Why Seed? Why Now? (Part 1)

Henry Wong, Artemis Ventures

An Investor's Perspective: The Case for Seed Stage Venture Investing Today

Despite the current economic recession, investing in seed stage technology companies remains a compelling investment strategy more than ever. Surprisingly, there is little written to date on the increasing value of seed stage investing during recessionary periods, despite an increasing focus by many investment firms and individuals on just such a strategy. This article will address the reasons why allocating capital to this historically high performing asset class in today's depressed market climate will help maximize investor returns tomorrow. Although seed stage companies encompass a breadth of industries, this report will focus specifically on the high technology and communications industries. Finally, the research presented in this report is based upon U.S. data only, and thus the conclusions drawn are only appropriate for investors considering an investment in venture capital funds targeting U.S. investments.

Part I will discuss why high technology continues to play a large and ever increasing role in driving and growing our economy. In particular, technology investment opportunities will continue to be attractive by providing high returns on investment for investors. Part II will show that seed stage investments continue to outshine all other asset classes and investment vehicles, even in today's depressed economy.

In the second half of this article, Part III will discuss current trends in venture capital, which have created tremendous and underserved investment opportunities in today's seed stage startups. Finally, Part IV will demonstrate that seed stage investing can be used as an effective hedge strategy in today's weak economic climate, and also provide investment strategies for investors to capitalize on this financial opportunity. In sum, the Artemis Ventures investment team remains more bullish than ever on seed stage technology investing.

I. Technology and Communications Sector Investment Opportunity

Much has been written in recent years on the growing importance of technology in business as well as its affect on our personal lives. The subject of this section is not an attempt to restate an obvious point, but instead to establish our viewpoint for why investing in this growth engine, in particular, is a sound investment strategy. Despite claims from industry pundits in recent months, the Artemis investment team continues to see the development of a new economy rooted in technological innovation. In our view, technology has not changed the old rules of economics, but instead has sparked a wave of innovation and surges in productivity within enterprises. In fact, the technology sector has accounted for a large percentage of overall U.S. investment activity for the past two years (See Figure 1).

Figure 1: Technology Investments: Percentage of Total U.S. Investments


Source: PriceWaterhouseCoopers MoneyTree Survey/VentureOne

This importance of technology investment is also evidenced by current trends in the enterprise. Companies ranging from the small/medium enterprise to the Global 2000 are reinventing their information systems, moving mission critical applications to intranets, extranets, and the Internet itself. As a result of scaling up and out, more power is moving to the network edge. Three important developments are increasing the adoption of technology:

  • Cost, size, and power consumption of computing, storage, networking, and interface technologies continue to decline, while performance and capabilities continue to increase.
  • Optical networking, wireless networks, and standards-based application services are enabling new classes of devices, services, and business models based on pervasive, low cost, always-on, broadband access to a global Internet.
  • Communications and computing technologies and business models are merging as the underlying network converges, creating demand for broad new classes of media- and data-intensive network applications.

This is where access meets infrastructure to deliver the always on, always pervasive, always fast, always personal "Evernet." Take for example the following three trends driving increased innovation and spending in corporate information technology:

  1. GDP. On a macro-level, economists predict the technology sector's contribution to the GDP will double within the next 10 years, increasing from less than the 20% of total goods and services it is today to about 40%.
  2. IT SPENDING. The Four Technology Laws (Storage, Bandwidth, Processing Power, and Networking) continue to drive demand in corporate spending. We believe storage needs are doubling every 12 months, while bandwidth requirements for the enterprise are doubling every 6 months. Moore's Law predicts processing power to double every 18 months, and Metcalf's Law states that the power of the network increases by x2 as you add an additional node to the network. In fact, our research indicates that companies will nearly triple their spending on information technology to 10% of sales by 2008, up from 3.5% today --- driven by the need for storage, bandwidth, processing power, and networking. We believe companies which align themselves with these prevailing laws will have the most upside growth potential in the future.
  3. REAL-TIME FIRM. On an application level, driving this increase will be the new efficiencies gained by the move to real-time computing by enterprises. We believe that for every 1% increase in I.T. spending, a company can cut their general and administrative expenses by 1.5 to 2%. That's a 50% to 100% ROI on the investment. A great example of a real time enterprise is Cisco: Cisco earned $7B in revenue in 1Q01 and $4B did not require human intervention.

Although we remain extremely cautious and recognize the severity of the current telecommunications downturn, we believe that the communications sector will eventually rebound and lead the overall technology sector out of its current doldrums. In this vein, there are still many opportunities in the communications and networking sector. These opportunities lie in infrastructure enhancements which improve bandwidth utilization, increase power amplification, and extend the coverage of networks. In addition, communications software and underlying applications which facilitate the migration, integration, and convergence of the wireless enterprise also provide strong investment opportunities. As a result, innovation continues to thrive and investors should remain bullish on technology and communications investing.

