Cheap start-up costs leave VCs with poor choices

January 19, 2011

By Robert Cyran
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Is getting people to post goofy pictures of cats and bad English signage a better business than venture capital? Cheezburger Network, the profitable publisher of “I Can Has Cheezburger?” and other absurd websites, recently raised $30 million to expand its business. The fact that venture capitalists are skirmishing to fund oddball businesses that don’t need their cash is a good illustration of the industry’s problems.

Venture capital’s best returns historically have come from the information technology industry — in companies like Nvidia, Sun Microsystems and Oracle. The trouble is, traditional hot sectors like chip making, computer production, and traditional software have matured. And the hottest area of growth — consumer Internet firms — doesn’t need much capital to thrive.

Companies like Cheezburger need comparatively little cash to get off the ground. Input costs, be they servers or Internet bandwidth, continue to fall. The software needed to run websites is often available for free. Furthermore, finding customers online can be done in a wildfire instant if an idea catches on.

So starting companies, using savings or seed financing from angels, to finance subsequent growth through internally generated cash flow is a cinch. That’s what Cheezburger did. Of course, venture capital can help supercharge growth: Cheezburger plans to hire extra programmers and introduce other improvements.

The upshot of not needing cash is that entrepreneurs are able to command huge prices for their babies, as Facebook recently did by selling stock to Goldman Sachs at a $50 billion valuation. Others can take money off the table, as Groupon’s founders plan to do with part of the $950 million they recently raised. Though those deals may turn out OK, it’s hard to see venture capital consistently earning outsized returns if business owners are in the drivers’ seat in capital-raising negotiations.

This dynamic partially explains the poor returns to the average VC fund. Cambridge Associates’ venture capital index has returned 4.25 percent over five years and negative 4.64 percent over 10. Considering the associated risk involved in investing in start-ups and the need to lock up capital, it’s no wonder new commitments to VC funds have fallen four years in a row. You can haz too many moneys chasing too few cheezburgers.

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