Red Herring has been running a series on the venture capital overhang and how it might be affecting the current venture valuations. This series is really more a look at how the venture business has matured. An old VC hand (started in 1969) explains that companies which used to require $2-3M then require more than $20M today. The venture business has commensurately evolved from a cozy club to a competitive cauldron. With it have evolved the deal structures.
The cozy world followed the original Capital Efficiency Model. Just enough was put in to get to the next milestone, and when reached the next round was done largely directed by insiders. The transaction cost to the entrepreneur was not large. This model began to break down during the PC Mania of 1978 - 1983, which had a similar frenzy of stupid deals (Kentucky Fried Computers is my favorite proto-dot-com), inflated valuations and eventual bubble. The quick IPOs drew in many new VC funds, and money flowed. Valuation inflation encouraged entrepreneurs to go to the free market to get higher valuations from new investors.
The cozy world thus gave way to the Free Market Model. In the PC bubble days, this worked fine, as the transaction cost of raising the next round was not large. In the post bubble period, the difficulty of finding new capital at attractive valuations dramatically increased transaction costs between rounds. A new model was experiemented with in the late '80s: treating venture finance more like project finance, with milestones and tranches agreed to in advance. One of the first proponents of this approach was Miles Gilburne, then a partner at the Cole Gilburne Goldhaber fund, and later a senior executive and director of AOL. Miles had first applied this approach to computer contracts in the late '70s with Dick Bernacchi of Irell & Manella in LA. Dick is one of the pioneers of computer law. (I should note that I had the pleasure of working for Dick shortly after Miles left for his own firm). The milestone approach lowered the cost of raising the next round and re-created the capital efficiency model in a more structured fashion. This approach is complex, however, and was not widely followed. The free market and its attendant costs held sway until the Internet Bubble in the '90s.
The Internet Bubble brought a new wave of funds as well as much larger funds, and with them emerged the Fully-Funded Model: fund the venture in one fell swoop to expected break-even. In a hyper-competitive environment, this locked in the supposedly hot deals to one fund, and put more money in play for the same effort. It greatly lowered transaction costs between rounds and presumably let management focus on winning at Internet Speed. It also let management overspend, and that they did. The Zeitgeist was captured in the 2001 Super Bowl ad Dot Com Graveyard, a spot every bit as worthy of Apple's 1984 ad. (The spot opens with a chimpanzee riding a horse through a ghost town of the remains of fictitious Internet companies, such as PimentoLoaf.com and TieClasp.com. He sees empty Aeron chairs swaying in the empty offices. As he rides, the infamous sock puppet lands at his feet, looking weathered and worn. Like the crying Indian in a famous pollution spot in the '70s, the chimp sheds a tear. It was the most talked about ad of the year.) As the dot-com bubble burst, so did the fully-funded model.
During the bubble, an interesting corporate venture approach emerged, led by Cisco: to finance companies with a Put/Call Acquisition Model. If the company hit milestones, they could call an investment by Cisco, or an outright acquisition, under a pre-set valuation price or formula. If they missed milestones, Cisco could nevertheless invest or acquire, at a lower value. This allowed the companies to accept corporate funding without at the same time pre-empting any alternative bidders, which would depress their eventual exit.
Post-bubble, many venture firms went back-to-the future and returned to smaller funds and the New Capital Efficiency Model. The new model is to fund just enough per round, but rely on the free market for next-round valuations. This is really a return to the standard model for the post 1983 era. It comes with the same higher transaction costs for entrepreneurs.
The larger funds have instead moved ahead with a new Milestone Model: put more money at play, but in tranches based on milestones. Unlike Miles Gilburne's project finance model of the late '80s, the new milestone model does not use the milestones to micro-manage the company's spending; the concept is to combine the discipline of the capital efficiency model with lower transaction costs of the fully-funded model. The tranches are designed as puts and calls: if the milestones are met, the company gets to call the money at a pre-set value; if the milestones are not met, the venture investors can still put the money at the same or sometimes a lower pre-set valuation anyway. The model is similar in structure to Cisco's put/call acquisition model.
We are now in a Bubble Echo. Venture valuations are rising. We shall see if competitive pressures causes a return to a 'New' Fully-Funded Model rather than a continuation of the discipline of the Milestone Model.