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.