A massive shakeout of venture capital firms has been predicted for years but it is finally going to happen over the next year because of a perfect storm of timing.
There are countless books, a few movies and mountains of silicon valley gossip about the good times of venture capital. Huge returns from the Internet bubble bred too many people who thought they were smart because they were rich and it seemed as if new funds were popping up all the time, staffed by VC wannabes from investment bankers to millionaires from companies like Netscape, eBay, and Cisco. As one of my investors said at the time "everyone wants to be a venture capitalist, even the landlord".
But that era came to an end 9 years ago now, and 10 years is the critical period for the venture capital industry because funds are 10 years in length so I predict the decimation will start by the end of this year (although some like Venture Beat are already counting the corpses).
The perfect storm will create an inability for all but the best firms to raise money - and funds need to keep raising money to stay alive - but they face a tempest:
- The 10 year look back will not look good for all but a very few by the end of this year. With the exception of a handful of funds, the great returns came off funds that started before the tech bubble burst. It burst in 2000 so by 2010 the look back will not include liquidity events in 1998 and 1999. Even some of the best firms don't have great returns over the last 10 years.
- Major LPs (limited partners like pension funds and endowments) are having to balance their portfolios away from alternative investments. Imagine you manage an endowment or pension fund that has a restriction on what percentage can be invested in alternative investments (like venture capital) . But the equities portion of your portfolio has dropped by 40% so now your venture capital portion is over your limit. You can't invest more in venture capital even if you want to participate in a new fund.
- For years now about $2B a year in new money was flowing into the venture capital world from new LPs. This was new family money diversifying, or countries bringing a portion of their sovereign wealth fund into venture - but now if you are a newly wealthy South American land owner and have a $100M that you are being advised to invest in higher risk/higher growth you'd look back at the 10 year returns of venture capital and say "no thank you".
- The IPO market is broken so smart investors know that the rates of return for venture capital will continue to be depressed. Being acquired just doesn't carry the same multiples as an IPO - especially now when buyers are taking advantage of the difficulties small companies have raising money in a recession.
Even the best funds are working harder than they have every worked before to raise their new funds. NEA has closed on over $2B of their $2.5B raise, Oak Investments will succeed in raising their $1B plus fund because the same small group of partners has been repeatedly successful over more than 20 years - as will the best of the best like Sequoia, Benchmark, Sutter Hill, Kleiner-Perkins et al when their time comes.
But we're seeing a significant flight to quality as the funding so far in 2009 is down almost 40%. LPs will be ruthlessly selective and this will weed out the new, the small and the weak.
The coming contraction will cause the startup industry to return to fundamentals. Good ideas into vibrant new markets that take 6-8 years to blossom not 2-3. Some in the valley think this will lead to less innovation but I disagree. I think we'll get a higher quality of company because great new companies don't come from the spray-and-pray approach - they come from creative, hard working entrepreneurs working hand in glove with nurturing investors and customers over a considerable period of time.
There are about 700 venture capital firms in the US according to the National Venture Capital Association. I readily admit I'm opinionated and think that probably less than 10% of these are really valuable to entrepreneurs (my friends who are partners in the best firms listed above would say the quality list is less than that!). As I've posted before - all venture money is not equal - pick your investors very carefully.
I predict decimation - but I realize as I conclude that I am not using the word correctly because it comes from the Latin for the destruction of one tenth - but I wonder if one in ten will be left standing? Will there be as many as 70 US venture capital firms two years from now?
And you may ask who cares in these tough times? As long as critical breakthroughs in new technology - from clean energy to bio technology to the way we communicate - come from innovative small companies as they often do today we all care.
The bottom line is that "long term greedy" needs to come back in vogue and "short term greedy" needs to go back to being the purview of middle schoolers out to steal lunch money, where it always belonged in the first place.
That investors do not understand the technology is not surprising, though. It's almost impossible to judge modern technology R&D without being an active scientist or engineer in the field. It's just too complicated. Some of the better VC firms have in-house experts and analysts, but even that's of questionable approach.
