A Super Fast Overview and History of Tech VC: Part II
The Recovery: America comes Online and the Cleantech Bubble (2001–2007)
Thanks to Michael Ramos-Lynch for co-writing this series with me.
This is the second of five posts on the history of venture capital and the technology industry. Check out our first post for an overview of the formalization of venture capital from the 1950s through the dotcom bubble as well as some background on who we are and why we’re writing.
In this post, we discuss the post-dotcom era, when investments diverged, America came online, and cleantech surged.
The Post Dotcom Refractory Period
After the peak of the dotcom bubble in March of 2000, the public and private markets both collapsed, taking until late 2002 / early 2003 to finally reach a bottom. This was three years of falling share prices. Three years of companies and venture funds failing. And three years of less investment in and by venture capital funds.
Without new investment, VCs and companies struggled to find their footing. As Jeff Clavier of Uncork Capital recalls:
“Public markets recovered first. It took more time for VCs to get weak companies to a more stable position. Getting exits, it was basically portfolio triage. Merge who has cash and assets together so cash and talent could get together. You’d try to redeem your cash too. Do anything to salvage value and not be too embarrassed. Nobody wanted to be a 0x fund… but they happened.”
A closer look at the data shows that the VC asset class still made money overall, as measured by TVPI (in red below). The median internalized rate of return was zero or negative until 2005 (in blue below). Factor in the opportunity cost of capital and most funds essentially lost money those years. Looking at the lower quartile (in navy below), and you can imagine some of those aforementioned 0x funds, funds that literally lost it all.
As VCs fought and scraped to provide some return to their investors, some of those fortunate enough to have realized meaningful gains continued investing, usually with a more conservative mentality.
Many institutional investors also became more conservative, eschewing funds in the dotcom/Internet category. This created opportunities for those willing to continue making bets. According to Homebrew general partner Satya Patel:
“The exit window shut from 2001–2005, so generating liquidity was a challenge. But firms that still allocated capital there were able to do really well. As the window opened again, those who kept investing did well and others missed incredible companies.”
The return of venture investment was visible but abated through the start of the Great Recession in 2008. Total investment only grew about 2x from the low point in 2003, never even coming close to the levels of investment seen in the dotcom era before being pulled down again. This time, the pullback came from outside the industry.
The Rise of “Other” Assets
Let’s go back to the crash. The severity and reach of the cratering public and private tech markets were enough to impact other markets. Beyond the tragic losses of human life, the attacks on 9/11 also hurt consumer and business confidence, further harming the economy. One response was the federal reserve cutting interest rates.
Also around this time, the Public Company Accounting Reform and Investor Protection Act aka Sarbanes-Oxley was passed. Following fraud, scandals, and meltdowns at large public companies like Enron and MCI WorldCom, the sprawling legislation increased the compliance costs associated with being public. The goal was to provide shareholders increased transparency and lower the risks of fraud, accounting discrepancies, and conflicts of interest. While investors disagree on whether or not it “worked” for many reasons, no one would disagree it made going public harder and more expensive.
The combination of a weaker economy, lower interest rates driving investment, and hurdles to IPO drove capital into certain assets and kept it out of others, including venture.
This time period saw a new “golden age” for leveraged buyouts after the junk-bond fueled 1980s.
Hedge funds also grew both in assets under management (AUM) and number of managers. Promises of unique investing strategies led to a 4x of AUM between 2000 and a relative peak in 2007.
The largest bubble in the recovery era was reserved one of the least volatile asset classes — real estate. Driven by low interest rates, misaligned incentives in the form of increased securitization and complex packaging of mortgages, aggressive lending beyond normal reason mirrored closely what the tech sector saw just a few years prior.
Circling back to the fed, we see low rates post-dotcom coinciding with minimal growth in venture while driving growth in these other assets. We see the rise of rates correlating with an attempt to tamp down this growth. And then the reaction to the Great Recession.
Meanwhile, back in the world of venture, the somewhat “starved” asset class was maturing with now seasoned institutional investors and fund managers. A gun-shy atmosphere post-dotcom bubble continued amidst new dynamics and the Internet actually seeing strong adoption.
Stay Lean, Move Fast, and Ride the Information Superhighway
The private and public markets of the dotcom era afforded excessive risk and spending, with businesses building products first and then spending heavily on sales and marketing after. As funding became harder to come by and market data became more organized and available, the idea of doing deeper customer development before engaging product development began its rise to present-day dogma.
Steve Blank’s “Four Steps to Epiphany” crystallized these ideas in 2005, the same year Paul Graham and team launched Y Combinator (although the famous “make something people want” seemingly didn’t arrive until 2008).
Both men gave credibility and a voice to this line of thinking, including a greater focus on customer development and faster iteration. Both were succeeded by their students, as Blank taught Eric Ries, who went on the write the Lean Startup, and Graham invested in and mentored Sam Altman, who is President at Y Combinator and one of the leaders of the Startup School which evangelizes methodologies for building startups.
Despite near-constant debate on “lean” vs. “fat” startups, better customer development is table stakes with investors expecting founders to have unique insights from customers that inform the products being built. It may seem obvious that one would want actual and strong evidence of demand for a product or service before building out said product or service, but even today, companies still attempt to divine customer and market needs, disregarding the risk of being flat-out wrong, often to their own demise and that of the investors who funded them.