II. Seed Stage Technology Investment Opportunity

The financial opportunity to invest in seed stage technology companies remains more compelling than ever. Despite poor venture capital industry performance in recent months, the Artemis investment team believes seed stage investing will continue to provide the highest returns for investors. Our belief is founded upon over 20 years of venture capital returns data showing seed stage consistently outperforming every asset class, including a balanced portfolio, later stage venture, buyout, mezzanine, and all private equity. Figure 2 shows venture capital returns have averaged approximately 25% for the past 20 years, while Figure 3 shows seed stage venture investing has averaged 33% in the previous 10 year timeframe.

Figure 2: VC IRR - Historical Returns

Figure 3: VC Returns by Stage
(For the Previous 10 Years)


Source: PricewaterhouseCoopers/VentureOne Source: Venture Economics/NVCA

Figure 3 also demonstrates that seed stage has outperformed every asset class in venture capital for the past 10 years, including balanced, later stage, mezzanine, and all private equity. Another venture industry tracking index, the Venture Economics' U.S. Private Equity Performance Index (PEPI) for historical returns provides further evidence of the superior performance of seed stage venture investing for the past 20 years (Figure 4).

Figure 4: U.S. Private Equity Performance (PEPI) Index

Venture Economics' U.S. Private Equity Performance Index (PEPI)
Investment Horizon Returns as of 06/30/2001
Calculation Type: Pooled IRR
Fund Type 3 Months 6 Months 1 Year 3 Year 5 Year 10 Year 20 Year
Early/Seed -3.3% -14.3% -20.6% 81.4% 55.1% 34.5% 22.4%
Balanced -2.6% -13.6% -16.1% 46.3% 35.5% 24.7% 16.6%
Later Stage -2.7% -11.3% -16.3% 28.3% 24.6% 25.4% 17.4%
All Venture -2.9% -13.5% -18.2% 54.5% 40.0% 28.4% 18.7%
All Buyouts 2.2% -1.7% -7.2% 6.1% 11.9% 14.4% 16.5%
Mezzanine 0.0% 2.6% 20.8% 11.0% 11.3% 12.2% 11.6%
All Private Equity 0.4% -6.0% -11.3% 20.1% 21.7% 20.2% 17.8%
Source: Venture Economics/NVCA

Although seed stage investing has consistently outperformed other private equity asset classes, it is also important to note its superior performance over other asset classes, including the public markets, hedge funds, and buyout funds. As shown in Figure 5, seed stage venture capital returns have beaten all other alternative asset and public market investment vehicles for the past 20 years as well.

Figure 5: Seed Stage vs. All Alternative Asset Classes


Source: Venture Economics, HFRI Equity Hedge Index

Notwithstanding the historical high performance of seed stage venture, it is also important to consider the performance of seed stage venture during recessionary periods. Recent quarters have shown that the venture industry is not immune to either public market conditions or economic cycles. Declining valuations, limited liquidity options, and the decline of the Internet sector are the primary reasons for the negative trend of venture returns. Nonetheless, for the one-year period ending 6/30/01, venture capital, including seed stage, returns have declined less than the public markets. Much of this decline can be attributed to the Internet "bubble" where equities were grossly overvalued. In Figure 6, seed stage technology investing has proven its resiliency over the dominant public company technology index, NASDAQ. In the trailing twelve months ending 2Q of 2001, venture capital returned -18.2%, seed stage venture investing was -21%, while the NASDAQ returned -36.2%. Thus, in one of the worst venture climates in recent history, both seed stage and venture overall are still outperforming NASDAQ.

Figure 6: Venture Performance vs. NASDAQ


Source: Venture Economics/NVCA

Despite the current negative returns, the long-term outlook for seed stage returns remains positive. It is important to note that seed stage returns are typically realized upon 5-7 year investment time horizons. Seed and venture returns have always been correlated to liquidity, and until the IPO market opens up again, returns will remain depressed. The National Bureau of Economic Research (NBER), the federal agency charged with examining the state of the U.S. economy, recently reported that the U.S. has been in a recession since March 2001. The good news for seed investors, however, is that the NBER also reiterated that recession markets typically last 11 months in the U.S., while economic expansion averages growth cycles of 50 months. Assuming the current recession follows previous economic cycles, investors should see liquidity markets opening again in late 2002. Venture returns, and seed stage in particular, will ultimately benefit from this resurgence. It is also important to restate an earlier fact that over the past 20 years seed stage venture investing has returned approximately 22% while venture capital has returned approximately 18%; and in comparison, the public markets have returned on average only 14%. Consequently, investors should feel confident that long-term seed stage returns will climb to their historical peaks.

Copyright © 2002, Henry Wong, Artemis Ventures

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