What really makes life hard for companies with VCs on the board is the interference in business decisions. It's hard enough to run such a business without someone without knowledge of facts interfering...
I do agree that the 2-3 year cycle that many investors dream about is probably nothing but that... a dream. 5, 10 and sometimes 15 years (in biotech, for instance) are more realistic funding cycles. Returns of 400% (or tens of thousands as in the case of Google and some other internet startups) can also not be expected. The average biotech return seems to be more around 125%, which is not much better than a good CD... but much, much more risky.
Venture Capital is down, Leverage Buyouts are down. When good times return, they will be back, or not.
As long as 3 things essential for economic growth " Property Rights, Markets, Monetary exchange" are not tinkered with, there will be companies seeking to innovate so they can profit.
BTW, average lifespan of a portfolio company for a Private equity fund is just over 10 years. but dont tell media that, according to them PE companies are evil.
In reality, PE companies have much longer time span than your average ceo of a company.
My exposure to VC funded companies does indicate, however, that even in funds that have ten year spans, investors expect to see individual investments to return money much sooner than the end of the fund. I can't name names, of course, but the boards of the companies I know are stacked with VCs and many management decisions are being made with regard to short term investor expectations and not with long term corporate strategy in mind. That's the reality of accepting VC money... you sell your soul to the people who bought the boardroom table for you.
He was talking to biotech scientists, of course, basically making the case that new biotechs will have to make significant changes to their R&D schedules to attract new investors.
But, you see, everybody who has ten million dollars to put into one of these funds probably has the $50 to $1500 (depending on venue) and the day or two of spare time to attend these conferences and to listen to both scientists and VCs about the future of the business. If they don't... they deserve to lose their money.
It's the same with every innovation-based boom and bust. But the whole point of venture capitalists should be that they have the firm-specific knowledge and endurance to withstand it. That's what they're doing. It's their job and daily bread.
Let's hope that web 2.0 and green energy and biotech and all that is just around the corner. And let's hope investors have learned their lesson about how to determine that high-risk high-return piece of their portfolio.
If venture capital would indeed suffer beyond repair it would be a disaster, but why would it? There may be a 'legacy' problem, as with banks. But there's nothing wrong with the business model, if done right.
I agree with the basic premise of this post: venture capital is dead as we have come to know it. I believe it may be resurrected in some other form. This type of investment is really more of an art form than science and will not fit a particular mold that is generally taught in business schools. You need people with razor sharp instincts that can readily size up people who approach you for VC. Pencil pushers need not apply.
Money continued to pour into venture funds well into the middle of this decade. Some of the funds will start to go belly up, but this cycle will continue for years....and the deadening effect of too much capital pursuing too much stupidity will have a long life.
What shape is the VC industry in if Twitter is the most exciting thing around???
This will indeed hurt the economy and innovation. The shotgun approach to Venture Capital is not bad, in between the stupidity and scams, true gems do happen. Do not worry for Kleiner Perkins, Sequoiah, and a few others, they have learned how to scam the Govt. and the "Green" future. Laws and regulations will be passed that will secure their future.
Much of what I witnessed with regard to start-up dot com funding oftentimes was influenced by relationships and NOT common or business sense. While relationships matter, there persisted the tech era habit of VCs funding laughable business models because those doing the pitch happened to have been lucky enough to be a founding employee of google, yahoo, goto, or any xyz comapny that went through the stratosphere, even if it eventually crashed and burned. As you stated, riches to not necessarily equate to smarts, president bush II being one perfect example.
Having been at the eye of the storm during the 90's dot com bubble, even then, most knew it was just a matter of time. I saw first hand, freshly minted HBS grads get funding for bad business models, simply because they had the ivy sheep skin. It is long past time for the many who mistook their luck for intellect and aptitude to come back to earth.
Thanks for the insight.