What Venture Capital Can Learn from Private Equity

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More Risk to Manage

In short, it has become clear since 2000 that financial risk/return is as important as execution risk in venture capital. Financial risk/return refers to weighing the risk that the financial markets may not be ripe enough soon enough to justify investing this much, at this valuation, now. Today's VCs have to pick great markets, great teams, and manage execution risk, as they always did. But they also have to manage valuation risk, timing risk, and investor syndicate risk.

Venture capitalists can learn a lot about managing this new set of risks from their counterparts in private equity. Whereas the traditional venture capital playbook has been about company-building, the private equity playbook has been about financial engineering. Private equity is focused on metrics, comparables, terms, and cost of capital—more so than innovation, market selection, and team development. Their teams and companies are more mature, reducing the need to be an expert in assessing execution risk.

Think about this in terms of an inflection point, or that period when an additional dollar invested yields far greater shareholder value than it would have at an earlier phase. It's the point at which a little gas fuels a huge fire. Finding the best companies and investing in them at inflection points are perhaps their two most important disciplines. Stage is not a consideration. It is all about that inflection point.

Venture capital is at the intersection of innovation and finance. Fortunately for investors, innovation continues without regard for the financial markets. The jet engine, the helicopter, FM broadcasting, fiberglass, nylon, photocopying, radar, sticky tape, and instant film were all invented during the Great Depression. Breakthroughs are everywhere today, in energy technology, biotechnology, and even information technology. These innovations will continue to disrupt incumbents and create new markets—and they will all need early-stage venture capital.

But the absence of buoyancy in capital markets means the early bet is not always the best bet. The new venture capital playbook begins by taking into account the macro drivers of growth. Which sectors are most ripe for disruption through innovation? Add to this the venture practice of building networks of entrepreneurs and partners who can place you in the flow of that innovation.

Inflection Points

Here's where the private equity model takes hold. Like private equity investors, VCs need to understand the entire sector, at every stage in the spectrum—seedlings through large public companies—to develop a theory of how the industry will evolve. Who will win and who will lose? When will incumbents need to make strategic acquisitions? What events have to transpire to enable big, new markets?

And, like other forms of private equity, the timing and probability of exits are as critical as their magnitude. This necessarily leads to a view toward finding inflection points, regardless of stage. Sometimes the best stage is the napkin sketch in the coffee shop; sometimes it's the phoenix rising from the ashes of $100 milllion of previous investors' capital. Either has the potential for venture capital success. The best performing venture capital investors will be able to find both.

At Crosslink Capital we have been evolving this new venture capital playbook since the late 1990s. We recognized early on that the bull market was over in 2000. We mostly sat on the sidelines for much of 2001 and 2002 with our 2000 venture fund. When we did return to investing, we did many restarts, turnarounds, and private investments in recently public companies, many of which were in Internet and services. This strategy of selectivity, stage independence, and a focus on companies at inflection has served us well.

Letting Go of the IPO Window

By 2006 we began to see two important shifts with our new venture fund. One was the emergence of energy technology as a new and important growth market opportunity. Many energy technologies had reached a point where the scientific risk was being replaced with commercialization risk. This transition is always a tipping point in the emergence of new growth venture markets.

The other shift was a rising inflation in later-stage valuations. It seemed many of our peers anticipated a forthcoming IPO window, whereas we did not. So we tended to find better values in earlier-stage opportunities, where the return multiples would justify the higher financial and execution risk. A few of these companies have had very attractive subsequent financings, suggesting we are off to a very good start. Among the companies funded were Twin Creeks Technologies (energy), Like.com (search), and OpSource (cloud computing).

There are lots of strategies for playing to win in baseball and in venture capital. The best strategies are context-specific. Entrepreneurship and innovation are eternal. A few venture firms will be able to continue to successfully swing for the fences without the bull market tailwind. Most will not. Great returns will continue in venture capital, but only for those who can successfully operate across the spectrum of private companies and find great value regardless of their stage.

Rip is a general partner at Crosslink Capital, a multistage technology venture capital and growth equity firm with more than $1.4 billion in capital under management.