By Chris Prestigiacomo

I recently spent time in Palo Alto and San Francisco with a few of SWIB’s Catalyst Portfolio venture capitalists. In addition to updates on portfolio companies and fund performance, discussions about industry trends were of interest.

Opportunities primarily revolved around the information technology sector, with an emphasis on social, mobile/wireless, consumer internet, disruptive cloud technologies and network security.

This was no surprise. Companies and technologies targeting the social graph and wireless/mobile space, especially the intersection of social, local and mobile, represent the “Holy Grail” of consumer Internet companies.

One reason for the interest in IT-based start-ups is capital efficiency and their ability to scale. No longer do companies need to invest in hardware or software. They can outsource their network requirements to the cloud and rent the software at a fraction of the cost of a decade ago or get it free. These companies need comparatively little capital to launch and are one of the primary factors why the IT sector has received much attention from VCs over the past few years.

When asked whether today’s start-ups focused on social or consumer Internet space are in a bubble, the response from the VCs was “no.” The companies we met had business fundamentals to support the interest shown in these sectors. Unlike the late 1990s, VCs and managers are cognizant of revenue and cash flow. Once the market validates the business, either through revenue or unique users, scaling the business becomes the focus.

Social is the hot sector in Silicon Valley, especially since Facebook announced plans to go public. From Facebook’s beginnings to make the world more open and connected for the “social good” to becoming the favored method for more than 800 million users to communicate and interact, it has created a new business model for startups. Companies, whether operated on the Facebook platform or not, are being created and funded by VCs. Important commonalities among these companies are unique customer experiences, ease of interface, the ability to generate and share content and mobility.

Two human attributes play a role in why these types of companies succeed. First, most people yearn to be creative but many lack the will, or resources, to do it publically. Second, there’s a push to engage consumers and provide individualized experiences, and have them share this with others.

Users generate web content through blogs, wikis, photo and video-sharing applications. The most amazing thing is individuals can do this without knowing how to build a web page. Users form communities through social networks or virtual worlds (think gaming) to interact, collaborate, share and consume. Successful start-ups in this sector share the ability to create an amazing experience users want to come back to again and again.

As the saying goes, “it takes 21 days to create a habit,” and companies that can create a compelling, easy-to-access experience, will attract traffic and eventually customers, albeit not paying customers at first.

That brings me to another topic discussed: revenue generation. Creating the consumer experience and brand to build a core user base before monetizing the site is critical. Careful planning of how and when to introduce revenue generating opportunities is also critical. It can take years before a company will begin to offer a “charge for service option” or use advertising, such as banner ads. The key is to build the best user experience first, creating the consumer “habit” then strategically layer in the revenue components over time.

Another hot topic was life science and healthcare. Life science start-up companies focused on medical devices or drug therapeutics have found it more challenging to access venture capital dollars over the past few years compared to their IT brethren. Long-time horizons, regulatory hurdles and needing large amounts of capital to commercialize and/or exit an investment have contributed to funding challenges. That said, the VCs we spoke to believe the current macro environment in the life science/healthcare industry offers much opportunity.
These trends include:

· A focus on innovation to improve human health and well being
· The FDA’s willingness to collaborate more with young companies
· Greater market acceptance of outside-U.S. clinical trials and studies
· Consumer growth in emerging markets for new devices and therapies
· An aging population willing to spend money to improve quality of life
· Strategic buyers flush with cash and no internal R&D desperate for new products
· Better early stage company valuations as a result of less venture capital availability (due to the rationalization of the number of VC firms or to strategy shift from healthcare to IT)

A common theme among VCs in Silicon Valley was “investing with a partner(s) in mind.” It’s a “build to buy” strategy in which a VC will invest in a company just before or after it has received interest from a strategic partner (or hopefully buyer). These strategies are growing more popular with partners paying something up-front, agreeing to fund the development/regulatory costs (possibly paying out some cash along the way based on milestones) and the option to purchase the company at a pre-negotiated price if things go well.

While this takes upfront work from the VCs, if such a partner can be identified, VCs and investors can protect some downside risk. This downside protection comes at a cost with investors giving up some upside return. The tradeoff may be worth it as limiting the downside can enhance returns especially under traditional venture capital models. These VCs remained bullish on life science and believe life science venture investing can generate very nice returns.

Prestigiacomo is the portfolio manager for the private markets group at the State of Wisconsin Investment Board.