Ten VC Prediction for 2010

Here's my Lux Capital partner Peter Hébert with a much-buzzed about

"Ten VC Predictions for 2010: Outrunning The Bear"

He who loses less, wins? Venture capital in the 2000s was much akin to the joke about the two campers who cross paths with a bear. As the angry bear begins charging out of the woods towards the campers, the first camper starts putting his sneakers on. The other camper screams, “It’s no use, we’ll never be able to outrun the bear!” And the first camper yells back, “I don’t need to outrun the bear, I just need to outrun you!”

Over the past decade, venture capitalists could claim top-quartile performance just by showing smaller losses than the rest of the pack.
The start of 2010 provides a clean slate—that is, after we break out the scorecard and grade last year’s predictions.

Last January, I envisioned a 2009 cleantech price correction, which pretty much hit the mark. While media gushed over the billions investors poured into cleantech during 2009,

Several VC-backed companies with valuations deep into the 9-digits opted for the M&A escape hatch (SunEdison, Optisolar), taking haircuts in the process. Other high-profile pioneers like GreenFuel closed up shop and called it a day. Even cleantech’s most promising ventures were unable to avoid the reset. Case in point: Solyndra, which just last month filed for its long-awaited IPO. The company’s valuation was recalibrated during its $286M Series F financing, priced at less than $4 per share, compared to a prior Series D-3 offering at $23 per share.

So what does 2010 hold in store for VC investors? I’m foolhardy enough to once again venture predictions. Behold the biggest stories in the coming year:

1) Venture-backed IPOs rebound smartly, with 50%+ first day price jumps on name brand offerings from Facebook, LinkedIn or Zynga. Among the S-1 clutter, another big beneficiary will be IPOs from smaller, little-known, and speculative-grade companies that also make it out. The visceral response to many IPO filings: Who?

2) At least one famed VC partnership fractures or sees an orderly wind-down, with insider gossip eventually leaking out. The changing of the venture guard moves full steam ahead, as weak fund performance from the lost decade finally forces LPs to question historic allocations to “franchise funds”.

3) A large, non-traditional investor enters the venture fray, boasting a very long fund duration (~20 years) vehicle focused on science and technology. Commence discussion on whether the traditional 10-year fund life makes structural sense for early-stage life sciences and energy investments.

4) Stealthy cleantech companies unveil. After years of intrigue and speculation, not to mention tens to several hundred million dollars invested, several energy technology companies finally lift the curtain and introduce themselves to the world. Will the emperor be wearing clothes?

5) Spike in biotech M&A. December 2009 served as an excellent indicator of what’s to come, with more than $1 billion returned to venture funds through the acquisitions of Acclarent, Calixa and Gloucester. Expect this month’s JP Morgan healthcare conference to play host to the industry’s ultimate speed dating session.

6) Semiconductors regain luster. After years spent languishing as pond scum in the VC pool, the public market chip rebound finally extends to its capital-starved, private brethren. Expect several IPOs and profitable M&A for some of the largest revenue generators.

7) Solar failures litter VC landscape. Schumpeter’s gale of creative destruction blows through the 250+ private solar companies. A handful of heavily-funded solar PV and CPV companies flame out, while sector leaders like First Solar consolidate their market position.

8) Energy investors swap wind and solar for abundant natural gas and carbon-free nuclear. Looking to replace a large swath of coal-fired power for base-load electricity generation? Natural gas and nuclear are not just attractive base-load alternatives—they are the only options.

9) Russian oligarchs and other foreign investors snap up late-stage U.S. tech. DST’s investments in Facebook and Zynga serve as a role model. Let’s hope they encounter more success than the sovereign funds that purchased big stakes in U.S. investment banks.

10) Return of the VC mystique. A counter-intuitive prediction, but one that reflects the above assumptions and data points. A select few IPO grand slams create massive returns and fanfare, sparking a resurgence of interest in the asset class. LPs actually begin to talk about new opportunities in venture capital!

My Take on 2010

Count me in the bullish category. In contrast to more cautious views in 2008, the venture marketplace has finally priced in reality. At Lux Capital, we’re finding far more value in venture investments today than throughout the 2000s. On a recent flight back from the West Coast, my seat-mate was a well-regarded LP, invested in many leading venture funds. He told me that he is “super bullish on VC”, more positive today on the asset class than at any time over the past 15 years.

Sure, there are structural challenges that serve as near- to intermediate-term headwinds. Outside of a few corner cases, public liquidity does not exist. Strategics are only now coming out of their shells to scavenge for M&A opportunities. Equity values have been crushed, wiping away years of incremental value creation. Investors today demand liquid assets that can be sold at a minute’s notice before the close of trading.

But historically, capital-scarce environments like today are exactly the times when fortunes can be minted. Genuine-article growth businesses are fetching valuations that bring later-stage share prices below seed rounds. New investors no longer require bubble markets to earn attractive risk-adjusted returns and gain some margin of safety. And don’t forget: in a slow-growth economy, venture capital is the only asset class that can create un-levered growth.

