer self-serviceStraight-through processingReal-time intelligent transactions

The vehicles for the Fifth Wave’s productivity revolution

The sources of major market discontinuities in IT infrastructure and applications

Two decades to mature/two decades to deploy

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The Status of The Technology

Standardization is in process (and costs are falling)

BUT:Complexity rises with convergenceComputing vs. communications paradigmsIntegration costs more than developmentSyntax versus semantics

Required: Higher levels of abstraction

Required: Technological innovation

Required: New ventures to bring innovation to market

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PRODUCT MARKET MANAGEMENT LIQUIDITY FOR FOUNDERSTECHNOLOGY

Round-by-Round

MANAGEMENT CHANNEL PRODUCTCREATE SELF-

SUSTAINING BUSINESS

MARKETDISCONTINUITY

Fully Funded

Two Models of Venture Investing

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Round-by-Round VC Model: 1

Focused on product innovation

Start with intersection of: Well-defined marketNew technology

Specify an innovative product (faster, cheaper, better)

Add management as needed

Achieve liquidity ASAP: IPO or sale

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Fund in multiple rounds/multiple investors per roundEach round validates (or NOT) continuing investmentNew investors leverage returns for earlier ones (and for entrepreneur)Value at each round = f (operational progress, Capital Market environment)

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Key attributesGoal = Deliver product to market Risks = Operational and Capital MarketTime horizon

12 months per round~3/4 years to liquidity event

Key exposure: Capital Market volatility

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Capital Market Volatility

The round-by-round VC model evolved to manage operational risk

But every new venture is also exposed to Capital Market risk

Ability to respond to Capital Market risk Potentially compromised by multiple VCsWith diverse cost bases, availability of capital

What the Bubble gave…hath been taken away

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$2.9 $6.6 $5.7 $6.8$13.3 $16.9

$25.7

$57.5

$83.7

$50.7

$13.3$3.4

$0

$20

$40

$60

$80

$100

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 YTD030

1,000

2,000

3,000

4,000

5,000

NASDAQ Index

Fundraising Barely Noticeable in 2003

Underlying data available in VentureSource

Commitments to Venture Capital Funds

Funds Raised ($ Billions)

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$8.5$10.7 $9.5

$11.2 $12.6$15.5

$22.0

$26.0

$16.8

$10.5 $10.0

$0

$10

$20

$30

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 1H03

Valuations at Mid-’90s Levels


Median Premoney Valuations by Year

Median Premoney Valuations ($ Millions)

0

1,000

2,000

3,000

4,000

5,000

NASDAQ Index

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$100

$17

$39

$14$5

$13

$3$5$0

$20

$40

$60

$80

$100

2Q00 4Q00 2Q01 4Q01 2Q02 4Q02 2Q03

Valuations Regress Toward Overall Median


Median Premoney Valuations by Round Class

Later RoundsSecond RoundFirst RoundSeedMedian PremoneyValuations ($ Millions)

0

1,000

2,000

3,000

4,000

5,000

NASDAQ Index

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0

1,000

2,000

3,000

4,000

5,000

NASDAQ Index

$7.6

$3.5

$6.7

$1.5$0.5 $0.3 $0.2

$0.8 $0.4$0.9

$0.0 $0.4 $0.0 $0.2 $0.462061

948455

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71

43

70

$0

$2

$4

$6

$8

$10

1Q00 2Q00 3Q00 4Q00 1Q01 2Q01 3Q01 4Q01 1Q02 2Q02 3Q02 4Q02 1Q03 2Q03 3Q030

15

30

45

60

75

IPO Liquidity Has Been Rare, now Recovering


“Normal” means ventures can go public that don’t need to

Amount Raised ($B) Venture-Backed IPOs

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4.0 4.13.5

3.22.8 2.8

3.1

4.5

3.6

5.7

0

2

4

6

1994 1995 1996 1997 1998 1999 2000 2001 2002 YTD03


Time from Initial Equity Funding to IPOIPO Companies Older

0

1,000

2,000

3,000

4,000

5,000

NASDAQ IndexYears

16


0

1,000

2,000

3,000

4,000

5,000

NASDAQ Index

$4.7 $6.3 $4.6 $5.2 $5.5 $6.9 $10.2 $9.5 $13.9 $14.0$18.7$23$19

$26

$100

$55

$31$34$40

$25$22$20

$0

$20

$40

$60

$80

$100

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 YTD03$0.00

$20.00

$40.00

$60.00

$80.00

$100.00


Median Amount Paid in M&As vs. Median Invested in Private Rounds Prior to M&ALess Gains in Current M&As

Median Invested in Private Rounds Median Amount Paid

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PRODUCT MARKET MANAGEMENT LIQUIDITY FOR FOUNDERSTECHNOLOGY

Round-by-Round

MANAGEMENT CHANNEL PRODUCTCREATE SELF-

SUSTAINING BUSINESS

MARKETDISCONTINUITY

Fully Funded

Two Models of Venture Investing

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“Fully Funded” Alternative: 1

Focused on market discontinuity

Partner with proven management team

Define business strategy:“Buy what you can/build what you must”

Estimate capital needed to cash flow break-even

Negotiate price and availability up-front

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Evolved to address Capital Market riskIf markets move favorably, can always take advantage of them If markets move unfavorably, keep building the business

Management of operational risk = Continuing responsibility of financial and operating team

Operating team wholly focused on building the business

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Key attributesGoal = Positive cash flow from sustainable competitive positionRisks = Operational only (Capital Market risk insured)Time horizon

4-7 yearsLiquidity event = “Nice” NOT “need” to have

Added benefit: this model was totally irrelevant during the Bubble!

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Where are we now?

The existence proofs are evident: Amazon, Dell, eBayThe innovators have proven their case“Main Street” has no choice but to follow

But transformational technology only becomes universal when it becomes transparent

Transparency requires higher levels of abstraction

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Levels of Abstraction

How to drive a car “Turn steering wheel 10 degrees to left”“Take Uncle Bob to the airport”

From railroads to railway express

From electrification to the assembly line

From distributed computing to resource virtualization and web services

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Abstracting the Infrastructure

Fundamental paradigm change:From bus-based to router-based processing: IP everywhereFrom remote calls to messaging: XML everywhereFrom the “smart” SMP system to the dumb crowd: numberless nodes

New architectures are needed:To manage heterogeneous, distributed resourcesTo make them work as an application platform

New architectures are the context for new point products

Delivering new architectures requires building sustainable businesses

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Abstracting the Application

Fundamental paradigm changeComposite applications: Functionality = ServiceValue from business process understanding

Ease of customizationEase of incremental extension

Payment for value delivered over time

New business model means new investment model

New product = $15 million-25 million

Sustainable business = $75 million-100 million

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Conclusion

The “fully funded” alternative is relevant again(f) The post-Bubble capital market environmentAND paradigm change at the infrastructure and application levels

But only for a sub-set of strategic venturesThe entrepreneurs are self-selected

Build a business versusDeliver a product

When the capital markets are “normal”, IPOs are available to the businesses that don’t need them

Strategic ventures require long-term capital

Alternative Models of the Venture Investing Process

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