According to Pagemill Partners, a well-known Silicon Valley venture capital (VC) firm, the number of semiconductor companies spawned with VC funding has been steadily declining for nearly a decade. In 2003, VCs gave life to 63 new chip companies. Last year the number was 13. It’s a trend that promises to reshape the semiconductor industry. (Note: the figures reflect companies formed in North America, Europe and Israel.)

Established chip companies planning to expand via acquisitions should take notice. Fewer start-ups mean two things will likely happen. First, a feeding frenzy will ensue for the handful of hot start-ups demonstrating impending dominance in their respective markets. Second, limited supply of these successful upstarts will force would-be suitors to rely more heavily on their own R&D organizations for new product development and revenue growth.

The problem with relying on internal R&D is that many executives will learn the hard way that their development organizations are not up to the task. They’ll discover R&D initiatives plagued by low R&D productivity, poor schedule predictability and missed market windows. Division by division, these groups probably will be shuttered or sold off to bargain hunters.

VCs are turning away from semiconductor investments because the return-on-investment (ROI) simply isn’t what it once was. Buyers won’t pay the risk-adjusted price premiums VCs demand. Today, some VCs claim their investments are nothing more than R&D subsidies for established semiconductor companies—and the free ride is over.

Imbalance in the ROI equation stems from the increasing investment necessary to develop complex chips—upwards of $100 million for a system-on-chip IC. For investors to part with that amount of cash, they must see a clear path to a $500 million to $700 million liquidity event. Buyers are loath to pay those prices in all but a few cases. That’s because they don’t think they can extract the requisite sales revenue from the end market to justify the purchase price—often due to cut-throat competition, which is pushing down revenue and margins faster than ever before.

On the other hand, buyers do seem willing to pay $150 million to $250 million for winning start-ups, which means that if VCs serve up companies whose cumulative investment is $30 million to $40 million, we’ll see a steady stream of win-win deals. Toward this end, VC’s are funding specialty chip companies that require substantially less capital, such as those developing analog, RF and mixed-signal chips.

VC firms raising exceptionally large investment funds will probably sideline themselves from the semiconductor game—$30 million to $40 million investments are usually too small for them to justify, especially since the investment is often divided among several firms. But that simply means smaller VC funds will take up the slack.

Another path investors will surely pursue is off-shoring R&D to lower cost geographies, where the size and quality of the labor force has been growing during the past decade. This will reduce start-up costs by 25 percent to 50 percent, or even more. But it will be quite a while before the supply and demand for these offshore-based start-ups comes into balance. Between now and then, semiconductor companies will need to rely heavily on their own R&D organizations.

Originally published at: http://www.eetimes.com/electronics-blogs/r-d-roi/4229889/End-of-the-free-ride#