Venture Capital is not in a Crisis, Just in a Market Correction

December 27, 2011

The Limits of Venture Investing

A friend tweeted: “Headline from the NVCA OPTIMISM WANES FOR START-UP ECOSYSTEM AS VENTURE CAPITALISTS AND CEOS FACE ECONOMIC REALITIES IN 2012″. This blog post is a response to him since I don’t share this pessimistic view about venture capital but I could not fit it into 140 characters to respond with Twitter.

A Historical Perspective  

On an elevator ride to the heights of Boston to a free lunch at the Bay Tower Room to listen to Alex Brown pitch an IPO I learned how to read a prospectus and invest in technology. Accompanying me in the elevator was an old dog of a senior analyst from Fidelity with an apprentice analyst who was Old Dog’s charge.  I overheard this conversation 20 years ago, but Old Dog’s words are still fresh as when I heard them during the short interval of the elevators ascent.

Old Dog’s Rules for Technology Investing.

With a  Red Herring (another term for the S1 Registrations Statement)  in hand  for illustration and pointing for emphasis Old Dog said:

“First you look at the numbers, because you pay the premium for growth.”

“Then you look in the back of the book and see who is involved to see if you like them.”

“Next you look at the summary of the business. If you still like the deal, you take the Red Herring home with you, read it through and do the rest of your homework before making a buy recommendation. “

Look for growth, like the track record of the management and board, find an attractive growth business and do your homework. Simple? Yes and no. This was simple until 1998, after which  venture capital suddenly exploded. The number of venture capitalists, the amounts of money and the number of deals grew by staggering unmanageable  proportions. And temporarily old dogs rules were suspended. Everyone bought. First everything went up then everything crashed down in 2000. In the financial rubble  the mortality of even the best brand name venture capitalists became apparent.

Finite Limits of Venture Capital Investing

As I watched mine and other’s technology fortunes decline, I called Dick Shaffer, founder of Technologic Partners to get his view.  Dick had been astutely watching venture deals for three decades as a Wall Street Journal reporter and later as the publisher of the Technologic Partners newsletters he founded in 1984. Dick’s point was simple and clear, venture capital was a $15 – $20 Billion a year investment market. No matter how much money you invest you can’t really change the rate of real invention and innovation.

So fast forward from 2000 to 2011: we are back to where we started. Too much money and too many deals out strip the rate of invention and innovation. At a certain point, the quality of the investments sinks precariously.

If one looks at the chart based on data from Dow Jones LP Sources via Silicon Valley Insider, the annual amounts raised by venture capitalists exceeded the limits  the start-up entrepreneurial market can absorb in 5 of the last 7 years. On average, compared to the upper and lower bounds Dick Shaffer noted, about $5 – $10 Billion more has been raised on average per year than needed.

The cost of too much money invested is lower quality companies and plummeting venture capital returns. The limited partners that fund venture capital firms reconsider their poor investment returns from venture capital and invest less.

Of course everyone moans about the drought of capital, especially the venture capitalists. They get paid partly on their performance and partly on the amount of capital they have under management, usually around 2 – 3% per year. So if a firm has 5 partners and $1 Billion under management from raising 3 funds, the management fees alone amount to $4 – $6 Million per partner per year to cover salary overhead and travel. Hard to give up a good deal. No one I have ever known has accepted a salary cut without some protest.

We are seeing a correction.  Limited partners such as university endowments, institutions and wealthy individuals that invest in venture capital are investing less because the over abundance of capital compared to the market has reduced the returns. We might even see an under investment in venture capital until real returns rise.

Venture capital is not on its deathbed. Just look at the performance of firms like Accel, Greylock and Sequoia to name a few.  They are all following Old Dog’s rules and in the end so are the limited partners and so should every entrepreneur and start-up employee: look for prerequisite growth, partner with people you like, believe in the business and market and do your homework.

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