Opinion

The Great Debate

Venture capital harms your wealth

October 12, 2009

knobel– Lance Knobel is a guest columnist. The views expressed are his own. He is an independent strategy advisor and writer based in the United States. His professional site is www.lknobel.com

The promise was certainly seductive: Lock up your money with me for five years and I’ll give you double-digit annual returns.

For years, that was an accurate equation for venture capital. From 1981 to 1998, there were ups and downs, but the 10-year return generally hovered around 20 percent, well above most other asset classes. That return came at a price of course. It was illiquid and there was no secondary market. And there was a further catch. Most potential investors were excluded: Venture funds were relatively modest in size, there weren’t very many of them and they were picky about whose money they’d take.

The dotcom boom changed all of that. Venture capitalists became business magazine stars, new funds sprouted up all over, and established firms with a decent track record were suddenly able to raise nine- and ten-figure funds. The 20 percent mark began to look pallid. In 1999, the U.S. venture industry was boasting five-year returns of nearly 50 percent, as a flood of IPOs provided swift and lucrative exits. The end-to-end return, net of fees, expenses and carried interest, for the year ended March, 2000, was 310 percent.

Alas, that was then. New York VC Fred Wilson, principal of Union Square Ventures, reckons average returns over the last 10 years are in the range of 6 to 8 percent. Aggregate industry figures are still flattered by the anni mirabili of the dotcom era, and the staggering venture bonanza of the Google IPO for a handful of elite firms. But when 1999 drops out of the 10-year calculation, average returns will slump to the low single figures or negative.

The returns have shrunk, yet the industry hasn’t contracted all that much. According to Thomson Reuters data, in 2008 there were 882 existing venture capital firms with $197.3 billion under management. That represents an increase from the go-go year of 1998, when there were 624 firms with $92 billion under management.

Venture investments have been ticking along at a fairly constant rate as well. There were two astoundingly anomalous years — 1999 and 2000 — when U.S. venture investment was $52 billion and $102 billion. After the dotcom crash, that slumped to $19 billion in 2003. Last year’s $28 billion was down from 2007′s $30 billion, but before 1999 the biggest year in the industry’s history, 1998, had seen just over $20 billion invested.

Returns have slumped and lucrative exits are vanishingly rare. Only six venture-backed companies went public in the U.S. last year. Earlier this year, the National Venture Capital Association launched a plan to increase the number of sub-$50 million IPOs.

Given all this, why do investors continue to back venture funds? After all, $28 billion went into VC funds last year. I asked Wilson, who is one of the more publicly skeptical VCs. “If you get into a good fund, you can still get 30 to 40 percent,” he said. “That’s what keeps the LPs interested.”

Everyone believes they are investing in the children of Lake Wobegon, who are all above average. But institutional investors won’t play the fool for long and the response from potential LPs is bound to get stonier for all but the most accomplished funds. So what, if anything, will save venture capital?

There will need to be fewer, smaller funds, making smaller bets with their investors’ money. Fewer exits won’t be such a problem, because fewer exits will be needed. It will be something that looks, in fact, a lot like the VC world pre-dotcom. That will be a wholly good thing, for venture capital, for investors and for entrepreneurs.

A smaller industry will have fewer hangers’ on who invest with the latest trend, and there will be less dumb money buoying poorly formed, unrealistic dreams.

(Edited by David Evans)

Comments
6 comments so far | RSS Comments RSS

the difficulty with sub-$50M ipos is that investors need assurance of aftermarket support for the stocks, particularly independent analysis. with a market cap that small the trading volume at today’s commissions will not support an analyst to follow the stock.

without analysis from the underwriter or somewhere else anyone would be very hesitant to buy a small high tech stock.

i doubt there will be a market for small cap high tech stocks in any numbers

Posted by bill topp | Report as abusive
 

Fewer and smaller do not go necessarily hand in hand. What will be needed is the right size of funds for the right size of deals, and actually with (i) the need for LPs to invest large sums of money, (ii) a decreasing number of interesting VC funds, (iii) the latter going after more late-stage assets and (iv) the numerous companies to invest into, this could well pave the way for large VC funds. Ask LPs, they will tell you their appetite to see if such scenario could happen. As well, if you only look into biotech, some recent articles were quoting industry people predicting that with the ongoing pharma consolidation, more start ups will have to find funding to finance their projects right to the market – fair enough, this won’t come only from VCs, but the latter will have to commit more money – which inherently raises a basic question about how to get any interesting returns when IPOs are off the table and buyers fewer and more stingy… Tough to redefine a business model long gone, where too few made money out of the carried, but rather thanks to the management fee in the good old days. Those times are over.

Posted by scarlett | Report as abusive
 

I think Scarlett makes some excellent points.

An additional factor for early-stage Silicon Valley-type VCs is the extent to which they are needed in their traditional area of information technology. The rise of outsourcing and web-based tools has meant that there is far greater scope for bootstrapping a good idea. You need money only when you need to scale, and services like Amazon’s EC3 reduce the need even there.

 

VC funding is anachronistic, at least in the software space. This is in large part due to the cost of building a software business having fallen through the floor in the last 10 years.

There are many factors, from outsourcing to hosted services to open source, but the reality is that most of the investment is now in sales & marketing rather than engineering and even the cost of those have come down hugely. So, instead of needing $5-10 million to get to scale, companies now need in the six figures. Perversely, most VC funds have grown larger in the last 10 years, which means that the average deal size per partner has to be larger. The net result of this is that VCs will only invest in capital intensive verticals like clean energy and biotech.

That said, there is still a need for early stage, small funding sub-$1million, something which is both sorely lacking and increasingly rare. Angel investors have picked up some of the slack, but they are too few of them to really make a difference.

The final nail in the coffin have been rules like SARBOX which dictate the minimum revenue size needed before a company can IPO. That has lead to a large number of ‘living dead’ companies with no chance of an exit despite quite good business models. Some are exiting on overseas markets like AIM, but the future of a VC-backed sub-$50million in revenue company is pretty bleak.

[full disclosure - I've done a lot of work for VC firms and serve as part-time adviser to a small firm]

 

I’m currently in the process of bootstrapping an internet service business with two partners. While some early stage capital would help to accelerate the sales & marketing efforts (to Chris M’s point), when doing our extensive research the cost is simply to high.

Horror stories abound around the VC industry of enterpreneurs who have killed themselves to build a successful business only to have the VCs walk away with all the cash at the end and the enterpreneur left with little else than being burnt out and jaded.

Chris M has it correct that the cost of entry to starting a business now is very low – heck look at Facebook, there first months of business were hosting fees of $65/month. I think if VCs are going to make another run, they are either going to have to find other industries that can deliver the kind of returns that high-tech did – which with any form of manufacturing is extremely difficult – or face the realities that their cash is longer a requirement, but merely an enabler, and therefore not ask for such ridiculous percentages of ownership in early stage investments. VCs need to get a grip on the current business realities.

As for my partners and I, we choose to go without them as we don’t want to put in the long hours and hard work to make others rich and gain nothing for ourselves. If we wanted to do that, we would just continue to be wage slaves in large corporations.

Posted by Stockwatcher66 | Report as abusive
 

there is no seed capital in America. VCs shouldn’t be surprised as to their mediocre returns. If companies can’t find a few hundred thousand dollars in seed capital, there’s nobody in the greenhouse. We need more funds doing seed capital. America needs to create tens of thousands of new companies a year for the next decade to create jobs growth. This is a strategic plan. You don’t rebuild America overnight. You need a long term plan that focuses on small companies and medium sized companies.

Posted by buildgrowth77 | Report as abusive
 

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