The feasibility of low-cost launches and rapid iterations increased as new technologies kept reducing the time and cost required to build, launch, and sell a minimally viable product. In this age of software and the Internet, agile development was born and new paradigms for building companies emerged. It’s only fitting that new venture investing theses would follow.
Less money needed to build and test allowed for smaller investment rounds to create evidence of business viability. Angel investors proliferated out of the PayPal Mafia. Early-stage funds became a formal subset of venture. In this era, now-famous “seed firms” came into being. FirstRound and SoftTech (now Uncork Capital) were founded in 2004, with True Ventures and Floodgate following in 2005.
In this new environment, many companies found a fast-growing base of users who were on their personal computers for hours a day and spending more and more of that time online. This time period saw the birth and financing of classic names in the social internet, including Friendster (2002), MySpace (2003), Facebook (2004), Digg (2004), Reddit (2005), and Twitter (2006).
Public Markets Remain Cautious
Predicting this consumer trend were successful enterprise-focused businesses, many of which had survived the crash and were now large enough to IPO. The best of them leveraged the Internet.
PayPal, enabling online payments, went public in early 2002, in the midst of the decline. Within six months, it was acquired for twice its IPO price by eBay. SalesForce, with its iconic embrace of the cloud over on-premises solutions, had its IPO in 2004, as did Google. The public markets began opening up to internet companies again, just much more conservatively than before.
Public market investors returned to expecting expenses to stay in line with revenues and looked for profitability as much as growth. The number of companies going public dropped severely after the crash, but by the recovery in 2004–2006, the recalibration had finally reached a point again where the public markets were more generous and welcoming to growing internet technology companies than private late-stage investors.
In addition to PayPal, Google, and Salesforce, other notable enterprise/Internet companies included NetGear, Loopnet, AthenaHealth, and Rackspace. Not a single one of these companies raised private financing at a valuation over $1 billion, and five out of the seven were profitable at IPO. Compare that to today, where we have 130 private companies valued over $1 billion, with profitability rare among them.
This more conservative market kept speculation lower, with high performing internet companies that had matured into fairly stable billion dollar cash generating machines leading the way instead of hype machines. However, at the same time, across the market, another tech bubble was forming.
The Cleantech Bubble
While institutional investors were skeptical of software and internet-based investments after the dotcom boom, VCs were still investing. But to keep institutions excited, something new was needed.
Led by some of the most respected venture investors, such as John Doerr at Kleiner Perkins and Vinod Khosla at Khosla Ventures, VC began flowing heavily into cleantech companies. A focus on global warming and increasing energy prices provided additional kindling (especially the steadily increasing price of oil).
Proclamations about rising oil prices and the trading positions to back them up from respected visionaries had many anxious and expectant of the coming of “peak oil.” Add in an increasing focus on sustainability and the growing desire to “do good while doing well” in the face of climate change, and investment into clean technologies grew dramatically.
But this spike in private investment was nothing compared to federal government disbursements. What started as a $4 billion loan program, repurposed from nuclear energy to cleantech, manifested into the hopes and desperation of rekindling a struggling national economy post-Great Recession.
The recession and poor returns caused a pullback in private investment as seen in the graph above, but federal subsidies caused a secondary resurrection in private investment with more than $16 billion in federal loan guarantees and $12 billion in tax credits coming after the crash in 2009. In many cases the tech wasn’t ready. Physical infrastructure and hardware are much more expensive than software and biotech. The R&D or technical risks were often too significant. Additional headwinds appeared in the form of collapses in the price of oil and natural gas as production/supply were increasing while consumption/demand dropped as a result of the recession. China was subsidizing its solar industry, flooding the U.S. market with cheap solar panels. Companies were growing too slowly and margins were too thin.
A review of the era and sector quantifies the challenges. After 2007, over 90% of Series A cleantech companies failed to return invested capital. If you remove Google’s acquisition of Nest in 2014 for $3.2 billion, cleantech as a class had significantly lower returns for VCs than software and medical technologies.
Still, despite the addition of government funding to the froth, the cleantech bubble never approached the size and scope of the dotcom bubble. It had served its purpose in the run-up, keeping America excited about technological innovation and the better future it promised. The added benefits, justifying continued federal investment, are the massive install bases of wind and solar and new categories of jobs. Even today, the sector is growing, albeit more conservatively and rationally and with capital from outside traditional venture. Analogous to the rise of internet companies after the dotcom crash, today we finally have successful clean tech companies like Tesla, ProTerra, and SunRun.
For more traditional tech VC, it wasn’t until the next generation, post-Great Recession, that the industry would have a new platform and evolution. More on that in Part III.
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Neil Devani is an early stage investor based in San Francisco, California working with companies that create positive externalities, with a focus on healthcare, financial services, and education as well as certain frontier technologies. He is also a licensed attorney in the state of California.
Michael Ramos-Lynch previously worked for a venture firm in Palo Alto, California and is currently an entrepreneur and practicing attorney in Austin, Texas.
None of the above post is intended as investment or legal advice.
