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06/29/2010 05:12 am ET Updated May 25, 2011

Venture Capital Danger: Angels and Thunder Lizards Ahead

You may find this hard to believe, but there's some evidence that venture capital is facing the same kinds of threats that the big music labels found themselves struggling with just a few years ago.

It seems that VC's, and the things they bring to entrepreneurs, just aren't as important as they once were. And there is new competition making it harder to build and run a successful VC firm.

Who's raising the alarm about the future of venture? Well, it seems, the venture capitalists themselves.

Venture capitalist Randy Komisar recently told Venture Beat that web startups may not actually need his money -- at least, not right away. Komisar is a partner at Kleiner Perkins Caufield & Byers. "So why do we need venture capitalists?" Komisar asked. "They may not be as important." That means he might tell an early-stage Web startup looking for funding, "You get my money later, at a higher valuation, when you need to accelerate a good idea to a great one."

A look at the market place shows three critical things are changing. First, the nature of VC itself, then, the elements startups need to be able to turn an idea in to a working prototype and even a business, and lastly the emerging power of the sector know as Angel Investors.

Finding the "Fun" in Funding

Standing in a room full of startups that haven't needed venture capital, a VC has to feel a bit uncomfortable. But David Aronoff is very much at ease. Aronoff was presenting the 'Future of Venture Capital' to the companies housed in one of New York's fastest growing incubators, Rose Tech Ventures. Aronoff is a partner at Flybridge Capital, and he says venture needs to reboot.

"Today there's an overabundence of similar ideas, and too much capital," says Aronoff. "The result is that VC's loss ratios go through the roof and limited partners lose patience with waning returns."

To make the point, Aronoff shows this slide, based on Harvard Business School research, which presents a grim picture of the returns for a full 95% of all venture firms. There are a handful of big, brand name, well-known firms that generate outsized returns. For the rest, the returns can be underwhelming.

Venture Capital Returns

What does that mean for the future of venture capital? "The number of VC's must shrink," says Aronoff. By some estimates the 1500 firms today will be just 500 within 5 to 7 years. This will mean less venture dollars, less funding and smaller rounds says Aronoff. But that may not be a bad thing.

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Adventures in Startup Land - without Venture $$$

It wasn't very long ago that businesses needed a whole bunch of physical and expensive things to get off the ground. Offices, desks, phones, computers, people and therefore dollars. But innovations like Skype and Amazon's scalable cloud infrastructure, and open source software have changed all that. Shared workspace like the Rose Tech Incubator or Brooklyn's New Work City make it possible for a small team to turn sketches on the back of a napkin into working code and often customers.

Bootstrapping, ultra light startups, or lean start-ups: the phrases all mean the same thing. Smart, small, driven teams with little or no money at the outset.
The New York Times reports: "Erik Brynjolfsson, a professor at M.I.T.'s Sloan School of Management, lists the business benefits of modern Internet technologies as new frontiers in measurement, fast experimentation, sharing information and insights, and the ability to get big fast."

The result of more, smaller, faster companies building and innovating is that the conventional metrics of Venture Capital have trouble finding a foothold. Needing less money means more entrepreneurs are looking to smaller early rounds (seed funding) and finding that seed funding comes from a new class of emerging investors -- known as angels.

Angels with Dollars for Wings

"Venture capital has to reinvent itself for this world," says Mitchell Kapor, an angel investor who has made 25 investments in lean start up companies in the last two years.

Angel investors began as smaller money, often more casually organized around friends and family with simple terms and relatively little money at risk. But the angel investor has grown into an important, highly active, and increasingly professionally organized category for startups looking for smaller early stage investments in lean startups.

Bloomberg's BusinessWeek reports that angel investing remains active, if not somewhat cooler last year. In 2009 "some 259,480 angels invested $17.6 billion in 57,225 entrepreneurial ventures, according to the University of New Hampshire's Center for Venture Research. The number of ventures held steady, compared to the previous year. Funding levels were down 8.3% percent but that's a heartening number when you consider that the recent downturn in the U.S. was the worst since the 1930s."

Angel investing accounts for almost as much money as venture capital funds combined (2007 US $26 billion vs. $30.69 billion) but in to a far larger number of companies (57,000 companies vs. 3,918 companies).

Dark Clouds on the Horizon for Angel Investments?

The Financial Reform bill from Senator Chris Dodd (D.-Conn.) has three provisions threatening to negatively impact angel investing. The Dodd bill requires money-raising startups to register with the SEC, which would get 120 days to review the filing. Currently high-net worth individuals don't need to invest in registered vehicles. The wealth and income baselines for Angels would also double.

Angels and Startups alike see these provisions as "anti-angel" which would mean anti-startup. That's not a good thing. But there may be amendments to these provisions if entrepreneurs and angels get their way.

Are you a Thunder Lizard? Breathing Life Into the New Digital Economy.

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When the Apple iPod came along, the music industry changed forever. Today more music is being made, and more music being listened to than ever before. But for big music labels that acted as the clearing house for music making and distribution, the party is over. Venture Capital faces the same environment. It used to be that entrepreneurs who needed capital had limited places to go. Today, startups need less money to prove their ideas, and there's more money available with flexibility as to terms, ownership and outcome.

VC David Aronoff says that the solution is a re-boot of the venture more. "Not all big opportunities require big financing, at least not at first," says Aronoff. "It's no longer necessary to only fund 'Home Runs,'" he explains. "In many cases a fund can do very will with a high On Base Perecentage."

Says venture capitalist Mike Maples at the Future of Funding Conference, "One of the things that bothers me is that people divide the world into folks that raise tiny amounts of money from seed folks and have modest exits, and then there's the VC over-funded steroids injected company, that's the only way you can have a huge exit. I just believe that's a false premise."

Maples says small companies with big ideas can raise modest money and become Thunder Lizards. (cue Godzilla Slide here). He points out that that Microsoft raised just $1 million and eBay just $5 million in venture capital. Thunder LIzards are market leaders.

Have a great idea? Go build it. Raise some money. Raise some hell. Have fun.


originally published on FastCompany.com