How I learned to stop worrying, and love dot.com 2.0

The $1bn flotation of US-based gaming company Zynga on Friday was a suitable ending to a good year for venture-backed flotations, or initial public offerings (IPOs). Even as the world seemingly teeters on the brink of another recession, many of the fast-growth companies created with venture funding in recent years that have made their way on to public markets appear to be the world-beaters of tomorrow. These companies have been created despite the worst global financial crisis, arguably since the 1930s.

The listings of Zynga, Nexon, RenRen, Groupon and LinkedIn (not forgetting to mention the forthcoming Facebook float next Spring, which is set to be the equity capital markets event of this decade) have caught the world’s eye in a way not dissimilar to technology euphoria a decade ago. Yet those who fear this to be another technology bubble should at least be glad of one thing: many of this generation’s stand-out venture-backed companies want to reinvest in the next crop of fast growth companies to come. For what its worth, this writer fears we are in a valuation bubble, largely because the debt problems of the developed world’s governments seem to have systemic implications that do not look like they have been priced in on the Nasdaq stock exchange or in some of the private company valuations for early and later-stage technology companies.

Zynga, for example, has invested in its largest venture shareholder, Kleiner Perkins Caufield & Byers’ sFund, that is targeting the next generation of social media businesses.  Japan-based Zynga rival Nexon, which raised $1.2bn this month, is pursuing corporate venturing on its own steam, backing South Korea-based gaming company 6Waves Lolapps this year. Smaller hot prospects, such as Box.net and CrowdStar, also recently set up corporate venturing funds, shortly after securing big rounds themselves. Other older shooting stars pursuing intriguing and developed corporate venturing strategies include Tencent, Google, Salesforce and Amazon (for more on the latter two see our forthcoming sector analysis in Q1 2012 available to subscribers).  It is also interesting to note incumbent companies are making decisions to partner with former venture backers. Earlier this year Microsoft teamed with August Capital to invest in advertising company Adchemy – August’s co-founder David Marquardt was the sole venture investor in Microsoft when he worked at Technology Venture Investors and insiders at both firms said this was the first deal the two had done together, although August has sold two other portfolio companies to Microsoft over the years.

The decision of new companies to invest in corporate venturing is good for two reasons:

1) Despite the eye-watering valuations these companies have achieved, their executives believe venture capital will be an intelligent way to make money for the foreseeable future and also presents a reasonable option to see potential threats or ideas as they emerge. If the present period is a bubble, it is one the companies involved in the possible euphoria buy into using their own high valuations and money-raising abilities to buy into others (similar to how Vodafone bought Mannesmann rather than the capital-destroying AOL-Time Warner deal during the dot.com 1.0 period around the millennium). This is no surprise, perhaps, given the successes these companies have achieved for their venture backers. Yet at least the seemingly smart money that has built multi-billion dollar companies from often simple ideas, see promise in entrepreneurs of the future. Their view is not just to take the money and run. If the current wave were concerned their success was in some way phoney, would they be so willing to risk their own cash on more of the same? However, that they are still effectively using ‘other people’s money’ to take these risks, whether it is venture backers or public shareholders’ means questions can still be asked – tracking the founders’ private investments and how it mirrors the corporate venturing bets is a more interesting and potentially more valuable guide to where they truly see value.

 2) These new companies entering the venture world potentially strengthen the wider ecosystem. Google Ventures, above all, has made significant impact on the venture sector in the few years since it took up corporate venturing in a co-ordinated way, and looks set to make a large mark on the entrepreneurial scene with its pledge to invest up to $200m a year, including in more than 50 seed-stage deals. This large scale commitment to venture has seen it tie up a number of times with the hottest firms in the past year including its former venture backers, Sequoia and Kleiner Perkins Caufield & Byers, as well as Salesforce and Khosla Ventures. If a few of the latest crop of corporate venturing prospects like Zynga or Nexon, become similar forces in venture, they are likely to be valuable additions to the wider entrepreneurial ecosystem. It seems to make intuitive sense that companies which have successfully disrupted their industry becoming venture capitalists would lead to a huge influx of original thinking into the provision of capital to entrepreneurial companies.  On the other side, it also suggests these shooting star companies are less likely to become stale, as they will be keeping track of innovation not only as corporations, but also through the different lens of investing.

Of interest is whether this interest in corporate venturing by the new stars of today is a good thing for venture firms themselves. The likes of Google Ventures being able to access the dealflow of Kleiner Perkins Caufield & Byers, potentially provides investors a way of disintermediating the top venture capital firms.  Should the more established corporate venturing units open up their funds to other investors in the way publisher International Data Group does with its second-generation funds round the world, charging smaller fees, the mystique of the top performers may lose its lustre, and their fees would presumably be forced down. But there seems little chance of this happening currently given the relatively few times the group co-invest.

Yet at the same time venture firms will benefit from closer working partnerships with companies that are the leaders in their sectors. Our editorial team thinks venture firms will actually benefit from the deal flow of corporate venturing companies over time, perhaps even more than the other way round. Effectively more smart people doing venture capital should lead to the sector flourishing in the long term.

Doubtless some of the fast growth companies that have floated at frothy valuations will become disasters for some public market investors. This will lead to a push back against the grandiose claims of the hot dot.coms of today, and a reduced appetite to subscribe to the next Zynga, Groupon or LinkedIn. Zynga’s first day of trading, with a 5% fall despite an early pop, suggest the animal spirits which have rewarded this year’s venture-backed crop are already swinging from greed to fear. Yet even if a healthy dose of scepticism returns to investors in go-go companies, the seeds are already being laid for a strong crop of profitable companies propelled forward by those who have been successful this time around. It is becoming more and more likely over-indebted countries and companies defaulting in the next five years will cause some kind of financial panic, yet the most innovative companies and far-sighted venture capital investors are positioning themselves to come through the resulting turbulence by backing entrepreneurs. This suggests creative companies will flourish even as the world’s economy is turned on its head. I hope I am right but let me know your thoughts.