The coming brick wall in venture capital

July 20, 2011

— Mark Suster is a former serial entrepreneur and a partner at Los Angeles-based venture capital firm GRP Partners. This article originally appeared on Suster’s blog “Both Sides of the Table”. The views expressed are his own. —

This is the final part of a three-part series on the major changes in the structure of the software and the venture capital industries. Read Part One and Part Two.

Or the Cliff Note’s version:

  • Open source and cloud computing (led by Amazon) drove down tech startup costs by 90 percent
  • The result was a massive increase in startups and a whole group of new funding sources: both angels and “micro VCs”
  • With more competition in early-stage many VCs are investing smaller amounts at earlier stages. Some are going later stage to not miss out on hot deals. I call this “stage drift.”
  • The opportunities for tech startups today are more immense than they’ve ever been with billions of people now connected to the Internet nearly all the time.

But …

Downsizing Venture Capital

The venture capital business itself is going through an even more fundamental change than just the entry of a new category at the earliest stage. The industry is shrinking back to a mid-90’s level in terms of both dollars and numbers of firms.

The doubling of the industry size was caused by the euphoria of the dot-com bubble and since funds take 10 years or more to dissolve the bursting of the funding bubble has taken its time. We all know the result of the over-funding of the asset class – poor returns in aggregate for the industry. The best firms have still delivered results, though.

So what’s happening now is the elimination of funds that probably should never existed as well as the questioned relevance of some older firms that failed to find good succession strategies or remain relevant.

That’s certainly good for our industry in terms of future returns for investors but I would argue also for entrepreneurs. In the last 90’s it was impossible to charge fair prices for products and services in a market where you had 5 competitors giving away free products to acquire “eyeballs” and fueled by an excess of venture capital.

A normalization of the venture capital market will bring more rational valuations over time but should produce more stable companies and better returns for VCs and LPs. It doesn’t feel like that now because we’ve entered a mini bubble in pre IPO valuations for a segment of the tech market but this, too, shall pass.

The Coming Brick Wall

What I’ve started to observe is that we’re certainly headed for a bit of a brick wall for early-stage companies. The explosion in number of startups coupled with the decrease in numbers and dollars of VCs portends this.

As an industry this is probably OK. Creative destruction is what drives capitalism and innovation. Some startups won’t make the cut but those founders will have developed invaluable skills and will join the ranks of the survivors. I’m proud to see this creative destruction happening more prevalently in the US right now because it gives me comfort that we haven’t lost our footing in terms of global innovation.

I would argue that the explosion in startups and the coming brick wall will continue to create compelling opportunities for venture capitalists. As an industry we have more startups feeding into the top end of our funnels from which to evaluate and choose the most prudent investments. The coming brick wall will ensure that valuations reach their natural limitations and return to normalcy. The coming brick wall will produce more second-time entrepreneurs whom we can fund that will bring real experience to the table in their next businesses.

I know that a brick wall is a rather nasty metaphor, but it’s not all bad. Like any market that overheats we will have the negative collateral damage but also the blossoming of the next wave of innovation and returns.

Borders, normalization and the continued relevance of venture capital

My prediction for what comes beyond the brick wall?

  • Continued high pace of startup innovation. The lower costs and lower barriers to entry support this. Also break-out companies like Rovio and NewToy that grew big without much capital will continue to encourage young entrepreneurs to try
  • Increased reluctance of angel investors to fund any new hot team based solely on the “social proof” of who else invested. Brick wall = lost money for early-stage capital primarily concentrated on angels. I’ve been on-record here for a while.
  • Return to focused strategy for investors where Micro VCs have a more established position in their market and traditional early-stage VCs become more comfortable waiting for products to be completed as FOMO (fear of missing out) subsides
  • Hedge funds and growth equity firms returning to their traditional segments of the market

Basically, I believe that each market participant brings strengths relevant to their stage and I don’t believe in huge stage drift. The software industry is changed for good and the next decade will truly be dominated by the open cloud and open platform companies that embrace this. And the IT segment of the Venture Capital industry will continue to evolve to meet the market needs, not vice-versa.

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