VC Investing Gets Seedier

LAS VEGAS -- Venture capitalists always seem to have an answer for the markets in which they are investing. But after a panel at the CES, I got the idea that VCs are becoming a little confused and uncertain about changes in their own industry.

VCs here talked about an industry that is changing, but it may even be in turmoil. Traditional institutional venture capital funding is in a decline, while angel investing by wealthy individuals is increasing. In addition, a lot of the action has gone into the really early days of a company's development -- the so-called seed stage.

Angel investors, who often form pools of money to invest as a group, are becoming more influential at the seed stage. That means traditional VCs are losing some control at the valuable early stage of financing that gets companies going.

During the hottest startups in the last 10 years -- the Facebooks and Twitters of the world -- seed and angel investors, who were in the companies first, have driven the initial surge of value.

"If you are not in the seed stage with Twitter, the valuations are much harder to get involved with later in the rounds," said Habib Kairouz, a managing partner at RHO Capital. "There is a new layer [of capital] at the angel layer. There is a lot of excitement. A lot of capital has been formed to go after the seed funding. People are coming up with ideas there."

Why the panic? Many VCs won't admit it, but they were caught off-guard by the post-2000 tech bubble. The social networking boom followed. And some of the recent tech IPOs have involved companies that were spotted only by a select few in their early stages. Think of the four largest tech IPOs of 2011: LinkedIn (Nasdaq: LNKD), Pandora (NYSE: P), Zynga (Nasdaq: ZYNG), and Groupon (Nasdaq: GRPN). They made gigantic amounts of money for the insiders who were in the companies early, but a lot of people were left out.

Here's the general pattern in a nutshell: A quirky Internet company run by 20-year-olds wearing T-shirts takes off by hitting some kind of consumer hotspot. A bunch of angel investors give the company money. The company takes off fast, and its valulation climbs. Institutional investors try to jump on board, and the valuation skyrockets before the IPO.

Many VCs portray themselves as methodically investing in companies and screening for success in the long term. In fact, the volatile pattern of the last few years has shaken things up and left the earlier-stage investors with more influence.

Scott English, a partner with Hearst Ventures, told the story of how Pandora was shunned for many years at the venture stage. "If you go look at the founder of Pandora... he went through remarkably hard times and now has been very successful. But it was very hard for Pandora to raise money early on."

Yes, it's true. The Internet radio company was around for a decade before it went public last year. At one point, it almost went out of business, due to the tricky process of working out licensing deals with music companies. English said the only reason Hearst invested in Pandora was that his firm had successfully invested in XM Satellite Radio. "When Tim came knocking on our door, we had a point of view" of Internet radio "that was contrarian that allowed us to appreciate his business in a way that others didn't."

The global IPO market produced 338 offerings in 2011, down 29% from 2010, according to Renaissance Capital. Social media ruled the tech scene. But these IPOs didn't perform well in the aftermarket -- in fact, 2011 IPOs underperformed the general market.

Four of the five largest US Internet IPOs ever -- Bankrate (NYSE: RATE), Groupon, LinkedIn, and Zynga -- took place in 2011 and raised $2.4 billion.

The companies received large valuations but have underperformed since going public.

Here's another thing VCs are loath to admit: Because of the low number of IPOs, the total amount of capital returned to the VC partnerships has been quite low, even though a select few firms that were in the right companies have made a bundle.

This year, we assume, we will have IPOs from Facebook and possibly Twitter, which look poised to give venture investors huge returns. These IPOs will make a concentrated number of investors massively rich. And the other members of the investment community will be pulling their hair out with jealously.

There are hundreds of VC firms out there, but less money is being committed to venture capital. In fact, venture capital investment has declined over the last 10 years. In the first three quarters of last year, only $21 billion of venture capital was invested, versus $30.7 billion in 2007. (In 2009, venture capital investment bottomed out at $20 billion, according to the National Venture Capital Association.)

Meanwhile, the number of angel investing groups has doubled in the last 10 years. In 2009 and 2010, the amount of money invested by angels actually rivaled the amount of institutional VC money, according to data from the NVCA and the Angel Capital Association.

With the limited pipeline of IPOs, it's hard to feed all these VCs. And they are increasingly competing with angel investors, who are growing in number and getting in at the earliest stage.

Kairouz says a big shakeout is still coming for both startups and VC firms. Companies will have more trouble finding money later in their life cycle as they look for institutional money, he says, even though it may be easier and cheaper than ever to grab money at the seed/angel stage. "My personal projection is that while it's good to get entrepreneurs in the game, you need proof to get the real institutional rounds done. It's going to be harder to get the real institutional rounds."