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Venture Capital: Getting Past the "Winning Company" Approach
IBM executive Claudia Fan Munce argues that investing in ecosystems of related companies helps reduce risk and create new paths to market
By Claudia Fan Munce
Viewpoint July 23, 2009, 12:01AM EST
Given the downturn in the venture capital industry, there's no shortage of suggestions about how to fix it. But the debate about how to restore healthy returns to VCs, and a flourishing group of startups to the technology market, still depends too much on the outdated strategy of picking winners, horse-race style.
Now could be the time for venture capital investors to look beyond the "winning company model" that's paid dividends for decades. In that approach, a VC analyzes a new market, chooses a startup from an often crowded field to invest in, then hopes that company emerges as the winner. In today's complex technology markets, with companies more interdependent than ever on the inventions of others, it's become extremely hard for investors to pick a single winner in a market, no matter how smart the founders are or how savvy their business plan appears.
Instead of trying to handicap the field too narrowly, VCs may do better to spread their bets. Some ~~ have begun a new style of investing that attempts to build networks of related companies, rather than betting on just one or two in a given field. The approach borrows a page from the well-known computer industry strategy of building ecosystems of companies whose work complements that of others in the network, expanding the market for all.
Targeting Energy Efficiency
Take American River Ventures, an early-stage investment firm co-founded by a former executive from my own company, IBM (IBM). American River has invested in several startups in the energy-efficiency market, including SynapSense, which makes sensors that can help companies lower their data centers' energy consumption.
Earlier investments in related companies have already paid off: A company from American River's portfolio, Clairvoyante, whose technology can lower power consumption during LCD screen manufacturing, was acquired by Samsung Electronics last year. Another, Incuity Software, a maker of manufacturing industry software, was bought in 2008 by Rockwell Automation (ROK). Communicating with IBM helps American River spot gaps in the market, and the approach works for other VCs and large tech vendors as well.
The ecosystem investing approach can multiply the number of jobs startups create, products customers want, and financial returns for investors by helping VCs spread out risk and generate new sales leads. Look at Silicon Valley, eastern Massachusetts, and other hotbeds of invention. These innovation centers incubate entrepreneurs by clustering knowhow from universities, research labs, large companies, and startups to create new businesses and new jobs. VCs' portfolios might benefit from the same synergy.
VC Model Being Questioned
To be sure, there well may yet be more venture-backed mega-successes like Google (GOOG), Intel (INTC), or Starbucks (SBUX) that come to dominate their fields. But smart VCs might also recognize the need to back networks of companies in order to help their investments succeed.
With the initial-public-offering market in a deep chill, and new investments in startups stalled, some investors are questioning whether the venture capital industry's business model is broken. VCs invested just $3.7 billion in startups during the second quarter—less than half of what they invested a year ago and matching the levels of a decade ago, the National Venture Capital Assn. reported July 21.
Others contend that traditional VCs have become too big and unwieldy to spot the best new opportunities. But those arguments, while rooted in financial measures, overlook the fact that venture capital remains an essential way that the U.S. promotes entrepreneurship.
A New Metric for Success
The debate over how to infuse new life into the VC industry focuses almost entirely on financial measures. We look at the size of investment rounds, whether funding is increasing or decreasing, and returns on investment. While important, these measures are too limited for evaluating an industry with the critical function of fostering the development of new companies, new talent, and new business ideas.
It may be time to look for fresh measures of success that go beyond financial metrics, and judge startup companies by technical milestones as well. Success doesn't come to startups solely from large venture investments. The ingredients that go into creating a healthy new company are far more complex. Startups need strong management teams, a killer idea that works as a business plan, and financial backing. Frequently, a venture capital firm's ability to recruit talented people for a startup is more important than its latest round of financing.
The venture capital industry has a wide breadth of talent. Its firms know how to build management teams and recruit effective boards. And they understand the hard work of forming new companies, including marketing, sales, and financial reporting.
Rather than question the relevance of the entire venture industry, the technology sector needs to better tap into VCs' expertise to build new companies, stimulate our economy, and create more jobs. Moving past the practice of betting on a single winner in each product category could be a helpful start.
By Claudia Fan Munce
Fan Munce is managing director in IBM's Venture Capital Group and vice-president for corporate strategy.