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Roughly eight years ago, I had lunch with an ex-McKinsey colleague who had started a venture capital firm. His partners were raising a second fund. He was leaving. I wish I had taken notes, but his message was that the industry did not work. He went through the deals done in the previous decade (remember, this was 2004), the returns were concentrated in a small handful of firms. And if you looked at those firms, their returns came from a remarkably small number of deals. I’m pretty sure I’m not exaggerating that his analysis said that if you took the top ten deals out, the industry returns would be subpar. And once you got further in the decade, the returns of these deals would roll off and would no longer be included in the pension fund consultants’ analyses, and thus would lead the industry to be deemed (correctly) to be less attractive and would have less in the way of funds allocated to it. This is critical because if you are in the fund management business, the saying goes that 75% of the work is raising the money.
Confirming the soon-to-be-ex VC’s grim forecast, earlier this year, the Kauffman Foundation, a major investor in venture capital funds, released an extremely critical analysis of both industry performance and the willingness of VC limited partners to accept lousy deal terms and limited (as in unreasonably limited) due diligence on the funds.
Despite the enthusiasm of bright young things to get on venture capitalists’ radar, I’ve also seen inventors do everything they can to steer clear of venture capitalists, at least any time before the late stages of their venture (where a round of funding from the right names is enormously helpful in getting a big Wall Street firm to handle your IPO). The view among quite a few more seasoned inventors (and their attorneys) is that VC is too costly in monetary terms and comes with too many strings attached, both in terms of interference and in that they usually over time displace the founding team for not having the right resumes and “look” an IPO. While it is often true that the founders may not have the skills to build a larger organization, I’ve often seen them bring in “talent” which has the right resume but managerially is not all that much better.
Nevertheless, venture capital is romanticized as one of the drivers of the American economy, when entrepreneurship expert Amar Bhide has ascertained that only about 1% of new ventures are funded by VC. A story today the Mercury News (hat tip bob) on how the poor performance of VC this year is part of a longer decline, raises bigger issues about the trajectory of the economy and the role of venture funders in it. It may simply be that (contrary to the McKinsey VC’s forecasts) funding levels have not fallen in line with the industry’s performance, and it needs to shrink further so that there aren’t too many investors chasing too few of the hot deals. It may also be that the VC industry is a casualty of the global financial crisis, in that individual investors remain skittish about the market, and their reservations are reinforced by high frequency trading, which leaves the little guy at a disadvantage. But predictably, even though the article makes it clear that the problems with VC are long-standing, many of the fund operators want to blame it on “uncertainty,” which at least on this coast, means the government.
[T]he venture capital industry has been down for more than a decade, long enough and deep enough to make me wonder: Is venture capital in a down cycle or a death spiral?…. it remains difficult to identify a clear path for turning things around for the battered venture capitalists who make Silicon Valley hum.
• Venture capital firms invested $6.5 billion in 889 deals in the U.S. during the most recent quarter ending in September. That’s down 11 percent in dollars, and down 5 percent in the number of deals, from the second quarter, according to the PwC/NVCA MoneyTree report based on data from Thomson Reuters. At that rate, the numbers for 2012 are expected to be below 2011.
• The venture money being raised is going to fewer firms. In the second quarter, the NVCA reported that 80 percent of all venture money was raised by just five funds.
• The number of venture firms has declined from more than 1,000 a decade ago to 462, according to the most recent NVCA numbers.
The article later gets around to the issue we raised earlier, the state of the stock market. Volume is crappy when you back out HFT. And even though mergers are another exit strategy, M&A prices are usually set with reference to IPO prices. Few IPOs results in lower M&A prices (a less robust IPO market means M&A buyers already are likely to be looking at lower prevailing cash flow multiples, plus they can bargain harder because they know the VC companies have fewer options). Again from the article:
So what’s wrong with the VC industry? The problems are many and complex. But they can be boiled down to this: Not enough exits.
For the size of venture capital being raised and invested, there simply aren’t enough initial public offerings of stock to generate the returns that funds need. Compounding that: mergers and acquisitions are also way down this year. That’s another way VC firms and their partners make money on their investments.
Venture insiders blame the global economic uncertainty. They believe that is part of the reason that giant corporations, which have amassed huge piles of cash, are just sitting on it, rather then using it to acquire startups.
“The numbers are way down,” said Ray Rothrock, a partner at Venrock. “All these companies with these fantastic balance sheets, and nobody is really buying anything. With all the uncertainty they’re facing with the economy and taxes, buying little companies is way down on their list. Liquidity is way off and that makes everyone grumpy.”
“Uncertainty” is so disingenuous. How about: “The financial services industry blew up the global economy and it still hasn’t recovered. What little recovery there has been had gone almost entirely to the top 1%. And you wonder why no one wants to invest?”
But over at Slashdot, the headline on this same story (which has all of one mention of the fiscal cliff, close to the end), the headline is “Amid Fiscal Uncertainty Venture Capital Is Way Down In Silicon Valley” and the comments are overwhelmingly about monetary and fiscal policy, not about the state of tech investing. As bob noted, “The fiscal cliff is the “cause of death” to venture capital as the staircase is to the guy who chain smokes and lives on nothing but McDondalds and beer.”