Weekly Insider (Guest Column- Cleantech & VC)

Proud to have my Lux Capital partner Peter Hébert provide a guest column this week. His insights on cleantech and VC must be heeded. Enjoy!

To paraphrase Warren Buffett: As prices fall, a huge amount of financial folly is exposed. You only learn who's been swimming naked when the tide goes out - and the financial shrinkage we're witnessing is uglier than George Constanza's worst nightmare.

It was in 2007 that adjustable-rate, subprime mortgages issued during the boom years began resetting to higher interest rates. During prior years, cheap capital from no-money-down Option ARMs (adjustable rate mortgages) helped flood the housing market with new buyers and pushed prices vertical. But when rate resets dramatically increased the cost of capital, buyers defaulted and home prices fell or were foreclosed.

I believe 2009 will bring a rate-reset for the cleantech investment sector (albeit, nothing close to the same scale!). When the cost of capital is low, investment dollars abound and valuations skyrocket. Too bad the process works in reverse too. Or as recent analysis from Lux Research (full disclosure: Lux Capital is an investor) summarized it, "The current bonanza in which all players are winners will come to an end."

If resetting the cost of capital pricked the real estate bubble, I expect cleantech's coming 2009 reset in this financing tundra to force scores of flimsy companies out of business, cause investors to realize losses, and significantly reduce unrealized IRRs.

Over the past few years, VCs and angels funded far too many undifferentiated business plans in a race to get "exposure" to cleantech. Solar, Biofuels, Wind. Touting cleantech credibility to their LPs left some VC portfolios with more "plays" than Bill Belichick on Sunday morning. Lux Research counted more than 1,500 start-ups operating in cleantech worldwide. All ventures had one thing in common-the cost of capital was far too low. This enabled turkeys to fly and hundreds of competitive imitators to gain funding, driving down long-term returns for all participants. But 2009 will see many of these companies return to the market for financings, to get to commercial scale or in many cases, just to survive the storm. It won't be pretty.

Value Trap

In my March 2008 post Something's Gotta Give, I said "I do not believe the disconnect between public and private prices can last much longer. Watch for a downturn in valuations for later stage VC deals when new market realities finally sink in."

Throughout 2008, as credit markets rumbled before the coming quake, VC-backed cleantech companies raised billions of dollars at valuations that increasingly departed from public equity comps. While blue chip shares plummeted by upwards of 75%, privately held solar companies with nary a dime of revenue, closed multi-hundred million dollar rounds with valuations pegged in the billions (yes, BILLIONS) of dollars. I know at least 3 private solar companies with post-money valuations over $1B-and dozens of other no/low-revenue solar, biofuel and battery ventures with values pegged in the hundreds of millions. Pity those late stage investors who bought the dream scenario and no margin of safety.

Why is tapping into a cheap cost of capital a bad thing? It's not-until the company seeks its next financing or a liquidity event. Later stage energy companies are capital vacuums. But the project finance well is dry and the cost of capital has surged. The need for money has forced punishing cram-down financings-for those still fortunate to receive fresh money. The resets are not just in price, but expectations. Most business plans I see still quote comps and commodities with pre-September 2008 prices. It's with no small irony that many of the private cleantech valuations now dwarf the prospective buyers mentioned in their pitch decks!

Stuck With You

While a 50% haircut on a subsequent round might still leave some early VCs in the black, it will be a hard pill to swallow for the later stage investors who signed up for what they were told were pre-IPO prices. During the cleantech boom, many early-stage VCs embraced two types of late stage investors willing to price up their earlier rounds by as much as 10x. On the one hand, the ultra-aggressive (and impatient) hedge funds and investment banks who adopted the "your price, my terms" philosophy. And on the other hand, bundler bankers who assembled less sophisticated doctors and dentists-perhaps under their own anesthesia, they were just happy to be there, much less negotiate the price they paid. The goal was seemingly: price the round up, take the company public and everyone wins. But now companies and their VC backers are stuck with both types of venture visitors...with no end in sight. Early investors should consider themselves lucky if the hedge funds or lenders do not take the keys to the company-and remain wary about lawsuits from individual investors who might feel they were sold a bad bill of goods.

The only sure thing: re-pricings will turn back the clock on paper profits (and IRRs) and require funds to choose: ante-up or get washed out.

The Opportunity

The irony: in spite of all of this, I could not be more excited about investing today in energy and environmental technologies.

Sure, the market stinks-but company valuations will at last approach levels at which investors can earn attractive risk-adjusted returns. The thinning of the herd will also separate the serious companies with scalable technologies from the pretenders. Imagine you had just been offered a $1 million house in Bakersfield, CA and just 12 months later, for the same price, you can get beachfront in Malibu.

The opportunity to apply new technologies to solve critical issues with multi-billion dollar addressable markets has never been riper. Breakthroughs in batteries and utility-scale energy storage, more efficient power electronics, and generation technologies like advanced nuclear and clean coal will yield billion dollar companies.

Bubbles get blown from too much trust and lofty expectations. The same forces that stimulate investment in a sector also leave naïve investors holding the bag. When the punch is flowing, judgment is impaired. A more sober environment is often the best time to invest in creative entrepreneurs to use capital judiciously and build extraordinary companies. I'll toast to that.

