How to invest like a VC in the hottest technology
If you want to get ahead of the pack in placing your technology bets, following venture capital money is a good strategy. Venture capitalists spend months parsing pitches from eager young start-ups, trying to figure out which have the potential to be the next Facebook, Google or WhatsApp. Right now VC investors are particularly flush with investment ideas and dollars.
In 2013, VCs pumped $29.3 billion into private companies, up 44 percent from the $20.3 billion in 2009, according to data from the National Venture Capital Association (NVCA). Two niches dominated the flow of VC bets on tech—software, which was lavished with near-$11 billion in VC investments last year; and biotechnology, which received $4.5 billion from VCs. VCs also bet near-$2 billion on IT services companies in 2013. Health care–linked technology companies have also caught the attention of venture capitalists. (See the full table of sector-by-sector 2013 VC investments below.)
The dollar figures have been steadily rising since the bleak period following the financial meltdown, and so has the enthusiasm from venture capitalists. "We are optimistic that 2014 is going to be a very good year," said Bobby Franklin, president and CEO of the NVCA.
One driver of the renewed enthusiasm is that investors are increasingly able to cash out. There were 82 venture-backed IPOs last year, the biggest crop since 2007, according to the NVCA. There were also 81 venture-backed M&A deals.
VC firms are instinctive crowdsourcers—mobile devices and applications, cloud computing and software services are receiving heavy bets. "Generally, there are two types of investing going on," said Howard Hartenbaum, principal at August Capital, which has invested more than $1.3 billion in tech. "Investors are betting on what looks like it can be a really great business, or investors are betting on something because of the perception that it's hot."
How can you think like a VC when it comes to the hottest tech trends? Here are six simple rules that VCs follow when betting on complex technology.
Where the VC money is flowing
|Business Products and Services||208,936,600|
|Computers and Peripherals||512,237,900|
|Consumer Products and Services||1,245,482,200|
|Media and Entertainment||2,927,607,900|
|Medical Devices and Equipment||2,109,286,400|
|Networking and Equipment||669,551,800|
1. Freeload on the freeloader economy like VCs do.
Companies like WhatsApp (on the receiving end of last week's $16 billion check from Facebook) and Tumblr (acquired by Yahoo for $1.1 billion) fit into the "hot" category despite the fact making money is secondary to attracting users.
"They are examples of companies that have huge user engagements—even if they don't have a business model," Hartenbaum said. Snapchat, a photo-sharing site where 400 million photos are posted daily, turned down a $3 billion offer from Facebook last year—and a reported $4 billion bid from Google. The customer base is king with these companies.
2. Share in the wealth of the sharing economy.
Venture capitalists like products that make people work together, and technology is creating new kinds of collaboration. Uber changed the limousine business, and Airbnb transformed the sleepy bed-and-breakfast business. Paul Straub, a director at Claremont Creek Ventures in Oakland, Calif., which manages $300 million in two funds, joined Volvo in investing $3.2 million in RidePal, a San Francisco-based bus service that can alter its routes on the fly to accommodate demand.
"It's Google Bus for the rest of us," he said, referring to the private bus services for tech-company employees that have caused friction with longtime residents in the Bay Area. Hartenbaum's firm has invested in RelayRide, which lets you rent out your car when you're not using it (Getaround is another example of this concept). The car-sharing service is now in 1,600 U.S. locations, he said.
(Read more: Why Google is tech's darling, not Apple)
3. Make your investments "personal."
In the post-industrial age, mass production is passé. VCs like technologies that bring a level of personal service unimaginable a decade ago. More than half of IPOs in 2013 were in biotech and health care, according to the NVCA, a dramatic leap partly due to looser Food and Drug Administration regulations for innovative companies.
Claremont Creek is betting on computational genomics, which has dramatically reduced the cost of sequencing genomes and promises drug treatment tailored to the individual. One of the firm's investments is Assurex Health, a Cincinnati-based start-up that uses a cheek swab to determine which psychotropic drugs or pain medications are most likely to work for an individual. Another is Natera, which uses a simple blood test to detect birth defects that once required a riskier amniocentesis.
Outside health care, August Capital has put its money on Gigwalk, a company that asks consumers to perform small tasks for big companies. Some 350,000 people have downloaded the software, which assigns users to check prices or missing stock in retail stores, do marketing tasks or take pictures of products in store windows. Gigwalk will alert a user of an available task when he or she is near a client location. A Gigwalk assignment can pay $20 to $30 dollars. "You can now have a worker driving around doing tasks for several companies," Hartenbaum said. Gigwalk customers include Frito-Lay, Nokia and eBay.
4. Love it or hate it, Obamacare will be an IPO moneymaker.
It seems everyone has had something bad to say about the Affordable Care Act. But where some Republicans see socialism, venture capitalists see a business opportunity. New York City-based Psilos Group Managers has raised more than $580 million in bets placed on the health-care economy.
Obamacare needs some tweaking, said Steve Krupa, a managing member at Psilos, but one of its core concepts is hugely important from a business perspective: "The most important part is a guaranteed insurance market in a certain price corridor," Krupa said. "That changes the game in health care completely."
Psilos invests in technology to improve care in hospitals and reduce insurance company costs. One investment is Patient Safe Solutions, a San Diego-based company that is taking on a 20 percent error rate in prescriptions by giving nurses a mobile device to scan prescriptions and verify the right patient is getting the right dose.
(Read more: An outrageous price for WhatsApp? Now hold on ...)
5. Yes, you should follow the herd.
Sure, a lot of money is flowing to cloud and mobile, but "the herd" is not the only reason to dismiss these tech niches. "Mobile is a fundamental game-changer," said Venky Ganesan, a managing director at Menlo Ventures in Menlo Park, Calif. "It's like going from radio to TV or going from rail to air. It's going to fundamentally reshape every aspect of our life (and economy)."
Ganesan understands Facebook's willingness to pay up for WhatsApp. "Getting a sticky mobile app (and mobile messaging is the most sticky app of them all) is equivalent to buying one of the few keys to the mobile kingdom."
Ashton Newhall of Owings Mills, Md.-based Greenspring Associates feels the same way about cloud computing, which provides computing power and storage on demand. It's been a hot area for investing in recent years." I worry more about pricing than overcrowding," Newhall said. "There are a lot of different verticals that are yet to go to the cloud. There needs to be infrastructure improvements, the plumbing."
(Read more: The right way to get ahead in the cloud IPOs)
6. Don't overlook the case for fundamentals amid all the buzz.
Even while VCs have to chase the hot start-ups, they look for solid fundamentals. And unlike the roaring years preceding recent bubbles, many investors prefer companies that turn a profit. Hartenbaum cited Zulily, the e-commerce site for infant clothes that had a $2.6 billion IPO last November.
Started by veterans of Blue Nile, a high-end jewelry site, the business was profitable from the start and could do $1 billion in business this year. The key is that the company can deliver personalized post-sale pitches to customers who will keep buying as their children grow, Hartenbaum said. "They are selling kids clothes to Mom. As soon as Mom makes the purchase, they know that Mom has a six-month-old boy. It's not a one-off thing."
Despite successes like Zulily, the venture capitalist said e-commerce as a niche has not been a winner—most sites have failed to make money. Another area that has failed to produce a winner is mobile payments, despite the obvious need. These missed opportunities are a reminder that no matter how much data you collect and regardless of the level of buzz, investing will always be a gamble. "We have general ideas, but there are always surprises," Claremont Creek's Straub said.
—By Joel Dreyfuss, Special to CNBC.com