Peter is a Co-Founder and Managing Partner of Lux Capital, focusing on investments in advanced materials and energy. In 2003, Peter led the spin-off of Lux Research.

Weekly Insider (Inches, Ounces, Rant on Rants)

A rant on all the rants: Remember this: as they say in my native Brooklyn: the one thing you can know for sure-- nobody knows nothin’.



Expectations and emotions rule the day. The market looks and feels like a skateboarder on a half-pipe: up-and-down and up-and-down, a few tricks that wow the crowd, eventually investors (the skateboarders) will adjust to (or tire of) volatility and things will settle down. High expectations give way to low expectations. Remember also: when climbing a mountain, good news adds a few feet, bad news send you off a cliff.



My friend and fellow investor Mike G wisely wrote, “Whatever the case, I stand proudly by my aversion to fiction — no writer’s imagination compares to the actual unfolding of history”.



Just check these two WSJ blurbs and remember: Do not act in desperation, else you’ll suffer gambler’s ruin. “On Monday night, after a day when stocks took their worst hit in years, Don Case bought a lottery ticket on his way home from work. Mr. Case, a 42-year-old data analyst in O'Fallon, Ill., is worried about the stability of the life-insurance policy he bought a few years ago from AIG…he's also concerned about his 401(k) and his…college savings plan. With a venerable institution like Lehman Brothers Holdings Inc. crumbling, "I'm sure all companies are vulnerable," he says. "If I win the lottery, I won't have to worry.”



The second headline read: “More Firms Tied to Tainted Formula”. It took me reading an inch of text to realize it was about ounces (ie. China baby formula) not equations (ie. flawed Black-Scholes, and all financial models based on normally distributed bell-curves). It ain’t what you don’t know. It’s what you know for sure that just ‘aint so.



Yes, it was the filling of a recipe for baby's food--not the falling of a recipe for disaster. When will the Nobel committee revoke an award for a failed theory? When will business schools stop teaching “professional” finance practitioners Black-Scholes and mean-variance theory as a measure of risk It’s like the doctor who teaches his medical students an outdated and incorrect procedure because its easy to teach: our financial businesses and our business schools teach incorrect formulas. 'Tis better to be roughly right than precisely wrong. Will someone –ahem, New York Times—please also hold Ben Stein accountable for being precisely wrong.



Here’s what you need to know: as a person or a business: if you spend or borrow more than you make or have you risk going broke. Nassim Taleb long ago called it. Bleed vs Blow-up. Make money, make money, makey money... file for bankruptcy. When banks were brokers they were fine. They were in the moving business, not the storage business. This business model is a "sold lottery ticket", an insurance claim or a sold-call on your equity and assets (remember Liabilities=Assets-Equity). Think of a lottery operator that sells you lotto tickets. Every day he collects a little bit--when the payday comes, you claim his stuff--all of it. All these banks were like a “7-11.”



VC is the inverse, we bleed a little everyday, spending, spending, spending...homerun.



Simply put: here's what's happening: credit contraction, asset deflation.



It’s the mirror image of what happened. Equity bubble, housing bubble, credit bubble. Capital was cheap. Lots of dollars. Residential construction boomed then peaked. Home prices boomed then dropped. Credit expanded then stopped. Profits rose, then fell. Employment rose, then stopped. Consumers spent then recessed. Lots of dollars meant cheaper dollar. That will change.



Jeremy Grantham was right. Profits are mean reverting and we're in a secular bear or range bound market, with lower earnings, smaller P/Es, stock prices falling and people selling what they have to.



What will happen: Interests rates rise. Dollars rise. Jobs fall. Stocks fall. Fund of funds redeem. Hedge funds sell. Stocks fall more. Maybe, just maybe time horizons lengthen, attention spans lengthen, reporting periods lengthen (hundredths of a second tickers on CNBC, monthly redemptions, quarterly reporting add only noise). Distressed sellers sell. Some go to the hosptial, some the morgue. Cash-rich buyer buy. Others save-or start.



If you didn't think you had to save, you spent. If the stuff you owned went up, you could always sell it later--until you couldn't. Tech stocks, your house. Like the scene from Bronx Tale, "Now you's can't leave".



‘Global warming’ takes a back row to ‘global meltdown’. Investors in project finance lose shirts. Reputations fall. Oil and commodities fall. Decoupling is debunked. Emerging markets have emergencies. Radical Islam took root in Indonesia after '98 Asia collapse. Hitler took root after Germany's post WWI economic collapse. Castro as Battista looted Cuba. Attention will turn to new theaters of operations: Venezuela, Pakistan.



Here’s what worries me: Dictators and despots rise when economies fall. It is the desperation of the destitute, their hopeful ears and nodding heads, that fashions his sword and forms brigades behind him--and marches.For the long term, I'm less worried about "Fuld folding", than "Putin's Put" or the "Chavez Shuffle".



If you think there’s safety in the crowd, come join the crowd next month in Boston at the Lux Executive Summit:

http://www.regonline.com/Checkin.asp?EventId=618658